Tax Law & Litigation
A State and Local Tax Perspective — an interview with Thomas H. Steele of Morrison & Foerster, LLP
Ronald Joseph Martinez

Posted Monday, January 10, 2005
5 U.C. Davis Bus. L.J. 7 (2004)

Thomas H. Steele is a 1976 graduate of University of California, Davis, School of Law. He was Editor-and-Chief of the U.C. Davis Law Review, Order of the Coif, and received the U.C. Davis Law School Medal. He began his career as an associate for the law firm Morrison & Foerster, LLP in 1976, becoming a partner in the firm in 1982. He currently co-chairs the firm's State & Local Tax Practice, and is a member of both the California and Colorado bars.

Mr. Steele has focused his practice on state and local tax matters over the last 15 years. He has litigated various tax issues in numerous states, including income, franchise, sales, and use tax, excise taxes, environmental taxes, gross receipts taxes and property taxes. Also, Mr. Steele has developed expertise in state and local tax issues faced by national communication companies, including telecommunication providers as well as emerging technologies. He has been involved in a number of proceedings in the United States Supreme Court, most recently as Counsel of Record in the certiorari petition proceedings of Farmer Bros. Co. v. Franchise Tax Board, 108 Cal. App. 4th 976 (2003). In addition to his practice, Mr. Steele has co-authored a lengthy BNA portfolio entitled, "The Imposition of Sales, Use, and Other Similar Taxes on Telecommunications and Electronic Commerce." His most recent published work focuses on constitutional issues faced by multistate business. Mr. Steele is the past Chairman of the Tax Section of the Bar Association of San Francisco and has lectured on tax subjects at Council on State Taxation (COST), Tax Executive Institute (TEI), Institute of Professionals in Taxation (IPT) and various universities. He is currently the Deputy Chair of BNA's Tax Management Multistate Advisory Board.

Q: As a state and local tax litigator and partner in Morrison and Foerster, LLP, what are your day to day duties and functions?

A: First of all I have been doing this for 28 years, so what I am doing now is very different from what I was doing 28 years ago when I first started. I am the west coast head of our State and Local Tax Group. My tax work over the last 15 years has been concentrated not on federal tax but on state and local tax, which makes me a little different as far as tax lawyers go. My practice is litigation orientated - I do some planning but mostly I am doing litigation.

What I do involves sorting through the issues that arise when you have businesses that are active in multiple tax jurisdictions. The clients that I deal with are Fortune 100 or Fortune 500 businesses; they tend to be doing business all over the country. Therefore they are coming into contact with competing jurisdictions, all of whom want a piece of their taxable income. A lot of what I am doing is resolving those conflicts. Sometimes I am looking for opportunities that, by planning, will allow our clients to minimize their exposure to taxes. But most often I am dealing with controversies where the tax authority has asserted that the taxpayer owes a certain amount of money, and my job is typically to litigate that.

Tax litigation is somewhat different from regular litigation in that there is not a lot of discovery. Typically the facts are not terribly in controversy, it is usually a very conceptual exercise to try to figure out what the statute means and how it applies to this business. Very frequently, I am dealing with constitutional issues. I deal with the Commerce Clause a lot - rarely a day passes when I am not involved in some analysis involving the Commerce Clause. In my daily practice, I manage and direct and hopefully inspire the younger lawyers who work for me, who, to tell you the truth, are doing much of the harder work.

Q: When you work with your business clients, do you work with the controller of the company or do you work with one the Big Four accounting firms (their auditor)?

A: I occasionally do work with the Big Four and more often than not they are providing services like what we provide. The lines between what we do and what they do are blurred, in fact one of the senior members of our group is at Ernst & Young. He is a Harvard trained tax lawyer and about four years ago he left the firm to work at Ernst & Young and what he is doing now is not terribly different than what he did when he was here. At the Big Four, you can't do litigation, but you can do just about whatever else we do here, so there is a lot of overlap and in many ways the major competition for us is the Big Four. We are the biggest state and local tax firm in the country and we are one of the few law firms that can compete with the Big Four in their work. I usually deal with the CFO, tax director, and state and local tax director - typically on that side of the company. Occasionally I work with their general counsel, but more often than not I work with the financial side of the company.

Q: What are your thoughts on the state of Taxation Law? Are there any new developing issues?

A: Tax law is a little like a lava lamp, things are constantly changing and the reason they are changing is partly because the dynamic of business keeps changing. Five years ago a lot of my practice involved counseling companies who were beginning in electronic commerce and so there were all sorts of issues that came about because of the Internet. Let's say you are selling something over the Internet, where is the sale going to take place? In the cyber world it is difficult to figure out where those things should be sourced. I developed one of my specialties in the taxation of telecommunication companies and that was one of the same issues the telecommunication companies had for years. I spent a lot of time counseling start up and Internet companies about the issues that they were going to face.

Those days are kind of behind us, so I don't do that type of work anymore. That is a long way of saying that taxation tends to be just as vibrant as the economy is and that as business changes, tax planning changes. When tax planning gets to a certain level, the states or the federal government change the rules so the tax planning doesn't work anymore and you have to come up with new tax planning. There is constant mix going on - taxation is going to be around for a long time and so it does offer a lot of opportunities.

My view at this junction is that the best opportunities for lawyers are going to be in the areas that I am in right now (state and local) or in international taxation. What I do in the state and local tax arena is more akin to what international tax lawyers do than what federal tax lawyers do. In the international context you are dealing with competing jurisdictions. In international tax, you are generally dealing with issues resolved by treaties. In my area, it is often resolved by the Commerce Clause and litigation, but the same issues apply. Different countries are trying to get to the same dollar and so I think there is a lot of opportunity in the future in that area.

One of the areas that we are looking at in our field, interestingly, is that what we do here in the state and local tax area turns out to be pretty much what the European Community is facing right now in forming the European Union. They are essentially trying to create a trade free zone within the members of the European Union. That is similar to what the Commerce Clause does here in the U.S., it creates a trade free zone which provides that you cannot discriminate against interstate commerce, you cannot favor the local boys. The European Union is going through the same thing and we are looking into a kind of the counseling that we can do in that arena, because the same issues that we have been dealing with here in the U.S., they are now just beginning to get into in Europe. So that just kind of shows you how we all evolve, we are always looking for opportunities as to where we can be useful and where we can do interesting work.

Q: Is Taxation Law an attractive field for today's law students?

A: I don't necessarily see the numbers increasing in the tax field because, when you think about it, what I do is really a niche in the tax field. Most people coming out of law school have never even heard of state and local tax law. When the summer interns come in and we mention state and local tax to them they are like, "Ok, I'll try it, but it seems kind of strange to me." Then they find that they like it, like I did, and that it is a terrific way to make a living. The opportunities are there and I would encourage law students to understand that tax law is not just one thing, but that it is a variety of things and to explore them.

Q: In undergraduate courses and in law school most taxation courses are in federal taxation, so how did you learn the state tax code and local tax code?

A: It is like so many other things, it is almost always done because other people need it. In my case, I knew that I wanted to practice tax law and that I want to be a litigator and Morrison and Foerster, LLP offered me both. I really believed that I was going to do federal tax but, literally, the first day I arrived the senior member of the State and Local Tax group asked me if I'd stop by his office to talk about a case. He gave me an assignment on this case that he thought would go to the U.S. Supreme Court and it did, six years later. It was a pretty exciting opportunity - that is how I got started in the field. Our group has had six cases go to the U.S. Supreme Court and we are a small group. So, the work was really attractive, it was interesting to me, and it appealed to my skill set.

Q: In representing your clients, who is usually the opposing party?

A: Well, I do this work all over the country so it is almost always the state tax authority or a local tax authority. We have occasionally been hired to represent a state or city, but normally we are representing companies against the state tax authority.

Q: Farmer Bros. Co. v. Franchise Tax Board, 108 Cal.App. 4th 976 (2003), is a recent case in which you were counsel for the plaintiff. The Supreme Court denied certiorari after the Court of Appeals ruled in your favor. Can you explain the important issues of the case?

A: The case involved a dividends-received deduction (DRD), which in this case was a deduction provided by §24402 of the California Revenue and Taxation Code for the recipient of dividends to be able to deduct those dividends provided they meet certain conditions. It is a policy that generally is intended to prevent multiple layers of taxation. This DRD was calibrated on the relative presence, in California, of the issuer of the dividends. The more the company did business in California, the greater the deduction available to the recipient of the dividend. That was a violation of the Commerce Clause because essentially, through the tax system, the state coerced companies into investing their investment dollar in companies that were heavily engaged in business in California. Simply put, if you had the opportunity to invest in a company in Arizona or essentially the same company in California, you'd be better off investing in the California based company if you were a California taxpayer because you wouldn't be taxed as heavily on dividends from the California company. That kind of coercion is kind of a paradigm example of what the Commerce Clause precludes, so we began litigation.

Q: It seems that the §24402 was set up to encourage investment by California corporations in Californiacorporations, who both pay California taxes, therefore benefiting the state. Should a state not be allowed to encourage such investment with tax incentives?

A: It is a very big issue because it calls into question every tax incentive program in the country. Every major state has them (tax incentive programs), every major jurisdiction has them, as a way of encouraging companies, particularly manufacturers, to locate in their jurisdiction. A number of us have felt for sometime that there was a tension created between the kind of coercion that I have suggested is impermissible under the Commerce Clause and the kind of incentives that were offered to businesses, because incentives can quickly become coercion and coercion can become an incentive. If you think about the §24402 DRD, the state is saying that it will lower the taxes on the recipient of the dividends if this subsidiary moves into the state. The state is trying to encourage/coerce the dividend issuer to come into the state, because it will be able to issue tax free dividends. Intuitively we see a difference between an incentive and coercion but it is hard to articulate it in some kind of principal way. It's a difficult question to answer.

Q: What are the differences between the federal corporate income tax rules regarding dividends-received deductions and the rules of §24402?

A: An important distinction to make is that Commerce Clause does not apply to the Federal Government, so the Internal Revenue Code and the Internal Revenue Service are not subject to the same kind of restrictions that the states and localities are. That is the difference.

Q: The Franchise Tax Board alleges that the purpose of the statute (§24402) is to prevent the imposition of a second tax upon the stream of income leading to the dividends and that California's only responsibility is to prevent "double taxation." Why does this argument fail?

A: It failed because it only eliminated double taxation if the issuing company was a California company. If the goal was to eliminate double taxation altogether, they should have given the same treatment to dividends that were issued by all companies. The Commerce Clause provides that you can not distinguish between different states.

Q: State laws discriminating against interstate commerce are considered unconstitutional unless the state can show that its actions advance a legitimate local cause which cannot be met by any other non-discriminatory means. Wasn't California trying to advance a legitimate local cause with this tax deduction? If not, are there any other "discriminatory" tax laws which are upheld because they advance a legitimate local cause?

A: I am not aware of any discriminatory state tax that has been able to qualify for this exception. In other words, discriminatory state taxes are virtually "per se" invalid because there is almost always a way of advancing the cause in a non-discriminatory way. For example, the problem with §24402 is easily solved by giving the same treatment to all dividends. You can prevent double taxation of California based companies' dividends by simply extending that benefit to all dividends.

Q: A discriminatory tax may still survive the Commerce Clause if it is truly a "compensatory tax," which is established to make interstate commerce bear a burden already borne by intrastate commerce. In Farmer Bros. Co., §24402 was not considered compensatory, can you give an example of a legitimate compensatory tax?

A: The only compensatory tax acknowledged by the U.S. Supreme Court to date is the sales and use tax. Every state that has a general sales tax also has a use tax. The use tax is usually the same amount as the sales tax. The purpose of it is to prevent the avoidance of the sales tax. This mostly arises when a consumer purchases a good, like an automobile, in another state. There is a four-part test the U.S. Supreme Court has applied in deciding whether a tax is truly compensatory and therefore valid despite possible discriminatory practices. To date the only tax that has ever met the four-part test is the use tax.

Q: The Court of Appeals affirmed the judgment of the lower court, which ruled that §24402 was unconstitutional. What happens to §24402, now that it has been ruled unconstitutional (under the Commerce Clause)?

A: That is a question that will probably spur another round of litigation. The Franchise Tax Board's position is that because the court effectively excised from the statute this calibration I mentioned before, the statute no longer exists because they view the calibration as such a vital part of the dividends-received deduction scheme that the whole statute is voided by the court. The tax payers believe it has not been voided by the court; they believe the court just took out the calibration limitation and that the rest of the statute remains. The taxpayer still gets the 100% deduction for dividends received, but now it is no longer limited to dividends received from only California companies, it applies universally. This is where the litigation is cueing up. The legislature may step in and do something about this uncertainty, and unless they do, there is going to be continuing litigation about what the Farmer Bros. Co. decision really means.

Q: The Court of Appeals does not address the amount awarded to your client in Farmer Bros. Co. because the Franchise Tax Board (FTB) did not dispute the amount at the trial level. It would seem that many tax disputes would arise out of a controversy over the actual amount due. Is the amount of taxes owed an issue in the majority of tax cases? And does the FTB make a mistake by not disputing the amount in this case?

A: No, they did not make a mistake. The amount of tax is always an issue, what's not an issue typically is the case's "binary calculation." If you win, it's X dollars. If you lose, it's Y dollars. But there is not much argument about the amount of X or Y. That would be a numerical calculation dispute. What is really at issue is a conceptual calculation, in most cases.