Focus On Tax Controversy And Litigation - June 2015

Supreme Court Decides Maryland v. Wynne and Rules that Maryland Tax Scheme Is Unconstitutional

In addition to a discussion of the Supreme Court's recent decision in Maryland v. Wynne, this month's issue features articles about two recent developments on FTC Generator cases, two decisions regarding the attorney-client privilege and the need for a properly detailed privilege log, a recent FSA ruling on the deductibility of an equitable disgorgement payment to the Federal Food and Drug Administration, penalties imposed in Castle Harbour and a discussion of Notice 2014-58, which provides guidance on codification of the economic substance doctrine under section 7701(o).

Maryland's Tax Scheme Ruled Unconstitutional

On May 18, 2015, the United States Supreme Court in Maryland v. Wynne affirmed a ruling from Maryland's highest court and held that a Maryland tax scheme that credits residents for taxes paid on out-of-state income at the state income level but not at the county level, violated the dormant Commerce Clause.1 The Court's 5-4 decision drew strong dissents from Justices Scalia, Thomas, Ginsburg and Kagan. The majority opinion by Justice Alito concluded that Maryland's tax scheme has the same effect as a state tariff and violates the "internal consistency test," which considers whether taxpayers would pay taxes at the same rate if every state adopted the same tax scheme.

A Maryland couple, Brian and Karen Wynne, brought the case. They owned stock in Maxim Healthcare Services, Inc., a subchapter S corporation. Maryland's personal income tax on state residents consists of a "state" income tax and a "county" income tax. The Wynne's reported Maxim's income and received a credit for state income tax paid to other states for their state income tax. However, in accordance with state law, Maryland would not grant a similar credit for income taxes paid to other states against the Wynne's county income tax. The Court of Appeals of Maryland, the state's highest court, ruled that Maryland's tax system violated the Commerce Clause. The Court of Appeals held because interstate commerce would be taxed at a higher rate than intrastate commerce that the tax law discriminated against interstate commerce.

The Supreme Court affirmed based on the Commerce Clause, which grants Congress the power to "regulate Commerce . . . among the several States." (Art. 1, § 8, CL. 3). The Court held that the Commerce Clause contains a negative command, known as the dormant Commerce Clause, which prohibits States from discriminating against or imposing excessive burdens on interstate commerce even when Congress has failed to legislate on the subject. See Oklahoma Tax Comm'n v. Jefferson Lines, Inc., 514 U.S. 175, 189 (1995). The dormant Commerce Clause precludes States from "discriminat[ing] between transactions on the basis of some interstate element." Boston Stock Exchange v. State Tax Comm'n., 429 U.S. 318, 332 (1977). The goal is to prohibit a state from providing a direct commercial advantage to intrastate (local) business.

The majority relied principally on three prior cases involving the taxation of the income of domestic corporations.2 In each case, the Court struck down a state tax scheme that may have caused double taxation of income earned out of the state. The schemes discriminated against interstate economic activity by creating an incentive to engage in intrastate rather than interstate business activity. The Court concluded that Maryland's tax scheme was unconstitutional for similar reasons. The Court's ruling is supported by the judicial doctrine referred to as the "internal consistency test." This test looks to the structure of the tax at issue to determine whether its identical application by every State in the Union would disadvantage interstate commerce compared to intrastate commerce.3 The test has been invoked by the Court in...