Kentucky Supreme Court Strikes Down Combined Tax Returns Under the Unitary Business Concept
In Department of Revenue v. Johnson Controls, Inc. et. al., Nos. 2006-SC-000416 and 2007-SC-000819, the Supreme Court of Kentucky (“Court”), in a divided Opinion, held that amendments to the Kentucky corporate tax statutes enacted by the 2000 General Assembly, which barred the filing of combined tax returns under the unitary business concept and the issuance of corporate income tax refunds related to same for years prior to 1995, were constitutional because the amendments were rationally related to the legitimate governmental purpose of regulating revenue.
The facts as recounted by the Court indicated that in 1988, the Kentucky Department of Revenue (“Department”) began interpreting KRS 141.120 [corporation income apportionment statute] to disallow the filing of combined tax returns under the unitary business concept. In Revenue Policy (“RP”) 41P225, the Department made clear that only separate returns would be allowed despite the fact that a group of corporations might function under a unitary business plan. For sixteen (16) years prior to that, the Department had allowed unitary business groups to choose whether to file separate returns or a combined return under the unitary business concept.
Johnson Controls, Inc. and the other Plaintiffs (“Plaintiffs”) had originally filed separate corporate income tax returns. In 1994, the Kentucky Supreme Court decided GTE v. Revenue Cabinet, 889 S.W.2d 788 (Ky. 1994), which held that related corporations could file a combined tax return under the unitary business concept and invalidated RP 41P225 under the Doctrine of Contemporaneous Construction. After GTE was decided, the Plaintiffs amended their returns by filing combined returns under the unitary business concept resulting in tax refunds.
The Court held that, according to the record, the Kentucky General Assembly recognized that following the GTE decision, a significant and unanticipated revenue loss occurred due to taxpayers filing numerous refund claims for overpaid taxes. The Court further held that the General Assembly had repeatedly amended the corporate tax statutes in an effort to bar the Plaintiffs’ refund claims. The Court further noted that in 1996, the General Assembly amended KRS 141.120 and KRS 141.200 [filing statute for corporate returns] to disallow combined tax returns under the unitary business concept, and that the amendments had a retroactive effect to any tax year ending on or after December 31, 1995. The Court also noted that the General Assembly inserted a provision in the 1998 Budget Bill barring the State Treasury from paying out any refunds sought pursuant to the theory announced in GTE.
In 2000, the General Assembly enacted House Bill 541 (“H.B. 541”), which made significant amendments to KRS 141.120 and KRS 141.200; these amendments were at issue in Johnson Controls. H.B. 541 prohibited corporate income tax refund claims originally filed as separate returns, and amended and filed as unitary returns after December 22, 1994 for tax years ending on or before December 31, 1995.
The Plaintiffs filed a declaratory judgment action in Franklin Circuit Court seeking a declaration that H.B. 541 was invalid due to a number of constitutional violations, including Due Process and Equal Protection. The Franklin Circuit Court granted the Department’s Motion for Summary Judgment. The Plaintiffs appealed and the Court of Appeals held that H.B. 541 was unconstitutional on Due Process grounds. The Department sought Discretionary Review with the Court, which was granted.
The Court reversed the Court of Appeals decision. The Court first addressed the Department’s sovereign immunity defense and held that the Plaintiffs’ claims were based on federal Due Process and as such, if there was a federal constitutional violation, that law prevails. In addressing the Plaintiffs’ Due Process claims, the Court stated that “a taxpayer has no vested right in the Internal Revenue Code…[n]or, by comparison, is there a vested right in the Kentucky Revenue Code.” The Court also stated that “matters involving taxation do not involve a fundamental right” and do not implicate substantive Due Process.
The Court then addressed whether “retroactive application of a tax statute, without causing loss to the taxpayer, would violate procedural due process.” The Court reviewed a long line of cases and determined that “as long as the statutory amendment was rationally related to a legitimate legislative purpose, it would not violate due process” and held that the Department’s purpose of preventing significant and unanticipated revenue loss following the GTE decision passed the rational basis test. Significantly, the Court’s analysis did not include a consideration of whether the period of retroactivity was “modest” or not, per Justice O’Connor’s concurring Opinion in United States v. Carlton, 512 U.S. 26 (1994).
The Court then turned to the Plaintiffs’ Equal Protection argument and held that no fundamental right was at issue, and that the rational basis test applied and was met. The Court did not address other claims raised by the Plaintiffs, including: special legislation, separation of powers and the Takings Clause.
The thirty-one (31) page Dissenting Opinion concluded that the 2000 General Assembly exceeded the bounds of Due Process when it enacted H.B. 541 in an effort to entirely undo the Court’s ruling over five (5) years earlier in GTE, and that “neither the complete ban of all outstanding tax refund claims associated with the GTE case nor the retroactive rewrite of state tax law to condone the retention of corporate taxes invalidly collected five to twelve years previously passes constitutional muster.”