Tax breaks offered by state or local governments can be attractive to those businesses that can take advantage of them. But when credits, deductions or exemptions are unavailable to a taxpayer whose competitors receive them, the taxpayer may seek to regain its competitive footing by challenging the constitutionality of those tax breaks in court. Until June 14, many observers believed that such suits could be brought only in state court, which can be an unfavorable forum. Now, in Hibbs v. Winn, No. 02-1809 (U.S. 2004), the U.S. Supreme Court has cleared the way for such suits to be brought in federal court.
In light of the Supreme Court’s decision, businesses should review their strategies for responding to discriminatory tax breaks that may give their competitors an unfair advantage. Potential challengers may conclude that federal court is a more favorable forum than the courts of the state whose laws they seek to challenge. Furthermore, if the challenge is based on the U.S. Constitution and is successful, a prevailing party may recover its attorneys’ fees from the state under 42 U.S.C. §§ 1983, 1988. For these reasons, the time may now be right for some businesses to proceed with challenges they have previously opted not to pursue.
The Tax Injunction Act
Conventional wisdom has held that the Tax Injunction Act, 28 U.S.C. §1341, which provides that federal courts may not “enjoin, suspend or restrain the assessment, levy or collection” of a state tax, bars access in such cases to the federal courts. (Federal Circuit Courts of Appeal have split on the question.) The June 14, 2004, decision by the U.S. Supreme Court now clarifies that, while the Tax Injunction Act restrains “state taxpayers from instituting federal actions to contest their liability for state taxes, [it does not stop] third parties from pursuing constitutional challenges to tax benefits in a federal forum.” The Tax Injunction Act prevents a corporation from using a federal court action to avoid paying its own taxes and, thus, requires it to pursue its challenge in state court, generally after contesting an audit assessment or pursuing a refund claim through the state’s administrative process. It is now clear, however, that the Tax Injunction Act does not bar challenges by third parties to the tax credits, deductions and exemptions claimed by others.
In Hibbs v. Winn, Arizona taxpayers brought a First Amendment Establishment Clause challenge to a law providing state tax credits for contributions to private schools, including those that provided religious instruction or gave admissions preference on the basis of religion. They brought the action in federal district court. Relying on the Tax Injunction Act, the district court dismissed the case for lack of subject matter jurisdiction. On appeal, the Ninth Circuit reversed, holding that the plaintiffs were not seeking to “enjoin, suspend or restrain the assessment, levy or collection” of a state tax. Winn v. Killian, 307 F.3d 1011 (9th Cir. 2002). Affirming the Ninth Circuit, the Supreme Court explained the critical elements that make the Tax Injunction Act inapplicable to this case: “Plaintiffs‑respondents do not contest their own tax liability. Nor do they seek to impede Arizona’s receipt of tax revenues. Their suit, we hold, is not the kind §1341 proscribes.”
Potential Challenges to State Tax Laws
For corporate taxpayers, Hibbs v. Winn gives the green light to federal court challenges of state and local tax credits, deductions and exemptions. The dormant commerce clause of the U.S. Constitution is perhaps the most fertile ground on which to base challenges to such tax breaks. The Commerce Clause prohibits states from discriminating against interstate commerce in favor of local products or companies. A state that adopts a tax scheme that has either the purpose or the effect of benefiting a business with local operations at the expense of an out-of-state business may run afoul of this constitutional proscription. In light of Hibbs v. Winn, an out-of-state corporation that is frustrated because its in-state competitors obtain a discriminatory tax break now clearly has an alternative to suing in state court.
State taxes can be challenged on other grounds, of course, such as unfair apportionment, federal preemption or even a state law claim of invalidity. As long as a constitutional challenge would result in an increase, rather than a decrease, in the state’s collection of taxes, it is now clear that the Tax Injunction Act does not bar bringing the action in federal court. Furthermore, it appears that this principle may extend as well to diversity actions challenging the validity of a tax under state law when the effect of such actions would be to increase state revenue collections.