The Court further held that the tax is inherently discriminatory and operates as a tariff.

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1 from State and Local Tax Services US Supreme Court - Failure to provide a credit against Maryland s local portion of personal income tax for out-of-state income taxes paid is unconstitutional May 21, 2015 In brief In a 5-4 decision, the United States Supreme Court found that the absence of a credit against the local portion of the state's personal income tax, with respect to tax paid to another state on pass-through income from an S corporation, is unconstitutional. Maryland s tax scheme failed the dormant Commerce Clause s internal consistency test because if every state adopted the scheme, interstate commerce would be taxed at a higher rate than intrastate commerce. The Court further held that the tax is inherently discriminatory and operates as a tariff. The Court rejected assertions that it reach a different result because applicable Supreme Court dormant Commerce Clause authority involves corporate gross receipts taxes. The Court provided that its conclusion was not affected by the fact that the instant case involved a state s personal income tax. The Court also recognized that although Maryland may have the power to impose the tax under the Due Process Clause, the tax may still violate the Commerce Clause if it impermissibly burdens interstate commerce. Accordingly, the Court affirmed the Maryland Court of Appeals decision in favor of the taxpayers. [Comptroller of the Treasury of Maryland v. Wynne, U.S. Supreme Ct., No (5/18/15)] In detail Maryland tax scheme unconstitutional, violates internal consistency test Facts During the 2006 tax year, the taxpayers, a married couple, were Maryland residents who earned income passed through to them from an S corporation. On their 2006 Maryland personal income tax return, the taxpayers reported the passthrough income of the S corporation and claimed an income tax credit for income taxes paid to other states on the same income. The Maryland Comptroller of the Treasury allowed the taxpayers a credit against their Maryland state income tax but not against the county portion of their state income tax.

2 Maryland Court of Appeals decision upheld Following several appeals, the Maryland Court of Appeals (the highest court in the state) ruled that Maryland s tax was unconstitutional because it failed the dormant Commerce Clause s fair apportionment and discrimination tests (click here for our summary of the appellate court decision). The court stressed that it was not 'striking down' the county income tax, or any element of it (i.e., the tax is not facially unconstitutional). Rather, what was found unconstitutional is "the application - or lack thereof - of the credit to the county income tax." It is the absence of a credit, when applied to the particular circumstances of the taxpayers that "contravene the Constitution." The Comptroller appealed to the US Supreme Court. Maryland allows a credit only against the state portion of the personal income tax Maryland s personal income imposed on residents is generally composed of (1) a state income tax and a (2) county income tax, both collected by the Comptroller. If Maryland residents pay income tax to another jurisdiction for income earned in that jurisdiction, Maryland allows its residents a credit against the state tax, but not against the county tax. As a result, a portion of the income a Maryland resident earns outside the state may be taxed twice. Regarding nonresidents, Maryland imposes a state tax on income earned in Maryland and a special nonresident tax in lieu of the county tax. The special nonresident tax is levied on income earned from sources within Maryland and is imposed at a rate equal to the lowest county tax rate in the state. Existing dormant Commerce Clause cases (the Three Cases ) support finding Maryland s tax scheme unconstitutional The Court stated that its conclusion was dictated by three of its prior decisions involving the taxation of domestic corporate income. In each case, the Court struck down a state tax scheme that had the potential to result in the double taxation of income earned outside the state and that discriminated against interstate economic activities and created a powerful incentive to engage in intrastate rather than interstate economic activity. In J.D. Adams. Mfg. Co. v. Storen, the Court invalidated Indiana s tax on income earned by an Indiana corporation on sales made outside the state. The Court stated that without apportionment, such receipts could be subject to double taxation, which the Commerce Clause forbids. In Gwin, White & Prince, Inc. v. Henneford, the Court invalidated a Washington tax levied on the income of a corporation earned by shipping fruit from Washington to other states. The tax discriminates against interstate commerce... the risk of a multiple burden to which local commerce is not exposed. In Central Greyhound Lines, Inc. v. Mealey, the Court invalidated New York s tax on a portion of a domiciliary bus company s gross receipts derived from services provided in neighboring states because the tax imposed an unfair burden on interstate commerce. The Court held in the instant case that Maryland s tax scheme is unconstitutional for reasons similar to its holdings in the Three Cases, as explained through the application of the internal consistency test. Maryland s tax violates internal consistency The internal consistency test helps courts identify tax schemes that discriminate against interstate commerce. The test involves examining a hypothetical situation assuming that every state has the same tax structure. The test asks whether the adoption of the same tax scheme by all states would place interstate commerce at a disadvantage as compared with commerce intrastate. The Court advanced an example illustrating how Maryland s tax failed the internal consistency test. The example assumes that every state imposes the following taxes, which are similar to Maryland s tax structure: a 1.25% tax on a resident s in-state income ( Resident In-State Tax ) a 1.25% tax on a resident s out-ofstate income ( Resident Out-ofstate Tax ) a 1.25% tax on a nonresident s instate income ( Nonresident In- State Tax ) In such a case, a resident of State A earning only in-state income (i.e., representing intrastate commerce) would pay only State A s Resident In- State Tax. However, a resident of State A earning in-state and out-ofstate income (i.e., representing interstate commerce) would pay both State A s Resident In-State Tax and the other state s Nonresident In-State Tax. The internal consistency test highlights that Maryland s tax scheme places a greater burden on income earned in interstate commerce than on income earned from intrastate commerce. Accordingly, the Court ruled that Maryland s tax scheme is 2 pwc

3 inherently discriminatory and operates as a tariff. The Court noted that Maryland could cure the defect in its tax scheme by granting a credit against the local portion of its tax for taxes paid to other states. The Court further stated that there may be other ways in which Maryland could comply with the Commerce Clause, but that they would not decide the constitutionality of a hypothetical tax scheme because such a scheme was not before them. Majority opinion s response to principal dissent and Comptroller arguments Wynne resulted in a majority opinion and three dissents. A significant portion of the Court s majority opinion was dedicated to addressing arguments raised by the dissent and the Comptroller. The Court s response to these arguments may be instructive for taxpayers asserting dormant Commerce Clause challenges because it reflects the current jurisprudence in the context of a successful taxpayer challenge. Commerce Clause violations involving corporations are applicable to individual taxpayers The Comptroller distinguished the Three Cases relied upon by the majority (summarized above) on the ground that they concerned the taxation of corporations rather than individuals. The Comptroller asserted that the dormant Commerce Clause should provide fewer protections for natural persons because states provide their residents with many services, including: local roads, local fire and police protections, local public schools, local health and welfare benefits, and the right to vote to change state law. The Court could not see why the dormant Commerce Clause should treat individuals less favorably than corporations. The distinctions raised by the Comptroller failed because corporations also enjoy the benefits of roads, police protection, and an educated workforce. Additionally, according to the Court, the application of an unconstitutional tax is not affected by a resident s right to vote ( the notion that the victims of such discrimination have a complete remedy at the polls is fanciful ). Gross receipts dormant Commerce Clause challenges relevant to income tax challenges The principal dissent distinguished the Three Cases on the ground that they involved taxes on gross receipts rather than net income. The distinction rests on the discounted historical notion that an income tax is an indirect burden on a taxpayer whereas a gross receipts tax is a direct and greater burden. The Court saw no reason why the distinction between gross receipts and net income should matter and followed the direction of prior decisions that have squarely rejected the argument that the Commerce Clause distinguishes between taxes on net and gross income. The Commerce Clause limits a state s ability to tax resident income The principal dissent argued that the Commerce Clause imposes no limit on Maryland s ability to tax the income of its residents. According to the dissent, Maryland has sovereign power to tax all the income of its residents, wherever earned, and therefore the dormant Commerce Clause cannot constrain Maryland s ability to expose its residents to the threat of double taxation. The Court dismissed this argument as confusing what a state may do without violating the Due Process Clause with what it may do without violating the Commerce Clause. The Court recognized that the Due Process Clause allows a state to tax all the income of its residents. However, the Commerce Clause imposes an independent restriction against burdening interstate commerce. The fact that a state has the jurisdictional power to impose a tax says nothing about whether that tax violates the Commerce Clause. Double taxation constitutionally permissible, but not in this case The principal dissent recognized that double taxation does not always result in a constitutional violation. The internal consistency test, for example, is designed to identify the difference between (1) a tax that inherently discriminates against interstate commerce without regard to other states tax policies, which is typically unconstitutional; and (2) a tax that may result in double taxation due to the interaction of two nondiscriminatory taxes, which is typically constitutional. The principal dissent asserted that the Maryland tax scheme was neutral rather than discriminatory because that tax applied equally to all three bases of tax. In other words, the same tax applies to: (1) residents who earn income in the state, (2) residents who earn income outside the state, and (3) nonresidents who earn income in the state. The Court agreed that double taxation could exist without a constitutional violation. However, the internal consistency test in this case demonstrated that double taxation arose from impermissible discrimination against interstate commerce. As summarized by the Court: In this case, the internal consistency test... confirm[s] that the tax scheme operates as a tariff and discriminates against interstate commerce, and so the scheme is invalid. 3 pwc

4 State s decrease in revenue from credit a red herring The principal dissent argued that providing residents a credit against the state portion of the tax resulted in the state receiving less tax revenue from residents who earn income from interstate commerce than from residents who earn income only from intrastate commerce. The dissent advanced an example involving two residents earning the same income. The resident earning interstate income receives a credit for taxes paid outside of Maryland. Accordingly, the state receives less revenue from the resident engaged in interstate commerce. The Court rejected this argument because the total tax burden on interstate commerce is higher under Maryland s tax scheme regardless of the impact on any one state from any single taxpayer. As in the instant case, the taxpayers are effectively taxed twice on their income due to the absence of the credit for the local portion of their tax. No priority rule to cure constitutional defects The principal dissent noted that nothing in the Constitution, or in prior Court decisions, dictates that one of two states must recede simply because both have lawful tax regimes reaching the same income. The Court acknowledged it was true that Maryland elected not to deny a credit for income taxes paid to other states. However, it is equally true that the other states that taxed the Wynne s income elected not to offer them a credit for their Maryland county income taxes. In this situation, the Constitution does not prefer one lawful basis for state taxation of a person s income over the other. Nor does it require one state (in this case Maryland) to limit its residencebased taxation, should the state also choose to exercise... its source-based authority. The Court disagreed with the dissent s position, stating that it is not establishing a priority rule among states. The Court noted that the fact that Maryland s existing tax unconstitutionally discriminates against interstate commerce is enough to decide this case. Principal dissent Authored by Justice Ginsburg, joined by Justice Scalia and Justice Kagan, the principal dissent raised several objections, many of which, as discussed above, were addressed by the majority opinion. One of the dissent s arguments mentioned above provides that Due Process allows a state to tax all the income of its residents, even income earned outside the taxing jurisdiction. The purpose of the Commerce Clause is not to protect state residents from their own taxes. A state provides many services to its residents (including public schools and health programs) and, therefore, a state should not be faulted for making support of local government an obligation of every resident, regardless of obligations such residents have to other states. Additionally, residents possess political means through the voting process to ensure that the power to tax their income is not abused. Justice Scalia and Justice Thomas dissents Justice Scalia would have upheld Maryland s tax scheme because the dormant Commerce Clause is, in his words, a judicial fraud. In his dissent, Justice Scalia detailed his view of the failings of the dormant Commerce Clause, including its lack of governing principle, its instability, and its incompatibility with the judicial role. Justice Scalia would set aside a state tax under the dormant Commerce Clause only if the tax discriminates on its face against interstate commerce or cannot be distinguished from a tax the US Supreme Court has already held unconstitutional. Justice Thomas joined Justice Scalia s dissent to the extent it would have upheld Maryland s tax scheme. Justice Thomas authored a separate dissent, which differed from Justice Scalia s in that Justice Thomas concluded that the dormant Commerce Clause cannot serve as a basis for striking down a state statute. The takeaway The Wynne Court ultimately sought to answer the question whether Maryland s tax scheme discriminates against interstate commerce. To do so, the Court applied the dormant Commerce Clause s internal consistency test to distinguish between the following: An unconstitutional tax is generally one that inherently discriminates against interstate commerce without regard to the tax policies of other states. Applying the internal consistency test, the Court assumes that every state applies the same tax and compares one taxpayer operating solely intrastate against another taxpayer operating interstate. If a cross-border tax disadvantage exists, it is attributable to the state s discriminatory tax policy. A constitutional tax is generally one that satisfies the internal consistency test without burdening interstate commerce. Such a tax scheme may create disparate incentives to engage in interstate commerce and may even result in double taxation. However, such incentive or double taxation occurs only as a result of the interaction of two independent non- 4 pwc

5 discriminatory and internally consistent tax schemes. In this case, the Maryland tax scheme failed the internal consistency test because if the tax were hypothetically applied in all states, a resident taxpayer with interstate income would incur a greater tax burden than a resident with solely intrastate income. Accordingly, the tax scheme was unconstitutional and the Court affirmed the state appellate court decision. This decision highlights the mechanics of applying the internal consistency test to a state tax regime. Taxpayers seeking to challenge a state tax on a dormant Commerce Clause theory should have a deep understanding of this decision in order to identify the characteristics that render a state tax consistent with or in violation of the internal consistency test. Taxpayers subject to tax schemes similar to that of Maryland s county tax should consider whether refunds may be available consistent with the Wynne opinion. Let s talk If you have questions about the Wynne decision, please contact: State and Local Tax Services Brian Rebhun Principal, New York +1 (646) brian.rebhun@us.pwc.com Renee Padousis Director, McLean, Virginia +1 (703) renee.p.padousis@us.pwc.com Chris Whitney Partner, Los Angeles +1 (213) chris.whitney@us.pwc.com Steve Arluna Partner, McLean, Virginia +1 (703) steve.arluna@us.pwc.com Click here to access our library of past state and local tax Insights. Stay current and connected. Our timely news insights, periodicals, thought leadership, and webcasts help you anticipate and adapt in today's evolving business environment. Subscribe or manage your subscriptions at: pwc.com/us/subscriptions 2015 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details. SOLICITATION This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors 5 pwc