Arizona v. California

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The Constitution’s Due Process Clause, incorporated to the states by the 14th Amendment, provides that the government cannot deprive someone of life, liberty, or property without due process of law. The State of California ran afoul of the Due Process Clause when it imposed a “doing business” tax on business entities that have no connection to California whatsoever except for purely passive investment in California companies. According to California, a business entity is “doing business” in the state when it is “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.”

Arizona estimates that its citizens are illegitimately paying over $10 million per year to California to “do business” in the state. In order to protect its citizens from California’s extraterritorial taxes, Arizona has sued California in the U.S. Supreme Court. Because it’s a suit between states, this is a relatively rare example of the Court’s “original jurisdiction,” meaning the case is originally filed in the Supreme Court rather than a lower court. Cato has joined the Southeastern Legal Foundation in filing an amicus brief asking the Court to take the case and remind California that it can only tax people who have a minimum connection to the state. If states can tax someone for merely investing money in an in-state company, the importance of state borders will diminish.

While many states impose taxes like the one here, California has overstepped its constitutional bounds. The state has interpreted “active” engagement to include passive investment in California companies, even when the company doing the investing has no presence in the state. This means that California would tax a company in Arizona just for investing in a California company.  By creatively interpreting the meaning of “doing business,” California has unconstitutionally taxed hundreds of thousands of out-of-state taxpayers over the last several years. Worse still, if a company does not pay the tax, the state demands that out-of-state banks turn over the funds directly. If a bank doesn’t comply, California simply takes the tax from the account, all without any notice, warrant, or judicial oversight.

As the U.S. Supreme Court has said, the Due Process Clause “requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.” The Court also established that even non-resident officers and directors of an in-state corporation don’t have a “minimum connection.” If a state can’t even tax non-resident directors of an in-state corporation, surely it can’t tax investors. California should be reminded that a state’s authority to tax outside its borders has a clear limit.