The District and several of the nation's largest corporations are locked in fiscal combat over the city government's efforts to tax a portion of the firms' worldwide income based on the presence of small lobbying offices here.
In a controversy that involves arcane tax issues and complex constitutional questions, International Paper Corp., Sonat Inc. and Freeport-McMoRan Inc. all have gone to court to try to get back millions of dollars they have paid the city after being hit with assessments stemming from their operation of what businesses like to call governmental affairs offices here.
Sonat, the hardest hit, has been assessed $2.1 million in taxes and interest over two years for an office that has an annual budget of around $500,000.
At issue is the city's application of its business franchise tax to lobbying offices. The questions before D.C. Superior Court are whether lobbying activities are protected from tax by the Constitution's "right to petition the government" provision, and whether a lobbying office, which has no sales or other direct commercial activities, represents the kind of business presence envisioned when the tax statute was drafted.
In addition, the companies are challenging the city government's method of calculating their taxable income.
District tax officials say there is nothing new in the way they are applying the tax and that they believe they are are on solid legal ground.
"We think we are proceeding properly," said J. Walter Lund of the city's tax compliance office, adding, "there has been no change in the way the tax is calculated or the income apportioned" in recent years.
"We have a uniform division of income act, similar to most states. We try to put income where it is reasonable to assume it was earned," he said.
No one disputes the city's right to tax multistate or multinational businesses that have normal commercial operations here. The companies filed franchise tax returns for the years in question, mostly in the early 1980s, and were hit with extra taxes and interest following audits in the past few years.
What makes these cases different, the firms contend in their legal arguments, is that they have no commercial presence in the District. Sonat, based in Birmingham, and Freeport-McMoRan, based in New Orleans, are energy companies whose offices monitor the activities of Congress and the regulatory agencies that are likely to have an impact on them. International Paper says that it does sell some of its products in the city but does so through salesmen and offices based elsewhere.
Thus, "the threshold issue," according to Sonat's argument, " ... is whether Sonat was engaging in 'any trade or business' " that would subject it to the city's business franchise tax "by engaging in activities related to 'petitioning' the government of the United States."
City officials cannot interpret the law that way "without bringing it into conflict with the right to petition the government guaranteed by the First Amendment," Sonat argues.
Beyond that, the legislative history of the District's business franchise tax, which dates back to the 1940s, makes it plain that Congress did not intend for the city to tax companies solely upon the presence of representatives dealing with the federal government, according to the argument.
Finally, the three companies are disputing the formula the city used to compute their taxes. Traditionally -- assuming the city turns out to have the right to apply the tax at all -- taxable income is arrived at by taking a company's entire business income and computing what share of it is attributable to its activities in the city. To do this, city tax officials use what is known as the "three-factor formula." Under this, the company's income is multiplied by the average of three ratios: the ratio of sales, property and payroll in the District to the same items elsewhere.
In each case, the District included the companies' income from all of their operating subsidiaries, but used only the sales, property and payroll of the small holding company perched atop the corporate hierarchy. This formula increased the income subject to D.C. taxation dramatically -- and, the companies say, unfairly.
"This method of assessment violates both the statutory and regulatory requirements and the standards of basic fairness mandated by ... the Constitution," Sonat argues.
The companies involved were reluctant to comment beyond their legal filings -- settlement talks have been under way for some months -- but accountants and lawyers familiar with one or more of the cases said the companies provided the District with a tax opportunity in part by making their lobbyists employes of the holding company.
Each company "should have formed a separate subsidiary and not drawn nexus to the entire affiliated group" of subsidiaries under the holding company, said one accountant here.
"Nexus" is a tax term used to describe a situation in which there is sufficient contact between a company or person and a jurisdiction to bring the company or person under the taxing power of the jurisdiction.
The trick is in not making lobbyists the employes of the holding company, this accountant said. But many companies do it "to get higher name recognition ... so their business card can say 'I am an employe of'" the well-known parent company, the accountant said.
"In that case, the District can say, theoretically, 'Since you the parent company have employes here, we can tax you,' " the accountant said. "The city apparently believes they are going to be successful in collecting the tax."
The District's Lund said, "We have been successful in maintaining nexus" with multistate companies in previous cases. He said there has been "no floodgate" of challenges to the city's methods, but he said, "We've beefed up our local auditing" of multistate companies over the past three years, "so we're probably out there stirring them up more."
He added, "We don't want to trample on anyone's rights, but we have to account for taxes attributable to this area."
As for the companies' suits, he said, "There are probably philosophical, constitutional and just plain business sense differences" between the firms and the city. "The taxpayer always has the right to go to court.