HUNT-WESSON, INC. v. FRANCHISE TAX BOARD OF CALIFORNIA

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458 OCTOBER TERM, 1999
Syllabus
HUNT-WESSON, INC. v. FRANCHISE TAX BOARD OF
CALIFORNIA
certiorari to the court of appeal of california,
first appellate district
No. 98–2043. Argued January 12, 2000—Decided February 22, 2000
A State may tax a proportionate share of the “unitary” income of a non-
domiciliary corporation that carries out a particular business both inside
and outside that State, Allied-Signal, Inc. v. Director, Div. of Taxation,
504 U. S. 768, 772, but may not tax “nonunitary” income received by a
nondomiciliary corporation from an “unrelated business activity” which
constitutes a “discrete business enterprise,” e. g., id., at 773. Califor-
nia’s “unitary business” income-calculation system for determining that
State’s taxable share of a multistate corporation’s business income au-
thorizes a deduction for interest expense, but permits (with one adjust-
ment) use of that deduction only to the extent that the amount exceeds
certain out-of-state income arising from the unrelated business activity
of a discrete business enterprise, i. e., nonunitary income that the State
could not otherwise tax under this Court’s decisions. Petitioner Hunt-
Wesson, Inc., is a successor in interest to a nondomiciliary of California
that incurred interest expense during the years at issue. California
disallowed the deduction for that expense insofar as the nondomiciliary
corporation had received relevant nonunitary dividend and interest in-
come. Hunt-Wesson challenged the disallowance’s constitutional valid-
ity. The State Court of Appeal found it constitutional, and the State
Supreme Court denied review.
Held: Because California’s interest deduction offset provision is not a rea-
sonable allocation of expense deductions to the income that the expense
generates, it constitutes impermissible taxation of income outside the
State’s jurisdictional reach in violation of the Federal Constitution’s Due
Process and Commerce Clauses. States may not tax income arising out
of interstate activities—even on a proportional basis—unless there is a
“minimal connection” or “nexus” between such activities and the taxing
State, and a “rational relationship between the income attributed to the
State and the intrastate values of the enterprise.” Container Corp.
of America v. Franchise Tax Bd., 463 U. S. 159, 165–166. Although
California’s statute does not directly impose a tax on nonunitary income,
it measures the amount of additional unitary income that becomes sub-
ject to its taxation (through reducing the deduction) by precisely the
amount of nonunitary income that the taxpayer has received. Thus,
that which California calls a deduction limitation would seem, in fact, to

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Syllabus
be an impermissible tax. National Life Ins. Co. v. United States, 277
U. S. 508. If California could show that its deduction limit actually re-
flected the portion of the expense properly related to nonunitary income,
however, the limit would not, in fact, be a tax on that income, but merely
a proper allocation of the deduction. See Denman v. Slayton, 282 U. S.
514. The state statute, however, pushes this proportional allocation
concept past reasonable bounds. In effect, it assumes that a corpora-
tion that borrows any money at all has really borrowed that money to
“purchase or carry,” cf. 26 U. S. C. § 265(a)(2), its nonunitary investments
(as long as the corporation has such investments), even if the corporation
has put no money at all into nonunitary business that year. No other
taxing jurisdiction has taken so absolute an approach. Rules used by
the Federal Government and many States that utilize a ratio of assets
and gross income to allocate a corporation’s total interest expense be-
tween domestic and foreign source income recognize that borrowing,
even if supposedly undertaken for the unitary business, may also sup-
port nonunitary income generation. However, unlike the California
rule, ratio-based rules do not assume that all borrowing first supports
nonunitary investment. Rather, they allocate each borrowing between
the two types of income. Over time, it is reasonable to expect that the
ratios used will reflect approximately the amount of borrowing that
firms have actually devoted to generating each type of income. Con-
versely, it is simply not reasonable to expect that a rule that attributes
all borrowing first to nonunitary investment will accurately reflect the
amount of borrowing that has actually been devoted to generating each
type of income. Pp. 463–468.
Reversed and remanded.
Breyer, J., delivered the opinion for a unanimous Court.
Walter Hellerstein argued the cause for petitioner. With
him on the briefs were Charles J. Moll III, Edwin P. An-
tolin, Fred O. Marcus, and Drew S. Days III.
David Lew, Deputy Attorney General of California, ar-
gued the cause for respondent. With him on the brief were
Bill Lockyer, Attorney General, and Timothy G. Laddish,
Senior Assistant Attorney General.*
*Briefs of amici curiae urging reversal were filed for General Electric
Co. by Carter G. Phillips, Scott J. Heyman, Nathan C. Sheers, John
Amato, Amy Eisenstadt, and Frank A. Yanover; and for Tax Executives
Institute, Inc., by Timothy J. McCormally and Mary L. Fahey.
Briefs of amici curiae urging affirmance were filed for the State of
Idaho et al. by Alan G. Lance, Attorney General of Idaho, and Geoffrey L.

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460 HUNT-WESSON, INC. v. FRANCHISE TAX BD. OF CAL.
Opinion of the Court
Justice Breyer delivered the opinion of the Court.
A State may tax a proportionate share of the income of a
nondomiciliary corporation that carries out a particular busi-
ness both inside and outside that State. Allied-Signal, Inc.
v. Director, Div. of Taxation, 504 U. S. 768, 772 (1992). The
State, however, may not tax income received by a corpora-
tion from an “ ‘ “unrelated business activity” ’ which consti-
tutes a ‘ “discrete business enterprise.” ’ ” Id., at 773 (quot-
ing Exxon Corp. v. Department of Revenue of Wis., 447 U. S.
207, 224 (1980), in turn quoting Mobil Oil Corp. v. Commis-
sioner of Taxes of Vt., 445 U. S. 425, 442, 439 (1980)). Cali-
fornia’s rules for taxing its share of a multistate corporation’s
income authorize a deduction for interest expense. But
they permit (with one adjustment) use of that deduction only
to the extent that the amount exceeds certain out-of-state
income arising from the unrelated business activity of a dis-
crete business enterprise, i. e., income that the State could
not otherwise tax. We must decide whether those rules vio-
late the Constitution’s Due Process and Commerce Clauses.
We conclude that they do.
I
The legal issue is less complicated than may first appear,
as examples will help to show. California, like many other
States, uses what is called a “unitary business” income-
calculation system for determining its taxable share of a
multistate corporation’s business income. In effect, that
system first determines the corporation’s total income from
its nationwide business. During the years at issue, it then
averaged three ratios—those of the firm’s California prop-
erty, payroll, and sales to total property, payroll, and sales—
to make a combined ratio. Cal. Rev. & Tax Code Ann.
Thorpe, Deputy Attorney General, Bruce M. Botelho, Attorney General
of Alaska, Joseph P. Mazurek, Attorney General of Montana, and Heidi
Heitkamp, Attorney General of North Dakota; and for the Multistate Tax
Commission by Paull Mines.

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Opinion of the Court
§§ 25128, 25129, 25132, 25134 (West 1979). Finally, it mul-
tiplies total income by the combined ratio. The result is
“California’s share,” to which California then applies its
corporate income tax. If, for example, an Illinois tin can
manufacturer, doing business in California and elsewhere,
earns $10 million from its total nationwide tin can sales, and
if California’s formula determines that the manufacturer
does 10% of its business in California, then California will
impose its income tax upon 10% of the corporation’s tin can
income, $1 million.
The income of which California taxes a percentage is
constitutionally limited to a corporation’s “unitary” income.
Unitary income normally includes all income from a corpora-
tion’s business activities, but excludes income that “derive[s]
from unrelated business activity which constitutes a discrete
business enterprise,” Allied-Signal, 504 U. S., at 773 (inter-
nal quotation marks omitted). As we have said, this latter
“nonunitary” income normally is not taxable by any State
except the corporation’s State of domicile (and the States
in which the “discrete enterprise” carries out its business).
Ibid.
Any income tax system must have rules for determining
the amount of net income to be taxed. California’s system,
like others, basically does so by asking the corporation to
add up its gross income and then deduct costs. One of the
costs that California permits the corporation to deduct is
interest expense. The statutory language that authorizes
that deduction—the language here at issue—contains an im-
portant limitation. It says that the amount of “interest de-
ductible” shall be the amount by which “interest expense
exceeds interest and dividend income . . . not subject to allo-
cation by formula,” i. e., the amount by which the interest
expense exceeds the interest and dividends that the non-
domiciliary corporation has received from nonunitary busi-
nessor investment. Cal. Rev. & Tax Code Ann. § 24344 (West
1979) (emphasis added); Appendix, infra. Suppose the Illi-

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Opinion of the Court
nois tin can manufacturer has interest expense of $150,000;
and suppose it receives $100,000 in dividend income from a
nonunitary New Zealand sheep-farming subsidiary. Califor-
nia’s rule authorizes an interest deduction, not of $150,000,
but of $50,000, for the deduction is allowed only insofar as
the interest expense “exceeds” this other unrelated income.
Other language in the statute makes the matter a little
more complex. One part makes clear that, irrespective of
nonunitary income, the corporation may use the deduction
against unitary interest income that it earns. § 24344.
This means that if the Illinois tin can manufacturer has
earned $100,000 from tin can related interest, say, interest
paid on its tin can receipt bank accounts, the manufacturer
can use $100,000 of its interest expense deduction to offset
that interest income (though it would still lose the remaining
$50,000 of deduction because of income from the New
Zealand sheep farm). Another part provides an exception
to the extent that the subsidiary paying the dividend has
paid taxes to California. §§ 24344, 24402. If the sheep farm
were in California, not New Zealand (or at least to the extent
it were taxable in California), the tin can manufacturer
would not lose the deduction. We need not consider either
of these complications here.
One final complication involves a dispute between the par-
ties over the amount of interest expense that the California
statute at issue covers. Hunt-Wesson, Inc., claims that Cali-
fornia (at least during the years at issue here) required inter-
state corporations first to determine what part of their inter-
est expense was for interest related to the unitary business
and what part was for interest related to other, nonunitary
matters. It says that the statute then required it to put the
latter to the side, so that only interest related to the unitary
business was at issue. California agrees that the form it
provided to corporations during the years at issue did work
this way, but states that the form did not interpret the stat-
ute correctly. In its view, the statute takes all interest ex-

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Opinion of the Court
pense into account. Apparently California now believes
that, if the tin can manufacturer had $100,000 interest ex-
pense related to its tin can business, and another $50,000
interest expense related to the New Zealand sheep farm (say,
money borrowed to buy shares in the farm), then California’s
statute would count a total interest expense of $150,000, all
of which California would permit it to deduct from its uni-
tary tin can business income if, for example, it had no non-
unitary New Zealand sheep farm income in that particular
year. This matter, arguably irrelevant to the tax years here
in question (Hunt-Wesson reported no nonunitary interest
expense), is also irrelevant to our legal result. Therefore,
we need not consider this particular dispute further.
The question before us then is reasonably straightforward:
Does the Constitution permit California to carve out an ex-
ception to its interest expense deduction, which it measures
by the amount of nonunitary dividend and interest income
that the nondomiciliary corporation has received? Peti-
tioner, Hunt-Wesson, Inc., is successor in interest to a non-
domiciliary corporation. That corporation incurred interest
expense during the years at issue. California disallowed the
deduction for that expense insofar as the corporation had
received relevant nonunitary dividend and interest income.
Hunt-Wesson challenged the constitutional validity of the
disallowance. The California Court of Appeal found it con-
stitutional, No. A079969 (Dec. 11, 1998), App. 54; see also
Pacific Tel. & Tel. Co. v. Franchise Tax Bd., 7 Cal. 3d 544,
498 P. 2d 1030 (1972) (upholding statute), and the California
Supreme Court denied review, App. 67. We granted certio-
rari to consider the question.
II
Relevant precedent makes clear that California’s rule vio-
lates the Due Process and Commerce Clauses of the Federal
Constitution. In Container Corp. of America v. Franchise
Tax Bd., 463 U. S. 159 (1983), this Court wrote that the “Due

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Process and Commerce Clauses . . . do not allow a State
to tax income arising out of interstate activities—even on a
proportional basis—unless there is a ‘ “minimal connection”
or “nexus” between the interstate activities and the taxing
State, and “a rational relationship between the income at-
tributed to the State and the intrastate values of the enter-
prise.” ’ ” Id., at 165–166 (quoting Exxon Corp., 447 U. S.,
at 219–220, in turn quoting Mobil Oil Corp., 445 U. S., at
436, 437). Cf. International Harvester Co. v. Department
of Treasury, 322 U. S. 340, 353 (1944) (Rutledge, J., concur-
ring in part and dissenting in part) (“If there is a want of
due process to sustain” a tax, “by that fact alone any burden
the tax imposes on the commerce among the states becomes
‘undue’ ”). The parties concede that the relevant income
here—that which falls within the scope of the statutory
phrase “not allocable by formula”—is income that, like the
New Zealand sheep farm in our example, by itself bears no
“rational relationship” or “nexus” to California. Under our
precedent, this “nonunitary” income may not constitutionally
be taxed by a State other than the corporation’s domicile,
unless there is some other connection between the taxing
State and the income. Allied-Signal, 504 U. S., at 772–773.
California’s statute does not directly impose a tax on non-
unitary income. Rather, it simply denies the taxpayer use
of a portion of a deduction from unitary income (income like
that from tin can manufacture in our example), income which
does bear a “rational relationship” or “nexus” to California.
But, as this Court once put the matter, a “ ‘tax on sleeping
measured by the number of pairs of shoes you have in your
closet is a tax on shoes.’ ” Trinova Corp. v. Michigan Dept.
of Treasury, 498 U. S. 358, 374 (1991) (quoting Jenkins, State
Taxation of Interstate Commerce, 27 Tenn. L. Rev. 239, 242
(1960)). California’s rule measures the amount of additional
unitary income that becomes subject to its taxation (through
reducing the deduction) by precisely the amount of nonuni-
tary income that the taxpayer has received. And for that

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reason, that which California calls a deduction limitation
would seem, in fact, to amount to an impermissible tax. Na-
tional Life Ins. Co. v. United States, 277 U. S. 508 (1928)
(finding that a federal statute that reduced an insurance com-
pany’s tax deduction for reserves by the amount of tax-
exempt interest the company received from a holding of
“tax-free” municipal bonds constituted unlawful taxation of
tax-exempt income).
However, this principle does not end the matter. Califor-
nia offers a justification for its rule that seeks to relate the
deduction limit to collection of California’s tax on unitary
income. If California could show that its deduction limit ac-
tually reflected the portion of the expense properly related
to nonunitary income, the limit would not, in fact, be a tax
on nonunitary income. Rather, it would merely be a proper
allocation of the deduction. See Denman v. Slayton, 282
U. S. 514 (1931) (upholding Federal Tax Code’s denial of in-
terest expense deduction where borrowing is incurred to
“purchase or carry” tax-exempt obligations).
California points out that money is fungible, and that con-
sequently it is often difficult to say whether a particular bor-
rowing is “really” for the purpose of generating unitary in-
come or for the purpose of generating nonunitary income.
California’s rule prevents a firm from claiming that it paid
interest on borrowing for the first purpose (say, to build a
tin can plant) when the borrowing is “really” for the second
(say, to buy shares in the New Zealand sheep farm). With-
out some such rule, firms might borrow up to the hilt to
support their (more highly taxed) unitary business needs,
and use the freed unitary business resources to purchase
(less highly taxed) nonunitary business assets. This “tax
arbitrage” problem, California argues, is why this Court
upheld the precursor of 26 U. S. C. § 265(a)(2), which denies
the taxpayer an interest deduction insofar as the interest
expense was “incurred or continued to purchase or carry”
tax-exempt obligations or securities. Denman v. Slayton,

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supra, at 519. This Court has consistently upheld deduction
denials that represent reasonable efforts properly to allocate
a deduction between taxable and tax-exempt income, even
though such denials mean that the taxpayer owes more than
he would without the denial. E. g., First Nat. Bank of At-
lanta v. Bartow County Bd. of Tax Assessors, 470 U. S. 583
(1985).
The California statute, however, pushes this concept past
reasonable bounds. In effect, it assumes that a corporation
that borrows any money at all has really borrowed that
money to “purchase or carry,” cf. 26 U. S. C. § 265(a)(2), its
nonunitary investments (as long as the corporation has such
investments), even if the corporation has put no money at all
into nonunitary business that year. Presumably California
believes that, in such a case, the unitary borrowing supports
the nonunitary business to the extent that the corporation
has any nonunitary investment because the corporation
might have, for example, sold the sheep farm and used the
proceeds to help its tin can operation instead of borrowing.
At the very least, this last assumption is unrealistic. And
that lack of practical realism helps explain why California’s
rule goes too far. A state tax code that unrealistically as-
sumes that every tin can borrowing first helps the sheep
farm (or the contrary view that every sheep farm borrowing
first helps the tin can business) simply because of the theo-
retical possibility of a hypothetical sale of either business is
a code that fails to “actually reflect a reasonable sense of how
income is generated,” Container Corp., 463 U. S., at 169, and
in doing so assesses a tax upon constitutionally protected
nonunitary income. That is so even if, as California claims,
its rule attributes all interest expense both to unitary and
to nonunitary income. And it is even more obviously so if,
as Hunt-Wesson claims, California attributes all sheep-farm-
related borrowing to the sheep farm while attributing all
tin-can-related borrowing first to the sheep farm as well.

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Opinion of the Court
No other taxing jurisdiction, whether federal or state, has
taken so absolute an approach to the tax arbitrage problem
that California presents. Federal law in comparable circum-
stances (allocating interest expense between domestic and
foreign source income) uses a ratio of assets and gross in-
come to allocate a corporation’s total interest expense. See
26 CFR §§ 1.861–9T(f), (g) (1999). In a similar, but much
more limited, set of circumstances, the federal rules use a
kind of modified tracing approach—requiring that a certain
amount of interest expense be allocated to foreign income in
situations where a United States business group’s loans to
foreign subsidiaries and the group’s total borrowing have
increased relative to recent years (subject to a number of
adjustments), and both loans and borrowing exceed certain
amounts relative to total assets. See § 1.861–10. Some
States other than California follow a tracing approach. See,
e. g., D. C. Mun. Regs., Tit. 9, § 123.4 (1998); Ga. Rules and
Regs. § 560–7–7.03(3) (1999). Some use a set of ratio-based
formulas to allocate borrowing between the generation
of unitary and nonunitary income. See, e. g., Ala. Code
§ 40–18–35(a)(2) (1998); La. Reg. § 1130(B)(1) (1988). And
some use a combination of the two approaches. See, e. g.,
N. M. Admin. Code, Tit. 3, § 5.5.8 (1999); Utah Code Ann.
§ 59–7–101 (19) (1999). No other jurisdiction uses a rule like
California’s.
Ratio-based rules like the one used by the Federal Govern-
ment and those used by many States recognize that borrow-
ing, even if supposedly undertaken for the unitary business,
may also (as California argues) support the generation of
nonunitary income. However, unlike the California rule,
ratio-based rules do not assume that all borrowing first sup-
ports nonunitary investment. Rather, they allocate each
borrowing between the two types of income. Although they
may not reflect every firm’s specific actions in any given
year, it is reasonable to expect that, over some period of

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Appendix to opinion of the Court
time, the ratios used will reflect approximately the amount
of borrowing that firms have actually devoted to generating
each type of income. Conversely, it is simply not reasonable
to expect that a rule that attributes all borrowing first to
nonunitary investment will accurately reflect the amount of
borrowing that has actually been devoted to generating each
type of income.
Because California’s offset provision is not a reasonable
allocation of expense deductions to the income that the ex-
pense generates, it constitutes impermissible taxation of in-
come outside its jurisdictional reach. The provision there-
fore violates the Due Process and Commerce Clauses of the
Constitution.
The judgment of the California Court of Appeal is re-
versed, and the case is remanded for proceedings not incon-
sistent with this opinion.
It is so ordered.
APPENDIX TO OPINION OF THE COURT
Cal. Rev. & Tax Code Ann. § 24344 (West 1979).
“Interest; restrictions
“(a) Except as limited by subsection (b), there shall be al-
lowed as a deduction all interest paid or accrued during the
income year on indebtedness of the taxpayer.
“(b) [T]he interest deductible shall be an amount equal to
interest income subject to allocation by formula, plus the
amount, if any, by which the balance of interest expense ex-
ceeds interest and dividend income (except dividends deduct-
ible under the provisions of Section 24402) not subject to
allocation by formula. Interest expense not included in the
preceding sentence shall be directly offset against interest
and dividend income (except dividends deductible under the
provisions of Section 24402) not subject to allocation by
formula.”

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Appendix to opinion of the Court
Ҥ 24402. Dividends
“Dividends received during the income year declared from
income which has been included in the measure of the taxes
imposed under Chapter 2 or Chapter 3 of this part upon the
taxpayer declaring the dividends.”