Think last decade's taxes are done? Maybe not

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(Bloomberg View) Imagine that you arrive home one day to find a letter from the Internal Revenue Service: “Dear Taxpayer: Although you paid your taxes in full four years ago, Congress has since decided to eliminate a deduction that you took at that time. The deduction was legal when you took it but isn’t legal anymore. We therefore require immediate payment of $10,000, the amount by which you benefited from the deduction that no longer exists.”

Your response would likely be unprintable.

But the U.S. Supreme Court will decide Friday whether to hear a case challenging the constitutionality of pretty much the same scenario. In particular, the justices are being asked to decide how far back the government can reach in taxing you retroactively. Nobody doubts that a legislature can change the tax rules for the current year or the year just past. It happens all the time. When the state reaches much further, might your rights be violated?

That’s the question the justices will face if they agree to hear Dot Foods Inc. v. Department of Revenue for the State of Washington; on Friday they'll decide whether to add the case to the calendar for argument next year. In 2010, the Washington legislature amended the state’s business and occupation tax law to curtail an exemption used by many out-of-state businesses to escape taxation. No problem there. What makes the case interesting is that the legislature made its amendment retroactive. In other words, out-of-state businesses can be sent bills for taxes they failed to pay when it was legal not to pay them.

Dot Foods is an Illinois company that did business for years in Washington without paying the business and occupation tax. Then the state Department of Revenue suddenly decided that the tax applied to out-of-state businesses after all. Dot paid under protest, sued to get the money back and won in the state Supreme Court, which ruled that the department’s interpretation was contrary to the plain meaning of the law.

In response, the legislature amended the law to apply the tax to companies such as Dot. The Department of Revenue then refused to refund the money Dot had paid going back to 2006— four years before the law was changed— on the ground that the amendment was retroactive. Dot sued again, claiming that the retroactive taxation violated the due process clause of the U.S. Constitution. This time the company lost. The Washington Supreme Court ruled that as long as a tax law is rationally related to a legitimate purpose, there exists no “absolute temporal limitation on retroactivity.”

Dot Foods is not alone in this battle. IBM, DirecTV and Goodyear, among others, have challenged a similar change in Michigan law. Should the court agree to consider the Washington case, its decision next year will affect those lawsuits as well. The outcome will influence policy choices facing governments short on funds.

Although state courts are all over the map on the issue, it has been a good nine decades since the U.S. Supreme Court has struck down a tax on retroactivity grounds. That case, Nichols v. Coolidge (1927), involved a change in federal estate and gift taxation that would have increased taxes due on a transfer that had taken place 12 years earlier. The justices found the tax “so arbitrary and capricious as to amount to confiscation,” and thus a violation of due process.

More recently, the justices have considered only cases in which a new tax law seeks to capture revenue going back a year or two. All of those enactments have been upheld against due process challenges. In United States v. Carlton (1994), the court upheld a change to correct an apparent legislative oversight in the tax treatment of stocks sold to employee stock ownership plans. The error had occurred less than a year before, and, if uncorrected, would have meant the loss of $7 billion in annual revenue. The justices concluded that the change “was neither illegitimate nor arbitrary” and that Congress “acted promptly and established only a modest period of retroactivity.”

That’s exactly what Dot Foods disputes in its appeal. Four years, the company argues, is not “a modest period,” and the original law in this case contained no error. Washington did not discover that a statute it enacted almost three decades earlier had accidentally failed to tax out-of-state companies making sales within the state’s borders. The legislature simply changed its collective mind.

This looks bad on the surface. All of us would be furious were Congress to decide to increase our taxes on transactions that took place many years ago. But poor policy is not necessarily unconstitutional policy. And that’s the puzzle. It is hard to imagine the Supreme Court decreeing that the Constitution allows a tax that is retroactive by X years but not X-plus-1. Yet that’s the very question the court has invited through its own jurisprudence.

Here the justices may miss the wise counsel of their late colleague Antonin Scalia. In his separate opinion in Carlton, joined only by Justice Clarence Thomas, Scalia pointed out the absurdity of trying to craft rules for determining the constitutionality of retroactive taxation. If a right to avoid “harsh and oppressive” changes exists, he wrote, “I would think it violated by bait-and-switch taxation.” Scalia thought a better rule was that there is no constitutional barrier to retroactive taxes. But if such a barrier is to be erected, he argued, it should cover all retroactive taxes. In short, Scalia preferred a nice, simple constitutional rule, easy for both taxpayers and governments to understand: Either the legislature can change its mind later about the tax consequences of what you do today, or it can’t. Period.

The need for a simple rule is reason enough for the court to take the Dot Foods case. Let’s get this question resolved once and for all.

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