Clark Kerr v. M killian/az Dept of Revenue

SUPREME COURT OF ARIZONA
En Banc
CLARK J. KERR and BILLIE SUE ) Arizona Supreme Court
KERR, husband and wife, SUSAN ) No. CV-03-0110-PR
MORAN, STEVE ALLEN and JOHN )
UDALL, individually and as ) Court of Appeals
representatives of the class ) Division One
comprised of federal employees ) No. 1 CA-TX 00-0023
who paid Arizona income taxes on )
federal retirement contributions ) Arizona Tax Court
during one or more of the years ) Nos. TX 97-00119
1984 to date, ) TX 97-00131
) TX 97-00150
Plaintiffs-Appellees, )
Cross-Appellants, )
) O P I N I O N
v. )
)
MARK J. KILLIAN, in his capacity )
as Director of the Arizona )
Department of Revenue, the )
ARIZONA DEPARTMENT OF REVENUE OF )
THE STATE OF ARIZONA, )
)
Defendants-Appellants, )
Cross-Appellees. )
__________________________________)
)
STATE OF ARIZONA ex rel., the )
ARIZONA DEPARTMENT OF REVENUE, )
)
Plaintiff-Appellant, )
Cross-Appellee, )
)
v. )
)
CLARK J. KERR and BILLIE SUE )
KERR, husband and wife, )
)
Defendants-Appellees, )
Cross-Appellants. )
__________________________________)
)
CLARK J. KERR and BILLIE SUE )
KERR, husband and wife; and )
their ATTORNEYS, BONN, LUSCHER, )
PADDEN & WILKINS, CHARTERED and )
O'NEIL, CANNON & HOLLMAN, S.C., )
)
Counterclaimants-Appellees, )
Cross-Appellants, )
)
v. )
)
STATE OF ARIZONA ex rel., the )
ARIZONA DEPARTMENT OF REVENUE, )
)
Counterdefendant-Appellant, )
Cross-Appellee. )
)
__________________________________)
Appeal from the Superior Court of Maricopa County
Arizona Tax Court
The Honorable William J. Schafer, III, Judge
The Honorable Susan R. Bolton, Judge
REVERSED IN PART AND REMANDED
Opinion of the Court of Appeals, Division One
204 Ariz. 485, 65 P.3d 434
VACATED IN PART
BONN & WILKINS, CHARTERED Phoenix
By: Paul V. Bonn
Randall D. Wilkins
D. Michael Hall
Brian A. Luscher
and
O’NEIL, CANNON & HOLLMAN, S.C. Milwaukee, WI
By: Eugene O. Duffy
Attorneys for Appellees, Cross-Appellants
TERRY GODDARD, ATTORNEY GENERAL Phoenix
By: Michael P. Worley
Attorneys for Appellant, Cross-Appellee
2
H U R W I T Z, Justice
¶1 The question in this case is whether Arizona’s income
tax scheme violates the intergovernmental tax immunity doctrine
because it effectively subjects federal employees’ mandatory
retirement contributions to current taxation, while deferring
taxation of similar contributions by state and local employees.
We conclude that the state income tax code does not discriminate
against federal employees because of the source of their pay or
compensation, and thus does not violate the intergovernmental
tax immunity doctrine, codified in 4 U.S.C. § 111(a) (2000).
I.
¶2 This case has a long and complicated procedural and
substantive history. This litigation commenced in 1989 and has
been the subject of five prior reported appellate opinions.1 We
begin with a review of the “long strange trip”2 that brought this
case here.
1
See Kerr v. Killian, 204 Ariz. 485, 65 P.3d 434 (App.
2003) (“Kerr V”); Kerr v. Killian, 201 Ariz. 125, 32 P.3d 408
(App. 2001) (“Kerr IV”); Kerr v. Killian, 197 Ariz. 213, 3 P.3d
1133 (App. 2000) (“Kerr III”); Kerr v. Waddell, 185 Ariz. 457,
916 P.2d 1173 (App. 1996) (“Kerr II”); Kerr v. Waddell, 183
Ariz. 1, 899 P.2d 162 (App. 1994) (“Kerr I”). We refer in this
opinion to these previous opinions by the parenthetical
shorthands above.
2
Grateful Dead, Truckin’, on American Beauty (Warner
Bros. 1970).
3
A. The Federal Tax Code
¶3 This controversy has its origins in several arcane
provisions of the federal tax code. Under various sections of
the Internal Revenue Code, including I.R.C. §§ 401 and 403,
governmental employers may choose to establish “contributory”
retirement plans. A typical plan requires employees to
contribute a portion of their income to the plan (the
“employee’s contribution”) and the employer then contributes
additional funds (the “employer’s contribution”).
¶4 In the abstract, both the employee’s and employer’s
contributions would seem to be current taxable income to the
employee; the former comes out of the employee’s salary, while
the latter is plainly a benefit conferred by the employer as a
result of the employee’s labor. See generally I.R.C. § 61
(defining gross income as “all income from whatever source
derived”). But, in what has aptly been termed “one example of
the dominance of form over substance in the tax code,” Howell v.
United States, 775 F.2d 887, 887 (7th Cir. 1985), federal tax
law distinguishes between the employee’s and the employer’s
contributions. An employer’s contribution to a retirement plan
“qualified” under I.R.C. §§ 401(a) and 403(a) is not treated as
taxable income for the employee until the plan pays benefits to
the employee. See Howell, 775 F.2d at 887. An employee’s
contribution to a retirement plan, however, is generally treated
4
as current taxable income to the employee, even if the employee
is mandated to make the contributions out of his current pay.
See generally United States v. Basye, 410 U.S. 441, 449-50
(1973) (treating contributions to retirement plan as
“anticipatory assignments of income”). The employee is not
taxed, however, on the eventual distributions from the plan
corresponding to his taxable contributions. See I.R.C. § 72.
¶5 In 1974, Congress complicated the situation further by
enacting Pub. L. No. 93-406, 88 Stat. 825 (1974), codified at
I.R.C. § 414(h)(2). Section 414(h)(2) provides that if a state
or local governmental employer “picks up” employee contributions
to a plan qualified under §§ 401(a) or 403(a), “the
contributions so picked up shall be treated as employer
contributions,” and thus not subjected to current income tax.
The Internal Revenue Service has established two criteria that
must be met before a state or local government can “pick up”
employee contributions:
First, the employer must specify that the
contributions, although designated as employee
contributions, are being paid by the employer in lieu
of contributions by the employee. Second, the
employee must not have the option of choosing to
receive the contributed amounts directly instead of
having them paid by the employer to the pension plan.
Rev. Rul. 81-35, 1981-1 C.B. 255.
5
B. Arizona’s Income Tax Scheme
¶6 In 1979, Arizona adopted federal adjusted gross income
(“AGI”) as the starting point for computing Arizona taxable
income. 1978 Ariz. Sess. Laws, ch. 213, § 2 (codified as
amended at Arizona Revised Statutes (“A.R.S.”) § 43-1001(2)
(Supp. 2003) (“‘Arizona gross income’ of a resident individual
means the individual’s federal adjusted gross income for the
taxable year, computed pursuant to the internal revenue
code.”)). The income tax statutes list a series of items
Arizona taxpayers must add to, or may subtract from, federal AGI
to reach their Arizona taxable income. See A.R.S. § 43-1021
(Supp. 2003) (listing twenty-seven additions); id. § 43-1022
(listing twenty-nine subtractions).
¶7 At the same time that the legislature adopted federal
AGI as the starting point for calculating Arizona taxable
income, it also amended the state tax code to allow state and
local employees to subtract their mandatory retirement
contributions from Arizona gross income. 1978 Ariz. Sess. Laws,
ch. 213, § 2 (codified at A.R.S. § 43-1022(2) (Supp. 1978)).
Under the version of § 43-1022(2) adopted in 1978,
“[c]ontributions made to the state retirement system, the
judges’ retirement fund, the public safety personnel retirement
system or a county or city retirement plan” could be subtracted
6
from the employee’s Arizona gross income.3 In 1982, the
legislature added mandatory contributions to the elected
officials’ retirement plan (“EORP”) to the list of subtractions.
1982 Ariz. Sess. Laws, ch. 126, § 2 (codified at A.R.S. § 43-
1022(2) (Supp. 1982)). In 1986, contributions to the
corrections officer retirement plan (“CORP”) were added to the
list. 1986 Ariz. Sess. Laws, ch. 325, § 3 (codified at A.R.S. §
43-1022(2) (Supp. 1986)).4
¶8 In addition to allowing subtractions from Arizona
taxable income of employee contributions to the various
retirement plans, Arizona law also provided until 1989 that all
benefits paid to employees under those plans could likewise be
subtracted. See A.R.S. § 43-1022(3) (Supp. 1988). Thus, state
and local employees could avoid Arizona taxation altogether on
retirement benefits, regardless of whether these benefits
derived from employers’ contributions or employees’
contributions. In 1989, however, Davis v. Michigan Department
of Treasury, 489 U.S. 803 (1989), held that a similar Michigan
statute violated principles of intergovernmental tax immunity,
by favoring retired state and local governmental employees over
3
We refer in this opinion to the Arizona state
retirement system as “ASRS” and the public safety personnel
retirement system as “PSPRS.”
4
The same law removed contributions to the judges’
retirement fund from the list of permitted subtractions, as that
fund had been combined with EORP. See A.R.S. § 38-802 (2001).
7
federal employees, who were not allowed to deduct retirement
benefits from their taxable Michigan income.
¶9 The Arizona legislature promptly reacted to Davis by
amending A.R.S. § 43-1022(3) to eliminate benefits received from
state and local retirement plans from the list of permitted
subtractions from Arizona gross taxable income.5 1989 Ariz.
Sess. Laws, ch. 312, § 12. The same statute also removed from
the list of statutory subtractions contributions to ASRS, EORP,
and county or city retirement plans. Id. In 1991, the
legislature removed mandatory contributions to CORP and PSPRS
from its list of subtractions from Arizona gross income. 1991
Ariz. Sess. Laws, ch. 155, § 8 (retroactively effective to
January 1, 1991).
¶10 Thus, for tax years after 1990, Arizona law has not
provided for subtraction from gross income for mandatory
employee contributions to any state or local retirement plans
and it has treated benefits received from federal, state or
local plans similarly. This did not mean, however, that all
employee contributions were immediately subjected to current
Arizona tax.
5
At the same time, the legislature amended § 43-1022 to
allow the annual deduction of up to $2500 of retirement benefits
received by the taxpayer from either state or federal retirement
systems. 1989 Ariz. Sess. Laws, ch. 312, § 12 (now codified at
A.R.S. § 43-1022(2) (Supp. 2003)).
8
¶11 Beginning in 1985, the legislature had enacted
statutes authorizing certain state retirement plans to “pick up”
employee contributions pursuant to I.R.C. § 414(h)(2). 1985
Ariz. Sess. Laws, ch. 294, § 4 (now codified at A.R.S. § 38-
736(B) (2001) (authorizing ASRS pick up)); 1985 Ariz. Sess.
Laws, ch. 309, § 4 (now codified at A.R.S. § 38-810(E) (2001)
(authorizing EORP pick up)); 1986 Ariz. Sess. Laws, ch. 325, § 1
(now codified at A.R.S. § 38-892 (2001) (authorizing CORP pick
up)). Prior to 1989, ASRS and EORP had already opted to pick up
employee contributions pursuant to § 414(h)(2); these
contributions were therefore not included in federal AGI, and
thus not subject to current Arizona tax, notwithstanding the
elimination of the previous subtractions in 1989.6
¶12 Although CORP had received legislative authorization
to pick up employee contributions in 1986, it did not elect to
6
In addition to the subtractions from income previously
set forth in A.R.S. § 43-1022(2) for contributions to state
retirement plans, the statutes governing ASRS and EORP have long
provided that member contributions “are exempt from state,
county and municipal taxes.” 1953 Ariz. Sess. Laws, ch. 128, §
22 (now codified at A.R.S. § 38-792(A) (2001) (ASRS)); 1985
Ariz. Sess. Laws, ch. 309, § 4 (now codified at A.R.S. § 38-811
(2001) (EORP)). The same statutes also previously exempted from
state taxation benefits received from these funds; those
exemptions were removed in 1989 in the same law that eliminated
the authorization for subtractions from income. See 1989 Ariz.
Sess. Laws, ch. 312, § 6 (ASRS); id. § 8 (EORP). Presumably,
the legislature did not remove the exemption of the member
contributions in 1989 in light of the preexisting pick ups under
§ 414(h)(2) by ASRS and EORP.
9
do so immediately; its pick up was first effective on July 1,
2000. PSPRS did not receive legislative authorization to pick
up employee contributions until 1999, 1999 Ariz. Sess. Laws, ch.
50, § 4; 1999 Ariz. Sess. Laws, ch. 327, § 22 (now codified at
A.R.S. § 38-843.01 (2001)), and its election was effective at
the same time as CORP’s.7 Thus, throughout the period from 1989
to 2000, the thousands of state and local employees covered by
these two plans paid current Arizona income tax on their
employee contributions.8
C. The § 1983 Action
¶13 Respondents are Arizona taxpayers, each of whom was
employed by the federal government and who paid state income
taxes on mandatory contributions to federal retirement plans.
See Kerr I, 183 Ariz. at 4, 899 P.2d at 165. In 1989,
respondents filed a class action under 42 U.S.C. § 1983 against
7
Until 1989, the statutes governing CORP and PSPRS,
like the statutes then governing ASRS and EORP, provided that
both benefits received from, and employee contributions to,
these plans were exempt from state taxation. A.R.S. § 38-852
(1985) (PSPRS); A.R.S. § 38-896 (Supp. 1986) (CORP). In 1989,
the legislature removed the exemption for benefits from these
statutes. 1989 Ariz. Sess. Laws, ch. 312, § 9 (PSPRS); id. § 10
(CORP). In 1991, the legislature removed the exemption for
employee contributions from the governing statutes. 1991 Ariz.
Sess. Laws, ch. 155, § 2 (PSPRS); id. § 6 (CORP).
8
As of June 30, 2001, some 26,520 state employees were
enrolled in PSPRS and CORP. Resp. Sep. App. Tab 9. This number
was approximately thirteen percent of the total state employee
population. Id.
10
the Arizona Department of Revenue (“ADOR”) and ADOR officials,
alleging that Arizona’s income tax scheme violated the
intergovernmental tax immunity doctrine codified in the Public
Salary Tax Act of 1939, 4 U.S.C. § 111(a), by treating the
employee contributions of federal employees differently than
those of state employees. Kerr I, 183 Ariz. at 4, 899 P.2d at
165.9 Respondents challenged both former A.R.S. § 43-1022(2),
under which all employee contributions (even if not picked up by
employers) could be subtracted from Arizona taxable income, and
the use in current § 43-1001(2) of federal AGI as the base for
Arizona taxable income, because it allowed state employees whose
contributions were picked up to avoid current taxation. Kerr I,
183 Ariz. at 5, 899 P.2d at 166.
¶14 The tax court held that the former version of § 43-
1022(2) violated § 111(a). Id. at 13-14, 899 P.2d at 174-75.
It rejected, however, the taxpayers’ attack on § 43-1001(2),
holding that any disparity resulting from the application of
I.R.C. § 414(h)(2) to determine federal AGI did not violate the
intergovernmental tax immunity doctrine. Id. at 14-15, 899 P.2d
at 175-76. The court of appeals affirmed the tax court with
respect to former § 43-1022(2), id. at 16-17, 899 P.2d at 177-
9
The putative class included respondents and all
Arizona taxpayers employed by the federal government who paid
state income tax on their mandatory retirement contributions.
Kerr I, 183 Ariz. at 4, 899 P.2d at 165.
11
78, but reversed with respect to § 43-1001(2), holding that the
effect of adopting federal AGI was to discriminate against
federal employees in favor of state employees whose employers
had picked up the employee contributions. Id. at 14-15, 899
P.2d at 175-76.
¶15 After ADOR petitioned for review we vacated Kerr I and
remanded for reconsideration in light of National Private Truck
Council, Inc. v. Oklahoma Tax Commission, 515 U.S. 582, 585
(1995), which held that before suing under § 1983, plaintiffs
must first exhaust all “adequate remedies.” On remand, the
court of appeals held that these plaintiffs had failed to
exhaust their state administrative remedies and remanded to the
tax court with instructions to dismiss the § 1983 action. Kerr
II, 185 Ariz. at 467, 916 P.2d at 1183.
D. The Refund Suit
¶16 At the same time that they instituted the § 1983
action, respondents filed administrative claims with ADOR on
behalf of themselves and the class requesting refunds based on
Arizona’s allegedly unconstitutional tax scheme. See Kerr III,
197 Ariz. at 215 ¶ 6, 3 P.3d at 1135. An ADOR hearing officer
held that the agency had “no legal authority to pass on the
legality of the statutory scheme or to recognize a class refund
claim.” Id. Respondents appealed to the Board of Tax Appeals
(“BOTA”), which held that neither ADOR nor BOTA had authority to
12
entertain class refund claims. Id. ¶ 7. As to respondents’
individual claims, BOTA held that the adoption of federal AGI in
§ 43-1001(2) did not violate the intergovernmental tax immunity
doctrine and therefore refused to grant refunds for tax years
after 1990. See Kerr IV, 201 Ariz. at 129 ¶ 11, 32 P.3d at 412.
BOTA, however, held that those respondents who were parties to
the administrative proceedings should be granted refunds for
taxes paid on their mandatory contributions from 1985 through
1990. Id. at 128-29 ¶ 11, 32 P.3d at 411-12.10 The governor
thereafter directed ADOR to make refunds for the tax years from
1985 to 1990 to all taxpayers who had filed timely refund
claims, whether or not they were parties to the administrative
action. Id. at 129 ¶ 12, 32 P.3d at 412.11
¶17 Respondents then sought review of the BOTA rulings in
the tax court. That court denied respondents’ motion to certify
a class consisting of “all current and former federal employees
who paid Arizona income taxes on contributions they made to
10
In June 1998, the tax court awarded respondents’
attorneys twenty percent of each refund as fees. The court of
appeals affirmed that award. Kerr III, 197 Ariz. at 220, 3 P.3d
at 1140.
11
ADOR later ruled that “taxpayers who were taxed on
mandatory retirement contributions to retirement plans
maintained by the federal government” for tax years prior to
1991 and who timely filed amended returns, refund claims, or
protective claims, were entitled to a refund of excess amounts
paid in those years. Ariz. Individual Income Tax Ruling 98-1,
available at http://www.revenue.state.az.us/rulings/itr98-1.htm.
13
United States Government retirement plans from 1984 to the
present who have not received refunds of such taxes.” Kerr IV,
201 Ariz. at 129 ¶ 13, 32 P.3d at 412. The court also denied
the taxpayers’ “alternative motion to certify a class of all
federal employees who filed timely refund claims for one or more
years from 1991 to the present.” Id. The tax court, however,
held that the use of federal AGI as the Arizona tax base in §
43-1001(2) violated § 111(a) because its effect was to
discriminate against federal employees in favor of state
employees. Id. ADOR appealed and respondents cross-appealed.
¶18 In Kerr IV, concluding the reasoning of Kerr I was
“incomplete and ultimately incorrect,” 201 Ariz. at 130 ¶ 18, 32
P.3d at 413, the court of appeals rejected respondents’ attack
on § 43-1001(2) and thus rejected any claims for refunds for tax
years after 1990. Id. at 131 ¶ 22, 32 P.3d at 414. The court
held that the Arizona taxing scheme did not violate § 111(a),
because it did not discriminate “‘because of the [federal or
state] source of pay or compensation.’” Id. (quoting 4 U.S.C. §
111(a)). Kerr IV concluded that the Arizona scheme
“distinguishes not between state and federal employees, but
rather between all those whose employers make or pick up their
mandatory contributions and all those whose employers do not.”
Id. ¶ 26.
14
¶19 With respect to tax years 1985 through 1990, Kerr IV
affirmed the tax court’s conclusion that certification of a
class of those whose refund claims had been denied would be
redundant and unnecessary. Id. at 133 ¶¶ 33-34, 32 P.3d at 416.
As to those in the putative class who had not filed written
refund claims, relying on Arizona Department of Revenue v.
Dougherty, 198 Ariz. 1, 6 P.3d 306 (App. 2000) (“Ladewig I”),
the court of appeals held that the tax court acted within its
discretion in denying class status to those taxpayers who had
failed to exhaust applicable statutory administrative remedies.
Kerr IV, 201 Ariz. at 133 ¶ 35, 32 P.3d at 416.
¶20 Shortly after the court of appeals issued Kerr IV, we
held in Arizona Department of Revenue v. Dougherty, 200 Ariz.
515, 29 P.3d 862 (2001) (“Ladewig II”), that a class action can
be used as a vehicle for bringing and exhausting certain
administrative claims. Respondents then moved for
reconsideration of the class action rulings in Kerr IV with
respect to tax years 1985 through 1990 in light of Ladewig II;
they also sought reconsideration of the court of appeals’
substantive rejection of their claims with respect to tax years
after 1990.
¶21 The court of appeals granted the motion for
reconsideration and issued the opinion now under review, Kerr V,
204 Ariz. 485, 65 P.3d 434. In Kerr V, the court of appeals
15
held that its analysis in Kerr IV rested on a “narrow, mistaken
application of the literal language of 4 U.S.C. § 111.” Id. at
491 ¶ 23, 65 P.3d at 440. Because the effect of § 43-1001(2)
for tax years after 1990 was to require federal employees to pay
current Arizona income tax on their mandatory contributions,
while deferring such taxation for state and local employees, the
court of appeals held that United States Supreme Court case law
interpreting § 111(a) mandated that the Arizona scheme be struck
down unless it was justified by “‘significant differences’”
between these classes. Id. (quoting Davis, 489 U.S. at 815-16).
Finding none, Kerr V concluded that § 43-1001(2) violated the
intergovernmental tax immunity doctrine. Id. at 493-95 ¶¶ 28-
37, 65 P.3d at 442-44. As to class action issues, the court of
appeals determined that it was best to allow the tax court “a
fresh look” in light of Ladewig II, and remanded to the tax
court for reconsideration of these issues. Id. at 496-97 ¶ 46,
65 P.3d at 445-46.
¶22 ADOR petitioned for review only on the
intergovernmental tax immunity issue. We granted review because
of the obvious statewide importance of the issue. We have
jurisdiction pursuant to Article 6, Section 5(3) of the Arizona
Constitution, Arizona Rule of Civil Appellate Procedure 23, and
A.R.S. § 12-120.24 (2003).
16
II.
¶23 The intergovernmental tax immunity doctrine has its
genesis in M’Culloch v. Maryland, 17 U.S. (4 Wheat.) 316 (1819),
which held that Maryland could not impose a tax on the Bank of
the United States. See Davis, 489 U.S. at 810. Until 1938, the
doctrine was expansively interpreted to prohibit state and
federal governments from taxing the salaries of the other’s
employees. See Jefferson County v. Acker, 527 U.S. 423, 436
(1999), and cases cited therein.
¶24 In the late 1930s, however, the doctrine underwent a
significant “contraction,” id. at 436 n.6, at the hands of the
Supreme Court. First, in Helvering v. Gerhardt, 304 U.S. 405
(1938), the Court held that the federal government could tax the
salaries of employees of the Port of New York Authority. Then,
in Graves v. New York ex rel. O’Keefe, 306 U.S. 466 (1939), the
Court expressly overruled a number of prior decisions and held
that a state’s imposition of an income tax on the salaries of
federal employees placed no unconstitutional burden on the
federal government. Since Graves, the Supreme Court has
proclaimed “a narrow approach to governmental tax immunity.”
United States v. New Mexico, 455 U.S. 720, 735 (1982). Case law
after Graves has made plain that the doctrine “barred only those
taxes that were imposed directly on one sovereign by the other
17
or that discriminated against a sovereign or those with whom it
dealt.” Davis, 489 U.S. at 811.
¶25 In its decisions contracting the intergovernmental tax
immunity doctrine, the Supreme Court has “recognized that the
area is one over which Congress is the principal
superintendent.” Jefferson County, 527 U.S. at 425. Shortly
after Graves was announced, Congress adopted the Public Salary
Tax Act of 1939, “the primary purpose of which was to impose
federal income tax on the salaries of all state and local
governmental employees.” Davis, 489 U.S. at 810. But,
“concerned that considerations of fairness demanded equal tax
treatment for state and federal employees,” Congress also
expressly waived in § 4 of the 1939 Act “whatever immunity would
have otherwise shielded federal employees from nondiscriminatory
state taxes.” Id. at 812. Section 4, codified at 4 U.S.C. §
111(a), provides that “[t]he United States consents to the
taxation of pay or compensation for personal service as an
officer or employee of the United States,” but only “if the
taxation does not discriminate against the officer or employee
because of the source of the pay or compensation.” Section
111(a) thus “codified the result in Graves,” and foreclosed
subsequent broader judicial interpretation of the
intergovernmental tax immunity doctrine. Davis, 489 U.S. at
812. The Supreme Court has held that the immunity provided in §
18
111(a) is “coextensive with the prohibition against
discriminatory taxes embodied in the modern constitutional
doctrine of intergovernmental tax immunity.” Id. at 813.
A.
¶26 The initial inquiry under § 111(a) is whether a
challenged state tax discriminates against federal employees
“because of the source” of their compensation. If the alleged
discrimination is not because of the federal source of income,
but rather for some other reason, there is no violation of the
intergovernmental tax immunity doctrine. See Jefferson County,
527 U.S. at 442-43 (holding that a facially nondiscriminatory
Alabama occupational tax exempting those who held licenses under
other state or county laws did not violate § 111(a),
notwithstanding the fact that the plaintiff federal judges could
never qualify for exemption, because the tax “does not
discriminate against federal judges in particular, or federal
officeholders in general, based on the federal source of their
pay or compensation”); Cheatham v. Eagerton, 703 So. 2d 389, 391
(Ala. Civ. App. 1997) (holding that exemption of state law
enforcement officers’ per-diem subsistence allowance from state
taxation did not violate § 111(a), notwithstanding that federal
officers received no comparable allowance, because the tax
scheme does not discriminate because of the “source” of the pay
or compensation).
19
¶27 When the state scheme does discriminate because of the
federal source of pay, the cases require a second level of
analysis. Imposition of a heavier burden on federal employees
because of the source of pay may be justified only by
“significant differences between the two classes.” Davis, 489
U.S. at 815-16 (quoting Phillips Chem. Co. v. Dumas Indep. Sch.
Dist., 361 U.S. 376, 383 (1960)). In determining whether this
standard of justification is met, decisions in the equal
protection field “are not necessarily controlling.” Id. at 816.
Rather, the inquiry is whether the inconsistent tax treatment
“is directly related to, and justified by, ‘significant
differences between the two classes.’” Id. (quoting Phillips,
361 U.S. at 383-85).
B.
¶28 The opinion below passed quickly over the first level
of analysis required under § 111(a). The court of appeals
apparently started from the premise that because the adoption of
federal AGI as the Arizona income tax base in § 43-1001(2)
effectively required respondents to pay current tax on their
employee contributions while deferring taxation for state and
local employees whose contributions had been picked up under
I.R.C. § 414(h)(2), the Arizona scheme necessarily discriminated
against respondents because of the federal source of their pay.
Kerr V, 204 Ariz. at 440-41 ¶ 24, 65 P.3d at 491-92.
20
¶29 We reach a contrary conclusion. At the outset, it is
worth noting that every Supreme Court decision cited by
respondents in which a state tax was found to violate § 111(a)
or the intergovernmental tax immunity doctrine involved a tax
statute which discriminated on its face against federal
employees or federal property. For example, in Davis, Michigan
law provided a deduction for retirement benefits paid by the
state or its political subdivisions, but not for benefits paid
by others, including the federal government. Davis, 489 U.S. at
805; id. at 814 (“It is undisputed that Michigan’s tax system
discriminates in favor of retired state employees and against
retired federal employees.”). Similarly, the Kansas tax scheme
struck down in Barker v. Kansas, 503 U.S. 594 (1992), provided a
statutory deduction for benefits received by various state and
federal retirees, but no deduction for military retirement
benefits. Id. at 596. And, the Texas scheme invalidated in
Phillips expressly treated lessees of state land differently
than other lessees, including lessees of federal property. 361
U.S. at 379-80. Thus, each of these cases quickly concluded
that the challenged tax scheme discriminated because of the
federal source of pay, and focused almost exclusively on whether
such discrimination was justified by significant differences
between the disadvantaged federal plaintiffs and the advantaged
class.
21
¶30 In contrast, § 43-1001(2) contains no overt
discrimination against any taxpayer because of the source of
pay. Every Arizona taxpayer, whether employed by the federal
government, the State, a political subdivision, or a private
employer, begins with federal AGI as the Arizona income tax
base. And, in contrast to the situation that obtained for tax
years before 1991, Arizona law no longer provides for
subtraction from that base of contributions made by state
employees, while denying such subtraction to federal employees.
¶31 Respondents have not identified any Supreme Court
decision in which a facially neutral state tax scheme was found
to have violated the intergovernmental tax immunity doctrine.
Respondents’ citation to Memphis Bank & Trust Co. v. Garner, 459
U.S. 392 (1983), as an example of such a case is unavailing.12
The Tennessee business tax at issue in Memphis Bank, like the
Arizona income tax code, started with a federal AGI base. Id.
at 394 & n.3. But a Tennessee statute then added to the base
all income derived from obligations of states other than
12
Memphis Bank did not involve an income tax, and thus
did not interpret § 111(a). Rather, the statute involved was 31
U.S.C. § 742, which allows nondiscriminatory franchise or other
non-property taxes to be imposed on federal obligations or
interest therefrom. Memphis Bank, 459 U.S. at 395-96. However,
because § 742, like § 111(a), is a “restatement of the
constitutional rule” of intergovernmental tax immunity, the
analysis under each section is functionally the same. Id. at
396-97.
22
Tennessee. Id. Because federal AGI already included
obligations of the United States, see I.R.C. § 103, the
Tennessee law thus provided an express exemption from taxation
for income from bonds issued by Tennessee and its political
subdivisions, while taxing similar obligations issued by the
United States and all other states. Id. The Tennessee
statutory scheme thus expressly differentiated between interest
received on that state’s obligations and all other obligations,
including those of the federal government.13
¶32 Respondents argue that even if there is no facial
discrimination in § 43-1001(2), we must examine the “practical
operation” of the Arizona scheme. See Phillips, 361 U.S. at
383. We agree. If the inevitable consequence of a facially
neutral state tax code were that federal employees were taxed
differently than similarly situated state employees because of
the source of their income, or if the distinctions drawn in the
state code were “only a cloak for discrimination against
federally funded [pay or compensation],” Barker, 503 U.S. at
604-05, § 111(a) would plainly invalidate such a scheme. But
this is not such a case. In “practical operation,” § 43-1001(2)
does not require that federal employees be taxed differently
13
Kraft General Foods, Inc. v. Iowa Department of
Revenue, 505 U.S. 71 (1992), upon which respondents also rely,
is even further afield. That case did not interpret the
intergovernmental tax immunity doctrine, but rather the Foreign
Commerce Clause, U.S. Const. art. 1, § 8, cl. 3.
23
than state employees with respect to mandatory retirement
contributions. Arizona taxes the employee contributions of
those state employees whose contributions have not been picked
up by their employers in precisely the same fashion as it treats
the employee contributions of federal employees.
¶33 The distinction is not simply theoretical; it has had
real practical effects on Arizona taxpayers. As noted above,
from 1990 through 2000, the majority of the tax years covered by
this litigation, the employee contributions of the thousands of
state and local employees covered by PSPRS and CORP were not
picked up, and each of these employees therefore paid current
state tax on those contributions. While the treatment of
numerous state and local employees in a fashion identical to the
allegedly disadvantaged federal employees may not itself
conclusively prove that a state scheme does not violate §
111(a), it surely demonstrates that the Arizona scheme is not
simply a “cloak for discrimination.”
¶34 More importantly, nothing in the Arizona scheme
discriminates between taxpayers based on the federal or non-
federal source of income; the distinction is instead based on
whether a particular governmental employer has voluntarily opted
to pick up the employee contributions and treat them as employer
contributions. Section 414(h)(2) is permissive; it treats
employee contributions as employer contributions for federal tax
24
purposes only if the employer voluntarily opts for such
treatment.
¶35 Respondents argue that because § 414(h)(2) only
authorizes state and local governmental employers to pick up
employee contributions, the effective distinction in § 43-
1001(2) between those employers who pick up and those who do not
necessarily discriminates against federal employees. This
argument, however, takes far too narrow a view of the national
government and the choices it has made. Section 414(h)(2)
simply gave state and local employers the option to choose to
pick up; without advance federal authorization, they could never
choose to do so. The federal government, however, already had
that option and, through its legislative branch, can exercise
that option at any time it desires. In “practical operation,”
the federal government has thus far simply voluntarily opted not
to pick up, just as some state employers voluntarily so opted in
Arizona throughout the 1990s. Once the state employers made the
choice to pick up, their employees’ contributions were treated
identically to those of governmental employers who had
previously made this election. When and if the federal employer
makes the same choice, Arizona tax law will treat its employees’
contributions in an identical fashion.
¶36 In short, § 43-1001(2) is not a subterfuge for
discrimination against respondents because of their federal
25
source of pay, nor is Arizona’s treatment of respondents’
employee contributions a necessary consequence of their federal
status. Rather, the difference is not who pays the employees,
but the voluntary choice made by the employer as to whether the
contributions should be picked up.
¶37 Cases dealing with military retirement benefits are
particularly instructive on this point. Barker invalidated a
Kansas tax scheme which allowed subtraction of various
retirement benefits, both state and federal, from taxable
income, because the statutes did not permit benefits received by
retired federal military personnel to be deducted. Barker, 503
U.S. 594. In contrast, Cooper v. Commissioner of Revenue, 658
N.E.2d 963 (Mass. 1995), decided some three years after Barker,
upheld a Massachusetts statutory scheme which exempted from
taxation retirement benefits received from any governmental
pension fund to which the taxpayer contributed during
employment, while taxing benefits received from all other plans.
The federal military retirement pension system involved no
employee contributions, and all military retirees were thus
subjected to Massachusetts income tax on their benefits. Id. at
964. The “practical operation” of the Massachusetts plan, at
least with respect to military retirees, was thus identical to
the Kansas scheme. Nonetheless, Cooper held that any differing
treatment of military retirees from other government retirees in
26
Massachusetts was not because of the “source of pay,” but rather
because the federal government had designed their plan as non-
contributory. Id. Because all non-contributory plans were
treated equally — even though virtually all Massachusetts
employees now participated in contributory plans14 — any
differing treatment was not because of the source of the
military retirees’ income, but rather because of a separate,
non-pretextual, distinction. Id.15
¶38 The same is true here. Arizona tax law effectively
distinguishes between taxpayers whose governmental employers
choose to pick up employee contributions and those whose
governmental employers do not choose to do so. That distinction
is not “because of the source” of the employee’s compensation
14
Massachusetts established its contributory retirement
system in 1936 and 1937. Cooper, 658 N.E.2d at 965. Thus, it
was doubtful that any current state retiree participated in a
non-contributory system, although the Supreme Judicial Court so
assumed for purposes of analysis in Cooper. Cf. Filios v.
Comm’r of Rev., 615 N.E.2d 933, 936 (Mass. 1993) (noting
theoretical possibility that state employee participants in old
non-contributory plans were still alive).
15
Respondents argue that Cooper is no longer good
authority because the Massachusetts legislature has since
changed the statutory tax scheme to exempt military retirement
pay from state taxation. See Mass. 1987 Legis. Serv., ch. 139
(amending Mass. Gen. Laws Ann. ch. 62, § 2(a)(2)(E)). But
nothing in the federal governmental tax immunity doctrine
prevents a state from exchanging one non-discriminatory scheme
for another, and we do not ordinarily infer any invalidity in a
statute from subsequent legislative amendment.
27
and therefore does not run afoul of the intergovernmental tax
immunity doctrine.16
III.
¶39 For the reasons above, we hold that the court of
appeals erred in Kerr V in concluding that the application of §
43-1001(2) to respondents violated the intergovernmental tax
immunity doctrine codified in § 111(a). We therefore vacate the
opinion below insofar as it so held and reverse the judgment of
the tax court to the same extent. Because ADOR did not seek
review of that portion of the opinion below remanding the class
certification issue with respect to tax years 1985 through 1990
to the tax court for further consideration in light of Ladewig
II, we do not address that portion of the opinion below.17 This
16
Because we conclude that use of federal AGI as the
Arizona tax base in § 43-1001(2) does not violate the
intergovernmental tax immunity doctrine, we do not need to
consider whether in this case any discrimination is justified by
substantial differences between respondents and state
governmental employees. Cf. Witte v. Dir. of Rev., 829 S.W.2d
436 (Mo. 1992) (upholding Missouri tax scheme which imposed
current taxation on employee contributions to federal Civil
Service Retirement System, while deferring taxation to other
retirement plans, because of plaintiffs’ failure to show a lack
of significant differences between the two classes).
17
Our disposition of the intergovernmental tax immunity
issue moots any question as to whether class certification
should have been granted with respect to claims relating to tax
years after 1990.
28
case is remanded to the tax court for further proceedings
consistent with this opinion.
Andrew D. Hurwitz, Justice
CONCURRING:
_
Charles E. Jones, Chief Justice
______
Ruth V. McGregor, Vice Chief Justice
_
Michael D. Ryan, Justice
_
John Pelander, Judge*
*
The Honorable Rebecca White Berch recused herself; pursuant
to Article VI, Section 3 of the Arizona Constitution, the
Honorable John Pelander, Judge of the Court of Appeals, Division
Two, was designated to sit in her stead.
29