97-20

January 17, 1997

Re: Application of Stockman’s Bank to Merge ________

Dear Mr. ________:

You have solicited our written views on the question of whether Subdivisions (d) and (g) of Section 3804 of the California Financial Code discriminate against out-of-state state banks in a manner that is prohibited by 12 U.S.C. Section 1831u(a)(3)(B)(i).

Your inquiry is apparently prompted by the fact that California law imposes different regulatory fees on California state banks than it imposes on out-of-state state banks with branches in California. A California state bank is assessed under California Financial Code Section 270. The assessment is based on the bank’s assets. Out-of-state state banks are not subject to Section 270. Instead, they are subject to regulatory fees prescribed by California Financial Code Section 3804. Subdivision (d) of Section 3804 imposes an annual flat fee of $1,000 per branch maintained in California, with a minimum of $3,000 and a maximum of $50,000. Subdivision (g) of Section 3804 imposes a variable fee of $50 per hour for each examiner engaged in the examination of the out-of-state state bank.

In our view, the question is misstated. The question is based on the assumption that Subdivisions (d) and (g) of Section 3804 constitute conditions enacted under authority of Section 1831u(a)(3)(B). The assumption is incorrect. Subdivisions (d) and (g) of Section 3804 were not enacted under authority of Section 1831u(a)(3)(B). For example, Subdivisions (d) and (g) of Section 3804 do not comply with the requirement of Section 1831u(a)(3)(B)(iii) that conditions enacted under authority of the Section not apply or require performance after May 31, 1997. Subdivisions (d) and (g) of Section 3804 have no such termination date.

Rather, Subdivisions (d) and (g) of Section 3804 were enacted under the authority of California as a host state to regulate and tax California branches of out-of-state state banks.

12 U.S.C. Section 1831a(j)(1) provides that the laws of a host state apply to a branch in the host state of an out-of-state state bank to the extent specified. 12 U.S.C. Section 1820(h)(1) authorizes the state bank supervisor of a host state to examine a branch operated in the host state by an out-of-state state bank to determine compliance with host state laws and to ensure that the activities are not conducted in an unsafe or unsound manner. 12 U.S.C. Section 1831a(j)(2) authorizes the state bank supervisor of a host state to bring an enforcement action if there is a violation of a law of the host state at a branch operated in the host state by an out-of-state state bank or if the branch is operated in an unsafe or unsound manner. 12 U.S.C. Section 1831a(j)(3) authorizes state bank supervisors to enter into cooperative agreements to facilitate state regulatory supervision of state banks.

Clearly, then, the state bank supervisor of a host state may exercise regulatory jurisdiction over a branch in the host state operated by an out-of-state state bank, including making examinations and taking enforcement actions. Of course, such regulatory activities must be funded. Accordingly, 12 U.S.C. Section 1831u(c)(1) reserves to the host state full authority to tax an out-of-state state bank.

Section 1831u(c)(1)(A) provides in pertinent part:

“No provision of [Section 1831u] . . . shall be construed as affecting the authority of any State . . . to adopt, apply, or administer any tax or method of taxation to any bank, bank holding company, or foreign bank, . . . to the extent such tax or tax method is otherwise permissible by or under the Constitution of the United States or other Federal law.”

Subdivisions (d) and (g) of Section 3804 impose taxes which, as discussed below, are permissible under the Constitution of the United States. Therefore, as applied to out-of-state state banks, they are permissible under 12 U.S.C. Section 1831u(c)(1)(A).

The two obvious constitutional hurdles a California tax imposed on out-of-state state banks must clear are the commerce clause and the equal protection clause of the U.S. Constitution.

A. Commerce Clause.

In general, the commerce clause of the U.S. Constitution (Article 1, Section 8, Clause 3) reserves to Congress the power to regulate interstate and foreign commerce. This constitutional grant of authority to Congress operates to prohibit states from imposing a tax that unfairly burdens such commerce.

The usual test as to whether a tax unfairly burdens interstate commerce is whether the tax discriminates against interstate commerce. In City of Los Angeles v. Marine Wholesale/ Warehouse Co., Inc. (1993, 2nd Dist.) 15 CA 4th 1834, 19 Cal. Rptr. 2d 664, 671, the California Court of Appeal stated:

“In Complete Auto Transit, Inc. v. Brady (1977), 430 U.S. 274, the Supreme Court established factors to determine whether a local tax is prohibited by the commerce clause. The tax will be approved ‘when the tax is applied to an activity with a substantial nexus with the taxing state, is fairly apportioned, does not discriminate against interstate commerce, and is fairly related to the services provided by the state’ [citation omitted]. . . . A business which is engaged in interstate commerce must ‘pay its just share of the cost of [local] government upon which [it] necessarily relies and by which it is furnished protection and benefits’ [citation omitted].”

In Constitutional Law, 13 Cal. Jur. 3d (Rev) Part 1, it is stated:

“When a part of a business can be identified as done locally and there is no danger that several states will impose cumulative tax burdens on the same subject, a tax on an activity that is a local incident of interstate commerce may be measured and that part taxed. Martin Ship Service Co. v. Los Angeles 34 CA 2d 793; 215 P 2d 24.”

B. Equal Protection Clause.

The Fourteenth Amendment of the U.S. Constitution prohibits a state from denying to any person within its jurisdiction the equal protection of the laws. However, a state may make reasonable classifications among such persons.

Corporations are entitled to the same guaranties of equal protection extended to natural persons; however, different kinds of corporations may be treated differently. Thus, legislation applicable to all corporations of a class based on substantial distinctions would not be unconstitutionally discriminatory. In Constitutional Law, 13 Cal. Jur. 3d (Rev) Part 1, p. 398, it is stated:

“Where taxation is concerned and no specific federal right, apart from equal protection, is imperiled, the states have large leeway in making classifications and drawing lines that in their judgment produce reasonable systems of taxation. Amador Joint Union High School District v. State Board of Equalization (1978) 22 CA 3d 208; 149 Cal. Rptr. 239.”

The California Supreme Court stated in Haman v. County of Humboldt (1973) 8 C. 3d 922, 925:

“Tax statutes are generally not subjected to close scrutiny, and distinctions can be justified on the basis of administrative convenience and the promotion of legitimate state interests.”

In O.N.C. Freight Systems v. Department of Motor Vehicles (1983, 1st Dist.), 149 CA 3d 11, 20, 196 Cal. Rptr. 592, the California Court of Appeal concluded:

“So long as the system of taxation is supported by a rational basis and is not palpably arbitrary, it will be upheld despite the absence of a precise, scientific uniformity of taxation.”

A state tax that is imposed on foreign corporations in a different manner than it is imposed on domestic corporations does not necessarily violate the equal protection clause.

In Western and Southern Life Insurance Company v. State Board of Equalization of California, 451, U.S. 648, the U.S. Supreme Court upheld a California law which imposed a retaliatory tax on out-of-state insurance companies. In the portion of the case which addressed the equal protection argument, the Court traced the development of the cases which have variously upheld and overturned state statutes that discriminate against foreign corporations and concluded as follows at page 2083:

“We consider it now established that, whatever the extent of a State’s authority to exclude foreign corporations from doing business within its boundaries, that authority does not justify imposition of more onerous taxes or other burdens on foreign corporations than those imposed on domestic corporations, unless the discrimination between foreign and domestic corporations bears a rational relation to a legitimate state purpose.”

The Court went on to state at page 2083,

“In determining whether a challenged classification is rationally related to achievement of a legitimate state purpose, we must answer two questions: (1) Does the challenged legislation have a legitimate purpose? and (2) Was it reasonable for the lawmakers to believe that use of the challenged classification would promote that purpose?”

The Court found that the purpose of the retaliatory tax law, which was to promote the interstate business of domestic insurers by deterring other states from enacting discriminatory or excessive taxes, was a legitimate purpose, stating at page 2084:

“There can be no doubt that promotion of domestic industry by deterring barriers to interstate business is a legitimate state purpose. This Court has recognized the legitimacy of state efforts to maintain the profit level of a domestic industry [citations omitted] . . . and of efforts to ‘protect and enhance the reputation’ of a domestic industry so that it might compete more effectively in the interstate market [citations omitted]. California’s effort on behalf of its domestic insurance industry is no less legitimate.”

The first prong of the equal protection test having been satisfied, the Court then looked at the second prong to determine whether it was reasonable for California’s lawmakers to believe that use of the challenged classification would promote that purpose. The Court noted that many persons believed that retaliatory taxes do not accomplish the goal of deterring discriminatory and excessive taxation of insurance companies by the various states. Nevertheless, the Court found, at page 2085:

“But whether in fact the provision will accomplish its objectives is not the question: the Equal Protection Clause is satisfied if we conclude that the California Legislature rationally could have believed that the retaliatory tax would promote its objective. [Citations Omitted.]”

C. Discussion of Constitutional Principles in Relation to Subdivisions (d) and (g) of Section 3804.

As discussed above, in order to withstand a constitutional challenge, any method by which California assesses regulatory taxes against out-of-state state banks differently than it assesses such taxes against California state banks must meet the following requirements:

1. The tax must

(a) be applied to an activity with a substantial nexus to California;

(b) be fairly apportioned;

(c) not discriminate unfairly against interstate commerce; and

(d) be fairly related to the services provided by California.

2. The tax must represent the taxpayer’s just share of the cost of government, must be supported by a rational basis, and must not be arbitrary.

3. Any classification of different types of corporations for the purpose of imposing an assessment must be founded on natural, intrinsic or fundamental distinctions that are reasonable in relation to the object of the legislation. Legislation based on classifications of foreign or domestic corporations must have a legitimate purpose and it must have been reasonable for lawmakers to believe that the use of the classification would promote that purpose.

4. Distinctions in tax applicability may be justified on the basis of administrative convenience and promotion of legitimate state interests.

California has responsibility to regulate and oversee the entire operation of a California state bank. With respect to an out-of-state state bank with a branch in California, on the other hand, California oversees only a portion of the bank’s operations. For example, an out-of-state state bank is not subject to all of the provisions of the California Financial Code to which a California state bank is subject. California Financial Code Section 3827. Accordingly, the scope of the California State Banking Department’s examinations of out-of-state state banks is different than the scope of its examinations of California state banks. In addition, the Department is required to examine each California state bank not less often than once every two years. Financial Code Section 900(a)(3). The frequency of examinations of out-of-state state banks is not fixed by statute (Financial Code Section 900(b)) and is largely dependent on coordination with the home state regulator. The frequency with which out-of-state state banks will be examined by the Department is uncertain, and the issues which may arise in connection with such examinations are yet unknown. The assessment scheme set forth in Section 270 of the Financial Code is designed to compensate the Department for supervising a California state bank, including regular periodic examinations. On the other hand, the overall supervision of an out-of-state state bank is performed by the home state supervisor.

Considering the different regulatory responsibilities that the Department has with respect to California state banks and out-of-state state banks, it is reasonable to assume that the two classes of banks would not be subject to regulatory taxation on the same basis. It was, therefore, considered appropriate to assess out-of-state state banks a flat fee based on the number of their California branches to cover general overhead expenses of regulation and to assess additional fees for actual time expended on examinations. This formulation was considered reasonable for approximating the true costs associated with regulating out-of-state state banks.

In view of the foregoing factor, we conclude, as follows:

The taxes imposed by Subdivisions (d) and (g) of Section 3804 clearly apply to activity which has a substantial nexus to California and are fairly apportioned.

Although the bases on which regulatory taxes are assessed on California state banks and out-of-state banks differ, the difference does not unfairly discriminate against out-of-state banks.

The assessment formulation regarding out-of-state state banks is fairly related to the services provided by California.

The present formulation represents the California Legislature’s best estimate of an out-of-state state bank’s just share of the expenses of its regulation.

There is a rational basis within the latitude granted by the U.S. Constitution to local taxing authorities for differentiating between California state and out-of-state state banks. The differences in the regulatory tax schemes for California state and out-of-state state banks are based on intrinsic and fundamental differences in the responsibilities of California in regulating these two types of entities.

For these reasons, it is our view that Subdivisions (d) and (g) of Section 3804 are constitutionally permitted forms of taxation, and that they are permitted under 12 U.S.C. 1831u(c)(1)(A).

Finally, we must respectfully question whether it is appropriate or necessary for the FDIC, before deciding an application for approval of an interstate merger, to determine the validity of the laws of the proposed host state that impose a tax on a branch operated in the host state by an out-of-state state bank. It may be proper for the FDIC in dealing with such an application to consider whether the laws of the proposed host state meet the requirements set forth 12 U.S.C. Section 1831u(a)(3)(A)(i) and (ii). However, it seems that only an out-of-state state bank would have standing to challenge the validity of fees imposed by the host state on a branch operated in the host state.

Since you made your request for our written views this afternoon, we have had only a limited amount of time to prepare this response. As a result, it is not the product that we would prefer to present under more favorable circumstances, and we must reserve the right to modify or correct it as necessary. Nonetheless, we trust that it is responsive to your request and will prove helpful to you.

If you wish to discuss these matters further, please call us. You may reach the undersigned at (415) 263-8512 (office). Also, James F. Carrig, Chief Counsel for the Department, is familiar with the subject and is prepared to discuss it with you. He may be reached at (415) 263-8517 (office).

Very truly yours,

CONRAD W. HEWITT
Superintendent of Banks

By

THOMAS M. LOUGHRAN
Senior Counsel

TML:lca

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