April 16, 2008
Tax Foundation Urges a Stop to South Dakota's Discriminatory Insurance Taxes
Brief Supports Challenge to Law Taxing Out-of-State Companies at Twice the Rate of In-State Companies
The Tax Foundation, in a friend-of-the-court brief filed on April 15 with the South Dakota Supreme Court, urged that state to stop its discriminatory insurance tax system that taxes out-of-state companies at twice the rate of in-state companies. The case, Metropolitan Life Ins. Co., et al. v. Kinsman, et al., is currently before the court on a petition for rehearing.
"Since explicit discrimination in rates was struck down by the U.S. Supreme Court in 1985, South Dakota is one of just eight states that seek to protect their domestic insurance companies by imposing heavier taxes on out-of-state companies doing business in the state," said Tax Counsel Joseph Henchman, author of the brief. "While on paper all companies pay the same 2.5% rate, in-state companies automatically receive rate reductions, lowering their tax bill to 0.75% to 1.25%. The result is effective discrimination against out-of-state companies which violates the Equal Protection Clause," Henchman added.
While the trial judge invalidated the statute in this case, late last month the state Supreme Court reversed. The Tax Foundation brief argues that the court's decision is problematic because (1) it does not consider the Findings of Fact by the trial judge, (2) the standard adopted by the Court will be problematic, and (3) the statute does not survive rational basis review.
"The State Supreme Court said that the tax scheme is non-discriminatory because an out-of-state company can avoid the punitive tax by opening an office in the state," Henchman said. "But this misses the point because what matters is discrimination in this case, not some hypothetical different case. The court's new rule would uphold any kind of discriminatory government behavior if the victim could conceivably avoid it."
The brief also reviews the issue of retaliatory taxes, which the Court's opinion ignored. South Dakota's domestic insurance industry suffers because of these taxes, which are imposed by other states on companies from states that practice tax discrimination. For example, a South Dakota company doing business in Minnesota must pay Minnesota's regular 2.0% insurance tax, plus a 0.5% retaliatory tax (representing the difference between Minnesota's rate on out-of-state companies and South Dakota's rate on out-of-state companies). Few South Dakota companies do business in other states as a result.
South Dakota is not alone in having in-state insurance companies automatically qualify for lower rates, but subjecting out-of-state companies to additional hurdles to do so.
"Colorado, Hawaii, and Nevada have insurance tax schemes similar to South Dakota's, and their constitutionality could be impacted by the outcome of this case," Henchman said. "Louisiana and Mississippi also favor in-state insurance companies, and Indiana gives them lower rates as a matter of law."
The Tax Foundation's brief concludes by arguing that South Dakota's tax does not survive "rational basis review," which invalidates laws unless they "bear a rational relation to a legitimate state purpose." For example, the tax does not help the state raise revenue or regulate insurance companies since those functions are not helped by a discriminatory tax law. Drawing on the Tax Foundation brief in the Kentucky v. Davis case and the principles of sound tax policy, the brief argued that states cannot promote in-state economic development by punishing out-of-state companies or economic activity with heavier taxes.
"South Dakota should aim to tax all similar activity at the same general rate in order to maintain a neutral tax system," Henchman said.
A decision on the petition for rehearing is expected in April or May.
Click here to read the brief. Click here for more on the Tax Foundation's Center for Legal Reform.
