Reed Smith Client Alerts

Last week, in Washington Bankers Association v. State,1 the Supreme Court of Washington rejected a facial constitutional challenge to the state’s business and occupation (“B&O”) surtax on large financial institutions and found that it is not discriminatory on its face or in purpose. However, as the Court’s decision in Washington Bankers involved a facial challenge to the B&O surtax, the decision does not necessarily mean that the surcharge is constitutional as applied to all taxpayers. The surcharge is vulnerable to an as-applied challenge on the grounds that it is imposed based on extraterritorial value because the surtax is triggered when a taxpayer has net income of $1 billion or more everywhere, rather than net income of $1 billion attributable to Washington. This extraterritoriality problem with the B&O surtax was not addressed in Washington Bankers.

The B&O surtax

By way of background, in 2019 Washington’s legislature enacted a 1.2% B&O surtax on “specified financial institutions” effective January 1, 2020.2  Specifically, the surtax applies to financial institutions that are members of a consolidated financial institution group that reported annual net income of $1 billion or more in its previous calendar year, without regard to where that income was earned. Combined with the 1.75% base B&O tax rate on most financial institutions, the total rate including the surtax is now 2.95%, a nearly 70% tax increase for large financial institutions.  

Before the surtax took effect, the Washington Bankers Association and American Bankers Association filed an action for declaratory relief that alleged that the surtax discriminates against interstate commerce because the burden of the surtax primarily falls on out-of-state banks. While the trial court, the Superior Court of King County, agreed with the plaintiffs and enjoined the tax, the Supreme Court of Washington reversed. The Court reasoned that, in the abstract, the mechanical operation of the surtax does not disfavor out-of-state banks in favor of in-state banks. The Court was not swayed by the fact that the burden of the surtax primarily falls on out-of-state banks or by informal legislative history that suggested that the surtax’s sponsor may have intentionally designed the surtax to target out-of-state banks.3  However, the Court did affirm the trial court’s decision that a trade group composed of financial institutions had standing to challenge the B&O surtax under Washington’s Uniform Declaratory Judgments Act (rather than needing to follow the state’s administrative procedures for challenging taxes).

Potential for as-applied challenges

Despite the Court’s decision in favor of the state in Washington Bankers, financial institutions that are subject to the B&O surtax may still have another opportunity to challenge the surtax. The Court’s decision in Washington Bankers did not address the question of whether the surtax has an extraterritorial effect in violation of the Due Process Clause and the dormant Commerce Clause.4 The extraterritoriality concerns with the surtax stem from the fact that it is triggered by reference to a financial institution’s net income earned everywhere, rather than the financial institution’s net income attributable to Washington. Due to this unusual feature, the surtax is not “rationally related to values connected with” Washington.5 For example, a large financial institution with just a small proportion of its customers in Washington would be subject to the surtax, while a small financial institution with a significantly higher proportion of its customers in Washington and with more Washington receipts than the large financial institution, would not be subject to the surtax. Furthermore, the surtax can be triggered by earning income outside Washington, and effectively penalizes taxpayers for doing business outside the state.6  As a result, the surtax has the “practical effect of . . . discriminating against interstate commerce.”7