Note: The following is an excerpt from the introduction to the article as published in The State and Local Tax Lawyer. Author citations have been omitted for brevity.

NOTE
Covenants Not to Compete and the Problem of Taxing at the Place of Abstinence: Milhous v. Franchise Tax Board

In Milhous v. Franchise Tax Board, 1 the California Court of Appeal affirmed the superior court’s holding that the imposition of tax on income derived from a covenant not to compete which was sold as a component of nonresident taxpayers’ successful printing business violated the Commerce Clause of the United States Constitution. 2 A crucial issue was whether California had the right to tax Florida residents on the proceeds of the sale of their right to do business within California. 3 Historically, the sale of an intangible right is taxable only in the domicile of the seller pursuant to the doctrine of mobilia sequuntur personam. 4 An exception to this doctrine allows a state to tax a nonresident seller that has sufficient connections to the state. 5

The court articulated two methods of connectivity. The first method relies on traditional notions of affirmative connectivity, such as the taxpayer’s physical presence in the state or positive steps taken to connect the taxpayer to the state. The second method is a novel theory of connectivity based on the value of abstaining from working in a state, and calculated by using the covenant’s value in that state. 6 Because the superior court found that the covenant had no value in California, it concluded that the state could not tax this particular covenant. The appellate court agreed, but decided not to address the larger issue of whether this new second method of taxation based on the value of the covenant is available in California. 7

Although the appellate court reached the correct result when it determined that the covenant not to compete could not be taxed in California, the court’s analysis is confusing. It leaves open the question of whether the ability to tax nonresident taxpayers should hinge on the value of the covenant to the buyer rather than to the seller-taxpayer’s affirmative connection to the taxing state. 8 A test in which the determinative factor is the value of the covenant to the buyer may produce absurd, unjust, and confusing results. Rather than leaving unresolved the tax treatment of future valuable covenants, the court should have employed a two-part test: (1) determine whether or not the allocation of money between the covenant and the sale of the business reflects economic reality and, if not, supply an allocation that does; and (2) using the appropriate allocation, apply the traditional connectivity method that taxpayers cannot be taxed absent some showing of an affirmative connection with the nonresident state. This two-part test places an appropriate limitation on a state’s authority to tax while also policing the line between tax evasion and justifiable allocations.

Part I of this Note provides background on the doctrine of mobilia sequuntur personam. Part II sets forth the relevant facts of the case and explains the California Court of Appeal’s opinion. Part III shows that the California Court of Appeal’s opinion is problematic because it allows value to determine taxation—a framework that creates unjust and absurd results. Part III also urges courts to adopt a two-part test that focuses first on establishing a proper allocation of money to the covenant and then on determining whether there are sufficient affirmative connections to the state. This approach creates a superior framework because it addresses underlying problems with the practice of covenants. Part IV concludes that while the court’s decision is understandable given its desire to keep options open and defer to lower court decisions, without clarification, this decision will be the source of much confusion.

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Published by
Section of Taxation, American Bar Association
With the Assistance of
Georgetown University Law Center