Cite as: 528 U. S. 458 (2000)
Opinion of the Court
reason, that which California calls a deduction limitation would seem, in fact, to amount to an impermissible tax. National Life Ins. Co. v. United States, 277 U. S. 508 (1928) (finding that a federal statute that reduced an insurance company's tax deduction for reserves by the amount of tax-exempt interest the company received from a holding of "tax-free" municipal bonds constituted unlawful taxation of tax-exempt income).
However, this principle does not end the matter. California offers a justification for its rule that seeks to relate the deduction limit to collection of California's tax on unitary income. If California could show that its deduction limit actually reflected the portion of the expense properly related to nonunitary income, the limit would not, in fact, be a tax on nonunitary income. Rather, it would merely be a proper allocation of the deduction. See Denman v. Slayton, 282 U. S. 514 (1931) (upholding Federal Tax Code's denial of interest expense deduction where borrowing is incurred to "purchase or carry" tax-exempt obligations).
California points out that money is fungible, and that consequently it is often difficult to say whether a particular borrowing is "really" for the purpose of generating unitary income or for the purpose of generating nonunitary income. California's rule prevents a firm from claiming that it paid interest on borrowing for the first purpose (say, to build a tin can plant) when the borrowing is "really" for the second (say, to buy shares in the New Zealand sheep farm). Without some such rule, firms might borrow up to the hilt to support their (more highly taxed) unitary business needs, and use the freed unitary business resources to purchase (less highly taxed) nonunitary business assets. This "tax arbitrage" problem, California argues, is why this Court upheld the precursor of 26 U. S. C. § 265(a)(2), which denies the taxpayer an interest deduction insofar as the interest expense was "incurred or continued to purchase or carry" tax-exempt obligations or securities. Denman v. Slayton,
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