Cities Beginning to Feel Impact of ’90 Court Ruling : Taxes: Decision involving a defense contractor could sap local treasuries of millions of dollars in sales tax revenue. A task force is formed to address the problem.

For two years, little notice was paid to a complicated and relatively obscure 1990 state Supreme Court tax decision involving a California defense contractor. Now it’s a bureaucratic monster that could sap local city treasuries of millions of dollars in badly needed sales tax revenue.

Only in recent months have municipal officials throughout the state and in Orange County come to realize the potentially devastating impact of the decision. In short, the court found that the state and cities should be forced to pay hefty tax refunds to defense contractors who successfully argued that the paper clips, pencils and other miscellaneous items needed to drive construction of missile systems and bombers provided tax-free to the government should be tax-exempt as well.

Long mired in state audits of claims filed by the defense firms, local city officials admit the decision rendered on March 20, 1990, had been largely ignored until tax refund requests recently began pouring into city halls throughout Orange County.

“They said it was not a big deal,” said Fullerton revenue manager Ed Paul, describing the initial notification from the State Board of Equalization on the court case. “Maybe a (statewide) total of $78 million and each of us would take a little hit. Then the claims started rolling in and this thing has grown up to $1.2 billion.”

The $1.2 billion represents a total estimate of what California cities and the state could be forced to refund to defense contractors who paid sales taxes on local purchases of equipment and supplies, Paul said.

Under the court ruling, even supplies such as floor cleaners and bathroom towels used indirectly in the manufacturing of defense weapons are exempt from the sales tax. The decision has sent defense firms and suppliers throughout the county back through their books looking for potential claims.

Frightened by the prospect of seeing their treasuries further depleted, a task force of county cities has been formed to counter a problem that some said could become “an instant budget crisis.”

Task force members have come from Anaheim, Fullerton and Newport Beach, but Anaheim city audit manager Kenneth H. Stone warned that every city in the county could ultimately be affected.

Last week, Anaheim was forced to refund $43,000 in sales taxes to Lockheed, a major defense firm that has since moved out of the city. Additional refund claims could eventually cost the city $1 million, according to city estimates.

Fullerton is currently disputing a refund for an undisclosed sum to a defense firm supplier, Paul said.

Anaheim and Fullerton officials believe their cities have been the first to be hit by what is expected to be a wave of refund requests to come in the next 18 months.

“The worst thing about this is that it is an unknown and can be applied retroactively,” Paul said. “But we really can’t make a determination of how much we will pay because we don’t know who has filed claims and for how much. . . . A worst-case scenario would put us way up there near $1 million.”

The State Board of Equalization is locked in the cumbersome process of auditing about 300 confidential claims from firms seeking refunds on supplies bought as long ago as the early 1970s.

Cities that are home to manufacturers and suppliers of equipment used by defense contractors would be forced to refund their portion of the exemptions in a lump sum, in what city officials have called an “instant grab.”

Fullerton City Manager William C. Winter said the task force members are conferring with lawyers to determine whether they will be able to spread out or postpone future refund payments over several months or years.

Tim McCoy, an aide to Board of Equalization member Matthew Fong, said state auditors expect the pace of refund notices to cities to increase in coming months and continue for several years as audits are completed.

Of the county’s 7.75% sales tax collected by the state, 1% of that goes back to the cities in monthly payments from the State Board of Equalization.

Fullerton, for example, receives about $1 million each month in payments, which make up about 25% of the city’s general fund. When refunds are granted, the money is taken off the top of those payments.

“The State Board (of Equalization) controls the purse strings on this. They notify cities with a phone call and ask how much we have in the general fund, then they will deduct the refund from our next check, leaving no real time to budget for it,” Paul said. “The cities just don’t know how to deal with it.”

Paul said several other cities in the county have expressed interest in joining the task force and that as the volume of refund notices increases, so too will the attendance at the task force meetings.

“In a matter of months, it could be standing room only at these meetings,” Paul said.

Times staff writer Kevin Johnson contributed to this report.