BEFORE THE UTAH STATE TAX COMMISSION
XXXXX, ) FINDINGS OF FACT,
: CONCLUSIONS OF LAW,
Petitioner, : AND FINAL DECISION
AUDITING DIVISION OF THE : Appeal No. 90-1521
UTAH STATE TAX COMMISSION, :
: Tax: Corporate Franchise
STATEMENT OF CASE
This matter came before the Utah State Tax Commission for formal hearing held XXXXX through XXXXX, XXXXX. XXXXX, Administrative Law Judge, Chairman W. Val Oveson, Commissioner Joe B. Pacheco, Commissioner Alice Shearer, and Commissioner Roger O. Tew heard the matter. Present and representing Petitioner, XXXXX, ("XXXXX") were XXXXX, and XXXXX, from the law firm of XXXXX, and XXXXX, from the law firm of XXXXX. Present and representing the Auditing Division of the Utah State Tax Commission ("Auditing Division") were XXXXX and XXXXX, Assistant Attorneys General. XXXXX, former XXXXX of XXXXX, XXXXX, former XXXXX of XXXXX, XXXXX, Professor of XXXXX at XXXXX, and XXXXX, Certified Public Accountant of XXXXX, the auditors for XXXXX and XXXXX, appeared as witnesses for Petitioner. XXXXX, auditor for the Auditing Division and Professor XXXXX of XXXXX appeared as witnesses for the Respondent.
FINDINGS OF FACT
1. The tax at issue is corporate franchise tax for the years XXXXX and XXXXX.
2. XXXXX is a single corporate entity which operates in all states and several foreign countries. It owns majority interests in XXXXX other corporations and files a federal consolidated tax return with those majority owned corporations. In several states, XXXXX has filed combined returns with the same entities.
3. XXXXX filed its XXXXX and XXXXX U.S. Corporation Income Tax Returns (Form 1120) on a consolidated basis. In XXXXX, XXXXX consolidated its income with XXXXX of its domestic subsidiaries and affiliates. In XXXXX, XXXXX consolidated its income with XXXXX of its domestic subsidiaries and affiliates. XXXXX was not one of the companies included in XXXXX consolidated returns.
4. XXXXX filed its XXXXX and XXXXX Utah
Corporation Franchise or Income Tax Returns (Form TC-20) on a combined basis
with the corporations included in the federal returns.
5. XXXXX did not, and was not required to, include the income of XXXXX in its combined report for Utah income tax reporting purposes, since XXXXX did not own more than %%%%% of the stock of XXXXX.
6. On its XXXXX and XXXXX Utah returns, dividends received from XXXXX were included in apportionable business income.
7. On its XXXXX Utah return, in calculating its net income, XXXXX subtracted $$$$$ on line 4(d). This subtraction was described as "Extraordinary gain on sale of entire XXXXX stockholding (%%%%%)."
8. XXXXX business activities are divided into three operating divisions named XXXXX, XXXXX, and XXXXX which constitute three separate lines of business. Each division has its own officers, employees, manufacturing facilities, and sales staff. Each division produces its own line of products which are marketed by its sales staff. XXXXX business activity in Utah was conducted through XXXXX. However, the three operating divisions are not separate corporations, but are all just a part of a single legal entity, i.e., XXXXX.
9. XXXXX headquarters in XXXXX provides administrative services to all three divisions. The XXXXX company provides some of its own administrative services.
10. XXXXX corporate organization included corporate headquarters offices or departments in addition to its three divisions. Such headquarters offices and departments included the Office of the President, international operations, finance and control department (which was “subdivided” into audit, banking, controller, treasurer, insurance, computer services, credit and tax), general counsel, secretary, business development department (which included research, marketing, special projects and licensing), human resources department (which included health, environment and safety services, salary planning, and recruiting), productivity management and operation services (which included distribution and supply, advanced office systems, and management support systems), and information resources. These headquarters offices and departments each provided various services to each of the three divisions of XXXXX.
11. XXXXX is in the business of manufacturing.
12. During its XXXXX year history, XXXXX has participated as a partner in more than XXXXX joint ventures with various partners.
13. In the late XXXXX's and early XXXXX's, under the leadership of Chairman, President, and CEO, XXXXX, XXXXX began restructuring. Its strategy was to reduce dependence on petrochemicals and other commodity chemicals, and increase its role as a supplier of value-added products. In carrying out this strategy, XXXXX made creative use of joint ventures to manage and, in some cases, divest its commodity chemicals business.
14. XXXXX resins are derived from petrochemicals.
15. Prior to XXXXX, XXXXX, XXXXX owned and operated XXXXX resin manufacturing facilities located at XXXXX, XXXXX; XXXXX, XXXXX; XXXXX, XXXXX; XXXXX, XXXXX; XXXXX, XXXXX, XXXXX; and XXXXX, XXXXX. XXXXX manufactured many grades and types of XXXXX which were used primarily in the manufacture of various plastic products in the automotive, fiber, packaging, housewares, and appliance industries as well as miscellaneous uses in other industries.
16. From the early XXXXX's, XXXXX primary objective for XXXXX was the enhancement of its value, for ultimate disposition.
17. In XXXXX, XXXXX ("XXXXX"), an XXXXX company, together with XXXXX of XXXXX, had developed an advanced catalyst-based technology for the manufacture of XXXXX. The XXXXX technology consisted of a chemical “XXXXX” process named the ”XXXXX”, which enabled the manufac ture of XXXXX with a wider range of properties and at a lower cost than the processes XXXXX then used.
18. On or about XXXXX, XXXXX and XXXXX formed XXXXX ("XXXXX") as a joint venture.
19. The formation of the XXXXX joint venture during XXXXX combined XXXXX's superior technology with XXXXX marketing strengths and presence in the North American markets.
20. XXXXX financial interest in the XXXXX joint venture was not a short-term investment of working capital.
21. Upon its formation, and until XXXXX, XXXXX, XXXXX and XXXXX each held XXXXX percent of the stock of XXXXX and were XXXXX's only shareholders.
22. At XXXXX's formation, XXXXX contributed substantially all of its XXXXX resin assets and technology to XXXXX. XXXXX contributed its XXXXX resin assets and technologies to XXXXX at its formation. XXXXX also contributed assets which it had purchased from XXXXX XXXXX and XXXXX subsidiaries. These purchases were made by XXXXX so that the contributions of XXXXX and XXXXX to XXXXX would be more equal in value.
23. Under the XXXXX Agreement, at Section XXXXX, XXXXX and XXXXX agreed that the working capital related to the XXXXX XXXXX resin assets being contributed to XXXXX exceeded the working capital assets related to the XXXXX XXXXX resin assets being contributed to XXXXX. XXXXX and XXXXX agreed that the differential between the working capital of the XXXXX XXXXX resin assets and the working capital of the XXXXX XXXXX resin assets would be equalized by XXXXX issuing a note to XXXXX, on the closing date of the XXXXX formation transaction, in an amount that was later determined by the parties to be $$$$$.
24. XXXXX received a $$$$$ dollar note from XXXXX for its transfer of working capital assets, including inventory and accounts receivable, to XXXXX at its formation.
25. On XXXXX, 19YY, all XXXXX employees who had
previously been directly and solely engaged in manufacturing or marketing XXXXX
terminated their employment at XXXXX and accepted employment with XXXXX. None of these employees were ever re-employed
26. XXXXX is a separate independent corporation whose activities are limited to one line of business, the manufacture and sale of XXXXX. XXXXX was created by XXXXX and XXXXX selling all of their respective XXXXX manufacturing assets to XXXXX and transferring all employees associated with this line of business to XXXXX in exchange for equal shares of XXXXX’s stock.
27. XXXXX and XXXXX entered into an agreement regarding the governance of XXXXX under the terms of which the shareholders’ interest would be equally balanced and the president of XXXXX would run the company and seek XXXXX’s independent profit objectives.
28. XXXXX and XXXXX also agreed to sell certain administrative services to XXXXX at their fully loaded cost.
29. In forming XXXXX, XXXXX and XXXXX agreed that they would not, except under limited conditions or with the consent of the other party, sell, assign, or pledge their XXXXX stock.
30. XXXXX and XXXXX each had and exercised authority to elect three of the six members of the board of Directors of XXXXX.
31. Each member of XXXXX’s Board of Directors elected by XXXXX also served as officers and/or directors of XXXXX.
32. XXXXX and XXXXX agreed that the primary responsibility for the worldwide operations of XXXXX would be vested in the president of XXXXX. The president would also serve as XXXXX’s chief operating officer. The parties agreed that XXXXX would select and, if appropriate, dismiss the president of XXXXX, in each case with the concurrence of XXXXX’s Board of Directors, for the first five years.
33. XXXXX and XXXXX agreed that they would vote their shares in the company or otherwise instruct the directors of XXXXX elected by them to act in such a way as to assure that the primary responsibility of the operation of the company worldwide was vested in its president.
34. XXXXX and XXXXX agreed that XXXXX would also select the Chairman, and XXXXX would select the Vice Chairman, of XXXXX’s Board of Directors for the first five years of the joint venture. XXXXX selected Mr. XXXXX, its own Chairman of the Board, to be President, CEO, and Chairman of XXXXX’s Board of Directors.
35. XXXXX and XXXXX agreed that after the first five years, the selection of the Chairman and Vice Chairman would rotate between XXXXX and XXXXX every three years with the choice of the selecting party subject to the concurrence of XXXXX’s Board of Directors, except when the person selected was the Chairman of the Board or the Chief Executive Officer of the selecting party.
36. XXXXX and XXXXX agreed that XXXXX would nominate two of the vice presidents of XXXXX, while XXXXX would nominate the other two. The appointment of such persons would be with the concurrence of the president of XXXXX.
37. XXXXX and XXXXX agreed that XXXXX would nominate the head of the North American operations of XXXXX, while XXXXX would nominate the head of the European operations. All appointments were to be with the concurrence of the president of XXXXX. XXXXX and XXXXX agreed that after the initial selection of these persons, replacements and the appointment of other heads of equal rank would be made to generally follow the principle of balanced representation between XXXXX and XXXXX. Other key officials of XXXXX and its subsidiaries would be selected by the president of XXXXX after consultation with XXXXX and XXXXX.
38. XXXXX and XXXXX agreed that XXXXX was to pursue its independent profit objectives.
39. XXXXX and XXXXX initially agreed to purchase all of their XXXXX resin needs from XXXXX as long as XXXXX met quality and product property requirements.
40. XXXXX and XXXXX agreed that XXXXX’ and XXXXX’s purchases from XXXXX would be at a discount from market price “to recognize the fact that the selling and other indirect expenses will be less for sales to the parent of the venture than that incurred in the open marketplace.”
41. The amounts of XXXXX and its subsidiaries' net sales of XXXXX to XXXXX, and the percentages of those net sales as compared with total revenues of XXXXX and its subsidiaries, for the years 19YY through 19YY are set forth in the following table:
42. XXXXX also made purchases of XXXXX resin from the other producers, including XXXXX and XXXXX, at some times during 19YY through 19YY.
43. Under the terms of the Services Agreements and the XXXXX Sales Agreement, either agreement could be terminated by either party upon written notice. The Service Agreement was terminable upon three (3) months notice and the XXXXX Supply Agreement was terminable upon six (6) months notice.
44. XXXXX and XXXXX agreed to cooperate with XXXXX in making available raw materials to XXXXX, providing operating services or utilities to XXXXX, and in purchasing operating services or utilities from XXXXX. It was agreed that purchases and sales of operating services or utilities between XXXXX and its parents would be based on the recovery of actual costs.
45. XXXXX ("XXXXX"), a domestic subsidiary of XXXXX, and XXXXX entered into a Services Contract whereby XXXXX would provide research and development services, accounting and financial support, management services, and health, environment, and safety services to XXXXX, in return for reimbursement of XXXXX's costs of such services.
46. XXXXX and XXXXX entered into a Corporate Auxiliary Services Contract whereby XXXXX would provide legal services, health, environmental, and safety services, human resource services, controller's department services, treasurer's services, audit services, advanced office systems services, management service support, and research and development services to XXXXX, in return for reimbursement of XXXXX's costs.
47. XXXXX and XXXXX also entered into a Corporate Auxiliary Services Contract whereby XXXXX would provide health, environmental, and safety services, human resource services, transportation services, purchasing services, controller's department services, treasurer's services, Computer Systems Department services, advanced office systems services, marketing services, operations services, management service support, corporate quality assurance services, and Development Department services to XXXXX, in return for reimbursement of XXXXX's costs.
48. The provision of services by XXXXX for XXXXX and its subsidiary provided the infrastructure necessary for the joint venture to begin operations immediately upon the formation of the joint venture.
49. From XXXXX's creation through 19YY, XXXXX rented office space to XXXXX in XXXXX, XXXXX's corporate headquarters building, in XXXXX, XXXXX. The property was rented under the terms of the Corporate Auxiliary Services Agreement.
50. The amounts which XXXXX paid XXXXX, and
which XXXXX paid XXXXX, pursuant to the Corporate Auxiliary Services Agreement
and the Services Agreement for the fiscal years 19YY through 19YY are set forth
in the following table:
51. Subsequent to the formation of XXXXX, XXXXX continued to fabricate XXXXX film and fibers for numerous applications using XXXXX.
52. During 19YY and 19YY XXXXX agreed to sell XXXXX to XXXXX and XXXXX at market prices less a negotiated discount for volume sales and to recognize the reduced marketing expenses XXXXX would incur in making sales to XXXXX and XXXXX.
53. On or about XXXXX, 19YY, XXXXX underwent an initial public stock offering. This constituted the final step toward XXXXX's planned ultimate disposition of its XXXXX business and allowed the markets to value XXXXX's accomplishments.
54. As a result of the public offering, both XXXXX's and XXXXX's ownership interests were diluted to approximately %%%%% and XXXXX's common stock was listed on the New York Stock Exchange.
55. Following the public offering, XXXXX could elect three members and XXXXX could elect three members to XXXXX’s eleven member Board of Directors.
56. In XXXXX 19YY, after XXXXX had refused to sell its XXXXX stock to XXXXX, XXXXX threatened a hostile takeover of XXXXX if XXXXX did not agree to sell its XXXXX stock to XXXXX. As a result of the hostile takeover threat, XXXXX entered into an agreement with XXXXX to sell its XXXXX stock to them.
57. On or about XXXXX, 19YY, XXXXX sold its stock in XXXXX to XXXXX at a negotiated price of $$$$$ per share and realized a gain of $$$$$.
58. During the audit period, XXXXX did not have any operations, plants, property or employees in Utah. XXXXX did not sell XXXXX to XXXXX in Utah, but it does sell a substantial portion of its products to other Divisions of XXXXX, and such other Divisions were all part of the same legal entity and same financial enterprise (XXXXX) as XXXXX.
59. XXXXX’ ownership of XXXXX stock was intended to be and was treated as an operational function to provide materials and supplies to the various divisions of XXXXX. That source of supply served a vital function in the day-to-day operations of one or more operating divisions of XXXXX.
XXXXX' Internal Organization
60. During 19YY and 19YY, XXXXX had an organizational scheme with three divisions named XXXXX, XXXXX, and XXXXX. The divisions were not separate corporations, but were all part of the single legal entity.
61. XXXXX's corporate organization included corporate headquarters offices or departments in addition to its three divisions. Such headquarters offices and departments included the office of the president, international operations, finance and control department (which was "subdivided" into audit, banking, controller, treasurer, insurance, computer services, credit and tax), general counsel, secretary, business development department (which included research, marketing, special projects and licensing), human resources department (which included health, environment and safety services, salary planning, and recruiting), productivity management and operation services (which included distribution and supply, advanced office systems, and management support systems), and information resources. These headquarters offices and departments each provided various services to each of the three divisions of XXXXX.
62. XXXXX's general corporate departments provided services directly to the XXXXX division including preparation and issuance of payroll checks, issuance of payments to vendors, preparation of tax returns incorporating the XXXXX division's information, preparation of financial reports incorporating the XXXXX division's information, industrial relations services, and benefit administration services.
63. XXXXX's corporate legal department provided general corporate services for the XXXXX division. The lawyers in the corporate legal department were available to consult with lawyers in the XXXXX division, and that attorneys in XXXXX's corporate legal department prosecuted patents for inventions of employees of the XXXXX division.
64. Synergies existed between XXXXX's XXXXX activities and its other divisions in research and development efforts. For example, the 19YY Annual Report documents efforts of XXXXX's XXXXX (another one of XXXXX's three divisions) to integrate XXXXX composite technology into other applications. Exhibit J-16 at 23. The 19YY Annual Report, mentioning that "[t]echnical skills . . . are very often readily transferable," notes "collaborative efforts of polymer chemists at [XXXXX's] central research facility and materials scientists at XXXXX." Exhibit J-19 at 18. Likewise, efforts to develop an on-line sensor for the paper industry is described as "the combined work" of several groups, including those involved with XXXXX. Exhibit J-19 at 18.
65. Though filing returns during the audit
period in every state which imposes a corporate franchise or income tax, XXXXX
did not file any state tax return on which it accounted separately for the
income of its three divisions, i.e., the income from all three Divisions was
included on the one return of XXXXX.
66. XXXXX, as a corporation, benefits from centralized management, economies of scale, functional integration, and flows of value, and flows of products between its corporate departments and divisions.
67. XXXXX, as a corporation, conducts a unitary business which includes its XXXXX operations along with the operations of its other divisions.
68. A portion of XXXXX's unitary business is conducted in Utah.
The Utah Audit
69. The Auditing Division issued a Preliminary Notice dated XXXXX, 19YY, and a Statutory Notice of Deficiency dated XXXXX, 19YY, both of which addressed XXXXX's tax returns for calendar years 19YY, 19YY, and 19YY.
70. For calendar year 19YY, the Auditing Division did not make any adjustment to XXXXX's treatment of the XXXXX dividend as apportionable business income.
71. For calendar year 19YY, the Auditing Division disallowed XXXXX's subtraction of $$$$$ from its federal taxable income in computing net income. This subtraction was described as "Extraordinary gain on sale of entire XXXXX stockholding (%%%%%)." The Auditing Division noted that there is no statutory provision supporting XXXXX's subtraction of this gain in arriving at net income. The disallowance of this subtraction resulted in apportionable income being increased by the same amount. The Auditing Division did not make any adjustment to XXXXX's treatment of the XXXXX dividend as apportionable business income in 19YY.
72. On XXXXX, 19YY, XXXXX timely filed a Petition for Redetermination and Request for Agency Action ("Petition") with the Tax Commission.
73. On XXXXX, 19YY, the Auditing Division timely filed an Answer to XXXXX's Petition.
74. On XXXXX, 19YY, XXXXX filed an Amended Petition with the Tax Commission.
75. On XXXXX, 19YY, XXXXX made partial payment to the Auditing Division for amounts which XXXXX claimed to be uncontested.
76. On XXXXX, 19YY, the Commission issued an Order which approved a settlement which the parties had reached for the 19YY deficiency. All issues related to 19YY have now been settled.
77. The Auditing Division issued a Second Statutory Notice of Deficiency dated XXXXX, 19YY, which reflected the settlement of tax year 19YY and made a minor change in the 19YY deficiency.
78. On XXXXX, 19YY, XXXXX submitted a Third Amended Petition to the Tax Commission. XXXXX was granted permission to file the Third Amended Petition by Order dated XXXXX, 19YY.
79. During the course of the formal hearing, the parties agreed to, and the Tax Commission verbally approved, the settlement of all outstanding non-XXXXX issues in this appeal.
80. Though filing returns during the audit period in every state which imposes a corporate franchise or income tax, XXXXX did not file any state tax return on which it accounted separately for the income of its three divisions.
81. The allocable share of income sought to be taxed by Respondent has not been taxed by any other state, so the efforts of Respondent will not result in “double taxation” of any such amounts of income.
A tax is imposed at the rate of five per cent on the Utah taxable income of each domestic and foreign corporation on income derived from sources within this state. (Utah Code Ann. §59-7-104 and §59-7-201).
"Business Income" is required to be apportioned by Utah Code Ann. §59-7-303, which provides:
(1) Any taxpayer
having income from business activity which is taxable both within and without
this state shall allocate and apportion its adjusted income as provided in this
(2) Any taxpayer
having income solely from business activity taxable within this state shall
allocate or apportion its entire adjusted income to this state.
If a business operates in more than one state, the business income of that business is apportioned among the various states by the Uniform Division of Income for Tax Purposes Act ("UDITPA"). Utah Code Ann. §59-7-311, is a part of that act, and provides for the apportionment of business income to the various states based upon a three factor formula, as follows:
All business income
shall be apportioned to this state by multiplying the income by a fraction, the
numerator of which is the property factor plus the payroll factor plus the
sales factor, and the denominator of which is three.
"Business Income" is defined by Utah Code Ann. §59-7-302 as:
income" means income arising from transactions and activity in the regular
course of the taxpayer's trade or business and includes income from tangible
and intangible property if the acquisition, management, and disposition of the
property constitutes integral parts of the taxpayer's regular trade or business
"Nonbusiness Income" is defined by Utah Code Ann. §59-7-302 as:
income" means all income other than business income.
To assist in determining whether income is business income or nonbusiness income, the Commission has adopted RuleR865-6F-8, Utah Code of Administrative Procedure, which provides in relevant part, as follows:
A. Business and Nonbusiness Income Defined. Utah Code Ann. Section 59-7-302(a) defines business income as
income arising from transactions and activity in the regular course of the
taxpayer's trade or business operations.
In essence, all income which arises from the conduct of trade or
business operations of a taxpayer is business income. For purposes of administration of the Uniform Division of Income
for Tax Purposes Act, the income of the taxpayer is business income unless
clearly classifiable as nonbusiness income.
1. Non business income
means all income other than business income and shall be narrowly construed.
Income of any type or class
and from any source is business income if it arises from transactions and
activity occurring in the regular course of a trade or business. Accordingly, the critical element in
determining whether income is business income or nonbusiness income is the
identification of the transactions and activity which are the elements of a
particular trade or business. In
general all transactions and activities of the taxpayer which are dependent
upon or contribute to the operation of the taxpayer's economic enterprise as a
whole constitute the taxpayer's trade or business and will be transactions and
activity arising in the regular course of, and will constitute integral parts
of a trade or business.
The determination of whether capital gains and losses are allocable to this state is made by Utah Code Ann. §59-7-308, which provides:
To the extent that the
following constitute nonbusiness income:
(1) capital gains and
losses from sales of real property located in this state are allocable to this
(2) capital gains and
losses from sales of tangible personal property are allocable to this state if:
(a) the property had a
situs in this state at the time of the sale; or
(b) the taxpayer's
commercial domicile is in this state and the taxpayer is not taxable in the
state in which the property had a situs; and
(3) capital gains and
losses from sales of intangible personal property are allocable to this state
if the taxpayer's commercial domicile is in this state.
Parts of RuleR865-6F-8, Utah Code of Administrative Procedure, deal with the classification of specific types of income, and with respect to gains and losses from the sale of assets, it provides:
3. Business and Nonbusiness Income, Application of Definitions--The following are rules for determining whether particular income is business or nonbusiness income:
(b) Gains or Losses
from Sales of Assets. Gain or loss from
the sale, exchange or other disposition of real or tangible or intangible
personal property constitutes business income if the property while owned by the taxpayer was used in the
taxpayer's trade or business. However,
if such property was utilized for the production of nonbusiness income the gain
or loss will constitute nonbusiness income.
"Commercial Domicile" is defined by Utah Code Ann. §59-7-302, as:
domicile" means the principal place from which the trade or business of
the taxpayer is directed or managed.
RuleR865-6F-8, Utah Code of Administrative Procedure, provides the following relevant definitions:
refers to the division of business income between states by the use of a
formula containing apportionment factors.
3. Allocation refers
to the assignment of nonbusiness income to a particular state.
4. Business activity
refers to the transactions and activity occurring in the regular course of the
trade or business of a taxpayer.
Utah Code Ann.
§59-7-311 (1992) provides:
business income shall be apportioned to this state by multiplying the income by
a fraction, the numerator of which is the property factor plus the payroll
factor plus the sales factor, and the denominator of which is three.
ANALYSIS AND CONCLUSIONS OF LAW
The issue to be decided in this case is whether XXXXX's gain on the sale of its interest in XXXXX constitutes business income, a portion of which may be taxed by Utah.
The test for whether income is business income or nonbusiness income is established by Utah Code Ann. §59-7-302.
Business income is defined as:
(1) “Business income” means income arising from
transactions and activity in the regular course of the taxpayer’s trade or
business and includes income from tangible and intangible property if the
acquisition, management, and disposition of the property constitutes integral
parts of the taxpayer’s regular trade or business operations.
Most states have a provision defining business income in almost identical words, and while the number of decisions in this state are minimal, there are several decisions from other states. Those court decisions have discussed the definition of business income as containing a transactional test and a functional test. The transactional test is set forth by the words “income arising from transactions and activity in the regular course of the taxpayer’s trade or business.” The functional test is set forth by the words “includes income from tangible and intangible property if the acquisition, management and disposition of the property constitutes integral parts of the taxpayers regular trade or business operations.” Some court decisions are at variance over whether a particular form of income must meet both the transactional test and the functional test before it is classified as business income, or whether compliance with either the transactional test or the functional test is sufficient for the income to constitute business income.
This Commission has on two prior occasions had an opportunity to rule on whether both the transactional test and the functional test are required, or whether the meeting of either test is sufficient for the income to constitute business income. Those two cases are appeal numbers 90-1607 and 93-0481. In appeal number 90-1607, in a decision issued on XXXXX, 19YY, the Commission made the following statement:
further argues that both elements of the foregoing test must be met before the
income in question is “business income.”
However, in the Commission’s view, the foregoing statutory definition
only requires that either portion of the definition be met. Petitioner concedes that the personal
property in question is integral and a part of its business operations. The Commission therefore concludes that gain
on sale of such property is business income for purposes of Utah’s Corporate
Franchise and Tax Act.”
In appeal number 93-0481, the Commission also ultimately used a single factor to find that the income was business income, and stated as follows:
“Resolution of this
matter must begin with an analysis of the statute. The first phrase of the statutory definition of business income
includes “income arising from transactions and activity in the regular course
of the taxpayer’s trade or business.”
This language lends itself to a transactional analysis which focuses on
the performance of a specific function in the normal, typical, or customary
procedure of the taxpayer’s trade or business.
The second phrase
includes income from “tangible and intangible property if the acquisition,
management and disposition of the property constitutes integral parts of the
taxpayer’s regular trade or business operations.” This language lends itself to a functional test wherein all gain
from property’s business income is included if the property were used by the
taxpayer in its regular trade or business. Under this analysis the
infrequency or the extraordinary nature of the transaction is irrelevant. The transaction itself need not reflect the
taxpayer’s normal trade or business under the functional test; gain from the
sale of assets constitutes business income if the assets themselves were used
to generate business income. Under
this approach, gain or loss from the sale of a business constitutes business
income or loss if the assets sold were used by the taxpayer in its unitary
business to produce business income.” (Emphasis added)
The functional test of the business income definition looks to the relationship between the asset producing the income and the trade or business of the taxpayer, i.e. the function which the asset serves in the taxpayer's business.
Prior to the formation of XXXXX, XXXXX's XXXXX resin assets were used by XXXXX in the generation of business income. Likewise, expenses related to these assets, including depreciation of the assets, reduced XXXXX's business income. XXXXX then contributed these assets to the XXXXX joint venture in exchange for XXXXX percent of the stock of XXXXX. The XXXXX stock was much more than a passive investment to XXXXX. The XXXXX joint venture was a continuation of the prior XXXXX resin business of XXXXX and the new entity provided the vehicle for XXXXX to enhance the value of its XXXXX business through use of XXXXX's superior technology. This enhancement of value fit squarely within XXXXX stated primary business objective of enhancing the value of the assets prior to ultimate disposition. The XXXXX joint venture provided XXXXX with access to a source of XXXXX, for use in the business of XXXXX, being produced at lower costs than those previously incurred by XXXXX.
XXXXX' Chairman of the Board, President, and CEO, XXXXX, became XXXXX's Chairman of the Board, and other officers and directors of XXXXX also served on XXXXX's Board of Directors. XXXXX appointed XXXXX's President who had the primary responsibility for the worldwide operations of XXXXX. XXXXX also provided XXXXX with the necessary infrastructure to enable the joint venture to begin its operations immediately upon its formation and take advantage of an upswing in the XXXXX market. Within the meaning of the statute, XXXXX's acquisition, management, and disposition of its XXXXX assets and its interest in XXXXX, and use of the products of XXXXX, constituted integral parts of its regular trade or business operations.
The property disposed of was used by XXXXX in its regular trade or business operations. Income from the sale of business assets produces business income or loss. This meets the functional test. The income from the sale of XXXXX was business income subject to apportionment.
XXXXX has asserted that XXXXX and XXXXX must be unitary for the gain from the sale of its interest in the XXXXX joint venture to be apportioned to Utah. This assertion is without merit. As the Supreme Court has stated in Allied-Signal v. Director, Div. of Taxation, 504 U.S. 768, 119 L.Ed.2d 533 (1992), "the payee and the payor need not be engaged in the same unitary business as a prerequisite to apportionment in all cases. . . . What is required instead is that the capital transaction serve an operational rather than an investment function." 119 L.Ed.2d at 552 (footnote added). The same factors which establish a functional relationship between XXXXX and the XXXXX joint venture support the finding that the XXXXX's interest in the XXXXX joint venture also served an operational function to XXXXX. XXXXX's interest and involvement in XXXXX amounted to more than a passive investment.
In noting "the important distinction between a capital transaction which serves an investment function and one which serves an operational function," the U.S. Supreme Court cited the case of Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955), in both the Allied-Signal decision and in Container Corp. of America v. Franchise Tax Bd., 463 U.S. 159, 77 L.Ed.2d 545 (1983). The Corn Products case arose in the context of federal taxation and addressed whether gains on the sale of corn futures would be treated as ordinary income or capital gains. While literally fitting the definition of capital gains, the Court looked to the relationship between the futures and the business of the taxpayer. Since the purchases of the futures constituted an integral part of the taxpayer's manufacturing business, the Court viewed the gains as ordinary income. In citing to Corn Products in both Container and Allied-Signal, the Court emphasized the need to examine the relationship between the asset generating the income and the business of the taxpayer.
The United States Court of Claims applied the Corn Products doctrine in another federal income tax case with facts similar to those in the instant case. In Booth Newspapers v. United States, 303 F.2d 916 (Ct. Cl. 1962), two newspaper publishers had each acquired fifty percent of a paper mill for the purpose of insuring an adequate supply of newsprint. Noting the reasons for the acquisition and its relationship to the newspaper publishing business of the taxpayers, the court held that the subsequent loss on the sale of stock in the paper mill would constitute ordinary loss rather than capital loss.
XXXXX's interest in XXXXX served the business purpose of enhancing the value of the XXXXX assets prior to disposition, and also provided XXXXX with an assured source of XXXXX which it could use in its XXXXX and XXXXX manufacturing operations. Upon formation of the joint venture, XXXXX had a source of supply which was being produced using the cost-saving technology contributed by XXXXX. XXXXX would also share in the profits attributable to all of its purchases made from XXXXX. The relationship between XXXXX and XXXXX could also prove to be important in reducing the risk of breach of contract, in securing product changes which may have been required by XXXXX, and in having a source of XXXXX XXXXX in the event of shortages. XXXXX's interest in XXXXX was much different than that of a mere passive investment. It served an operational function to XXXXX's regular trade and business operations.
XXXXX has also suggested that in order for the gain to be apportioned, XXXXX would need to own more than %%%%% of the stock of XXXXX. The definition of "common ownership" as previously contained in the statute at Utah Code Ann. §59-7-302(3) (1992)(superseded January 1, 1994) had application in determining the group of corporations required to join in a combined return. XXXXX did not include XXXXX in its combined return and the Auditing Division has not asserted that XXXXX and XXXXX should be required to file a combined return. The statutory definition of common ownership has no application to the issue of whether the gain on the sale of XXXXX stock constitutes business income or nonbusiness income.
XXXXX's also asserted that its gain on the sale of XXXXX stock cannot be taxed in Utah since its interest in the XXXXX joint venture had no operational function to its XXXXX activities conducted in Utah. This argument ignores the fact that XXXXX's XXXXX activities constituted a part of XXXXX's unitary business. XXXXX has three major divisions as a unitary business within a single legal entity, and XXXXX would have the burden of proving that those three divisions were not part of a unitary business. XXXXX did not meet that burden of proof.
The tax returns which XXXXX filed in Utah elected to file as a unitary business which combined its XXXXX activities with the activities of its other divisions. XXXXX has likewise elected to file returns which combine the XXXXX activities with the activities of its other divisions in every other state imposing a filing requirement. Furthermore, XXXXX did not petition for separate accounting for its XXXXX activities, and it does not go so far as suggesting that separate returns are appropriate.
XXXXX's annual reports document synergies existing between its XXXXX activities and its other divisions in research and development efforts, as set forth in finding of fact number 59, above.
XXXXX's general corporate departments also provided other services directly to the XXXXX division including preparation and issuance of payroll checks, issuance of payments to vendors, preparation of tax returns incorporating the XXXXX division's information, preparation of financial reports incorporating the XXXXX division's information, industrial relations services, and benefit administration services. See Answers to Respondent's Second Set of Interrogatories dated XXXXX, 19YY. This evidence suggests a substantial flow of goods, services, and value between the corporate headquarters departments and the XXXXX division.
XXXXX has not introduced evidence that would support a finding that its XXXXX operations are not part of its unitary business. To the contrary, as to the one general corporate department which was discussed in any detail, it appears that XXXXX's corporate legal department provided general corporate services for the XXXXX division, that the lawyers in the corporate legal department were available to consult with lawyers in the XXXXX division, and that attorneys in XXXXX's corporate legal department prosecuted numerous patents for inventions of employees of the XXXXX division. This evidence again suggests another flow of value between the corporate headquarters and the XXXXX division.
The evidence is that XXXXX, like most other single corporate entities, is conducting an "integrated business which benefits from an umbrella of centralized management and controlled interaction." Exxon Corp. v. Wisconsin Dept. of Revenue, 447 U.S. 207, 65 L.Ed.2d 66, 81 (1980). Treating a single corporation as having more than one trade or business and attempting to split the corporation for tax purposes would, in essence, result in separate accounting.
Both of the conditions required for Utah to apportion income from the XXXXX sale are satisfied: (1) XXXXX constitutes a unitary business, part of which unitary business is conducted in Utah; and (2) the income from the XXXXX sale constitutes business income. Because both of these conditions are satisfied, the total business income from the unitary business is properly subject to apportionment.
The required relationship to support apportionment of the gain from the sale of the XXXXX joint venture is that the investment in XXXXX served an operational function to XXXXX's unitary business, a portion of which was conducted in Utah. As long as the activities being conducted in Utah constitute a part of XXXXX's unitary business, the total business income from the unitary business is properly subject to apportionment. The Supreme Court has described the theory underlying formulary apportionment as follows:
The unitary business/formula apportionment method is a very different approach to the problem of taxing businesses operating in more than one jurisdiction. It rejects geographical or transactional accounting, and instead calculates the local tax base by first defining the scope of the "unitary business" of which the taxed enterprise's activities in the taxing jurisdiction form one part, and then apportioning the total income of that "unitary business" between the taxing jurisdiction and the rest of the world on the basis of a formula taking into account objective measures of the corporation's activities within and without the jurisdiction.
Container, 77 L.Ed.2d at 553 (emphasis added). Even where the unitary business consists of multiple corporate entities, the Supreme Court has noted that "intangible 'flows of value' within the unitary group will serve to link the various members together as if they were essentially a single entity" Barclays Bank v. Franchise Tax Bd., 512 U.S. ___, 129 L.Ed.2d 244, 258 fn. 10 (1994). In this case, all of the divisions of XXXXX are a legal, practical, and actual single entity.
XXXXX has asserted that treating its gain as apportionable business income and applying the three factor formula of UDITPA would result in distortion. As noted by the U.S. Supreme Court, "[o]ne who attacks a formula of apportionment carries a distinct burden of showing 'by clear and cogent evidence' that it results in extraterritorial values being taxed." Butler Brother v. McColgan, 315 U.S. 501, 86 L.Ed. 991, 996 (1942), citing to Norfolk & W.R. Co. v. North Carolina, 297 U.S. 682, 688 (1935). XXXXX has not met that burden of proof.
In claiming distortion, XXXXX suggests that the tax imposed under the audit varies greatly from that which would be calculated under a separate accounting approach. Its expert witness, Mr. XXXXX, described an attempt to separately account for the income earned from XXXXX's Utah operations only. Mr. XXXXX's exhibit illustrating his approach was offered as "primarily an illustration" and was received "almost in the nature of a hypothetical." Tr. at 525 and 528. On cross-examination, Mr. XXXXX admitted: (1) that he had not conducted a "full audit" in preparing his illustration, (2) that in the preparation of his illustration, he had relied on information provided by XXXXX employees who did not testify as witnesses at the formal hearing, and (3) that he had resorted to the use of a formula to apportion certain items of income and expense at least five times in the preparation of his illustration since certain accounting records were not available and it was not possible for him to determine exact amounts of certain items related to XXXXX operations "seven years after the fact." Tr. at 571- 589.
Even if XXXXX had been able to present a more accurate separate accounting analysis, the Supreme Court has previously noted the problem in relying on such an approach to establish distortion. In Container, supra, the taxpayer challenged California's application of the three factor formula on the grounds that it failed to recognize that the taxpayer's foreign subsidiaries were significantly more profitable than the domestic parent. The Court responded:
The problem with this argument is obvious: the profit figures relied on by appellant are based on precisely the sort of formal geographical accounting whose basic theoretical weaknesses justify resort to formula apportionment in the first place. Indeed, we considered a very similar argument in Mobil, pointing out that whenever a unitary business exists, "separate [geographical] accounting, while it purports to isolate portions of income received in various States, may fail to account for contributions to income resulting from functional integration, centralization of management, and economies of scale. Because these factors of profitability arise from the operation of the business as a whole, it becomes misleading to characterize the income of the business as having a single identifiable 'source.' Although separate geographical accounting may be useful for internal auditing, for purposes of state taxation it is not constitutionally required."
103 S.Ct. at 2948-2949, quoting Mobil Oil Corp. v. Commissioner of Taxes of Vermont, 445 U.S. 425, 438 (1980) (emphasis added).
XXXXX's cites the case of Hans Rees' Sons, Inc. v. North Carolina ex rel. Maxwell, 283 U.S. 123 (1931), in support of its contention that apportioning its gain on the sale of XXXXX using UDITPA's three factor formula would result in distortion. In Hans Rees', the court was evaluating an apportionment fraction based on the single factor of the ownership of tangible property within the state and found such a formula to be problematic under the facts of that particular case.
Several years after Hans Rees, in the case of Butler Brothers v. McColgan, supra, a taxpayer attempting to rely on the Hans Rees' rationale argued that California was improperly attempting to convert a loss into a profit. In that case, California had applied a three factor formula to all of the income from the taxpayer's unitary business in determining that the taxpayer should pay tax on $93,500 of income. By employing separate geographical accounting, the taxpayer asserted that it incurred a loss in California of $82,851. The court, in upholding the assessment, held that "the results of the accounting system employed by appellant do not impeach the validity or propriety of the formula which California has applied here." 86 L.Ed. at 996.
Likewise, in Exxon, supra, the taxpayer's separate state accounting methods resulted in losses in the amount of $821,320 for 1965, $1,159,830 for 1966, $1,026,224 for 1967, and $919,575 for 1968. The Wisconsin Department of Revenue asserted that rather than losses, the taxpayer should report taxable income of $4,532,155 for the four year period based on formulary apportionment applied to the total income of the unitary business.
The court stated:
Exxon contends that Moorman
sanctions the use of separate functional accounting in order to prove the
extraterritorial reach of a state tax statute, and that its accounting in this
case demonstrates that the Wisconsin Supreme Court's application of the state
apportionment statute violates the Due Process Clause.
We cannot agree. As this Court has on several occasions recognized, a company's internal accounting techniques are not binding on a State for tax purposes.
65 L.Ed.2d at 79-80.
The three factor formula employed by UDITPA has withstood attack under Hans Rees' distortion analysis. For example, in Container, supra, the Supreme Court stated:
not only has the
three-factor formula met our approval, but it has become . . . something of a
benchmark against which other apportionment formulas are judged.
. . . .
The three-factor formula used by California has gained wide approval precisely because payroll, property, and sales appear in combination to reflect a very large share of the activities by which value is generated. It is therefore able to avoid the sorts of distortions that were present in Hans Rees' Sons, Inc.
77 L.Ed.2d at 564-565.
XXXXX, through the testimony of Mr. XXXXX and his effort to try to separately account for the income earned in the Utah Operations of XXXXX, has attempted to show the alleged distortion. However, it is clear both in fact and as decided in prior U.S. Supreme Court rulings, that attempts at separate accounting are not successful in demonstrating distortion. Further, not only is separate accounting not successful at demonstrating distortion, but it is also not the solution to any distortion which may exist. The proposals of Mr. XXXXX such as his suggestion to treat the perceived distortion were based largely on separate accounting concepts. Those proposals are not lawful because they are not based upon the Utah statutorily required apportionment formula. Those proposed solutions also do not accurately calculate any possible distortion, and they would not achieve a legally permissible solution to any such possible distortion. If an apportionment formula, such as the UDITPA three factor formula, results in distortion, the normal relief would be “factor relief” by modifying one of the three factors, or by including other factors. Those alternatives were not proposed by Mr. XXXXX, and there is testimony or evidence upon which such factor relief could be fashioned.
As noted above and by the U.S. Supreme Court, “[o]ne who attacks a formula of apportionment carries a distinct burden of showing ‘by clear and cogent evidence’ that it results in extraterritorial values being taxed.” Butler Brother v. McColgan, 315 U.S. 501, 86 L.Ed. 991, 996 (1942), citing to Norfolk & W.R. Co. v. North Carolina, 297 U.S. 682, 688 (1935). Petitioner has not presented clear and cogent evidence that extraterritorial values are being taxed. XXXXX has not met that burden of proof.
XXXXX attempts to argue the issue as to the proper treatment of dividends received from XXXXX in 19YY and 19YY. It argues that such dividends should be treated as nonbusiness income. Since it treated such dividends as business income on its returns, it now asserts that it should be entitled to a refund of taxes paid on such dividends. This issue was not raised in XXXXX's original Petition for Redetermination or any of its subsequent amendments. Having not been raised in an original or amended petition for redetermination, the issue is not properly before the Commission in connection with this appeal. Moreover, this issue does not arise in connection with this audit. The Auditing Division made no adjustments to the treatment XXXXX had given the XXXXX dividends. XXXXX, in filing its returns, treated the dividends as business income subject to apportionment. It has not attempted to alter this treatment by timely filing amended returns.
XXXXX is beyond the statute of limitations for seeking any refund of taxes paid in connection with the XXXXX dividends. Utah Code Ann. § 59-7-141 (renumbered §59-7-522 as of January 1, 1994) provides that no credit or refund of a tax overpayment "shall be allowed or made after three years from the time the tax was paid, unless before the expiration of such period a claim therefor is filed with the commission by the taxpayer." Having filed its 19YY and 19YY returns in 19YY and 19YY respectively, more than seven years has elapsed from the time the tax relating to the dividends was paid by XXXXX. There is no evidence of a claim having been made for credit or refund within the three year statute of limitations period.
a final note, XXXXX based almost all of its arguments and evidence upon the
assumption that the unitary business was the XXXXX Division, whereas it is
clear that the unitary business includes at least the three major divisions of
XXXXX. It may have been possible for
XXXXX to create separate legal entities for each of its three major divisions,
and to possibly have removed the functional integration, centralization of
management, and economies of scale which were present in the three major
divisions which formed the unitary business.
If XXXXX had taken those actions, then it is very possible that the
results of this proceeding would be different.
However, XXXXX did not take those actions and it should not be taxed as
though it had taken such actions.
The gain realized by XXXXX on the sale of XXXXX stock is properly treated as apportionable business income, satisfying the functional test of the statutory definition. As apportionable income, the gain is properly apportioned on the basis of the UDITPA three-factor formula as determined by the Auditing Division. XXXXX has failed to carry its distinct burden of showing by clear and cogent evidence that the application of the statutory formula results in extraterritorial values being taxed. The determination of the Auditing Division is affirmed and the petition for redetermination is denied. It is so ordered.
DATED this 19th day of September, 1996.
BY ORDER OF THE UTAH STATE TAX COMMISSION.
W. Val Oveson Roger O. Tew
Joe B. Pacheco Alice Shearer
NOTICE: You have twenty (20) days after the date of a final order to file a Request for Reconsideration with the Commission. If you do not file a Request for Reconsideration with the Commission, have thirty (30) days after the date of a final order to file a.) a Petition for Judicial Review in the Supreme Court, of b.) a Petition for Judicial Review by trial de novo in district court. (Utah Administrative Rule R861-1A-5(P) and Utah Code Ann. §§59-1-601(1),63-46b-13 et. seq.)