BEFORE THE UTAH STATE TAX COMMISSION
Petitioner, ) FINDINGS OF FACT,
: CONCLUSIONS OF LAW, AND
v. ) FINAL DECISION
AUDITING DIVISION OF THE ) Appeal No. 93-0004
UTAH STATE TAX COMMISSION, :
) Serial No. XXXXX
Respondent. ) Tax Type: Corporate/Income
STATEMENT OF CASE
This matter came before the Utah State Tax Commission for a Formal Hearing on XXXXX, 19YY. G. Blaine Davis, Administrative Law Judge, heard the matter for and on behalf of the Commission. Present and representing Petitioner were Mr. XXXXX and Ms. XXXXX from the law firm of XXXXX in XXXXX, XXXXX, together with Mr. XXXXX and Ms. XXXXX. Present and representing Respondent were Mr. XXXXX, Assistant Utah Attorney General, together with Mr. XXXXX, Mr. XXXXX and Mr. XXXXX from the Auditing Division.
Based upon the evidence and testimony presented at the hearing, the Tax Commission hereby makes its:
FINDINGS OF FACT
1. The tax in question is corporation franchise and income taxes.
2. The period in question is the year ended XXXXX, 19YY.
3. The XXXXX ("XXXXX") petitioned the Tax Commission to make a redetermination of the Auditing Division's assessment of a corporate franchise tax deficiency against XXXXX for the 19YY tax year.
4. The Auditing Division apportioned XXXXX's capital gains income earned from the final sale of its ownership of XXXXX ("XXXXX").
5. XXXXX realized a net capital gain of $$$$$ from the second sale of XXXXX stock. After deducting certain capital losses from that amount, XXXXX reported a total net capital gain of $$$$$ on its 19YY Utah Corporate Franchise Tax return. XXXXX classified the capital gains income as "nonbusiness income" and excluded that income from apportionment between all of the states in which XXXXX does business, including Utah.
6. The Auditing Division reclassified income from the "second sale" of XXXXX stock as "business income" and assessed the corporate franchise tax on the apportioned basis of the income. This apportionment of the capital gains income from the second sale is consistent and uniform with the tax treatment of the apportionment of the capital gains income from XXXXX's sale of the first %%%%% of its XXXXX ownership. The treatment of the capital gains income by the Auditing Division assigns a portion of the gain on the sale of the XXXXX stock to the state of Utah based upon the standard three factor UDITPA (Uniform Division of Income for Tax Purposes Act) formula contained in Utah Code Ann. '59-7-311. This formula apportioned the gain to Utah in the same ratio as other business income was apportioned to the state of Utah. The position of XXXXX is that the capital gains income on the sale of XXXXX stock is "non-business" income which is all allocable to its state of commercial domicile, which is XXXXX.
7. The Auditing Division sent a Preliminary Notice to XXXXX on XXXXX, 19YY, assessing a franchise tax deficiency for the year ending XXXXX, 19YY. A Statutory Notice was sent on XXXXX, 19YY. The amount of the tax deficiency assessed by the Auditing Division is $$$$$. In addition to the tax deficiency of $$$$$, the Auditing Division assessed XXXXX interest of $$$$$ on the deficiency. Additional interest has accrued at the statutory rate.
8. On XXXXX, 19YY, XXXXX acquired all of the stock of XXXXX, pursuant to a Stock Purchase Agreement among XXXXX, XXXXX and XXXXX. Therefore, XXXXX owned %%%%% of the stock of XXXXX from XXXXX, 19YY to XXXXX, 19YY.
9. XXXXX is, and for several decades has been, engaged in the primary business of retail convenience store marketing, of which petroleum retailing is a part in some locations. In 19YY, XXXXX's operations included ##### convenience stores (primarily XXXXX stores) in the United States and Canada, XXXXX and XXXXX, ##### XXXXX stores, ##### multi-pump self serve XXXXX outlets, ##### distribution centers, and ##### food processing centers. In 19TT, XXXXX transferred, as a dividend, ##### XXXXX XXXXX stores to XXXXX.
10. Between 19YY and 19YY, one of the operations of XXXXX was the refining, marketing, transportation and distribution of petroleum products through its %%%%% owned subsidiary, XXXXX. Between 19YY and 19YY, one of the operations of XXXXX continued to be the refining, marketing, transportation and distribution of petroleum products through its %%%%% owned subsidiary, XXXXX.
11. When XXXXX originally purchased and acquired XXXXX, it did so with a business purpose of XXXXX being an integral part of the regular trade and business of XXXXX. Part of the business purpose was to assure itself of a reasonable supply of numerous petroleum products at a reasonable prices. It also would be able to benefit by the additional profits that would be earned by XXXXX on the sales by XXXXX. The existing XXXXX convenience stores would also provide a quick, convenient and easy way to expand and increase the number of outlets selling XXXXX products. The success of that strategy is demonstrated by the large profit earned on the sale of XXXXX stock.
12. XXXXX managed XXXXX as a part of XXXXX's unitary business operations until it sold %%%%% of XXXXX to XXXXX in 19YY. After selling %%%%% of its XXXXX holding, XXXXX's original motivations for purchasing XXXXX remained. Selling motor fuels continued to be an integral part of XXXXX's business operations, providing approximately %%%%%% of XXXXX's gross sales. XXXXX continued to purchase approximately %%%%% of its motor fuel requirements from XXXXX, and to sell at its convenience stores between %%%%% and %%%%% (%%%%%-%%%%%) of the total product sales of XXXXX. The business of XXXXX and XXXXX were therefore significantly integrated.
13. XXXXX did not submit any evidence to demonstrate that its motivation for purchasing and owning XXXXX changed from 19YY to 19YY.
14. The purchase of XXXXX provided XXXXX with a source of petroleum products to expand the XXXXX retailing component of its XXXXX retail convenience stores, and provided XXXXX with a substantial and guaranteed market for some of its refined petroleum products. Between 19YY and 19YY, XXXXX purchased approximately %%%%% of its XXXXX needs from XXXXX. In 19YY, XXXXX and the XXXXX Supply division supplied approximately %%%%% of XXXXX's retail XXXXX requirements.
15. From at least 19YY, XXXXX has owned and maintained its own facilities, including its headquarters in XXXXX, XXXXX.
16. XXXXX is primarily engaged in the business of refining and marketing XXXXX products, including XXXXX, XXXXX and other XXXXX, XXXXX, XXXXX and approximately ##### types of XXXXX.
17. From at least 19YY, XXXXX has owned and maintained its own facilities, including its headquarters in XXXXX, XXXXX.
18. From XXXXX, 19YY, until XXXXX sold %%%%% of its interest in XXXXX on XXXXX, 19YY, XXXXX and XXXXX filed unitary state tax returns in the state of Utah and other states. After the first sale, XXXXX and XXXXX did not file Utah and other state tax returns on a combined basis because they were not under "common ownership" (more than 50% ownership) as that term is defined for purposes of the Utah combined reporting statutes. (Utah Code Ann. '59-7-302-(3)). However, in 19YY and 19YY, XXXXX realized dividends from XXXXX of $$$$$ and $$$$$, respectively. XXXXX apportioned the required portion of those dividends to Utah as business income in its 19YY and 19YY Utah Corporate Franchise Tax Returns. The amount apportioned to Utah was determined by the standard UDITPA three factor formula provided by Utah Code Ann. '59-7-311. That apportionment was a tax benefit to XXXXX for those years because XXXXX suffered net operating losses from its operations for those years. The dividend income from XXXXX for those years was applied to the net losses which resulted in a reduced net loss for those years. Those losses were then apportioned to Utah. It also resulted in XXXXX not paying any taxes to Utah or the other states on $$$$$ of dividend income in 19YY and 19YY.
19. On XXXXX, 19YY, XXXXX sold %%%%% of the stock in XXXXX to a subsidiary of XXXXX -- the XXXXX ("XXXXX") (the "first sale").
20. XXXXX is, and from at least 19YY, has been engaged in exploration and production of XXXXX.
21. XXXXX and PDVSA,the %%%%% shareholders of XXXXX, have been completely unrelated businesses.
22. From at least 19YY, XXXXX and XXXXX have participated in some, but not the full range, of the activities of the XXXXX industry. XXXXX has been engaged in the refining, transportation and marketing activities. XXXXX has been engaged in only marketing activities.
23. From at least 19YY, XXXXX and XXXXX have participated in the full range of XXXXX industry activities ranging from exploration for XXXXX reserves to production, refining, transportation and marketing of XXXXX and XXXXX products. XXXXX has been engaged in exploration and production activities. XXXXX has been engaged in refining, transportation and marketing activities.
24. As a condition to closing the first sale, XXXXX and XXXXX entered into a Product Purchase Agreement (the "PPA"). The PPA states that XXXXX will purchase and XXXXX will sell specified volumes of XXXXX based on prices reported in a daily pricing survey of XXXXX for the market areas where the XXXXX are lifted on the date of delivery. The PPA also calls for the sale of any additional, incremental volumes that XXXXX requires if, and only if, XXXXX can sell such incremental volumes at a profit. Sales and purchases under the PPA were to continue for XXXXX (#####) years unless terminated by either party upon six (6) months notice after XXXXX sells its XXXXX stock.
25. The daily pricing survey used to price XXXXX sold under the PPA is the Oil Price Information Service ("OPIS"). OPIS is a pricing index widely used in the XXXXX industry. Its compilation and publication is performed in a manner making the index completely independent, and wholly beyond influence or control by XXXXX.
26. The PPA also provides that XXXXX will pay XXXXX for the ordering, dispatch and transportation functions and that the fee for such service will be equal to the published tariffs of licensed common carriers of XXXXX in the respective areas to deliver the XXXXX from the relevant terminals to the respective destination points. The published tariffs are arm's-length charges.
27. In order to ensure that XXXXX is able to obtain additional incremental volumes at a fair price, the PPA provides that upon ninety (90) days notice XXXXX may request XXXXX to act as XXXXX's processing agent to order and deliver spot purchases of incremental volumes, up to ##### gallons per month, of XXXXX from third party suppliers, and in return XXXXX will receive a commission for its buying services.
28. In the event of product shortages, the PPA subjects XXXXX to ratable cutbacks in supply on terms similar to those applied to other XXXXX customers during periods of XXXXX and
XXXXX shortages. Between 19YY and 19YY, the PPA provision requiring ratable cutbacks in the event of product shortages was never triggered and the supply of XXXXX from XXXXX was never reduced.
29. As a condition to closing the first sale, XXXXX and XXXXX entered into a #####-year XXXXX contract under which XXXXX supplies XXXXX to XXXXX at prices based on refined product prices.
30. Following the first sale, XXXXX continued to purchase approximately %%%%% of its fuel requirements from XXXXX, and XXXXX sold %%%%% to %%%%% of its total output to XXXXX.
31. At the time of the first sale, XXXXX's XXXXX refinery was well-suited for the processing of XXXXX produced by XXXXX.
32. After the first sale, XXXXX XXXXX accounted for approximately %%%%% of the XXXXX refined in the XXXXX refinery.
33. After the first sale, XXXXX continued to display the XXXXX name and utilize XXXXX card terminals for the sale of XXXXX in XXXXX's XXXXX stores. By 19YY, there were over one million active "XXXXX" credit card accounts. These accounts could be used to finance limited purchases of XXXXX and merchandise at XXXXX stores.
34. Simultaneous with the first sale, XXXXX's by-laws were amended. Under the amended by-laws, each %%%%% owner (i.e. XXXXX and XXXXX) was allowed three designees on XXXXX's Board of Directors. XXXXX therefore appointed three of the six directors of XXXXX. XXXXX appointed the three other directors. The XXXXX board members appointed by XXXXX had previous experience with both XXXXX and XXXXX operations. One of XXXXX's appointees, XXXXX was a previous president of XXXXX and Vice President of XXXXX. Two of the board members appointed by XXXXX to XXXXX's board were interlocking for two years, i.e., they served on the Boards of directors for both XXXXX and XXXXX. One of the board members appointed by XXXXX was interlocking, i.e., served on both Boards of Directors for the entire period after the first sale in 19YY, until XXXXX's complete divestiture of XXXXX in 19YY. The vote of four directors was required for any action. Accordingly, no board action desired by XXXXX could be taken by the directors appointed by XXXXX without the consent of at least one of the directors appointed by XXXXX, and no board action desired by XXXXX could be taken by the directors appointed by XXXXX without the consent of at least one of the directors appointed by XXXXX.
35. Neither XXXXX nor the directors appointed by XXXXX had any power to change XXXXX's by-laws or Articles of Incorporation without the consent of XXXXX or one or more of the directors appointed by XXXXX. Similarly, neither XXXXX nor the directors appointed by XXXXX had any power to change XXXXX's by-laws or Articles of Incorporation without the consent of XXXXX or one or more of the directors appointed by XXXXX.
36. Pursuant to the new XXXXX by-laws, after the new Board of Directors was designated following the first sale, the new Board of Directors had the ability to create one class committee, composed of one XXXXX and two XXXXX designees (who were members of the Board of Directors) to deal with XXXXX-XXXXX matters and another similar class committee, composed of one XXXXX and two XXXXX designees (who were members of the Board of Directors), to deal with XXXXX-XXXXX matters. The class committees were designated to ensure that all arrangements between XXXXX and either XXXXX or XXXXX after the first sale were fairly negotiated and conducted at arm's length.
37. Pursuant to the new XXXXX by-laws, the class committees were granted authority to take action in connection with (I) the modification, amendment, termination, assertion of rights, resolution of disputes, institution or settlement of litigation or similar proceedings, or waiver of rights by XXXXX under, or in connection with, any contract or arrangement between XXXXX and either XXXXX or XXXXX; (ii) indemnification by XXXXX of directors appointed by either XXXXX or XXXXX; and (iii) the right of first refusal to purchase the shares of XXXXX stock offered for voluntary disposition by either XXXXX or XXXXX.
38. Although the by-laws of XXXXX created class committees to deal with potential problems, those class committees were never utilized and were never required to make any decisions.
39. At all times after the first sale until XXXXX, 19YY, when XXXXX sold its remaining %%%%% interest in XXXXX:
a. No action was ever taken by a class committee of XXXXX;
b. The day-to-day operational authority over XXXXX matters was granted to the executive officers of XXXXX;
c. Approval of the XXXXX Board of Directors was required for certain non-day-to-day actions taken by XXXXX, including:
(1) Capital projects involving expenditures over $$$$$ and capital expenditures over $$$$$ not otherwise contemplated in the approved annual capital budget, which exceeded %%%%% of such budget;
(2) With respect to large capital projects previously approved by the Board of Directors, expenditures exceeding %%%%% of the amount approved by the Board of Directors in the annual capital budget;
(3) Amendment, modification, termination, suspension of material operations or waiver of any material rights under contracts relating to XXXXX's interest in or obligations with respect to the certain specified entities:
(4) Entry into contracts providing for:
(a) the issuance of securities, or
(b) the acquisition, sale or encumbrance of
(I) material assets (other than in the ordinary course of business),
(ii) shares of any subsidiary of XXXXX by XXXXX, any subsidiary of XXXXX or any Operated Joint Enterprise, or
(c) the sale or encumbrance of fee owned or leased product terminal, and
(5) Entry into contracts or commitments or other actions which constitute a material deviation from the current operating plan or operating budget of XXXXX:
d. XXXXX and XXXXX had no common executive officers, operational officers or personnel;
e. XXXXX and XXXXX had at most two directors in common and after XXXXX 19YY, had only one common director;
f. Neither XXXXX nor XXXXX had the power to unilaterally control XXXXX's Board of Directors;
g. Neither XXXXX nor XXXXX had the power to unilaterally control XXXXX's operations, policies, or procedures.
h. No management contract existed between XXXXX and XXXXX;
I. XXXXX and XXXXX had no common employee training programs;
j. Neither XXXXX nor XXXXX provided XXXXX with corporate policies or guidelines but, did as shareholders, appoint three members each to XXXXX's Board of Directors;
k. Neither XXXXX nor XXXXX had the ability to unilaterally control the policy decisions of XXXXX.
l. Other than the specific services performed under the PPA by XXXXX on behalf of XXXXX for which XXXXX was paid an arm's-length price, XXXXX and XXXXX separately performed all of their own legal services, tax service, financial services, insurance programs, purchasing services, contracting services and auditing services;
m. There were no inter-company employee transfers between XXXXX and XXXXX; however, approximately ##### individuals who were employed by XXXXX but performed services primarily for XXXXX before the first sale were terminated by XXXXX in connection with the first sale and were presumably re-hired by XXXXX;
n. No XXXXX officer or department was responsible for overseeing any aspect of XXXXX's day-to-day operations, although two executive officers of XXXXX were appointed to XXXXX's Board of Directors from XXXXX 19YY to XXXXX 19YY; after 19YY, only one executive officer of XXXXX was appointed to XXXXX's Board of Directors. Such director(s) provided Board input by voting on non-day-to-day actions of XXXXX.
o. XXXXX's officers and personnel made all of XXXXX's day-to-day operational decisions as well as its long-term decisions without consulting XXXXX, although XXXXX did appoint three members to XXXXX's Board of Directors who provided Board input by voting on non-day-to-day actions of XXXXX.
p. Neither XXXXX nor XXXXX had the power to unilaterally control XXXXX's capital expenditures or XXXXX's incurrence of debt.
q. XXXXX and XXXXX maintained separate insurance programs, employee benefit and retirement plans, although there was a transitional period from XXXXX 19YY through XXXXX 19YY, when certain XXXXX employees were allowed to participate in a XXXXX benefit plan, with XXXXX's costs related to those employees being reimbursed by XXXXX.
r. No real property leases existed between XXXXX and XXXXX.
s. The only equipment leases between XXXXX and XXXXX were a sublease or assignment from XXXXX to XXXXX at fair market (flow-through) value of some XXXXX equipment related to a pre-existing contract with XXXXX and the lease from XXXXX to XXXXX at fair market value of credit card verification equipment used in some XXXXX stores pursuant to the Credit Card Agreement between XXXXX and XXXXX dated as of XXXXX, 19YY.
t. XXXXX did not make any bulk purchases on behalf of XXXXX and did not provide XXXXX with any central purchasing services.
u. The activities that occurred between XXXXX and XXXXX were primarily sales of XXXXX products from XXXXX to XXXXX in accordance with the PPA at arm's-length contract prices published in a trade publication over which neither party had control.
v. XXXXX never filed a combined reporting tax return in any state claiming XXXXX as part of XXXXX's unitary business, although (as stated above in paragraph 6) it did file unitary state tax returns in Utah and other states prior to XXXXX, 19YY.
40. In XXXXX 19YY, XXXXX was taken private in a leveraged buyout transaction (the "LBO") and announced plans to concentrate its efforts on its convenience retailing business.
41. From 19YY to 19YY, as a result of the LBO, XXXXX experienced severe financial problems. It entered into a divestiture plan under which it sold the XXXXX Group, the XXXXX Division, XXXXX, XXXXX, XXXXX, XXXXX, XXXXX, and XXXXX. XXXXX also sold real estate holdings and stores during that period.
42. After the 19YY LBO, XXXXX's ability to exercise control over its interest in XXXXX was restricted by LBO debt covenants.
43. On XXXXX, 19YY, partly as a result of its financial problems, XXXXX sold its remaining %%%%% interest in XXXXX to XXXXX, a wholly owned subsidiary of XXXXX (the "19YY sale" or the Asecond sale@). At that time, XXXXX was on the verge of bankruptcy and was having significant difficulties trying to pay its debts. The divestiture of the other holdings and the second sale of the last 50% of XXXXX was an attempt by XXXXX to save its convenience store business. The disposition of XXXXX served a significant business purpose by providing the necessary capital in a manner that would still protect the source of supply for XXXXX products at a reasonable price.
44. The basic terms of the PPA were not amended as a result of the 19YY sale, and remain in effect today. The primary change to the PPA that was amended at the time of the 19YY was to allow either XXXXX or XXXXX to terminate the PPA upon the other party's bankruptcy. Although XXXXX later filed for Chapter 11 bankruptcy in XXXXX 19YY, which activated the permissive termination provision in 19YY, XXXXX elected not to terminate the PPA.
45. Arm's-length transfers of product from XXXXX to XXXXX under the PPA continue to today even though XXXXX now has no ownership interest in XXXXX.
46. Based on the 19YY sale, XXXXX realized a capital gain for federal income tax purposes of $$$$$ on the XXXXX shares XXXXX held for almost XXXXX (#####) years.
47. XXXXX has other arm's-length long-term contracts for its convenience store operations with unrelated parties. For example, XXXXX has long-term contracts of XXXXX (#####) years or longer with the XXXXX and XXXXX for the purchase of products to be sold in XXXXX's convenience stores. The ATM automatic teller system provided to XXXXX's retail convenience stores is also under a long-term arm's length contract with a third party.
48. In the early 19YY=s, a general trend began to add XXXXX pumps to convenience stores. In the 19YY's, XXXXX stations began to move into the convenience store market. The acquisition of XXXXX by XXXXX in 19YY was reflective of those trends. By 19YY, XXXXX sold XXXXX branded XXXXX and other products at approximately ##### of its ##### XXXXX stores.
49. Petitioner has not challenged the fairness or unreasonableness of the standard UDITPA three factor formula used to apportion a share of the business income to Utah, and Petitioner has also not challenged the correctness of the calculation of the amount apportioned to Utah by Respondent. Petitioner=s primary challenge is that the gain on the sale of the stock is not apportionable.
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 (1990), which provides, in relevant part:
(1) When the income of a taxpayer subject to the tax imposed under this part is derived from or attributable to sources both within and without the state the tax shall be measured by the net income derived from or attributable to sources within this state in accordance with this chapter.
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 allocation 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:
(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.
"Nonbusiness Income" is defined by Utah Code Ann. '59-7-302 (1990), as:
(7) "Nonbusiness income" means all income other than business income.
To assist in determining whether income is business income or nonbusiness income, the Commission has adopted Rule R865-6F-8 (in 1990, Rule R865-6-8F), 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.
2. The classification of income by the labels occasionally used, such as manufacturing income, compensation for services, sales income, interest, dividends, rents, royalties, gains, operating income, nonoperating income, etc., is of no aid in determining whether income is business or nonbusiness. 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 (1990), which provides:
(1) Capital gains and losses from sales of real property located in this state are allocable to this state:
(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 Rule R865-6F-8 (in 1990 R865-6-8F), 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:
(2) "Commercial domicile" means the principal place from which the trade or business of the taxpayer is directed or managed.
Rule R865-6F-8(B) (in 1990, R865-6-8F), Utah Code of Administrative Procedure, provides the following relevant definitions:
2. Apportionment 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.
As was stated in the Findings of Fact, the Auditing Division reclassified the income from the "second sale" of XXXXX stock as "business income" and assessed the corporate franchise tax on the apportioned basis of the income. If the income from that second sale is "business income", then the determination of the Auditing Division is correct and the assessment should be sustained. If the income from the second sale is "nonbusiness income" then such income is all assigned to the state of the commercial domicile for XXXXX, which is presumably the state of XXXXX.
The tests for whether income is business income or nonbusiness income are established by Utah Code Ann. '59-7-302 which provides:
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 normally 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 normally 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." The parties and 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:
"The Petitioner 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 the 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)
In comparing the facts of the present case with prior decisions from this Commission, it is evident that the business of XXXXX and the business of XXXXX were so intertwined and inter-related that it clearly complied with the functional test as set forth by the statutes of the state of Utah. It is arguable, as Petitioner has argued, that the sale of the stock was not the taxpayer's normal trade or business. While the sale of the stock may have been an infrequent transaction and one of an extraordinary nature, that is irrelevant. The gain from the sale of the assets constitutes business income if the assets themselves were used to generate business income. The assets which were sold, namely the XXXXX operations of XXXXX, were clearly themselves used to generate business income for XXXXX where %%%%% of the total sales of XXXXX constituted sales of the products of XXXXX.
Petitioner has also argued that even if the Commission accepts either the transactional test or the functional test as sufficient to meet the statutory definition of business income, the transaction at issue did not comply with the statute. It is the argument of the Petitioner that even if the acquisition and management of the stock of XXXXX was an integral part of the taxpayer's regular trade or business, the disposition of the property was not an integral part of the taxpayer's regular trade or business operations. The Commission rejects that argument. Where XXXXX was having such substantial financial difficulties and was on the verge of bankruptcy, the disposition of the XXXXX stock was a desperation effort to try to save the core business of XXXXX from financial destruction. Without the sale of the XXXXX stock, the corporation (XXXXX) and its many businesses may have ceased to exist. As it was, the sale of the XXXXX stock was one of the factors which enabled XXXXX to continue its business operations.
In addition, where the acquisition and management of XXXXX was an integral part of the taxpayer=s regular trade or business, then the XXXXX stock constituted a business asset and not just a casual investment. The sale of a business asset will create either business gain or business loss which must be included with other business income for apportionment purposes.
The Commission has previously ruled on this concept in Appeal No. 93-0481, referred to above. In that case, a company incorporated in XXXXX, but doing business in Utah and other western states, sold all of the assets of the corporation and claimed that it was a nonbusiness transaction which created nonbusiness income under the transaction test. The Commission stated in its opinion:
AThe 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.@
This case clearly meets the test set forth above in Appeal No. 93-0481. XXXXX was a business asset of XXXXX. XXXXX had included the dividends from XXXXX as business income on its Utah tax returns. Therefore, the sale of the business asset created business income, and the disposition of the business asset constituted an integral part of the taxpayer=s regular trade or business.
Accordingly, the Commission finds and concludes that the acquisition, management and disposition of the XXXXX assets constituted integral parts of the taxpayer's regular trade or business operations. The gain on the disposition of those assets is business income.
This finding is bolstered by Rule R865-6F-8, which provides, "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." The Commission finds that the Petitioner has failed to meet its burden of proof to establish that the income was clearly classifiable as nonbusiness income. Therefore, pursuant to the rule, the income is business income.
Petitioner has further argued that even if the statutes and rules of the state of Utah can be interpreted to tax the second sale of the XXXXX stock, decisions from the United States Supreme Court impose a limit upon the state's ability to impose the tax at issue. It is true that the United States Supreme Court has, through numerous cases, attempted to strike a balance between the competing interests of the power of the various states to tax a corporation's activities, and the need to promote interstate commerce and not discourage corporations from operating and trading freely by any excessive taxation. The primary case at issue is Allied Signal, Inc. v. Director, Division of Taxation, 119 L.Ed.2d 533, (1992). Through a number of cases, the United States Supreme Court has suggested a number of fact situations which point to a unitary relationship between two or more companies. In those cases, the court has identified three primary factors to use in determining a unitary relationship, which are functional integration, centralization of management, and economies of scale. Petitioner has suggested that those factors are not present in this case, and therefore the businesses were not unitary, so even if the income is business income, it would not be taxable by the state of Utah. The Supreme Court decisions have clarified that a business need not be unitary for its income to be apportioned. The United States Supreme Court has also made it clear that the three factor tests of functional integration, centralization of management, and economies of scale are not the only methods to be used, or analysis used, in determining whether a state may apportion income.
One of the additional factors which can be used to determine possible apportionment is to determine when the capital transaction serves an operational function rather than an investment function. Allied Signal, Inc. v. Director, Division of Taxation, supra, at 552. In setting forth that test, the court was recognizing that the three factor analysis outlined by the court in Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425, 437 (1980) is only one way of determining whether the income the state is seeking to tax is sufficiently related to the taxpayer's activities in the state which is attempting to impose the tax. In fact, the court clarified that point in Allied Signal, supra, at 552, when it stated, "[w]e did not purport, however, to establish a general requirement that there be a unitary relation between the payor and the payee to justify apportionment. . . .".
Accordingly, the Commission concludes that the three factor analysis of functional integration, centralization of management, and economies of scale are not the only methods to be used to determine whether income from the sale of one by the other is business income and therefore apportionable and taxable within the taxing state. The Commission's interpretation of the Allied Signal case is that ownership of a corporation which serves an operational function, and not just an investment function, to the parent, is sufficient connection and justification for taxing the the apportioned amount of gain from the sale of the stock of the corporation.
It is clear to the Commission that XXXXX served an operational purpose for XXXXX. From 19YY to 19YY, XXXXX owned %%%%% of XXXXX, XXXXX was vertically integrated with XXXXX, XXXXX and XXXXX filed their Utah returns on a combined basis, and XXXXX controlled the management and operations of XXXXX. XXXXX purchased XXXXX as a means of expanding its retail convenience store business, and that purchase was consistent with, and reflected a trend, in the convenience store industry to include XXXXX with the products offered for sale at those convenience stores. A substantial portion of the products of XXXXX was sold to and by XXXXX. The investment of XXXXX in XXXXX was clearly not a "mere investment" of XXXXX's excess working capital, but was made for an operational purpose.
After the first sale, XXXXX continued to fulfill an operational need for XXXXX. As a condition precedent to the sale of the first %%%%% of XXXXX, XXXXX entered into a product purchase agreement (PPA) with XXXXX to insure that its guaranteed supply of XXXXX would continue. XXXXX purchased %%%%% of its fuel requirements from XXXXX, which constituted %%%%% of the total sales of XXXXX, and XXXXX further continued to guarantee some loans, contract performance and equipment leases for XXXXX. As a further condition precedent to the sale of the first %%%%% of XXXXX, XXXXX was to control %%%%% of the Board of Directors. While XXXXX could not force any action through the Board of Directors of XXXXX without at least one other director who was named by XXXXX, which owned the other %%%%% of the stock, XXXXX in essence had the power to veto any proposal by XXXXX. As has been demonstrated by numerous government officials, the power to veto is a substantial power of control, even though it is not absolute or total control.
When XXXXX moved into the XXXXX distribution business in 19YY, that move was benefitted by its ownership of XXXXX. The XXXXX ownership continued to serve an operational function of XXXXX after the first sale of XXXXX stock, and XXXXX continued to be benefitted by its continuing ownership interest in the XXXXX stock. XXXXX was an integral part of the day-to-day operations of XXXXX, and they were a day-to-day integral part of XXXXX being able to make money.
After the first sale in 19YY, XXXXX's XXXXX supply division became a part of XXXXX, and the supply network developed by XXXXX continued operating as part of XXXXX. There was a continuing flow of goods, profits and value between the two companies.
In 19YY, XXXXX sold XXXXX as part of a plan of divestiture which was started in 19YY, and when XXXXX sold its final %%%%% of XXXXX for a substantial profit, it was part of an overall plan to return XXXXX to its core business of convenience store retailing. It was the sale of a business asset to try to save the business of XXXXX. Therefore, even the sale or disposition satisfied an operational and business purpose for XXXXX.
Also, in reviewing Allied Signal v. Director, Division of Taxation, supra, there are significant differences between that case and the case at hand. In that case, the parties had stipulated that the two companies were "unrelated business enterprises each of whose activities had nothing to do with the other." In addition, the parent company never held more than 20% of the stock of the subsidiary, only had power to appoint two of fourteen directors, did not purchase any products from the subsidiary and, therefore, did not provide a substantial line of supply for a substantial portion of the products. Accordingly, those factors are significantly different from the factors in this case. There has been a substantial flow of product and value between XXXXX and XXXXX.
Accordingly, the Commission finds that the acquisition, management and disposition of XXXXX served an operational function and business purpose to XXXXX by providing XXXXX with a guaranteed source of XXXXX, and on the initial acquisition, a potential for substantially increasing its business. XXXXX had substantial effective control over the management of XXXXX through the Board of Directors and its veto power, and the disposition of XXXXX saved the convenience store business which was the core operation of XXXXX.
One of the last arguments of Petitioner is that the characterization of the XXXXX and XXXXX relationship must be made at the time of the tested transaction, i.e., at the time of the second sale. The Commission, in general, agrees with that statement. This decision discusses the full history of the XXXXX and XXXXX relationship. The history of that business relationship is helpful in understanding how that relationship served an operational function rather than an investment function. The Commission has based its decision only upon the facts which existed at the time of the second sale.
Based upon that analysis, it is clear to the Commission that as of the time of the second sale in 19YY, the business relationship between XXXXX and XXXXX continued to serve an operational function rather than an investment function, the gain on the sale of XXXXX stock was business income, and a portion of that gain is therefore apportionable to Utah.
DECISION AND ORDER
Based upon the foregoing, it is the order of the Utah State Tax Commission that the audit assessment made by Respondent against Petitioner should be sustained, and the Petition for Redetermination of Petitioner is hereby 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, you have thirty (30) days after the date of a final order to file a.) a Petition for Judicial Review in the Supreme Court, or 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.)