97-1416
____________________________________
PETITIONER., )
. ) ORDER
Petitioner, :
: Appeal No.
97-1416
v. : Account No. #####
:
AUDITING
DIVISION OF : Tax Type: Corporate Franchise
THE UTAH STATE
TAX ) Audit Period: January 1, 1994 through
COMMISSION, : December 31, 1995
:
Respondent. : Judge: McKeown
_____________________________________
Presiding:
Richard B. McKeown, Commission Chair
R. Bruce Johnson, Commissioner
Appearances:
For
Petitioner:
For
Respondent: Clark
L. Snelson, Assistant Attorney General
Mark Wainwright, Assistant Attorney General
STATEMENT OF THE CASE
This matter came before the Utah State Tax Commission for
an Initial Hearing pursuant to the provisions of Utah Code Ann. §59-1-502.5, on
March 3, 1999.
FACTS
Petitioner, PETITIONER, a STATE holding company, owns all of the outstanding stock of COMPANY .
(hereafter referred to as "COMPANY ") and several other
subsidiaries. PETITIONER. and its
subsidiaries, including COMPANY , operate as a unitary business and filed a
combined return for the years in issue.
COMPANY
restaurants are mid-priced family-style restaurants featuring high
quality food and beverages and specializing in the sale of pie and other bakery
items. They operate primarily in the
western United States, including Utah. As of December 28, 1995, there were
##### restaurants which operated under the COMPANY name. Of these, #####
were wholly owned and operated by PETITIONER. ##### were owned by partnerships
in which PETITIONER had a majority interest.
##### were owned by partnerships in which PETITIONER had a minority
interest and ##### were owned by franchises.
The company has less than a 50% ownership in ##### of the ##### co-owned
restaurants and a 51-90% ownership in the remaining ##### locations. COMPANY operated all of the wholly-owned restaurants, ##### of the
partnership owned restaurants and ##### of the franchise owned restaurants.
In September of 1985, COMPANY entered into a Trademark License Agreement with NAME, the founder
of COMPANY, that granted NAME the exclusive right to license and use the
COMPANY trademark in connection with
the manufacture, distribution,
marketing and sale of food products through retail food and grocery
store outlets in the United States in exchange for % of the gross proceeds from
all marketed products.
Pursuant to the Trademark License Agreement, OWNER was
granted quality control of the recipes and ingredients to be included in the
products marketed. Otherwise, NAME had
control over all aspects of marketing the products produced under the Trademark
License Agreement.
Shortly after the Trademark License Agreement was
executed, PETITIONER terminated his relationship with COMPANY. COMPANY, in his personal capacity, retained
the rights he was granted under the Trademark License Agreement.
Approximately two years after NAME entered into the
Trademark License Agreement with COMPANY, NAME required working capital in
order to comply with his obligations under the Trademark License
Agreement. COMPANY loaned $$$$$ to NAME company, NAME, to
provide working capital.
In August, 1987, COMPANY and NAME formed a STATE limited
partnership, COMPANY, to develop, manufacture, promote, distribute, and sell a
comprehensive line of food products bearing the name and/or logo of COMPANY.
COMPANY USA, a STATE corporation,
formed by NAME and his associates NAME and NAME, was the Managing General
Partner of Retail, owning a 75% interest in Retail. COMPANY owned a 20% limited partnership investment interest in
Retail. COMPANY, a wholly owned
subsidiary of COMPANY created for this purpose, owned a 5% general partnership
investment interest in Retail.
Retail's partnership agreement ("Partnership
Agreement") vested management and control of Retail in COMPANY USA, the Managing General Partner. COMPANY , the limited partner, had no
authority to manage, control, or transact business on behalf of Retail. Except as otherwise provided in the
Partnership Agreement, COMPANY agreed not to take part in the management of
Retail and was not authorized to sign for, bind, or transact business of behalf
of Retail. The General Partners
COMPANY'S were precluded from selling any part of their general partner's
interest in Retail without the prior written consent of all the partners, COMPANY,
COMPANIES The Managing General Partner, COMPANY, had the right and power to
sell the business and all of the assets of Retail, provided, however, that
prior to such sale, COMPANY USA offered
to sell these items to COMPANY on identical terms.
COMPANY contributed $$$$$ cash to Retail, which included
the $$$$$ COMPANY had previously loaned to NAME company, NAME. COMPANY contributed $$$$$ cash to
Retail. COMPANY USA, the Managing
General Partner, was credited with contributing $$$$$ to Retail, consisting of
$$$$$ in prior expenses incurred and the Trademark License Agreement. The original royalty fee percentage remained
the same after the assignment of the Trademark License Agreement from NAME to
COMPANY USA, and after the assignment from COMPANY USA to Retail.
Pursuant to the terms of the Partnership Agreement and
consistent with the Trademark License Agreement, Retail was required to pay
COMPANY an annual consulting fee of $$$$$.
Retail paid the fees as required.
Pursuant to the terms of the Partnership Agreement, Retail also had a
consulting agreement with COMPANY USA for an annual consulting fee of
$$$$$. The consulting fees were in
direct proportion to the partners' ownership interest in Retail.
For the period in issue, both the consulting fee and the
royalty income were treated as business income by PETITIONER and apportioned among
the states in which PETITIONER and its subsidiaries conducted the unitary
business. Counsel for PETITIONER stated
at the hearing that COMPANY distributive share of Retail's income was also reported by PETITIONER as business
income.
Retail was not part of PETITIONER's "unitary
group" as that term is defined in Utah Code Ann. §59-7-101(28). There were no common executives of any
member of the PETITIONER unitary group and Retail. Retail did not share any common services with PETITIONER or its
subsidiaries.
COMPANY agreed to guarantee certain loans to Retail. Retail's assets were listed in PETITIONER's
Consolidated Financial Statements as "investment in unconsolidated
partnership."
Since Retail was a limited partnership, rather than a
corporation, it was not subject to tax according to either federal or Utah
income tax statutes. As a partnership,
the income, assets, and attributes of a partnership "flow through" or
are attributed to the partners according to their ownership interests pursuant to
federal and Utah income tax statutes.
In September of 1994, Retail entered into an agreement
with COMPANY B to sell substantially all of the assets of the limited
partnership to COMPANY B for $$$$$. The
Asset Purchase Agreement required COMPANY to execute and deliver an extension
to the Trademark License Agreement granting COMPANY B the right to market foods
with the COMPANY name, logo and trademark. PETITIONER, through COMPANY and its
subsidiary COMPANY, held a 25% ownership interest in Retail at the time of the
asset sale. The asset sale resulted in
a net gain to PETITIONER in the amount of approximately $$$$$.
PETITIONER filed returns in Utah classifying the income
from the sale of Retail's assets as non-business income, thus excluding it from
the taxable base to be apportioned under the Utah statutory framework. In STATE, its commercial domicile, the gain
on the sale of the partnership assets was apportioned pursuant to STATE
Regulation §25137-1.
On September 19, 1997, the Division sent a Statutory
Notice to PETITIONER assessing a tax deficiency of $$$$$. Interest at the statutory rate continues to
accrue on the assessment. The
assessment is based upon the Division's conclusion that the gain realized by
COMPANY on the sale of its share of the partnership assets of Retail to COMPANY
B should be classified as "business income."
PETITIONER timely filed a Petition for
Redetermination of the audit assessment.
APPLICABLE
LAW
Utah Code Ann.:
§59-7-302. Definitions.
As used in this part,
unless the context otherwise requires:
(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.
* * *
(4) "Nonbusiness income" means all
income other than business income.
* * *
§59-7-303.
Apportionable Income.
(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 part.
* * *
Allocation of
capital gains and losses.
(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.
(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.
* * *
§59-7-311. Method of apportionment of business income.
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.
* * *
§59-10-301. Not subject to tax.
A partnership is not
subject to the tax imposed by this chapter.
Persons carrying on business as partners are liable for the tax imposed
by this chapter only in their separate or individual capacities.
§59-10-302. Character of partnership items.
(1) Each item of partnership income, gain, loss,
or deduction has the same character for a partner under this chapter as it has
for federal income tax purposes. When
an item is not characterized for federal income tax purposes, it has the same
character for a partner as if realized directly from the source from which realized
by the partnership, or incurred in the same manner as incurred by the
partnership.
* * *
(5) A nonresident partner's distributive share
of items of income, gain, loss, or deduction shall be determined under
Subsection 59-10-302 (2). The character
of partnership items for a nonresident partner shall also be determined under
Subsection 59-10-302(1).
* * *
Utah
Administrative Rules:
R865-6-8F. Allocation and
Apportionment of Ret. Income (Uniform Division of Income for Tax Purposes
Act) Pursuant to Utah Code Ann.
§59-7-302 through §59-7-321.
* * *
J. Special Rules.
* * *
(5) Partnership or Joint Venture Income. Income or loss from partnership or joint
venture interest shall be included in income and apportioned to Utah through
application of the three-factor formula consisting of property, payroll and
sales. For apportionment purposes, the
portion of partnership or joint venture property, payroll and sales to be
included in the corporation's property, payroll and sales factors shall be
computed on the basis of the corporation's ownership interest in the
partnership or joint venture, and otherwise in accordance with other applicable
provisions of this rule.
DECISION AND ORDER
At issue in this case is the proper classification of PETITIONER’s
distributive share of Retail’s gain on the sale of its assets to COMPANY
B. If that gain constitutes “business
income,” it must be apportioned among all the states, including Utah, in which
PETITIONER does business. If that gain
constitutes “nonbusiness income,” it is properly allocable to the state of
PETITIONER’s commercial domicile.
“Transactional test” versus “Functional test.” “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.” Utah Code Ann. §59-7-301(1). The Auditing
Division argues that this definition includes two tests, a “transactional” and
a “functional” test. Under the
“transactional test,” gain on the sale of an asset would be business income if
the sale itself occurred in the regular course of the trade or business. Under the “functional test,” such gain would
be business income if the asset itself had been used in the trade or business,
even if the sale of the asset was an extraordinary or unusual transaction. PETITIONER, on the other hand, argues that
the definition contains only a “transactional test” and that the purported
“functional test” is only a particular application of that test. According to PETITIONER, if the sale in question
is not a transaction in the regular course of taxpayer’s trade or business, it
cannot give rise to business income, regardless of the prior use of the
underlying asset.
An extended analysis of this dispute is not necessary
here. Suffice it to say that the
dispute has been argued extensively in courts throughout the land, with mixed
results. See Polaroid Corp. v. North
Carolina, No. 70PA98 (N.C. Sup.
Ct., Dec. 4, 1998) and the cases cited therein. The Multistate Tax Commission, of which Utah is a member, has
aggressively supported the position espoused by the Auditing Division
here. That position has also been
upheld by the this Commission in prior cases, including some cases that are
currently on appeal to the Utah Courts.
At this time, however, the Utah courts have not spoken on this
issue. Pending further guidance from
the courts, we continue to hold that the income in question will qualify as
“business income” if it meets either the “transactional test” or the
“functional test.”
Classification of income at the Retail level. The sale of assets was a sale by Retail
of all is assets to COMPANY B.
Accordingly, the test must be applied in the first instance to
Retail. The Auditing Division argues
that the gain to Retail was clearly business income because the assets being
sold were acquired, managed and disposed of by Retail in the ordinary course of
its business. It is not clear that
PETITIONER disagrees. Under ARrw law,
PETITIONER reported its distributive share of the gain as business income. We understand, based on the STATE rules
provided to us and the explanation of PETITIONER’s counsel, that this treatment
was based on the following analysis:
(1) Retail operated a separate trade or business from
PETITIONER;
(2) Accordingly, the income must be analyzed based on
Retail’s operation;
(3) The gain, so analyzed, was business income to Retail;
(4) The gain was properly apportioned among the states in
which Retail did business, based on Retail’s factors;
(5) To the extent Retail’s business income was
apportioned to STATE, PETITIONER included its distributive share of Retail’s
income in its own STATE income; and
(6) That distributive share constituted business income
to PETITIONER.
Utah, on the other hand, does not apportion the income of
the partnership based on the partnership’s factors. Rather, for apportionment purposes, the corporate partner
includes a pro rata portion of the partnership’s property, payroll and sales in
its own factors, based on its ownership interest.
Although the apportionment formulas are applied
differently by STATE and Utah, the determination of whether the gain is
business or nonbusiness income is still based on the same factors. At the Retail level, this income was treated
as business income in STATE. At the
Retail level, this income should be treated as business income in Utah as well.
Classification of the income at the PETITIONER
level. As noted above, for STATE
purposes, this income was also classified as business income at the PETITIONER
level. PETITIONER argues that this
result follows from STATE’s Regulation and, in the absence of such a
regulation, the classification of the income for PETITIONER is different from
its classification for Retail. It analogizes
its ownership of a minority partnership interest in Retail to a minority stock
position in a corporation. A
corporation may generate business income which, in turn, may result in a
dividend to the shareholder. The
dividend, however, may still constitute nonbusiness income.
We believe this analogy in inapt. A corporation is a taxable entity. A partnership is not. Section 59-10-302 provides that an item of partnership
gain “has the same character for a partner as if realized directly from the source
from which realized by the partnership.”
Retail sold operating assets to COMPANY B and realized business
income. PETITIONER should report its
share of such gain “as if” it sold operating assets directly to COMPANY B.
Even if the analogy is appropriate, however, we would
still hold for the Auditing Division.
It is clear from the undisputed facts that PETITIONER’s decision to
invest in Retail had an operational purpose.
See Allied Signal v. Director of Taxation, 504 U.S. 768
(1992). COMPANY originally entered into
the Trademark License Agreement with NAME to generate royalty income from NAME
use of the COMPANY trademark. It is not
seriously disputed that royalty income was business income. When NAME
encountered financial difficulty, that royalty income was at risk. COMPANY then loaned NAME company $$$$$ to
help ensure that NAME operation “could maintain its obligations under the
Trademark License Agreement.”
(Declaration of Stephen Jennings, par. 16.) Shortly thereafter, COMPANY was formed with a large infusion of
additional COMPANY cash, at least in part to insure that NAME would have the
ability to repay that loan. (Ibid.) COMPANY also hoped for a good return on its
additional cash contribution--it was not just throwing good money after bad. We find, nevertheless, that the investment
in COMPANY fulfilled an operational function, i.e., it strongly enhanced the
likelihood that COMPANY would continue
to receive business income from the Trademark License Agreement.
For the foregoing reasons, we hold that PETITIONER’s
distributive share of gain from the sale of COMPANY’s assets is business
income, a share of which is apportionable to Utah. The Auditing Division’s assessment is upheld.
This decision does not limit a party's right to a Formal
Hearing. However, this Decision and
Order will become the Final Decision and Order of the Commission unless any
party to this case files a written request within thirty (30) days of the date
of this decision to proceed to a Formal Hearing. Such a request shall be mailed to the address listed below and
must include the Petitioner's name, address, and appeal number:
Utah State Tax Commission
Appeals Division
210 North 1950 West
Salt Lake City, Utah 84134
Failure
to request a Formal Hearing will preclude any further appeal rights in this
matter.
BY ORDER OF THE UTAH STATE TAX COMMISSION.
DATED
this 29TH day of April, 1999.
Richard B.
McKeown Pam
Hendrickson
Commission Chair Commissioner
R. Bruce
Johnson
Commissioner