STATE TAX LITIGATION UPDATE

Transcription

1 Federation of Tax Administrators Annual Meeting June 10, 2013 STATE TAX LITIGATION UPDATE

2 I. NEXUS ISSUES 1. Ann Sacks Tile and Stone, Inc. v. Department of Revenue, Oregon Tax Court, No. TC 4879, November 20, The Oregon Tax Court held the activities of in-state independent contractors that were hired by the taxpayer s parent company created nexus for the parent, Kohler. Therefore, Kohler s Oregon payroll and sales were required to be included in the numerator of the Oregon apportionment factors. The taxpayer is a subsidiary of Kohler. Kohler had minimal business activities in Oregon but it did employ sales representatives within the state. The activities of the sales representatives were limited to solicitation of the sales of Kohler s products. Therefore, the activities fell within the jurisdiction of P.L In addition to the sales representatives, Kohler contracted with distribution and authorized services representatives to perform warranty repair services. Kohler employees also entered Oregon to perform tasks related to Kohler s business operation. The Tax Court first determined that Kohler was doing business in Oregon. It then turned to the application of P.L and found, based on a strict reading of the federal statute, the warranty repair work performed by the independent contractors exceeded the protection of P.L The Tax Court held that the distributor and the independent contractors performing warranty work created nexus for Kohler. The Tax Court also concluded that the activities of Kohler employees in Oregon exceeded the de minimis exception. 2. Telebright Corporation, Inc. v. Director of Taxation, Superior Court of New Jersey, Appellate Division, No. A T2, March 2, The Superior Court affirmed the Tax Court holding that an employee telecommuting from her New Jersey home subjected the company to New Jersey Corporate Income Tax. The court held this was no violation of either the Due Process or Commerce Clause. Telebright has operations in Maryland and employed a New Jersey resident to develop and write software codes. The employee s work was integral to a work application product that Telebright sold. The company withheld New Jersey income tax on the employee. The company had no other payroll or property in New Jersey. The court noted that New Jersey had a broad definition of doing business and concluded that the New Jersey resident carried out the purpose of the organization in New Jersey. Thus, Telebright was doing business in the state and subject to the tax.

3 Page 2 The court rejected the company s Due Process argument concluding the tax was not a result of having an employee who resided in New Jersey but rather because that employee performed work on a full-time basis for Telebright. That employee was entitled to the legal protections provided New Jersey residents. Also, Telebright could file a New Jersey action should the employee violate her employment contract. The Commerce Clause argument was also rejected because Telebright failed to support its contention that the second, third, and fourth prongs of Complete Auto were not met. With respect to substantial nexus, the court rejected the argument that one employee was de minimus and failed to create the requisite connection. Rather, the first prong was met because the New Jersey employee was producing some of the company s product within New Jersey. 3. In the Matter of the Income Tax Protest of Scioto Insurance Company, 2012 OK 41, May 1, The Oklahoma Supreme Court reversed the Appellate Court and held that Scioto was not doing business in Oklahoma and thus was not subject to the Oklahoma corporate income tax. Scioto Insurance is an insurance company formed under the laws of Vermont. Scioto held the interest in a single member limited liability company that owned the intellectual property of Wendy s International. The intellectual property was licensed to Wendy s International who in turn sublicensed it to the restaurants and franchises. The payments for use of the trademarks, trade names and restaurant operating practices were based on the individual restaurant sales and paid by Wendy s International to Scioto. Oklahoma sought to tax the income derived from the license arrangement. The Court held Oklahoma had no power to regulate the licensing agreement. Further, it was Wendy s International s obligation to pay for the use of the intangible property based on the percentage of sales and that obligation was not dependent on the Oklahoma restaurants making payments to Wendy s International. Thus, the sum paid was a bona fide obligation. Further, this is the source of income for the insurance business which is not carried on in Oklahoma. The Court distinguished the Geoffry case concluding that, unlike Geoffry, the Scioto Insurance Company was not a shell and the licensing agreement was not a sham obligation. The Court found no authority to tax an out-of-state corporation that has no contact with Oklahoma other than the receipt of payment from an Oklahoma taxpayer.

4 Page 3 4. Tennessee Department of Revenue, Letter Ruling, 12-03, May 10, 2012 The Tennessee Department of Revenue found that a Taxpayer s sale of natural gas into the state was subject to the gross receipts tax on gas distribution. The Taxpayer does not own pipelines but has contractual access to interstate pipelines. The company purchases natural gas and transports it via an interstate pipeline system to a Tennessee LDC for deliveries to Tennessee customers. The Taxpayer retains legal title to the natural gas until used by the end consumer. The Department concluded that the company was subject to the tax because although the taxpayer did not own the pipeline it did have contractual access to the pipeline and in fact uses it to deliver gas. Because the Taxpayer is the party that makes the delivery to the end user, it is properly characterized as a distributor under the statute. The transactions are not in interstate commerce because the activities from the time the gas reaches the city gate in Tennessee to the time it is sold at retail in Tennessee are intrastate in nature. Thus, the transaction s are subject to the tax. 5. In re Washington Mutual, Inc. et al, U.S. Bankruptcy Court for District of Delaware, Dkt. No , December 19, 2012 The Bankruptcy Court held that Washington Mutual, Inc. ( WMI ), the parent holding company of banking subsidiaries, did not have nexus with Oregon. The Department had argued it had jurisdiction to tax WMI by virtue of the company s ownership of banks operating in the state, the ownership of intangibles used by the banks in Oregon, and the receipt of dividends from the banks. In September 2008, the Office of the Thrift Supervisor seized the bank subsidiaries and sold the assets to J.P. Morgan Chase. WMI then filed for bankruptcy under Chapter 11. Oregon filed a proof of claim in bankruptcy asserting that WMI and its subsidiaries owned additional corporate excise taxes in the amount of $30 million. WMI objected to the claim arguing if any tax was owned, it was that of the subsidiaries. The Department acknowledged that the taxes sought were for the obligations of the subsidiaries but argued WMI was joint and severally liable for the tax because an Oregon consolidated return had been filed in the name of WMI. The court rejected Oregon s assertion stating that the inclusion of a company in the consolidated return was an admission that WMI was doing business in Oregon. Such a conclusion would be inconsistent with the Department s own interpretation that the inclusion of a company in a unitary return does not mean that the state is taxing the company. Further, the court argued that under the due

5 Page 4 Process Clause, WMI did not purposely avail itself of the benefits of the state. The company did not have offices or own property in Oregon. The company was a mere holding company. The court also rejected Oregon s assertion that WMI was doing business as a result of the ownership of intellectual property that was used by the subsidiaries. WMI received no benefit because it did not earn income on the use. There were no royalty payments. The court did reject WMI s argument that physical presence was required and also rejected the significant economic presence test for nexus under the Commerce Clause. Rather, the court concluded the tax should be analyzed under the substantial nexus test set forth in Complete Auto Transit. Applying this standard, the court concluded that to find WMI liable for the corporate income tax of its subsidiaries because it allowed the free use of intellectual property and received dividends, would burden interstate commerce. Thus, WMI did not have substantial nexus. 6. Tennessee Department of Revenue, Revenue Ruling #12-27, November 24, The Department has concluded that a corporation that licenses patents which ultimately lead to Tennessee sales is not subject to Tennessee franchise and excise tax. The company at issue is principally engaged in the business of holding, managing, and licensing of patents. The company had no office or employees in Tennessee. The patents are licensed to an affiliate which arranges for the manufacture of the products by a third affiliate. The manufacturer supplies the products to a partnership which sells and distributes the products. Some of the products are sold in Tennessee. The Department concluded the company does not purposefully engage in the licensing activity with the object of a gain in Tennessee. The sole contact with Tennessee is solely from the eventual sale and delivery of the product manufactured outside of Tennessee into the state by an affiliate. Based on these facts, the contacts with Tennessee are too remote to be purposefully engaged in business within the state. II. UNITARY ANALYSIS 1. Tesoro Corporation & Subsidiaries v. State of Alaska Department of Revenue, Superior Court No. 3AN CL, April 28, (Appeal Pending.) The Alaska Superior Court affirmed the holding of the Administrative Law Judge that Tesoro and its subsidiaries were unitary in nature during the 1994 through 1998 audit period. During the period, Tesoro had an exploration and production

6 Page 5 unit ( E&P ) located in Texas. The company also owned an Alaska refinery and a marketing unit ( R&M ). In addition to the E&P and R&M units, the company had three other business segments: (1) finance; (2) corporate; and (3) marine services. In upholding the ALJ s decision, the court cited the fact there were overlapping directors and senior staff, the board-level decisions were made by the Tesoro Board of Directors. Further supporting the existence of centralized management was the fact that Tesoro and its operating subsidiaries entered into administrative service agreements for such services as financial reporting, accounting, and cash management. The court rejected Tesoro s argument that a significant portion of the company s revenue stream was unrelated to its Alaska business activities. Rather, the court found the Alaska business activities to be part of a unitary business. The factual finding supported the existence of centralized management, a flow of value that was inherent in the shared services and economies of scale were found in loan guarantees, consolidated purchasing functions, insurance coverage, and collective financing. Finally, the court concluded that Tesoro failed to establish that an alternative apportionment method was required to adequately reflect its Alaska business activities. 2. CLARCOR, Inc. v. Brian Hamer et. al., Illinois Appellate Court, Dkt. No , (May 11, 2012). The Appellate Court affirmed the Circuit Court s decision holding that CLARCOR was unitary with both its packaging and filtration subsidiaries. In reaching its holding, the Court rejected the company s argument that as a result of the Envirodyne decision, there must be horizontal integration between the subsidiaries to establish a unitary relationship. CLARCOR is a publicly traded corporation that is headquartered in Rockford, Illinois. The company historically had been engaged in lithographic packaging business. In the mid-1970s, the company entered the filtration business. CLARCOR s officers were also officers of the packaging and filtration subsidiaries. Each business unit had its own purchasing, accounting, sales and human resources departments. The business units did not share common facilities. The parent did, however, provide services to the subsidiaries such as filing tax returns, managing pension plans, and payroll services.

7 Page 6 The Court in rejecting CLARCOR s horizontal integration argument found the existence of common pension plans, health insurance, and 401(k) plans established a horizontal integration, that conclusion was further supported by the fact that the stock option compensation for the subsidiaries officers was based on the parent s performance. In addition, the interlocking officers was evidence of vertical integration. Therefore, the unitary relationship was established. 3. Indiana Department of State Revenue v. United Parcel Services, Dkt. No. 49 S TZ-417 (June 21, 2012). The Indiana Supreme Court reversed the Tax Court and held the income received by UPS s foreign reinsurance affiliate was subject to the Indiana Gross Income Tax because the reinsurance transactions that occurred outside of Indiana were not subject to the Indiana premium tax. UPS filed a consolidated Indiana corporate income tax return. The company decided to bear its own risks for both worker s compensation and liability insurance for package damage losses. To accomplish this during the years at issue, UPS contracted with three unrelated insurance companies and then UPS affiliates in turn re-insured or indemnified the three primary insurers for the risks. UPS filed amended returns for the 2000 tax year to exclude from both federal taxable income and Indiana adjusted gross income the income of the re-insurance affiliates. The Department denied the refund request for the 2000 tax year rand issued a notice of proposed assessment for the 2001 tax year. UPS timely protested both the refund denial and the assessment. The question before the court was whether the affiliates were subject to the Indiana premiums tax and thus, exempt from the adjusted gross income tax. The court in reversing the Tax Court noted that the two affiliates had to show they were doing business in Indiana before they were entitled to the exemption. Further, the mere fact that the affiliates collected premiums for insurance of risk in Indiana did not establish that the companies were doing business in Indiana. There was in no evidence that the reinsurance transactions took place in Indiana. Thus, because there is no evidence that the two affiliates were doing business in Indiana which is a prerequisite for by subject to the premium tax UPS has failed to meet the burden that it was entitled to summary judgment. 4. US West, Inc. and Subsidiaries v. Department of Revenue, State of Oregon and Qwest Dex Holdings, Inc. and Subsidiaries v. Department of Revenue, State of Oregon, Tax Court Dkt. Nos. TC 4896 and TC The Oregon Tax Court held that for income tax purposes, a formerly affiliated company may only carry forward net operating losses incurred by its parent

8 Page 7 corporation for the period in which affiliation existed between the entities. US West Inc. and Qwest Dex Holdings Inc. (collectively USW) were members of an affiliated group of corporations in which Media One was the common parent. In June 1998 Media One distributed all outstanding shares of USW to its shareholders in a spinoff transaction. Under the federal tax rules the calendar year 1998 was divided into two tax years for USW: a pre-spin year and post-spin year. On its consolidated return, Media One reported an NOL, which was based on a significant NOL incurred by Media One and a positive net income for USW for the pre-spin period. USW filed its federal return for the post-spin year reporting a positive net income. On its Oregon return, USW reported a positive net income and claimed an NOL carryforward from the pre-spin tax year. Following an audit, the Department determined USW was entitled to a reduced NOL because only the losses of Media One incurred on or before June 1998 should be considered. USW filed a complaint in the Oregon Tax Court, arguing that the amount of NOL should be determined by taking into account the total Media One loss amount for the full 1998 tax year. USW sought clarification on the proper amount of NOL carryover available for its short year ending December 31, 1998, and subsequent years. The court rejected USW's position after finding that the department's ratable allocation method used to determine carryover was reasonable. The court noted that the federal regulations provide a similar method that allows taxpayers filing a federal consolidated tax return to calculate separate results for individual members. Moreover, the court found that ORS (2) also provides that Oregon shall follow the federal consolidated return regulations on separate company determinations. The court rejected USW's reliance on ORS after finding that the statute does not address the calculation of an operating loss carryover or how to assign the loss to members of a unitary group. Rather, the court said that ORS applies to apportionment of group loss between or among several states when a taxpayer or group of taxpayers had business operations in more than one state. USW's reliance on ORS (5)(c), the court found, was also misplaced because the statute only applies if two or more corporations are in a unitary relationship and therefore required to file a consolidated state return. The court found in favor of the department.

9 Page 8 5. Apple Inc. v. Franchise Tax Board, CA Court of Appeals, First Appellate District Dkt. Nos. A and A129090, September 12, (Petition for Review denied January 23, 2012.) The Appellate Court rejected Apple's claim for preferential ordering for dividends paid by foreign subsidiaries. In 1989 Apple filed its California returns on a worldwide basis, so all earnings of its foreign subsidiaries were factored into the calculation of tax. For corporate income tax purposes the dividends were eliminated. Subsequently, in 1989 Apple made a water's-edge election but, only a small portion of the earnings of the foreign subsidiaries the subpart F income was included in the water's-edge tax base. Therefore only a small portion of the foreign earnings generated in 1989 was taxed. During 1989, Apple repatriated foreign earnings by way of dividends. To determine whether the dividends were eliminated, Apple applied Fujitsu's preferential ordering approach. The pool of previously taxed earnings was the subpart F income in 1989 and all of the world-wide earnings from years before Applying the preferential ordering approach, Apple eliminated the dividends to the extent of the previously taxed earnings. The FTB argued for a LIFO approach. Specifically the dividends were deemed paid first from current year's earnings until exhausted and then, from the most recent prior years' earnings on a year-by-year basis until each year's earnings are exhausted. Applying the LIFO method, Apple was required to take into account any untaxed earnings generated in 1989 before it could utilize the worldwide reporting years. The Appellate Court agreed with the FTB s analysis. In so doing, the court determined that Fujitsu only required preferential ordering with respect to current year earnings. 6. In the Matter of the Appeal of Comcast CableVision Corp. of California and Common Production Services I, Inc., California State Board of Equalization, No (February 2,2012). Petition for Rehearing withdrawn. (Appeal Pending.) The California State Board of Equalization in a 3 to 2 unpublished decision held that Comcast was unitary with the majority-owned QVC and that the break-up fee received as a result of a failed merger with MediaOne was properly characterized as business income apportionable to California. The first issue addressed by the SBE was whether Comcast was unitary with QVC. Comcast owned a 57.5% interest and Comcast officers sat on the QVC Board and were officers of the Company. QVC was managed by the officers who were in place prior to the Comcast acquisition. Comcast argued the relationship did not meet the three unities test nor did it meet the contribution and depending

10 Page 9 test. The SBE concluded these were alternative tests and the failure to meet one is not conclusion that a unitary relationship does not exist. The Board members who voted against Comcast relied on the flow of value between the companies, citing the ability to pay the executives with options and overlapping board members. Thus, the view of the majority was the contribution and depending tests were met. With respect to the termination fee, the SBE adopted the FTB s position that it was apportionable business income. In support of its position, the FTB argued that Comcast has built the business through acquisition and, in fact, the termination fee was nothing more than lost profits from the business. Thus, the transactional test was met. Further the merger agreement was relevant property that was integral to Comcast s business. Therefore, the functional test was met. In reaching this conclusion, the SBE rejected Comcast s argument that the termination fee was a once-in-a-lifetime transaction and as such, did not meet the transactional or functional tests. 7. Costco Wholesale Corp. & Subsidiaries v. Department of Revenue, Oregon Tax Court Dkt. 4956, July The Tax Court granted the Department s Motion for Partial Summary Judgment concluding that the income of a wholly-owned insurance company should be included in the combined income of the Costco unitary group. The insurance company, a Bermuda entity that elects to be treated as a domestic corporation, is a wholly-owned subsidiary of Costco. The company did not own or rent property in Oregon, nor did the company have employees in the state. The company was not registered in Oregon and did not file corporate excise tax returns in the state. The insurance insures general liability worker s compensation and automobile risks for the Costco affiliated group. It was determined the company was unitary in nature with Costco. Costco argued that the income of the insurance company had to be excluded from the unitary group because an insurance company under Oregon law would be required to use a different apportionment formula. The court rejected the argument that the Oregon statute precluded the inclusion of the company because the statute applies only to those corporations over which Oregon has jurisdiction. Oregon does not have jurisdiction over the insurance company and because there is no statutory provision that indicates an insurance company is exempt from tax, the income is includable in Costco s tax base.

11 Page Standcorp Financial Group, Inc. v. Department of Revenue, Oregon Tax Court Dkt. 5039, January 8, The Oregon Tax Court granted Standcorp s Motion for Summary Judgment holding the income from a wholly-owned insurance company should be excluded from the Oregon group. The income took the form of dividends paid by the insurance company to its parent. The Department included the dividend income in the tax base and then allowed an 80% dividend received deduction. The Tax Court, in ruling for the taxpayer, concluded the insurance company was unitary in nature with the taxpayer and but for the fact an insurance company apportions its income using a different method, the company would have been included in the unitary return. The federal consolidated returns provisions apply to companies which are affiliated for federal purposes and unitary for Oregon purposes. Thus, because the insurance company is subject to Oregon tax, and the starting point is federal taxable income, the dividends should be excluded from the unitary group tax base. 9. Delhaize America, Inc. v. Kenneth R. Lay, North Carolina Court of Appeals Dkt. No. COA11-868, August 23, The North Carolina Court of Appeals held that the Department of Revenue s decision to combine a parent company s income with its nonresident affiliate for corporate tax purposes was proper because the company had sufficient notice of the definition of true earnings. Delhaize America Inc. formed a wholly owned subsidiary, FLI Holding Corp., and an affiliated Florida-based corporation, FL Food Lion Inc. (FL), to reduce its North Carolina corporate tax obligation. Delhaize received tax-free dividends from FL after paying royalties and fees. Delhaize and FL separately filed North Carolina corporate tax returns for the tax year at issue. After an audit, the Department of Revenue concluded that Delhaize s income should be combined with FL s income to reflect its true net earnings. Delhaize paid the additional income tax, interest, and penalties and requested a refund. After the Department denied the refund claim, Delhaize filed a complaint alleging due process violations. The trial court determined that the Department properly combined Delhaize and its affiliates income but abated the imposed penalties. Both parties appealed. The appeals court rejected Delhaize s argument that the Department failed to give proper notice that the definition of true earnings changed for combined reporting purposes. Because final Department decisions indicating the current definition of true earnings were available to Delhaize when executing its tax

12 Page 11 strategy program, the court concluded that the company was given sufficient notice that its income should be combined with its affiliate. Further, the court determined that the Department did not violate Delhaize s procedural due process rights by forcing it to combine income with Florida. The court held Delhaize is not entitled to a refund of the penalties assessed by the Department. Because the penalty imposed against Delhaize does not violate its Due Process rights, the court reversed the trial court s summary judgment motion in Delhaize s favor. 10. AT&T Teleholdings v. Hamer, 2012 IL App (1 st ) (September 28, 2012). The Illinois Appellate Court affirmed the Circuit Court s holding refusing to allow the taxpayer to claim a refund based on its request to carry back a net capital loss suffered by its parent company to offset a capital gain the taxpayer had reported on a prior year s return. On its amended return, the taxpayer included the capital loss reported by members of the consolidated group of which it was a member. The taxpayer itself did not have any such losses. In support of its position, the taxpayer referred to Section 304(e) of the IITA, which requires unitary business groups to apportion their business income using the combined apportionment method. The Department, however, took the position that the net capital loss is a preapportionment element that is allocated to the members of the unitary business group by multiplying the total net capital loss by a fraction, the numerator of which is each individual member s own separate net capital loss and the denominator of which is the group s total net capital loss. The IITA does not provide guidance on this issue, but rather directs the Department to draft regulations regarding the treatment of unitary group members as a single taxpayer for purposes of filing a combined return and determining their joint liability. Regulation Section accordingly provides that before base income is apportioned, it must be computed by applying the pertinent federal regulations which require any net capital losses incurred by those members to be allocated in a manner consistent with the separate-company accounting method. The court held that no statutory authority nor case law requires that capital net losses be apportioned among members of a unitary group under the combined apportioned method. Because the Department appropriately characterized the net capital losses as a factor in determining base income, the combined apportionment method was not necessary. Unlike net operating losses, which reflect the type of losses that result from the operations of a unitary business group as a whole, net capital losses are only the excess losses from sales of capital assets over the gains from sales of other capital assets. Such losses, the court reasoned, may not result

13 Page 12 from the activities of other members to the same extent as its net income or its net loss. Such an approach is not unconstitutional, the court concluded, because while it may result in taxing some income that does not have its source in Illinois, that taxation is not out of all appropriate proportions to the business transacted in the state. The court held that the taxpayer s reliance on Container Corp. for the proposition that separate accounting to allocate an item of a taxpayer s base income is necessarily disproportionate to the business that the taxpayer transacts in Illinois was misplaced. Indeed, while the Container Corp. court found that when a unitary business exists, separate accounting is not constitutionally required because the income of members of such unitary business groups comes from the operation of the business as a whole, and it becomes misleading to characterize such income as having a single identifiable source. However, simply because combined apportionment is constitutional does not mean that separate accounting is necessarily unconstitutional. 11. Express Scripts, Inc. v. Commissioner of Revenue, Minnesota Tax Court, No R (August 20, 2012). The Minnesota Tax Court has held that an out-of-state provider of pharmacy benefit management ( PBM ) and mail-order pharmacy services was not unitary in nature with a Minnesota joint venture in which it had a one-third interest. The joint venture was engaged in electronic prescription and information routing services. Express Scripts and two other companies engaged in PBM formed RxHub, a limited liability company headquartered in Minnesota under the terms of the LLC agreement, each entity contributed one-third of RxHub s total capital. Express Scripts also paid RxHub for the use of its products which allowed it to provide physicians with patient-specific medication histories. The companies did not share employees and maintained separate business operations. The Department issued an assessment for the 2001 through 2004 tax years on the basis that Express Scripts was unitary in nature with RxHub. The Tax Court in reaching its conclusion held there was no flow of value or sufficient control to establish a unitary relationship. There was no flow of value because all transactions between the entities were arm s-length. The fact that there were capital contributions did not establish a unitary relationship. RxHub operated as an independent entity. Further, Express Scripts did not have the control necessary to find a unitary relationship. There was neither preferential treatment of Express Scripts nor were the products developed expressly for the

14 Page 13 use of Express Scripts. Thus, even the minimum potential for control was not met. III. BUSINESS PURPOSE/ECONOMIC SUBSTANCE AND ADDBACK STATUTES 1. Comptroller v. Gore Enterprise Holdings, Inc., Dkt. No and Comptroller v. Future Value, Inc., Dkt. No. 1697, MD Court of Special Appeals, January 24, The Maryland Appellate Court Reversed the Circuit Court and upheld the Comptroller s assessments against Gore Enterprise Holdings, Inc. ( GEH ) and Future Value, Inc. ( FVI ). GEH was founded in The company held and licensed all of the W.L. Gore patents. FVI was formed in 1996 and functions as a finance company making loans to W.L.Gore. Neither company had any employees or property in Maryland. The Comptroller audited the two entities and determined that both were subject to corporate income tax. Further, for purposes of apportioning the entities income, the Comptroller used the W.L. Gore apportionment ratio. The entities challenged the resulting assessments. The Appellate Court first addressed the appropriate standard of review concluding the court was not bound by the Tax Court s interpretation of the law but rather whether the administrative agency erred in its application of the law. Specifically, whether there was substantial evidence in the record to support the Comptroller s finding and conclusion. Reviewing what was before them, the court concluded this was an issue of law. The court analyzed the matter by applying the unitary business principle. Utilizing that concept, the court held that a nexus sufficient to justify taxation arises from an economic reality that the parent s business in the taxing state produces the subsidiary s income. Specifically, Gore generated income in Maryland and in turn deducted as expenses the payments made to GEH and FVI who in turn recognized income from those payments. In the opinion of the court, these transactions reflect a unified business. As such, their unified business creates sufficient nexus to subject GEH and FVI to tax. Further, the court found it illogical that Gore deducts expenses in Maryland but that the corresponding income is not Maryland income as part of a unitary business.

15 Page Kimberly-Clark Corporation v. Commissioner of Revenue, MA App. Ct. No. 11- P-632, January 11, 2013 The Massachusetts Appeals Court affirmed the Appellate Tax Board and held that the Commissioner of Revenue property disallowed a corporation s deductions for interest expense, royalty, and rebate payments because the intercompany transactions lacked economic substance and business purpose. Kimberly-Clark Corp. manufactures and sells paper-related consumer items. During the 1990s and early 2000, Kimberly-Clark reorganized and created Kimberly Clark Worldwide ( Worldwide ) to hold and control the company s and its affiliates intellectual property. Worldwide entered into license agreements with Kimberly-Clark and the affiliates, which permitted the companies to use the intellectual property in exchange for royalty payments made to Worldwide. Kimberly-Clark also implemented a centralized cash management system whereby all cash receipts from its subsidiaries were deposited into a lockbox maintained by Kimberly Clark Financial Services Inc. ( Financial ). The cash was swept up daily to Kimberly-Clark and subsequently placed into a pool to be used for the subsidiaries expenses. Kimberly-Clark Global Sales Inc. ( Global ) was also created to control the entire organization s supply-chain management process. Global implemented a rebate program, whereby Kimberly- Clark and other suppliers paid Global the amount of cost savings realized from the use of patents, and Global would then rebate those funds to Worldwide. The Commissioner disallowed interest expenses claimed by Kimberly-Clark on transfers made to its subsidiaries through the cash management system. The Commissioner also disallowed deductions for royalty payments made to Worldwide as well as rebate payments to Global. Kimberly-Clark appealed to the Appellate Tax Board, which ruled that the company failed to show that the interest expenses related to the cash management system were valid because the loan agreements between the companies did not contain any collateral or default provisions. Turning to the royalty expense issue, the Board concluded that the centralization of the intellectual property was primarily for tax reduction purposes because the license agreements between the companies were de facto exclusive licenses. It determined that Kimberly-Clark was required to add back the royalty payments to its income. The Board also ruled that the rebate payments made to Worldwide constituted royalty payments for use of the patents, and therefore Kimberly-Clark was required to add back the payments to its income. Kimberly- Clark appealed to the Appeal Court. The Appellate Court first addressed whether the Board used the proper burden of proof. The court agreed with the Board that Kimberly-Clark was required to show by clear and convincing evidence that the Commissioner s adjustments were

16 Page 15 unreasonable. Citing the Board s conclusion, the court noted that applying a clear and convincing standard for Commissioner decisions while permitting a preponderance of the evidence standard as required by Kimberly-Clark for Board Appeals would lead to an absurd result, because the Commissioner s decision could be easily overturned by the Board on identical evidence if the taxpayer were to succeed in meeting the lower burden of proof. Turning to the merits of the case, the Court held that Kimberly-Clark was not entitled to the interest expense deductions because the company did not incur any true debt. Next, the court found the Commissioner properly disallowed the royalty payment deductions because the payments lacked economic substance and business purpose. The royalty payments, the court noted, were returned to Kimberly-Clark via the cash management system and not subject to investment by the subsidiaries. It also agreed with the Board s conclusion that the license agreements between the companies were de facto exclusive licenses. Finally, the court held that substantial evidence supported the Board s conclusion that the rebate payments were royalties subject to the add back statutes. 3. Sysco Corporation v. Commissioner of Revenue, Massachusetts Appellate Tax Board, Dkt. Nos. C and C (October 20, 2011). (Appeal Pending.) The Massachusetts Appellate Tax Board ruled that a food distribution corporation was not entitled to claim interest deductions on loans resulting from intercompany transfers. Sysco Corp., a Delaware corporation, distributes food and related products to various restaurants, hospitals, hotels, schools, and recreation centers. During the tax years at issue, Sysco and its subsidiary operating companies participated in a centralized cash-management system. The operating companies maintained separate bank accounts to deposit all revenue generated from their businesses. At the daily close of business, Sysco initiated a transfer of funds from the depository accounts to a concentration account. Sysco used the concentration account to fund capital investment projects and disburse money back to the operating companies for their expenses. When Sysco disbursed less or more to an operating company, the difference was accounted for as a loan from either Sysco or the operating company. Following an audit, the Commissioner of Revenue disallowed Sysco s interest deduction on loans resulting from intercompany advances. The Commissioner contended that the claimed loans to Sysco constituted dividends while the claimed interest income received by the operating companies constituted capital contributions from Sysco. Sysco appealed to the Massachusetts Appellate Board, arguing that the intercompany transactions associated with its cash-management system gave rise to bona fide debt. The Board disagreed and ruled that the structure and operation of Sysco s cash-management system indicated that the

17 Page 16 companies did not intend to repay the excess cash advances. It explained that there were no formal agreements, repayment schedules, or fixed dates of maturity in the daily operation of the cash-management system. The Board noted that the purported loans were not secured in any manner. Moreover, it found that Sysco s argument that it made daily interest calculations and accounting entries for interest accrued on intercompany accounts was without merit. The Board rejected Sysco s Commerce and Due Process Clause arguments after finding that it failed to show that the Commissioner s adjustments resulted in taxation of extraterritorial values. The Board found in favor of the Commissioner. 4. Hormel Food Corporation v. Wisconsin Department of Revenue, Wisconsin Tax Appeals Commission, Dkt. No. 17-I-17, March 29, (Appeal Pending.) The Tax Commission has held that the Department properly disallowed royalty expenses paid to an affiliate for the use of intellectual property. The Commission applying a version of the sham transaction doctrine found the affiliate lacked economic substance and a valid business purpose. In reaching its conclusion the Commission rejected Hormel s argument that the affiliate was formed to protect and promote the corporation s intellectual property. The evidence presented established the primary purpose for the creation of the affiliate and the payment of royalties was the reduction of state tax. Although the reduction of tax is a legitimate business purpose the evidence established that Hormel retained control over all decisions related to the intellectual property. Further, the property was not licensed to third parties. Thus, there was no evidence that the affiliate had any economic substance or business purpose. The fact that the engineering and research and development groups were transferred to the affiliate was not sufficient to support the fact the company had economic substance because the movement of the activities did not change the operation of those divisions. The movement did not support the alleged business purpose. 5. Beneficial New Jersey Inc. v. Director, Division of Taxation, New Jersey Tax Court No (August 31, 2010). (No appeal taken.) The Tax Court held that the interest expense incurred by Beneficial New Jersey ( BNJ ) on its loans from its parent was a reasonable expense and deductible. BNJ offered consumer finance products to its customers from its New Jersey retail lending branches. The company would make loans to its customers and then finance those loans by borrowing funds from its parent HSBC Financial Corporation ( HSBC ). In turn, HSBC borrowed funds from unrelated third parties. BNJ deducted the interest payments made on the loans from its parent. The Director, on audit, added the interest expenses back to taxable income under

18 Page 17 N.J.S.A. 54:10A-4(k)(2). exceptions applied. The Director took the position that none of the BNJ argued that three of the exceptions were met, (1) guarantor/conduit; (2) a reasonable expense, and (3) the 3% exception. The Tax Court in its decision concluded the 3% exception was not met because the statute does not contemplate a tax rate but rather the taxpayer s effective tax rate is what the test is. The effective tax rate in the eyes of the Tax Court is the most representative of the extent of the taxation of the taxpayer s activity in the state. Thus, because BNJ effective tax rate did not meet the 3% test it fails that exception. With respect to the exception to the guarantee exception the taxpayer must guarantee the parent s debt. BNJ failed to provide sufficient evidence to support this exception. The agreement between BNJ and the parent does not include the third-party lender. The Tax Court agreed the unreasonable exception was met. The HSBC loans had economic substance and the reason for the practice of HSBC making the loans to its affiliates was creditable because HSBC could receive more favorable rates from third-party lenders. Further, HSBC paid tax to other jurisdictions on the interest income. Finally, the Director failed to explain his approach to the unreasonable exception. 6. New Jersey Division of Taxation, TAM 13, February 24, 2011 The Department has issued a Technical Advise Memorandum ( TAM ) that addresses the addback of a related member interest. Specifically, the TAM sets forth fact patterns where the addback of the interest would be unreasonable. Included in those fact patterns are the cash sweep forms of cash management. The TAM indicates that the holding of Beneficial of New Jersey will be applied on a case-by-case basis. Finally, the TAM addresses the Foreign Nation and Conduit exceptions. 7. New Jersey Division of Taxation, TAM , (December 5, 2011). The New Jersey Division of Taxation issued a Technical Advisory Memorandum addressing deductions for intangible expenses when the recipient is a foreign corporation. Pursuant to the TAM, where a domestic affiliate pays royalty expenses to a foreign affiliate for use of intangibles, the Division of Taxation will use the principles found in IRC 482 to determine arm s-length pricing. Further, the Division may request certain documentation, including a description of the organizational structure, identification of the transfer pricing method and an explanation as to why it was the appropriate method. A third-party transfer

19 Page 18 pricing study or advance pricing agreement will satisfy the document request. The failure to provide such documentation can result in disallowance of the expenses. See also: TAM Discussing Advance Pricing Agreements. 8. Wendy s International Inc. v. Virginia Department of Taxation, Circuit Court of City of Richmond, Case No. CL , March 29, The Richmond Circuit Court held that Wendy s International was not required to add back the royalties paid to a related entity for use of intellectual property. The payments fell within one of the exceptions because the intellectual property was ultimately sublicensed to unrelated third-parties. The royalties in question were paid to Oldmark LLC, a disregarded entity for tax purposes. As a subsidiary of Wendy s International, Scioto Insurance held the interest in Oldmark. Oldmark licensed the intellectual property to Wendy s International who in turn sublicensed it to restaurants owned by related and unrelated companies. The Department argued that Wendy s did not qualify for the exception because the related member did not directly license the property to the unrelated third-party. The Circuit Court in rejecting the Department s arguments concluded that the statutory language did not support the conclusion that Oldmark must receive the royalties from the direct licensing to qualify for the addback exception. Therefore, the Circuit Court reversed the Department s denial of the refund. 9. Craig A. Griffith, West Virginia State Tax Commissioner v. Conagra Brands, Inc., W.V. S. Ct., Dkt , May 24, The West Virginia Supreme Court has held that a foreign licensor is not subject to corporation net income and business franchise tax on royalties earned from the licensing of trademarks in a state if the products bearing the trademarks are not manufactured in the State, the foreign licensor does not direct how the licensee distributes the products, and the licensor does not operate retail stores in the State. ConAgra Foods, Inc. ( CA Foods ) established ConAgra Brands, a wholly-owned subsidiary of CA Foods, to centralize its trademark and trade name portfolio. ConAgra Brands began collecting royalty payments for the use of its trademarks and trade names by various unrelated, third party licensees and CA Foods affiliated licensees. The royalties were collected from the sale by the licensees of food products bearing the trademarks and trade names to customers throughout

20 Page 19 the United States, including West Virginia. ConAgra Brands obtained substantial royalties related to products sales in West Virginia. ConAgra Brands did not manufacture or sell the products, and all products in question were manufactured by the licensees in facilities outside West Virginia. The various licensees sold or distributed products bearing the trademarks and trade names to wholesalers and retailers located in the State. Additionally, ConAgra Brands conducted its business of licensing and protecting the value of its trademarks and trade names entirely outside of West Virginia, and did not rent or own facilities or employ agents in the State. Moreover, ConAgra Brands did not dictate how the licensees distributed the products bearing the trademarks. However, ConAgra Brands paid all expenses in defending its trademarks and trade names against infringement and in overseeing national marketing by developing marketing strategies. The court addressed the issues of whether ConAgra Brands under both Due Process and the Commerce Clause was subject to corporation net income tax or business franchise tax in West Virginia when it collected substantial royalties from licensing of food industry trademarks and trade names in the State? The court concluded that assessments against ConAgra Brands, a foreign licensor, for West Virginia corporation net income and business franchise tax, on royalties earned from the nation-wide licensing of food industry trademarks and trade names, did not satisfy purposeful direction under the Due Process Clause nor significant economic presence under the Commerce Clause for the following reasons: 1) all products bearing the trademarks and trade names were manufactured solely by unrelated or affiliated licensees of the foreign licensor outside of West Virginia; 2) the foreign licensor did not direct how its licensees distributed the products; 3) and the licensees, operating no retail stores in West Virginia, sold the products only to wholesalers and retailers in the State. 10. Microsoft Corp v. Office of Tax and Revenue, District of Columbia Office of Administrative Hearings, Dkt OTR-00012, May 1, (Appeal withdrawn.) The District of Columbia Office of Tax and Revenue (OTR) issued a tax deficiency assessment for the tax years in the amount of approximately $2.75 million against Microsoft Corporation. The assessment was based upon a transfer pricing analysis conducted by Chainbridge Software. Chainbridge used a comparable profits method to analyze Microsoft s profit-tocost ratio for the 2002 tax year compared to the profit-to-cost ratios for a similar entity. However, Chainbridge did not limit its analysis to controlled transactions between Microsoft and affiliated businesses, and instead, included all of

21 Page 20 Microsoft s controlled and uncontrolled transactions. As a result of the analysis, the OTR determined Microsoft was shifting income to avoid paying tax in the District and Microsoft s carrying forward of a 2002 net operating loss for the 2005 tax year should not be allowed. Microsoft filed a protest of the assessment with the OAH. The question addressed was whether under Internal Revenue Code Section 482, whether Chainbridge s transfer pricing analysis was arbitrary, capricious, and/or reasonable when it served as the basis for the assessment against Microsoft? Under the federal regulations, the standard for transfer pricing analyses is whether the controlled transactions are conducted at arm s length. The controlled transactions must yield results that are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (b)(1). An evaluator is permitted to aggregate only when the transactions are so interrelated that consideration of multiple transactions is the most reliable means of determining the arm s length considerations for the controlled transactions and the transactions involve related products or services. A comparable profits method may be used to evaluate whether transactions are conducted at arm s length. An evaluator must select a tested party and determine the amount of operating profit it would have earned on related party transactions if its measures of profitability were equal to an uncontrolled comparable s operating profit. The Administrative Hearing Officer found Chainbridge s transfer pricing study was arbitrary, capricious, and unreasonable for the following reasons: 1) Chainbridge s aggregation of all income, whether controlled or uncontrolled, was overly broad; 2) Chainbridge s entire framework was flawed because it considered all transactions for the comparables and Microsoft; 3) Chainbridge s analysis failed to compare transactions that are functionally comparable. IV. BUSINESS INCOME 1. E.I. DuPont DeNemours & Company v. Department of Treasury, Dkt. No , MI Court of Appeals, August 7, The Michigan Court of Appeals in an unpublished decision held the capital gain recognized by DuPont on its sale of DuPont Pharmaceuticals Company ( DPC ) to Bristol-Meyer was non-business income. In reaching its holding, the court concluded that DPC was not unitary in nature with DuPont. The conclusion was based on the fact that the entities were not in the same line of business; the transactions between the entities were arm s-length; there was no evidence presented that the initial flow of capital served an operational function; and the management by DuPont was nothing more than occasional oversight.