On August 20, the Minnesota Tax Court held that an out-of-state provider of pharmacy benefit management (PBM) and mail-order pharmacy services did not have a unitary business relationship with its one-third owned Minnesota joint venture partnership that created an electronic prescription and information routing service.1 The Court determined that there was no flow of value or sufficient control to establish a unitary relationship between the taxpayer and the joint venture partnership. Therefore, the taxpayer's income was not required to be combined with the joint venture partnership's income for combined reporting purposes. Separately, the Court held that a subsidiary of the taxpayer was not required to apportion its Internal Revenue Code (IRC) Section 382 limitation on net operating losses (NOLs).
Background
The taxpayer, a provider of PBM and mail-order pharmacy services, has increased the size of its business through a variety of methods, including organic growth, acquisitions and joint ventures, as displayed by the facts in this case. In 1999, the taxpayer acquired all of the stock of Diversified Pharmaceutical Services, Inc. (DPS). At the time of the acquisition, DPS had accumulated substantial federal NOLs during the 1995 through 1997 tax years.
In 2001, the taxpayer joined forces with two other entities providing PBM services to form RxHub,2 a limited liability company (LLC) headquartered in Minnesota. RxHub was designed to provide electronic prescription and information routing services, facilitating prescription benefit communications. Under the LLC agreement, the taxpayer and the other two members each contributed one third of RxHub's total capital. In addition, between 2002 and 2004, the taxpayer paid RxHub for the use of one of its products, which permitted the taxpayer to provide prescribing physicians with patientspecific medication histories and pharmacy benefits information at the point of care.3
The taxpayer and RxHub did not share employees. They maintained separate human resources personnel, separate employee benefit plans, separate legal and accounting departments, separate purchasing offices, separate bank accounts, and separate data processing systems, and neither entity licensed intellectual property to the other.
The Minnesota Commissioner of Revenue issued an assessment for additional corporate franchise tax and interest for the years 2001 to 2004. This assessment was based on the Commissioner's determination that the taxpayer and RxHub were part of a "unitary business" and thus, required to combine their income to be apportioned to Minnesota. The taxpayer appealed the assessment and argued that it was not unitary with RxHub. Also, the taxpayer argued that DPS was not required to apportion its federal NOL limitation.
No Unitary Business Relationship
The first issue before the Court was whether the taxpayer and RxHub were part of a unitary business and required to combine their income for Minnesota combined reporting purposes. The Court explained that there must be a flow of value4 and at least potential control5 to support a determination that entities are in a unitary business relationship.
No Flow of Value
The Court determined that there was no flow of value between the taxpayer and RxHub because the transactions between the entities were made at arm's length. In reaching its conclusion, the Court reviewed the history of U.S. Supreme Court decisions that clarified the unitary business concept. These decisions emphasized the requirement that the entity in question must be "functionally integrated" with the in-state affiliate.6
The Court analogized the present case with two decisions, ASARCO, a U.S. Supreme Court decision, and Hercules, Inc., a Minnesota Supreme Court decision,7 finding no unitary business where the entities engaged in transactions at arm's length. Because the prices were fair in these cases, the Courts held that the transactions did not indicate a "flow of value" necessary to create a "unitary business" relationship. In the present case, the taxpayer demonstrated that its transactions with RxHub were conducted at arm's length and without any discounts.
Based on Hercules, the fact that the taxpayer made significant capital contributions to RxHub did not indicate a unitary relationship.8 Moreover, based on ASARCO, the mere fact that RxHub's formation served the taxpayer's corporate business purpose did not mean there was a unitary business; to hold otherwise would "destroy the concept of unitary business."9
Overall, the evidence showed that RxHub operated independent of the taxpayer. Among other things, RxHub had its own departments to make operational and strategic decisions, as well as its own employees, bank accounts, purchasing and office facilities, data processing system, and intellectual property. Therefore, the interactions between the taxpayer and RxHub failed to establish a sufficient flow of value between the two parties to conclude that there was a unitary business relationship.
Lack of Control
The Court determined that the taxpayer did not have the control necessary to find that there was a unitary business. According to the Court, case law required, at a minimum, an exercise of "potential control."10 In this case, there was no preferential treatment of the taxpayer compared to other prospective customers of RxHub. The programs and products were not developed solely for the benefit of the taxpayer. In fact, the taxpayer was not a customer of some of the main product offerings. In addition, the fact that the taxpayer had only one of the three votes to set the fees of RxHub, and the taxpayer desired to be informed of RxHub's solicitation of the taxpayer's existing clients, did not establish control. Furthermore, the taxpayer's capital or service contributions to RxHub could not be viewed as an exercise of "control" without also viewing the contributions by the other owners of RxHub as control. In Hercules, the Minnesota Supreme Court held that a parent company did not control its subsidiary "because it had to share [that] control."11
Net Operating Loss Limitation
The Court determined that the taxpayer's subsidiary, DPS, was not required to apportion its federal NOL limitation under Section 382.12 Due to the taxpayer acquiring all of DPS' stock in 1999, and the fact that DPS had generated significant federal NOLs during the 1995 through 1997 tax years, a Section 382 limitation computation was required. Relying on a Revenue Notice,13 the Commissioner apportioned the Section 382 limitation, using the apportionment ratio of the income years to dramatically reduce the limitation amount from $30 million to $120,000.
The taxpayer argued that apportionment was improper based on the language of the applicable statute that provides "[t]he limitation amount determined under section 382 shall be applied to net income, before apportionment, in each post change year to which a loss is carried."14 The Court agreed with the taxpayer's interpretation of the statute, finding that apportionment is inappropriate where the statute specifically states that the limitation is to be determined "before apportionment." The Court also stated that the Revenue Notice upon which the Commissioner relied did not carry the weight of law.
Furthermore, another part of the same statute explicitly provided that the NOL is to be apportioned to Minnesota based on the apportionment percentage of the loss year.15 If the legislature intended for apportionment with respect to the Section 382 limitation, it would have drafted the statute in a similar manner. Another important factor was the federal treatment of the Section 382 limitation. Under the federal rules, the NOL limit is fixed at the time of the corporate ownership change and is not subject to change as a result of post-change actions taken by the new corporate owner. The Commissioner's computation deviated from the federal rules by taking into account these post-change actions. Therefore, both the plain language of the statute and the federal treatment of the Section 382 limitation supported the conclusion that the limitation must be applied to the taxpayer's net income before apportionment.
Commentary
This decision provides further guidance with respect to the unitary business principle in Minnesota. The outcome highlights the need to adhere to standards adopted by the U.S. Supreme Court, under which the flow of value in a unitary business relationship requires more than the mere flow of funds relating to passive investment.16 The facts and evidence in the case showed that the flow of funds was a reflection of typical investment activities and did not rise to the level necessary to conclude that a unitary business relationship existed. Likewise, the "management" activities in dispute constituted standard activities engaged in by owners to oversee an investment. The decision may cause some taxpayers to evaluate their joint ventures to consider whether they may be excludible from a unitary group. Despite states' efforts to broaden unitary business tests to include as many entities as possible, particularly in recent incarnations of combined reporting statutes and regulations, the constitutional limits to these tests may provide for a less expansive conception of unitary business than previously thought.
The rejection of the Department's attempted apportionment of the Section 382 limitation could portend interesting times with respect to the state income tax treatment of this complex concept. Taxpayers should be aware that states are becoming more aware of the Section 382 limitation, particularly as the economic difficulties in the past several years have resulted in takeovers of numerous businesses with historic losses. The attempt by several state tax authorities to require apportionment of the Section 382 limitation in recent years, in some cases through administrative pronouncements, could be considered violative of existing statutes. Accordingly, the taxpayer-favorable determination with respect to the Section 382 limitation in Minnesota, comes as welcome news. This holding should cause taxpayers to review their historic Section 382 limitation calculations as applied to Minnesota, potentially resulting in refund opportunities.
Footnotes
1 Express Scripts, Inc. v. Commissioner of Revenue, Minnesota Tax Court, No. 8272 R, Aug. 20, 2012.
2 Note that RxHub elected to be taxed as a partnership.
3 RxHub also developed and provided two other products during the years at issue, but the taxpayer did not utilize either one of these other products.
4 Container Corp. v. Franchise Tax Board, 463 U.S. 159 (1983); MINN. STAT. § 290.17(4)(b).
5 ASARCO, Inc. v. Idaho State Tax Commission, 458 U.S. 307 (1982); Woolworth Co. v. Taxation and the Department of Revenue, 458 U.S. 354 (1982).
6 The Court cited to Container, 463 U.S. 159; Woolworth, 458 U.S. 354; and Exxon Corp. v. Department of Revenue, 447 U.S. 207 (1980).
7 ASARCO, 458 U.S. 307; Hercules, Inc. v. Commissioner of Revenue, 572 N.W.2d 111 (Minn. 1998).
8 In Hercules, 572 N.W.2d 111, the owner made capital contributions to the subsidiary and despite these contributions, the Court held there was no unitary relationship.
9 In ASARCO, 458 U.S. 307, the subsidiaries sold ore to the parent company, serving the parent company's business purpose. Nonetheless, the Court found no unitary business.
10 The Court cited to Woolworth, 458 U.S. 354, and Watlow Winona, Inc. v. Commissioner of Revenue, 495 N.W.2d 427 (Minn. 1993).
11 Hercules, 572 N.W.2d 111.
12 IRC § 382 imposes a cap on the amount of the deduction that can be claimed per year. 13 Revenue Notice 99-07, Minnesota Department of Revenue, Aug. 9, 1999. 14 MINN. STAT. § 290.095(3)(d) (emphasis added).
15 MINN. STAT. § 290.095(3)(c) states "[w]here a corporation apportions its income under the provisions of section 290.191, the net operating loss deduction incurred in any taxable year shall be allowed to the extent of the apportionment ratio of the loss year."
16 See Container, 463 U.S. 159.
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