United States: Missouri Administrative Hearing Commission Holds Intercompany Dividends Are Excluded From Sales Factor Denominator

On October 17, the Missouri Administrative Hearing Commission (AHC) held that dividends paid to a parent corporation and its subsidiaries by affiliates that were part of the same consolidated group were required to be excluded from the sales factor denominator because the facts failed to determine the amount of dividends that arose from operations in Missouri, and the inclusion of dividends only in the sales factor denominator would prevent the fair operation of the apportionment formula.¹

Background

The taxpayer, a Missouri holding company that provided telecommunication services through its subsidiaries, elected to file a Missouri consolidated income tax return² with its subsidiaries using a three-factor method of income apportionment for a short taxable year beginning May 18, 2006 and ending December 31, 2006. For purposes of apportionment, the taxpayer included $1,276,822,176 in dividends paid to the taxpayer and its subsidiaries by other affiliated companies (local exchange carriers) in the consolidated group in its sales apportionment denominator. The taxpayer recorded these dividends as "cash distributions" which were not considered to be the sales of goods or services by the payers or recipients.

In 2008, the Missouri Department of Revenue's Field Compliance Bureau ("Bureau") began an audit of the taxpayer's 2006 tax year and adjusted the sales factor denominator to exclude the dividends paid by affiliates from the sales factor denominator. The Bureau issued a Notice of Deficiency, assessing an additional amount of $74,924.45 (including interest and penalties), the vast majority of which was a result of the audit adjustment that excluded the dividends paid by affiliates from the sales factor denominator. The taxpayer appealed the Notice directly to the AHC. The sole issue before the AHC was whether the dividends paid by the taxpayer's affiliated companies should be included in the sales factor denominator.

Dividends Not Included in Sales Factor Denominator Under Intercompany Transaction Regulation

A Missouri regulation defines the term "sales and business transactions" to include all intercompany sales (business transactions as defined in Treas. Reg. Section 1.1502-13 (relating to federal consolidated reporting of intercompany transactions).³ Relying on this regulation, the taxpayer argued that the dividends from affiliates were distributions with respect to stock between members of the same consolidated group, and as a result, they constituted "intercompany transactions" that should be included in the sales factor denominator.

Since the issue raised by the taxpayer was a matter of first impression in Missouri, the AHC considered precedent from other states. The AHC ultimately gave weight to a Florida court decision to determine that dividends were not includable in the sales factor denominator under the regulation relied upon by the taxpayer. The Director had presented the AHC with Department of Revenue v. Anheuser-Busch, Inc.⁴ due to the fact that Florida had a similar intercompany transaction regulation. In Anheuser-Busch, Inc., the transactions were deemed intercompany transactions because there were indicia of sales, such as an invoice from the subsidiary to the parent company and delivery of the sold items from the subsidiary to the parent company. In the present case, however, the taxpayer recorded the dividends as cash distributions, and not the sales of goods or services. Due to this distinction, the AHC found that the dividends were not includable in the sales factor denominator as "intercompany transactions" under the regulation cited by the taxpayer.

Inclusion of Dividends in Sales Factor Denominator Resulted in Unfair Apportionment

While the dividend was not includible pursuant to the regulation addressing intercompany transactions, a second regulation addressing exceptions and special rules applicable to the sales factor was analyzed as well.⁵ Under this regulation, the Department contended that the income from the dividends resulted from the mere holding of intangible personal property and could not be attributed to any particular income-producing activity of the taxpayer. As such, the dividend income could not be includible in the sales factor denominator. The taxpayer argued that this exclusion rule only applied to passively held stocks or stocks that are "merely held" and not to its dividends, which were business income from income-producing activities.

To bolster its argument, the taxpayer presented Legal Ruling 2003-3 issued by the California Franchise Tax Board (FTB).⁶ In that ruling, the FTB was confronted with regulatory language that was very similar to the regulatory language at issue and decided that business income dividends were gross receipts as long as they represent more than just the holding of intangible property. Applying this ruling to the case at hand, the AHC found that the taxpayer's participation in management and operations of other affiliated companies showed that the dividends were gross receipts qualified to be included in the sales factor denominator under the specific regulatory provisions addressing income-producing activity.

However, the Department also contended that including the taxpayer's dividends in the sales factor denominator would effectuate unfair apportionment under the regulations.⁷ Pursuant to this argument, the Missouri-sourced dividends could not be separately identified since there were not enough facts to establish the dividends that arose from operations taking place in Missouri versus operations taking place elsewhere, and as such, this prevented fair apportionment. The AHC agreed with the Department's position, excluding the dividends from the sales factor denominator, and upheld the assessment against the taxpayer.

Commentary

Missouri permits taxpayers, under certain circumstances, to include the effect of intercompany transactions in the sales factor. In this case, however, the AHC denied application of the intercompany transaction regulation used by the taxpayer in support of its argument. While this regulation was unavailable to the taxpayer, the AHC ultimately based its exclusion of the dividends from the sales factor on a different ground. The lack of factual support to identify the dividends that arose from Missouri operations, and therefore, the inclusion of dividends in the sales factor denominator, prevented the fair apportionment of income in the eyes of the AHC.

Significantly, the AHC appears to suggest that had the taxpayer been able to separately identify the dividends arising from Missouri, the taxpayer would have been able to include the dividends in the apportionment factor. This would have been a positive development for the taxpayer if the dividends could be sourced entirely outside of Missouri, as the inclusion of such dividends solely in the denominator of the sales factor would have reduced the taxpayer's apportionment percentage to Missouri.

Footnotes

1 Embarq Corp. v. Department of Revenue, Missouri Administrative Hearing Commission, No. 10-1485 RI, October 17, 2012.

2 The affiliated companies participating in the Missouri consolidated income tax return were identical to the companies participating in the taxpayer's federal consolidated return.

3 MO. CODE REGS. ANN. tit. 12, § 10-2.045(19).

4 Department of Revenue v. Anheuser-Busch, Inc., 527 So.2d 877 (Fla.1st DCA 1988).

5 MO. CODE REGS. ANN. tit. 12, § 10-2.075(43) and (57); MO. CODE REGS. ANN. tit. 12, § 10- 2.075(64)(C).

6 Franchise Tax Board Legal Ruling 2003-3, December 4, 2003.

7 MO. CODE REGS. ANN. tit. 12, § 10-2.075(43).

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