The Arizona Court of Appeals has held that a major retailer was required to file a combined corporate income tax return with its subsidiary that owned and licensed trademarks to the retailer because both entities were conducting a unitary business.1 According to the Court, unitary treatment was required because the operations of the two corporations were substantially interrelated. The use of the trademarks was an integral component of the retailer's delivery of products to its customers. Also, the subsidiary did not license trademarks to other companies.

Background

Home Depot, a Delaware corporation headquartered in Georgia, operates retail stores selling home improvement products throughout the United States. In 1991, Home Depot created a wholly-owned subsidiary, Homer, to hold its trademarks.2 Home Depot originally entered into a licensing agreement to pay a royalty of 1.5 percent of gross sales for its use of the trademarks. The royalty amount was increased to 4 percent of gross sales during the tax years in question. Under the license, Home Depot placed the trademarks on a wide variety of items, including its advertising, stores and some of the products that it sold. The Arizona Department of Revenue conducted an audit and required Home Depot to include Homer in its Arizona corporate income tax return as part of its unitary business. After timely protesting and exhausting its administrative remedies, Home Depot appealed the assessments to the Arizona Tax Court, which ruled in the Department's favor. Home Depot appealed the Tax Court's ruling to the Arizona Court of Appeals.

Determination of Unitary Business

In the case of an affiliated group of corporations with operations in multiple states, courts apply the unitary business principle to determine whether a particular corporation "has the requisite minimal state connection to include its income in the tax base."3 If the affiliated corporations comprise a unitary business, Arizona requires them to file a combined return.4 In State ex rel. Arizona Department of Revenue v. Talley Industries, Inc., the Arizona Court of Appeals adopted an "intermediate approach" to determine whether to apply unitary treatment.5 Under this approach, unitary treatment is appropriate when there is "substantial interdependence of basic operations among the various affiliates or branches of the business."6 In Talley, the Court of Appeals examined 25 subsidiaries that manufactured distinct lines of products, imported clothing and bought and sold property. The parent company sought unitary treatment and argued that it controlled the subsidiaries' operations. The Court held in Talley that the parent company and its subsidiaries could not file a combined return because there was "no substantial interrelationship or interdependence of basic operations" between the parent and the affiliates.7

In R.R. Donnelley & Sons Co. v. Arizona Department of Revenue, the Court of Appeals applied the Talley test to a subsidiary that licensed trademarks to its parent company.8 The Court held that unitary treatment was required because the trademarks were part of the parent's "basic operations" and the subsidiary's licensing business was "functionally interdependent" with the parent's business. To support its decision, the Court relied on the factors that the parent paid the subsidiary royalties of between $25 million and $100 million a year and the subsidiary did not license the trademarks to any other companies.

Unitary Treatment Required

The Court of Appeals held that unitary treatment was required because the operations of Home Depot and Homer were substantially interrelated.9 In reaching its decision, the Court acknowledged that Home Depot and Homer were separate organizations. However, the Court explained that the trademarks that Home Depot licensed from Homer for its retail stores, advertising and Web site were fundamental to its business. Also, the Home Depot trademarks, which were Homer's only assets, would be worthless without Home Depot's continuing efforts to promote its brand. In fact, the trademarks had value to Homer only to the extent that customers valued the Home Depot brand.

Home Depot argued that the businesses were not unitary because Homer was in the distinct business of licensing trademarks. In rejecting this argument, the Court noted that the only trademarks that Homer licensed were those that it acquired from Home Depot. The Court determined that there were basic operational ties between the two entities and explained that 97 percent of Homer's revenue was derived from domestic Home Depot affiliates. Home Depot also argued that Homer's licenses were an "accessory" to Home Depot's business and, similar to Talley, did not require or allow unitary treatment.10 In the instant case, the Court noted that Donnelly held that the trademark the parent company licensed from the subsidiary was not an accessory service. Similar to Donnelley, the trademarks that Home Depot licensed from Homer were an integral component of Home Depot's delivery of products to its customers. According to the Court, it did not matter that most of the products that Home Depot sold displayed the trademarks of other manufacturers.

Home Depot argued that unitary treatment was not required because its transactions with Homer were at arm's length and the royalties paid to Homer were not challenged by the Department. However, the Court rejected this position and explained that "[w]e cannot accept the argument that unitary treatment is not appropriate under Talley whenever an affiliate's contribution to income can be fairly approximated." The Court in Talley noted that the inability to accurately account for an affiliate's income was a consideration that contributed to the unitary business doctrine, but the Court did not hold that unitary treatment is appropriate only when the taxpayer is unable to calculate the value of the activities performed by the subsidiary. Talley established the principle that unitary treatment is appropriate when the activities of the affiliated companies disprove that the companies function independently of each other. As explained by the Court, "Home Depot's argument that substantially interdependent businesses may escape unitary treatment if they can prove they deal with each other at arm's length flies in the face of our desire in Talley to adopt a 'quantifiable, objective' test for unitary treatment."

The Court also explained that its holding was supported by an Arizona regulation that lists factors for determining whether a taxpayer has sufficient operational integration for unitary treatment.11 Under the regulation, the following threshold characteristics must exist in order to consider whether a group of entities is a unitary business: (1) the entities comprising the unitary business are owned or controlled, directly or indirectly, by the same interests that collectively own more than 50 percent of the voting stock; (2) the entities or components share common management; and (3) the entities or components have reconciled accounting systems.12 If these three characteristics are evident, the entities also must demonstrate operational integration. The regulation lists 15 factors that may be considered in determining operational integration, including the same or similar business conducted by the entities or the vertical development of a product by the entities.13

The Court did not address the threshold characteristics contained in the regulation, and instead concentrated on the 15 factors considered in determining operational integration. After listing all of the factors from the regulation, the Court specifically found that Home Depot and Homer met the following factors:

  • The same or similar business was conducted by components because the trademarks that Home Depot licensed from Homer were an integral part of Home Depot's delivery of goods to its customers;
  • The vertical development of a product by components because Homer was involved in the trademarks' distribution and sales;
  • The transfer of materials, goods and products because the trademarks were transferred from Home Depot to Homer;
  • The sharing of assets by components due to the transfer of the trademarks;
  • Sales or leases occurred between components of the business because "leases" include a license; and
  • Any other integration between components at the basic operational level because Homer conducted 97 percent of its business with Home Depot. Similar to Donnelley, the factors in the regulation weighed in favor of unitary treatment for an operational entity and its corresponding trademark company.14

Commentary

This decision, which may be appealed by Home Depot, provides useful guidance in determining whether subsidiaries are part of a unitary business in Arizona, which applies a unique unitary standard. It is not uncommon for related entities to meet unitary requirements in other states, but fail to meet the standards imposed by Arizona. The Court of Appeals' decision may be questioned on the basis that Homer neither had tangible property nor did it directly contribute to the sale and delivery of the Home Depot products. Unlike the taxpayer in Donnelly, many of the products sold by Home Depot contained different brand names and did not display the Home Depot trademark. However, as explained by the Court, the Home Depot trademark was fundamental to its operations even though it did not appear directly on all of its products. With this decision, the Court reiterated its consistent unitary treatment of intangible holding companies with related operational entities.

Footnotes

1. Home Depot U.S.A., Inc. v. Arizona Department of Revenue, Arizona Court of Appeals, No. 1 CA-TX 12-0005, Dec. 5, 2013.

2. The assignment included trademarks, trade names and service marks that were valued at $354 million.

3. R.R. Donnelley & Sons Co. v. Arizona Department of Revenue, 229 P.3d 266 (Ariz. Ct. App. 2010).

4. ARIZ. ADMIN. CODE R15-2D-401(B); see also ARIZ. REV. STAT. § 43-942(B).

5. 893 P.2d 17 (Ariz. App. Ct. 1994).

6. Id., quoting Jerome R. Hellerstein & Walter Hellerstein, State Taxation, ¶ 8.11[5] at 8-92.

7. Id.

8. 229 P.3d 266 (Ariz. Ct. App. 2010).

9. Interestingly, the Court noted that Home Depot had filed an amicus curie brief in the Donnelley appeal. In Donnelley, the Court commented that the subsidiary's operations differed from Home Depot's description of Homer's business. In the instant case, the Court explained that "[d]irectly presented for the first time with the facts of the relationship between Home Depot and Homer, however, we reach the same result as in Donnelley."

10. In Talley, the Court explained that "accessory services" such as accounting, purchasing and training were services not contained in the product or its delivery to the customer.

11. ARIZ. ADMIN. CODE R15-2D-401.

12. ARIZ. ADMIN. CODE R15-2D-401(D).

13. ARIZ. ADMIN. CODE R15-2D-401(E).

14. R.R. Donnelley & Sons Co. v. Arizona Department of Revenue, 229 P.3d 266 (Ariz. Ct. App. 2010). Note that the court in this case found a trademark affiliate to be unitary, but determined that an investment affiliate and receivables affiliate did not meet the unitary requirements because the investment affiliate provided a service which could have been provided by a third party and the investment affiliate provided an accessory service.

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