United States: Colorado Court Finds Holding Company Not Subject To Combination With Operating Affiliates

A Colorado district court has held that the Colorado Department of Revenue erred in requiring the inclusion of a holding company in a corporation's combined corporate income tax returns because the holding company did not meet the definition of an "includible C corporation" under state law. To be considered an "includible C corporation," more than 20 percent of the C corporation's property and payroll must be assigned to locations inside the United States. Because the holding company had no property or payroll of its own, it did not meet the more than 20 percent property and payroll test required to be an "includible C corporation."¹

Background

Colorado requires that a combined income tax return be filed by the includible members of an affiliated group of C corporations. Colo. Rev. Stat. Sec. 39-22-303 provides extensive rules governing which C corporations must be included in a combined group.

Under Colorado's combined accounting method, an affiliated corporation or group is defined as "one or more chains of includable C corporations connected through stock ownership with a common parent C corporation."² An includable C corporation is defined as "any C corporation which has more than twenty percent of the C corporation's property and payroll...assigned to locations inside the United States."³ Further, an includable C corporation must meet at least three of six enumerated factors in the current and two preceding tax years in order to be included in a Colorado combined return.⁴

Agilent Technologies, Inc. (Agilent), the head of a corporate structure doing business in Colorado, filed Colorado combined corporate income tax returns with several of its unitary affiliates. One of Agilent's affiliates, Agilent Technologies World Trade, Inc. (World Trade), a holding company with its own foreign subsidiaries, was part of Agilent's unitary business. At issue in the case was whether World Trade had to be included in Agilent's Colorado combined corporate income tax returns.

Agilent's arguments

Agilent raised four arguments in support of its position that World Trade was not required to be included in the Agilent Colorado combined return:

• World Trade and four of its foreign subsidiaries were taxed together as a single entity in their federal return and should have been treated in the same manner for Colorado corporation income tax purposes. Under this treatment, at least 80 percent of the property and payroll of World Trade was located outside the United States and, as a result, World Trade could not be included in Agilent's combined return.
• World Trade did not meet the definition of an "includible C corporation" under Colo. Rev. Stat. Sec. 39-22-303(12)(c).
• World Trade did not meet the requirement under Colo. Rev. Stat. Sec. 39-22-303(11)(a) under which a C corporation must meet at least three of six enumerated factors in order to be included in a Colorado combined return
• Including World Trade in Agilent's Colorado combined returns was unconstitutional because it resulted "in impermissible discrimination against corporations that own foreign subsidiaries, and in favor of corporations that own domestic subsidiaries."

Department's arguments

The Department raised two arguments in response:

• The Department was not bound by Agilent's federal "check-the-box" designations and all statutory requirements were met to include World Trade in Agilent's Colorado combined return, and such action did not violate the U.S. Constitution's Commerce Clause.
• In order to accurately reflect Agilent's income apportionable to Colorado, World Trade's income had to "be considered as a part of Agilent's domestic unitary business," and this inclusion was required under its discretionary authority to clearly reflect the taxpayer group's income under Colo. Rev. Stat. Sec. 39-22-303(6) and under the economic substance doctrine.

After addressing each of the above arguments, the court ultimately concluded that World Trade was not required to be included in Agilent's combined return because it did not meet the definition of an "includible C corporation" under Colo. Rev. Stat. Sec. 39-22-303(12)(c).

Department's Regulation Defining "Includible C Corporation"

The court explained that a Department regulation addressed how the includible C corporation designation applies to companies with no property or payroll. The regulation states:

Based on the regulation, the court concluded that World Trade was not an includable C corporation. As a holding company with no property or payroll of its own, World Trade could not have satisfied the 20 percent United States property or payroll factor tests.

In the opinion, the court rejected the Department's argument that World Trade had value factors that would result in meeting the thresholds required to be an includible corporation, because it used Agilent's property and personnel.⁶ The court based its decision on the rejection of an earlier version of the Department's regulation at issue, which provided that a "corporation without property and payroll, which functions through the use of personnel services and/or property of an includible corporation, shall also be considered an includible corporation."⁷ The court noted that the legislative history showed that this regulation was allowed to expire because it directly conflicted with the definition of "includible corporation" in Colo. Rev. Stat. Sec. 39-22-303(12)(c).⁸

Court's Consideration of Alternative Agilent Arguments

While the court concluded that World Trade did not meet the definition of "includible C corporation," settling the matter in favor of Agilent, it is instructive to consider the analysis used by the court in rejecting Agilent's alternative arguments.

Interplay of Federal Check-the-Box Rules and 20 Percent Calculation

Agilent argued that the federal income tax treatment of World Trade and four of its foreign subsidiaries as a single entity (pursuant to the subsidiaries' check-the-box elections) should have resulted in similar treatment for purposes of determining whether the 20 percent payroll and property test was met. The court determined that the federal check-the-box designations did not automatically inform the treatment of Colorado taxpayers under the combined reporting / unitary business rules. Accordingly, the four foreign subsidiaries did not need to be grouped with World Trade for purposes of determining whether the definition of "includible C corporation" was satisfied pursuant to the 20 percent test.

Applicability of Combination Factors

Agilent also argued that World Trade was not subject to combination with Agilent's group because the three of six factor test for combination was not met. Specifically, Agilent claimed that it did not meet the requirement that World Trade substantially use "the trademarks or other proprietary materials of Agilent" as required under Colo. Rev. Stat. Sec. 39-22-303(11)(a)(IV). In disagreeing with Agilent, the court noted that Agilent trademarked the terms "Agilent" and "Agilent Technologies" and World Trade's use of Agilent's trademark constituted "substantial use" within the meaning of Colo. Rev. Stat. Sec. 39-22-303(11)(a).⁹

Constitutionality of Corporate Income Tax Regime

Finally, the court rejected Agilent's argument that Colorado's corporate income tax regime discriminated against corporations with non-combinable foreign subsidiaries and favored corporations with domestic subsidiaries, on the basis that the treatment of dividends received from United States subsidiaries differed from dividends received from foreign subsidiaries. Instead, the court concluded that Colorado's version of combined reporting, which may have contributed to the disparity in treatment, was constitutional, both facially and as applied to Agilent.¹⁰

Department's Discretionary Authority Statute and Economic Substance Doctrine Inapplicable

The Department argued that its power of discretionary authority to clearly reflect the taxpayer group's income, as well as the economic substance doctrine, required that World Trade be included in Agilent's Colorado combined return. The court rejected both these arguments.

Discretionary Authority to Clearly Reflect Income

The Department argued that Colo. Rev. Stat. Sec. 39-22-303(6) allows it to "allocate income without the combination of affiliated corporations." The court disagreed, pointing to language in 1 Colo. Code Regs. 201-2, Sec. 39-22-303.6 which indicates that Colo. Rev. Stat. Sec. 39-22-303(6) "is not a vehicle for combining income of affiliated corporations, and cannot be used to circumvent the combined reporting regime found in C.R.S. §§ 39-22-303(8) through (12)." To hold otherwise would "render Colorado's combined reporting statutory regime moot," the court said.

Economic Substance

The Department also argued that the economic substance doctrine allowed it to "disregard a structure that has no practical effect beyond the creation of tax benefits." The court rejected this argument, finding that the economic substance doctrine did not apply because there was nothing to indicate that the Agilent/World Trade structure was created to avoid Colorado tax. The court noted that World Trade provided "bona fide" non-tax related benefits such as protection against foreign creditors' claims.

Commentary

The decision by the Colorado district court provides valuable guidance on the treatment of holding companies under Colorado's combined reporting regime. While the court's decision turned on whether World Trade met the statutory and regulatory definition of an "includible C corporation," its detailed analysis of the arguments made by both the Department and Agilent provide guidance on the potential inclusion of holding companies in a combined return.

The decision provides the taxpayers with some clarity on an issue that has been the subject of debate with regard to proposed updates to Colorado's combined reporting regulations. Specifically, the Department has indicated its desire to issue a regulation expanding its discretionary powers to combat perceived taxpayer abuse of the combined reporting rules to include or exclude affiliates from the Colorado combined filing group. As the court noted, allowing the Department such "broad authority" would "render Colorado's combined reporting statutory regime moot." It would be reasonable to assume that the Department will view this aspect of the opinion as a setback.

On the other hand, the Department will likely find value in the court's language defining the most vague of the tests of unity, relating to the "...substantial use of patents, trademark, service marks, logo-types, trade secrets, copyrights, or other proprietary materials owner by [another affiliate]." Observing that World Trade incorporates "Agilent" into its formal legal name, the court applied a common sense approach in concluding that such use "is important to both World Trade and Agilent in that it reflects a unified group. World Trade's use of the trademark conveys an affiliation with Agilent to all third-parties in the ordinary course of trade."

The court's interpretation of the nature of the federal entity classification rules may cause issues for taxpayers that have long assumed that a check-the-box election for federal income tax purposes is fully recognized for all aspects of Colorado corporation income taxation. The court stated that "[t]he federal "check-the-box" rules...allow affiliated companies to elect consolidation for federal tax calculation by choosing to be disregarded as a separate entity." However, instead of concluding that the election governed determinations under the Colorado corporation income tax statute, the court surprisingly found that "an entity's choice of federal designation is not binding for purposes of state application." Taxpayers that may have relied on the "flow through" of attributes (payroll and property) from disregarded entities, foreign or domestic, in determining whether entities meet the more than 20 percent property and payroll test must now re-evaluate positions taken on current and prior returns. The conclusion that the federal "check-the-box" rules are not binding on the state could have further unintended consequences for all Colorado taxpayers with such entity classification elections in place.

The Department has already indicated that new or revised regulations are likely to be promulgated to address issues arising from this case. In addition, taxpayers should be aware that the Department issued a notice cautioning taxpayers against relying on the Department's regulation in certain circumstances.¹¹ The Department explained that the regulation was intended to apply to foreign sales corporations (FSCs) and not to domestic holding companies. In the notice, the Department states that "some taxpayers have interpreted Regulation 303.12(c) to apply to domestic holding companies with no foreign operations and have argued that they can exclude any domestic C corporation from their combined returns if it has no property or payroll, even if it does not do business in a foreign country." The Department specifically states that it disagrees with this interpretation. Noting that this issue is currently being litigated, the Department said that it would revisit the matter after a decision is released: "Pending that determination, taxpayers should not rely on this regulation except as it applies to an FSC."

Footnotes

1 Agilent Technologies, Inc. v. Colorado Department of Revenue, District Court, 2nd Judicial District (Colorado), No. 2014CV393, January 20, 2016.

2 COLO. REV. STAT. § 39-22-303(12)(a).

3 COLO. REV. STAT. § 39-22-303(12)(c).

4 COLO. REV. STAT. § 39-22-303(11).

5 1 COLO. CODE REGS. 201-2, Reg. 39-22-303.12(c). It should be noted that COLO. REV. STAT. § 39-22-303(12)(c) statutorily defines the term "includable C corporations" as "any C corporation which has more than twenty percent of the C corporation's property and payroll . . . assigned to locations inside the United States." In contrast, Colorado's regulation states that the test for classification as an includible C corporation may be met when a corporation has "twenty percent or more" of its property and payroll factors assigned to the United States.

6 Based on a reading of COLO. REV. STAT. § 24-60-1301(IV)(10) and 1 COLO. CODE REGS. 201-3, Reg. IV.18.(b). COLO. REV. STAT. § 24-60-1301 (IV)(10) provides: "The property factor is a fraction, the numerator of which is the average value of the taxpayer's real and tangible personal property owned or rented and used in this State during the tax period and the denominator of which is the average value of all the taxpayer's real and tangible personal property owned or rented and used during the tax period." 1 COLO. CODE REGS. 201-3, Reg. IV.18.(b) provides: "If property owned by others is used by the taxpayer at no charge or rented by the taxpayer for a nominal rate, the net annual rental rate for such property shall be determined on the basis of a reasonable market rental rate for such property."

7 Former 1 COLO. CODE REGS. 201-2, Sec. 39-22-303.12(c).

8 Citing to a memorandum from the Office of Legislative Services to the General Assembly's Committee on Legal Services: "Both regulations conflict with the definition of "includible corporations" as set forth in section 39-22-303(12)(c), C.R.S. The regulations allow corporation with no property or personnel to be considered includible corporations even though such corporations do not satisfy the statutory requirements of having more than twenty percent of its property and payroll located in the United States. By allowing such corporations to qualify as includible corporations, Regulations 39-22-303.8(2) and 39-22-303.12(c) modify the definition of "includible corporations" as set forth in section 39-22-303(12)(c), C.R.S."

9 "World Trade is a wholly owned subsidiary of Agilent that employs the trademarked terms "Agilent" and "Agilent Technologies" in its own name and in its tax returns, regulatory filings, its agreements with third parties, and in its accounting statements. This use is not incidental or occasional but systemic and intentional to signify its place in a unified group. The trademarked name carries prestige and credibility, and its use is important to both World Trade and Agilent in that it reflects a unified group. World Trade's use of the trademark conveys an affiliation with Agilent to all third-parties in the ordinary course of trade."

10 Citing to In re Appeal of Morton Thiokol, Inc., 864 P.2d 1175 (Kan. 1993); Emerson Elec. Co. v. Tracy, 735 N.E.2d 445 (Ohio 2000); E. I. Du Pont de Nemours & Co. v. State Tax Assessor, 675 A.2s 82 (Me. 1995); Caterpillar, Inc. v. Comm'r of Rev., 568 N.W.2s 695 (Minn. 1997); Bernard Egan & Co. v. State De't of Rev., 769 S.2d 1060 (Fla. Dist. Ct. App. 2000); Caterpillar Fin. Servs. Corp v. Whitley, 680 N.E.2d 1082 (Ill. App. Ct. 1997); GE v. Comm'r, 914 A.2s 246 (N.H. 2006), cert. denied, 552 U.S. 989 (2007). The court distinguished itself from the unconstitutional tax system found in General Foods, Inc. Iowa Dep't of Rev., 505 U.S. 71 (1992).

11 Colorado Department of Revenue, "Notice Regarding Revenue Regulation 39-22-303(12)(c)," Jan. 19, 2016.

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