California Office Of Tax Appeals Rejects Unitary Business Treatment For Gain From Sale Of Company Division

In a pending precedential decision, the California Office of Tax Appeals (OTA) found that a beverage distribution division was not unitary with the taxpayer’s other divisions. As a result, the income from the sale of the beverage division was nonbusiness income and not apportionable to California. Based on the evidence presented, the OTA also held that the tax benefit rule did not require recovery of deductions previously taken on a unitary basis.

Background

The taxpayer, an S corporation, conducted business through 14 divisions. Its largest divisions were an interstate trucking business and a Colorado beverage distribution business. Other divisions included, for example, a division that manufactured parts for automobile racing, a graphic design and printing shop, and a travel agency. In 2010, the taxpayer sold the assets of its beverage distribution business, consisting mostly of beer distribution rights, with the remainder including inventory and other assets.

The California Franchise Tax Board (FTB) asserted that the taxpayer was engaged in a single unitary business across all 14 divisions, and thus the income from the sale was business income apportionable to California.

Unitary Business Issue

In considering whether the taxpayer was engaged in a unitary business, the OTA applied both the “three unities test” and the “contribution and dependency test,” finding neither was satisfied.

The three unities test considers whether there is (1) unity of ownership, (2) unity of operation as evidenced by central purchasing, advertising, accounting, and management divisions, and (3) unity of use in the centralized executive force and general system of operation. As the OTA explained, “All three must be present for a unitary business to exist.”

• Unity of Ownership. The OTA found this element satisfied because all operating divisions were commonly owned.
• Unity of Operations. The OTA found that unity of operations existed, but noted “the issue [was] a close one.” Important factors pointed to decentralized operations, such as separate purchasing decisions, checking accounts, advertising, and sales functions. Factors pointing to centralized operations included shared human resources and functions as well as a common insurance policy. Applying Tenneco West, Inc. v. Franchise Tax Bd. (1991) 234 Cal.App.3d 1510 (Tenneco), and Chase Brass and Copper Co. v. Franchise Tax Bd. (1970) 10 Cal.App.3d 496 (Chase Brass), OTA concluded there were more shared operational activities present than in Tenneco, making the case closer to Chase Brass, and thus unity of operations was established.
• Unity of Use. The OTA found unity of use — which can be indicated by common management or intercompany transactions — was lacking. The FTB argued “there was complete overlap between [the taxpayer’s] board of directors and executive officers and the management of divisions.” The OTA found, however, that divisions were managed independently, with shared directors and officers handling minimal oversight akin to that of an investor. Notably, the majority owner of the taxpayer’s voting shares spent 40 weeks per year as a pro stock race car driver — not managing day-to-day operations. The OTA also found that the divisions engaged in minimal intercompany transactions, and to the extent they did, those transactions were conducted at arm’s length.

Given that OTA found no unity of use, the three unities test was not satisfied.

The OTA also held that the taxpayer’s divisions were not unitary under the “dependency or contribution test,” which evaluates whether the business activities are “dependent upon or contribute to each other and the operations of the taxpayer as a whole.” (A.M. Castle & Co. v. Franchise Tax Bd. (1995) 36 Cal.App.4th 1794, 1803-04.) While the divisions shared some common administrative services, they lacked common advertising, significant intercompany sales, centralized management, or other indicators of dependency or contribution. The divisions operated independently, and there was no significant intercompany financing. Accordingly, the contribution and dependency test was also not satisfied.

Because neither the “three unities test” nor “contribution and dependency test” were met, the OTA found the taxpayer was not engaged in a unitary business with its beverage division, and the income from the sale of the beverage division was not apportionable to California.

Tax Benefit Rule

As an alternative argument raised for the first time on appeal, the FTB contended that, to the extent the operations were not unitary, the taxpayer’s prior year deductions should be recovered under the tax benefit rule. Where the tax benefit rule applies, it requires “the inclusion of income when events occur that are fundamentally inconsistent with an earlier deduction.” (Hillsboro Nat’l Bank v. Commissioner (1983) 460 U.S. 370, 372.) The basic purpose of the rule “is to achieve rough transactional parity . . . and to protect the Government and the taxpayer from the adverse effects of reporting a transaction on the basis of assumptions that an event in a subsequent year proves to have been erroneous.” (Id. at p. 384.) Because the FTB raised this issue for the first time on appeal and it required new evidence, the OTA found that the FTB bore the burden of proof. The OTA further found that the FTB failed to meet its burden of establishing that the taxpayer received tax benefits from prior year deductions due to previously filing on a unitary basis. The OTA therefore rejected the FTB’s position under the tax benefit rule.

Conclusion

With few California decisions holding that a taxpayer was not engaged in a unitary business, taxpayers considering whether they are engaged in a unitary business may wish to review this pending precedential decision, and its impact on their California tax filings.

The opinion is available here.