United States: Oregon Tax Court Makes Unitary Business Determination

The Oregon Tax Court has determined that a rent-to-own retailer and its operating subsidiary engaged in the same line of business did not share centralized management, and accordingly were not considered to be unitary for Oregon corporation excise tax purposes.¹ The Court also found that the subsidiary franchisor lacked Oregon corporation excise tax nexus and a wholly owned captive insurance company was unitary with the retailer.

Background

The taxpayer, a rent-to-own retailer, acquired an operating subsidiary in 1996, which subsequently focused solely on franchise operations. The operating subsidiary had also engaged in the rent-to-own business in competition with the taxpayer, but its primary source of revenue was from the sale of rental equipment to its franchisees, who in turn offered the equipment to the general public for rent or purchase under a rental-purchase program. During 2003, seven stores franchised by the operating subsidiary were located in Oregon and the operating subsidiary filed an Oregon corporation excise tax return on a separate company basis.

The taxpayer was issued a notice of deficiency assessment in 2011 by the Oregon Department of Revenue for the 2003 tax year which alleged that the operating subsidiary had Oregon corporation excise tax nexus, and that the taxpayer and its subsidiary were part of a unitary group which also included the taxpayer's wholly-owned captive insurance company.

The taxpayer challenged the Department's assessment in the Oregon Tax Court on the basis that its operating subsidiary and captive insurance company operated autonomously and were not members of the same unitary group. The taxpayer also claimed that its operating subsidiary lacked nexus for Oregon excise tax purposes and that the statute of limitations prevented the assessment.²

Unitary Determination

The Oregon Tax Court began by addressing the substantive issue regarding how to determine which entities are members of a unitary group for purposes of the Oregon corporation excise tax. Oregon imposes a tax on the income of every corporation that derives income from sources within the state, including income from tangible or intangible property located or having a situs in Oregon and income from any activities carried on in Oregon.³ Members of a unitary group are required to file corporation excise tax returns on a combined basis.⁴ A unitary group is defined as a corporation or group of corporations engaged in business activities that constitute a single trade or business.⁵ For the tax year at issue, a single trade or business was defined by statute as a business enterprise in which "there exists directly or indirectly between the members or parts of the enterprise a sharing or exchange of value as demonstrated by (i) centralized management or a common executive force; (ii) centralized administrative services or functions resulting in economies of scale; and (iii) flow of goods, capital resources or services demonstrating functional integration."⁶ An administrative rule also provided that all three criteria must be met for separate entities to be engaged in a single trade or business.⁷

At issue in this case was whether the current or previous version of the statute in effect for the 2003 tax year addressing the "single trade or business" definition was controlling with respect to making the unitary determination. Although the parties stipulated that the tax year at issue in this case was 2003, the term "tax year" is not defined by statute in Oregon. Because the taxpayer filed the 2003 amended Oregon return upon which the Department issued the deficiency in 2009, the Department attempted to apply the current version of the statute⁸ to prove the unitary nature of the relationship between the taxpayer and the franchise subsidiary.

In determining that the statute in effect for the 2003 tax year was the proper version to use, the Court examined the legislative intent of the changes to the statute that were made in 2007. According to the Court, the Oregon legislature originally planned to amend the statute by making the changes effective for all returns filed from the effective date forward subject to the new law. However, testimony during the legislative process led to a change in the enacted language, making the modification prospective and giving taxpayers "predictability" that the 2007 amendments would not be applied to tax years prior to January 1, 2007.⁹ Similarly, the Court refused to apply to the 2003 tax year an administrative regulation also amended in 2007,¹⁰ despite the Department's protests that the rule simply brought the construction of the statute in harmony with a prior decision of the Court.¹¹ The Oregon Supreme Court had previously provided guidance indicating that the presence of all three factors was crucial to a unitary determination due to the conjunctive nature of the statute.¹²

Operating Subsidiary

Following the conclusion that the statute in effect for the 2003 tax year was the proper version of the statute to use, the Tax Court focused on whether the three unitary factors were present in making a unitary determination regarding the operating subsidiary. At the time of its acquisition in 1996, the operating subsidiary had its own employees, systems, and policies and performed its own business functions. The operating subsidiary also had its own brand separate from the brand developed by its parent. Other than limiting its business to franchise operations, the operating subsidiary did not appear to change its business substantially after being acquired by the taxpayer. The taxpayer, which processed its own payroll for its 15,000 employees, also processed payroll for the operating subsidiary's eighteen employees in 2003 and shared some other corporate services. The taxpayer included the operating subsidiary's bank accounts in its daily cash sweep process.

Focusing on whether the taxpayer and its operating subsidiary had centralized management or a common executive force, the Court acknowledged that two members of the operating subsidiary's board of directors also served as executive officers of the taxpayer, but did not perform services for the operating subsidiary.¹³ Dismissing this fact as well as the factors presented by the Department as indicative of centralized management, the Court found that the relationship between the taxpayer and its operating subsidiary did not meet the statutory requirement of having centralized management or a common executive force.

Because the first factor necessary to prove the existence of a unitary relationship between the taxpayer and its franchise subsidiary was not found to be present, the Court did not consider the presence of the remaining two factors,¹⁴ and rendered moot the issue of including the operating subsidiary's sales in the numerator of the taxpayer's unitary group sales factor.

Captive Insurance Subsidiary

The Court also focused on the three factors demonstrating a unitary relationship between the taxpayer and its captive insurance company subsidiary. With respect to this subsidiary, the taxpayer conceded that centralized management was present. Therefore, the Court considered only whether economies of scale and functional integration were present.

Noting that the centralized administration of insurance in the captive insurance company subsidiary relieved the other members of the enterprise from administering that function, the Court determined that economies of scale were present. Likewise, a substantial exchange of value demonstrating function integration existed as indicated by the very creation of the captive insurance company subsidiary. Thus, all three unitary factors were found to be present and the captive insurance company was held to be properly includable in the combined excise tax return with the taxpayer.

Nexus

After determining that the operating subsidiary was not required to file with the taxpayer's unitary group, the Court addressed the question of whether the operating subsidiary should even be subject to the Oregon corporation excise tax. In determining whether the operating subsidiary was doing business in Oregon during 2003, the Court focused primarily on the term "doing business" as defined by statute for purposes of Oregon corporation excise tax. The term "doing business" includes any transaction or transactions in the course of activities conducted within the state by the corporation.¹⁵ Furthermore, regulations clarify that a corporation with receipts from royalties or franchise fees or the sale or transfer of tangible personal property pursuant to franchise or license agreements may be subject to the excise tax if the corporation engages in activities that rise to the level of doing business in Oregon.¹⁶

The operating subsidiary participated in relatively minimal activities within Oregon in the 2003 tax year. For example, the operating subsidiary did not own or rent any real or tangible personal property in Oregon, did not have an office in Oregon, and did not have any resident employees or agents in the state. The Department claimed that two employees, including an executive officer, visited Oregon to physically inspect Oregon franchisees' operations and provide on-site training. In addition, the operating subsidiary's employees visited Oregon for portions of eight days during 2003 to visit the seven franchisee stores located there. Focused on the regulation addressing this point, the Court noted that there was no evidence that the operating subsidiary engaged in transactions other than the receipt of royalties that were exempt from the Oregon corporation excise tax in 2003. Noting the sporadic and non-recurrent nature of the activities in Oregon, the Court concluded that based on the regulatory requirements stipulated, the operating subsidiary was not doing business in Oregon in 2003.

Due to the restrictive nature of the regulation enacted by the Department, the Court declined to consider the broader constitutional and statutory limits on the imposition of nexus.

Commentary

The Oregon Tax Court's decision includes testimony from a recognized industry expert, highlights the level of authority of an administrative regulation, and contemplates retroactive application of enacted legislation. It provides an example of a unitary determination which is well-thought out and carefully made.

University of Connecticut School of Law Professor Richard Pomp testified as an expert witness for the taxpayer in this controversy. Professor Pomp provided interesting explanations of the rationale behind the concept of a combined report, including how the concept was developed, and the three primary methodologies (separate accounting, formulary apportionment, and combined reporting) commonly used by states to tax interstate companies. Professor Pomp explained the essence of the unitary relationship, noting that "if a corporation is operating a unitary business within and without Oregon, the State has the necessary nexus with the out-of-state activities to allow it to apportion a share of all of the corporation's unitary income."

When considering the existence of a unitary relationship, Pomp cautioned against inferring intercompany flows of value based on trivial non-operational functions performed by a parent company on behalf of its wholly owned subsidiaries. In this case, the Court carefully examined the facts and heeded this warning to conclude that the operating subsidiary was not unitary with the taxpayer.

Also of note was the Court's clear adherence to a regulation adopted by the Department. By refusing to allow the Department to depart from its restrictive regulation specifically addressing nexus for a franchisor and apply the more liberal general nexus rules allowed by statute and case law,¹⁷ the Court respected the regulation limiting the Department's power to tax interstate franchisors.

Finally, the Court demonstrated its deference to the legislative process to determine whether retroactive application of a statute was appropriate. The act of diligently examining legislative testimony led to the conclusion to reject retroactive application of the law which changed the definition of a unitary business.

Footnotes

1 Rent-A-Center Inc. v. Department of Revenue, Oregon Tax Court, No. TC-MD 111031D, May 12, 2014.

2 The taxpayer chose not to maintain the position that the Department failed to issue a timely notice of deficiency in accordance with the Oregon statute of limitations during the Tax Court challenge. 3 OR. REV. STAT. § 318.020(2).

4 OR. REV. STAT. § 317.710(2); OR. ADMIN. R. 150-317.710(5)(a)-(B).

5 OR. REV. STAT. § 317.705(2).

6 OR. REV. STAT. § 317.705(3)(a).

7 OR. ADMIN. R. 150-317.705(3)(a)(2).

8 OR. REV. STAT. § 317.705(3)(a). The current version of the statute served to clarify and broaden the instances in which a unitary return would be required by replacing the term "single trade or business" with "unitary business" and replacing the word "and" with "or" in the list of requirements that explain the demonstration of sharing or exchange of value. The amendment was applicable to tax years beginning on or after January 1, 2007 and was included in Or. Laws 2007, Ch. 323, Section 1.

9 As noted in the Senate amendments to S.B. 178 (deleting "[a]ny tax year for which a return is subject to audit or adjustment by the Department of Revenue on or after the effective date of this 2007 Act"). 10 OR. ADMIN. R. 150-317.705(3)(a).

11 Maytag Corp. v. Dep't. of Rev., 12 OTR 502 (1993). The three statutory criteria for making a unitary determination were considered in this ruling where a unitary determination was based on the operational nature of the subsidiaries despite the absence of one of the three criteria, not because two of the three unitary criteria were present.

12 Preble v. Dep't. of Rev., 14 P.3d 613 (Or. 2000), holding that OR. REV. STAT. § 305.265(2) listed "three different requirements . . . [that] are connected by the word 'and,' which indicates that they [the three different requirements] are not alternatives." 13 Additional facts presented by the taxpayer included: (i) the subsidiary controlled its own full time management and daily operations; (ii) there was no active daily management of the subsidiary by the taxpayer; (iii) there were no transfers of personnel between the entities, (iv) the taxpayer did not offer centralized training or require the subsidiary to adopt its manuals or policies; and (v) the taxpayer did not include the subsidiary's financial results in the profits used to determine bonuses for its own management team. The Department cited the following as factors indicating centralized management: (i) the taxpayer's officers received stock options from the publicly traded franchise subsidiary; (ii) the subsidiary's previous executive officer was promoted to the executive team of the taxpayer; and (iii) the taxpayer's board of directors discussed a growth strategy which included the potential acquisition of some of the franchised stores associated with the subsidiary and closely monitored legislation affecting the rent-to-own industry.

14 The other two factors provided in OR. REV. STAT. § 317.705(3)(a) are: (i) centralized administrative services or functions resulting in economies of scale; and (ii) the flow of goods, capital resources or services demonstrating functional integration.

15 OR. REV. STAT. § 317.010(4).

16 OR. ADMIN. R. 150-318.020(2)(3). Such activities specifically include inspection of the franchisees' businesses or records and providing training in Oregon to franchisees. The regulation also stated that companies subject to the excise tax would not be subject to the state income tax. The reason for this statement is that the Oregon corporation excise tax is a tax for the privilege of carrying on or doing business in Oregon and is measured by net income, while the Oregon corporation income tax is for corporations not carrying on or doing business in Oregon, but with income from an Oregon source.

17 OR. REV. STAT. § 317.010(4); Ann Sakes Tile & Stone, Inc. v. Dep't. of Rev., 20 OTR 377 (2011).

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