RICHMOND WHOLESALE MEAT CO., Plaintiff and Appellant, v. FRANCHISE TAX BOARD, Defendant and Respondent.
Richmond Wholesale Meat Co. (Richmond) appeals from a judgment denying its request for a refund of $389,485.32 in corporate franchise taxes it paid to the Franchise Tax Board (Board) for tax years 1979, 1980, and 1982. The court determined that Richmond's wholesale food operations and its oil and gas operations 1 did not constitute a unitary business for franchise tax purposes, and, therefore, Richmond could not offset income from its food operations with losses from its oil operations. We disagree with the trial court and find that Richmond's two distinct operations did constitute a unitary business for franchise tax purposes. Consequently, we reverse the judgment.
Before reciting the facts that support our decision, we set forth the nature of the problem this case presents. When a corporation such as Richmond conducts business in more than one state, it is necessary to determine how much of its income and losses are attributable to one taxing state as opposed to another. In order to accomplish this in a fair and consistent manner, California, like some 23 other states, has enacted the Uniform Division of Income for Tax Purposes Act (Division of Income Act) (Rev. & Tax.Code, §§ 25120–25139).2 (Times Mirror Co. v. Franchise Tax Bd. (1980) 102 Cal.App.3d 872, 874, 162 Cal.Rptr. 630; see generally, Table of Jurisdictions Wherein Act Has Been Adopted, 62 West's Ann.Rev. & Tax.Code (1995 pocket supp.) preceding § 25120, pp. 153–154.) Section 25128 of the act requires apportioning “business income” among the states by use of a prescribed formula involving various factors. Diverse businesses of a single taxpayer may constitute a single unit for this purpose in order to achieve a fair valuation. (Tenneco West, Inc. v. Franchise Tax Bd. (1991) 234 Cal.App.3d 1510, 1518, 286 Cal.Rptr. 354 (Tenneco ).) Whether a taxpayer's diverse operations constitute a single trade or business depends on the facts of each case. (Cal.Code Regs., tit. 18, § 25120, subd. (b).) 3 In addition, section 25123 provides that to the extent they constitute “nonbusiness income,” certain classes of income, including rents and royalties from real or tangible personal property, shall be directly allocated to the states as provided in the Division of Income Act, and are not subject to unitary treatment. (See tit. 18, § 25101.) This case involves both of these aspects of the Division of Income Act. That is, we must determine whether Richmond's food business and its oil operations constitute a single unitary enterprise and whether Richmond's oil revenues are “business income” subject to unitary treatment.
Richmond is a family-owned California corporation that was formed in 1962. Initially, Richmond concentrated on selling meat products, but later added other food products and some hard goods to its wholesale lines.
In 1979 Richmond branched out and became involved in the oil and gas business. It did so by investing in oil and gas working interests. Generally speaking, a working interest is an ownership interest in a specific tract of land, which gives the holders of the interest the exclusive right to exploit minerals beneath the land. In California, a “ ‘[w]orking interest’ ” is statutorily defined as “․ an interest held in lands by virtue of fee title, ․ a lease, operating agreement or otherwise, under which the owner of such interest has the right to drill for, develop and produce oil and gas.” (Pub.Resources Code, § 3316.11.) Because of the great risk involved in exploring for oil and gas, single individuals or entities seldom hold entire working interests. Instead, working interests are usually divided among several parties who share the risk and expense of exploring for oil and gas. An operating agreement controls the relationship among the various working interest owners. This agreement specifies who the operator will be; that is, which working interest owner will actually perform the day-to-day work of drilling for and producing oil and gas. The operating agreement also specifies how the various working interest owners will share the costs and revenues.
During the tax years 1979 to 1982, Richmond purchased working interests in more than 20 separate properties located in Oklahoma and Texas.4 Richmond's percentage interest in those properties ranged from 1 percent to 40 percent. Richmond was not the operator in any of its working interests.
Richmond filed timely tax returns for the 1979, 1980, and 1982 tax years, each of which showed losses from its out-of-state oil operations. Richmond used those losses to offset income from its food operations. For each of the tax years at issue, the Board assessed additional taxes against Richmond based on a determination that Richmond's food operations and its oil operations did not constitute a unitary business, and, therefore, Richmond could not offset losses from the oil operations against income from the food operations. Richmond paid the additional taxes and filed timely claims for refunds.
B. Relationship Between Richmond's Food Operations and Its Oil Operations.
Richmond maintained one bank account from which it paid all of its bills and into which it deposited all of its receipts from both its food operations and oil operations. Richmond purchased each of its working interests with funds drawn from this single operating account.
Richmond maintained only one office, located in Richmond, California. At the time pertinent to this appeal, Werner Doellstedt was the president and general manager of the corporation. His wife, Jeanne Doellstedt, was the personnel manager and corporate secretary. Jeanne Doellstedt had primary responsibility for managing the oil and gas working interests but reported to Werner Doellstedt on a regular basis. The Doellstedts jointly made major decisions, such as which working interests to purchase and whether to commit Richmond's working interests to significant additional expenditures.
Although the operating agreements that controlled the various working interests varied in some particulars, all of the operating agreements offered in evidence at trial 5 shared certain basic provisions. First, all of the operating agreements provided for the drilling of at least one test well. Second, the agreements named one of the working interest owners to act as an operator to conduct the day-to-day drilling and production operations. Third, all of the operating agreements contained clauses stating that the liability of each working interest owner was several, not joint or collective, and that the owners did not intend to create a partnership relationship by entering into the operating agreement. Fourth, under each operating agreement, the working interest owners had the right to take their share of production in kind, rather than in cash.
Finally, all of the operating agreements contained a consent-nonconsent procedure by which the working interest owners could elect to participate (or decline to participate) in certain major activities or expenditures. Examples of decisions that were subject to these election provisions include: whether to continue with a test well after the reaching of a certain specified depth; whether to drill additional wells, or to rework, plug, or deepen an existing well; and whether to join in any single project expenditure that exceeded an amount that the operating agreement defined (usually $10,000). A working interest owner could decline to consent to an expenditure subject to the consent-nonconsent provision and, consequently, would not have to make an out-of-pocket contribution to the expense. However, the nonconsenting owner would not receive any revenue until the owners who did contribute received repayment out of the oil or gas revenue and a penalty payment from that revenue. Thus, although working interest owners could opt out of any major expense the consent-nonconsent clause covered, they suffered a penalty for doing so, generally in the amount of 100 percent to 400 percent of their share of the expense.
There was evidence that Jeanne and Werner Doellstedt actively participated in making decisions under the consent-nonconsent clauses, and, at times, they refused to consent to certain expenditures. Such decisions depended on Jeanne Doellstedt's independent research into the viability of the drilling prospect, which included speaking with the operator, reviewing the drilling logs, and questioning the field engineer.
After a successfully completed well started producing, Richmond received a monthly joint interest bill for its share of the expenses for each working interest it owned. Jeanne Doellstedt reviewed and corrected all bills and routed them to the Richmond accounts payable department for payment. The accounts payable department paid all of Richmond's bills for both its food and oil operations. In addition, Richmond's internal accounting department prepared summaries for both its food and oil operations.
C. The Trial Court's Decision.
Based on the evidence outlined above, the trial court determined that Richmond's oil and gas “joint ventures” were not unitary with its wholesale food operations because Richmond failed to prove that it exercised sufficient management and control over the oil and gas ventures. The court stated: “The evidence introduced at trial indicates that, as an owner of a working interest, [Richmond] left all the major executive functions of drilling exploratory oil and gas wells in the hands of the operators. No one from Richmond ․ was involved in any way in the actual management of the well drilling operation. The operator was responsible for choosing the drilling location[,] ․ leasing ․ the oil field equipment, ․ [and] strik[ing] deals with buyers to purchase the production of a successful well․ [Richmond] has failed to prove that it exercised any major policy or operational decisions in the oil and gas ventures.” Moreover, the trial court concluded that each working interest operation was actually a “partnership” within the meaning of section 17008. The court concluded: “The Richmond ․ management team may have had the potential to be an active manager of its working interests, but in actuality it was a passive investor. As a passive investor, Richmond ․ is not entitled to ‘unitary’ status.” (Italics added.)
In essence, the trial court concluded the act of purchasing and managing nonoperator working interests does not constitute a trade or business, but is instead a passive investment in partnerships. As we explain below, we disagree with this determination.
A. The Food Operations and the Oil Operations Are a Unitary Enterprise.
California imposes a franchise tax on corporations doing business within this state. That tax depends on the corporation's net income attributable to in-state sources. (§§ 23151, 25101.)
“The unitary method of taxing interstate businesses[, which the Division of Income Act utilizes,] is a principle of taxation in which several elements of a business are treated as one unit for taxation purposes, with the goal of achieving a fair valuation. [Citation.] ․ When one or more business operations are considered separate businesses, each is required to pay a tax on its own income derived from sources within the state, without regard to the profit or losses of any related operation. However, if a business enterprise is a ‘unitary business,’ it files a combined report, and the income from its operations within the state is determined by a formula based on property, payroll and sales. (§§ 25128–25136.)” (Rain Bird Sprinkler Mfg. Corp. v. Franchise Tax Bd. (1991) 229 Cal.App.3d 784, 787–788, 280 Cal.Rptr. 362, quoted in Tenneco, supra, 234 Cal.App.3d at pp. 1518–1519, 286 Cal.Rptr. 354; see also Dental Ins. Consultants, Inc. v. Franchise Tax Bd. (1991) 1 Cal.App.4th 343, 347, 1 Cal.Rptr.2d 757 (Dental Consultants ).)
As a general rule, a business is unitary if “․ there is evidence to indicate that the segments under consideration are integrated with, dependent upon or contribute to each other and the operations of the taxpayer as a whole․” (Tit. 18, § 25120, subd. (b); see also Edison California Stores v. McColgan (1947) 30 Cal.2d 472, 479, 183 P.2d 16; Dental Consultants, supra, 1 Cal.App.4th at p. 347, 1 Cal.Rptr.2d 757; Tenneco, supra, 234 Cal.App.3d at p. 1525, 286 Cal.Rptr. 354.) However, a more specific three-part test (three unities test) provides greater structure to the analysis. Unity exists where there is (1) unity of ownership; (2) unity of operation evidenced by central purchasing, management, and accounting; and (3) unity of use in the centralized executive force and general system of operations. (Butler Brothers v. McColgan (1941) 17 Cal.2d 664, 678, 111 P.2d 334; Dental Consultants, supra, 1 Cal.App.4th at pp. 347–348, 1 Cal.Rptr.2d 757; Tenneco, supra, 234 Cal.App.3d at p. 1525, 286 Cal.Rptr. 354.)
In reviewing the trial court's decision on the unity issue, we must accept its underlying factual findings to the extent substantial evidence supports them. However, the ultimate issue of whether those facts establish that the business is unitary is a question of law upon which we may exercise our independent judgment. (Dental Consultants, supra, 1 Cal.App.4th at p. 348, 1 Cal.Rptr.2d 757; Tenneco, supra, 234 Cal.App.3d at pp. 1520–1521, 286 Cal.Rptr. 354.)
In applying the three unities test, “[t]he decisive inquiry is whether ․ two diverse businesses were sufficiently interconnected in the shared performance of their operational functions and the executive decisionmaking to be treated as a unitary business. No bright line exists to aid in this determination as each case must be decided on its unique business arrangements.” (Dental Consultants, supra, 1 Cal.App.4th at p. 348, 1 Cal.Rptr.2d 757, italics added; see also tit. 18, § 25120, subd. (b) [“The determination of whether the activities of the taxpayer constitute a single trade or business or more than one trade or business will turn on the facts in each case.”].) In our view Richmond has satisfied the three unities test to the extent it is possible to do so given its “unique business arrangement[ ]”: that is, a business composed of wholesale food operations and fractional nonoperator oil and gas working interests. (Dental Consultants, supra, 1 Cal.App.4th at p. 348, 1 Cal.Rptr.2d 757, italics added.)
First, it is clear that Richmond owned all of the fractional oil and gas working interests at issue. Thus, the first unity (ownership) is clearly established. (See Dental Consultants, supra, 1 Cal.App.4th at p. 348, 1 Cal.Rptr.2d 757.)
The remaining categories of unity of operation and unity of use are not easy to distinguish and often overlap. “These descriptions are useful only to the extent they reflect the organizational and economic interrelation between the [distinct operations]. This interrelation must be significant in order to find a unitary business. (Keesling & Warren, The Unitary Concept in the Allocation of Income (1960) 12 Hastings L.J. 42, 50–52.)” (Dental Consultants, supra, 1 Cal.App.4th at p. 349, 1 Cal.Rptr.2d 757.)
Unity of operations is characterized by centralized purchasing, accounting, and other departments. (Dental Consultants, supra, 1 Cal.App.4th at p. 349, 1 Cal.Rptr.2d 757; Tenneco, supra, 234 Cal.App.3d at p. 1525, 286 Cal.Rptr. 354.) Here, Richmond commingled in one corporate account all income from both operations, and paid all expenses from that account. After a successfully completed well started producing, Richmond received a monthly joint interest bill for its share of expenses for each working interest it owned. Jeanne Doellstedt reviewed and corrected all bills and routed them to the Richmond accounts payable department for payment. The accounts payable department paid all of Richmond's bills for both its food and oil operations. In addition, Richmond's internal accounting department prepared summaries for both its food and oil operations. Finally, the corporation used a line of credit that the oil and gas interests secured to provide more than $1.6 million in borrowed funds to the food operations during a depressed period in the food business. This is significant evidence of unity of operation. (See Dental Consultants, supra, 1 Cal.App.4th at p. 349, 1 Cal.Rptr.2d 757 [“Substantial intercompany loans ․ are significant evidence of unity of operation. [Citation.]”].) In our view, these facts establish unity of operation between Richmond's two distinct enterprises. (See Dental Consultants, supra, 1 Cal.App.4th at pp. 349–350, 1 Cal.Rptr.2d 757.)
The evidence also shows unity of use between Richmond's food operations and its oil operations. Unity of use is characterized by a centralized executive force and general system of operation. (Edison California Stores v. McColgan, supra, 30 Cal.2d at p. 478, 183 P.2d 16; Dental Consultants, supra, 1 Cal.App.4th at p. 350, 1 Cal.Rptr.2d 757.) Indeed, the Board's own regulations provide that the presence of “[s]trong centralized management” creates a “strong presumption that the activities of the taxpayer constitute a single trade or business․” (Tit. 18, § 25120, subds. (b), (b)(3).) According to the regulations, “[a] taxpayer which might otherwise be considered as engaged in more than one trade or business is properly considered as engaged in one trade or business when there is strong central management, coupled with ․ centralized departments for” various corporate functions. (Tit. 18. § 25120, subd. (b)(3).) Here, Jeanne Doellstedt, the corporate secretary, in conjunction with Werner Doellstedt, the corporate president and general manager, made the major decisions with respect to the working interest operations. The Doellstedts were also largely responsible for managing Richmond's food operations. Thus, both the food operations and the oil operations were subject to the “[s]trong centralized management” the Doellstedts provided.
In sum, the Doellstedts' close control of both the food and oil operations “and the shared administrative functions, coupled with the undisputed unity of ownership, establish the requisite economic, operational and managerial interdependence to [prove] the unitary nature of these businesses.” (Dental Consultants, supra, 1 Cal.App.4th at p. 352, 1 Cal.Rptr.2d 757.) 6
B. Revenue from Richmond's Oil Operations is Business Income.
The difficult issue in this case is not whether Richmond's food and oil operations are unitary, as such, but whether Richmond's investment in nonoperator working interests is in fact a “trade or business.” (Tit. 18, § 25120.) The crux of the trial court's decision was not that Richmond failed to manage and control its fractional working interests, which it clearly did, but that it did not manage and control the actual drilling and production of gas and oil on the properties in which it held working interests. As the court put it: “The Richmond ․ management team may have had the potential to be an active manager of its working interests, but in actuality it was a passive investor. As a passive investor, Richmond ․ is not entitled to ‘unitary’ status.” (Italics added.) In short, the court concluded that Richmond's oil operation was not a “trade or business” at all because Richmond did not control the actual drilling for and production of hydrocarbons. In the trial court's view, Richmond's oil operations were instead a series of passive investments in partnerships, which were not subject to unitary treatment. We disagree with this conclusion.
The corporate tax statutes and regulations distinguish between an interstate corporation's “ ‘business income’ ” and “ ‘nonbusiness income.’ ” (Tit. 18, §§ 25101; 25120, subds. (a), (c); §§ 25123, 25128.) Business income is allocated to the various states by an apportionment formula involving a taxpayer's property, payroll, and sales within the state, and may be subject to unitary treatment. (Rain Bird Sprinkler Mfg. Corp. v. Franchise Tax Bd., supra, 229 Cal.App.3d at pp. 787–788, 280 Cal.Rptr. 362; §§ 25128–25136; tit. 18, § 25101.) Nonbusiness income, on the other hand, is allocated directly to specific states pursuant to sections 25124 through 25127, and consequently is not subject to unitary treatment. (Tit. 18, § 25101.) 7
The distinction between business and nonbusiness income is not easily defined. The Division of Income Act generally defines “ ‘[b]usiness income’ ” as “income arising from transactions and activity in the regular course of the taxpayer's trade or business and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations.” (§ 25120, subd. (a), italics added.) “ ‘Nonbusiness income’ ” is all income other than business income. (§ 25120, subd. (d).) Importantly, income is business income “unless clearly classifiable as nonbusiness income.” (Tit. 18, § 25120, subd. (a), italics added; see also Times Mirror Co. v. Franchise Tax Bd., supra, 102 Cal.App.3d at pp. 879–880, 162 Cal.Rptr. 630.)
The statutory definition of business income is circular, however, because it requires that we determine what constitutes the taxpayer's trade or business. As the Board's regulations point out, the labels that describe income, such as sales, interest, dividends, or rents, are not helpful in determining whether income is business or nonbusiness income. This is because “[i]ncome of any type or class and from any source is business income if it arises from transactions occurring in the regular course of a trade or business. Accordingly, the critical element in determining whether income is ‘business income’ or ‘nonbusiness income’ is the identification of the transactions and activity which are the elements of a particular trade or business․” (Tit. 18, § 25120, subd. (a), italics added.)
The ultimate question in this case is whether a series of investments in nonoperator oil and gas working interests is a “trade or business” as opposed to a series of investments in partnerships. If it is a trade or business, then income from that enterprise is clearly “business income” and is subject to unitary treatment.8 As in our earlier analysis, although the trial court's pure findings of fact bind us to the extent substantial evidence supports them, we must independently interpret the tax statutes and apply the facts to the statutory definitions relevant to this case. (Ramos v. Estrada (1992) 8 Cal.App.4th 1070, 1074, 10 Cal.Rptr.2d 833; see also Dental Consultants, supra, 1 Cal.App.4th at p. 348, 1 Cal.Rptr.2d 757; Tenneco, supra, 234 Cal.App.3d at pp. 1520–1521, 286 Cal.Rptr. 354.)
1) The Working Interest Operating Agreements Did Not Create Partnerships.
As the statement of decision indicates, the trial court specifically found that each working interest in which Richmond invested was actually a “partnership” within the meaning of section 17008. This finding was significant because partnerships are subject to special tax treatment under the Division of Income Act. In particular, title 18, section 25137–1, subdivision (a), provides in pertinent part: “When the activities of the partnership and the taxpayer do not constitute a unitary business under established standards, disregarding ownership requirements, the taxpayer's share of the partnership's trade or business shall be treated as a separate trade or business of the taxpayer. In such a case the taxpayer is engaged in two trades or businesses.” (Italics added.) Here, there is no question that Richmond's food operations were not unitary with the whole of each working interest in which it invested. That is, Richmond did not manage, control, or administer the entire working interest, but only its proportional share of that interest. Thus, if the working interest/operating agreement arrangements constitute partnerships, then Richmond's share of the partnership business income (or losses) must be separate from its food operations, and not subject to unitary treatment. However, as the Board itself conceded at oral argument, the operating agreements did not create partnerships for tax purposes.
The definition of “partnership” is identical under federal and state tax statutes. A partnership “includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on․” (§ 17008; 26 U.S.C. § 7701(a)(2).) Because the state and federal statutes are identical, “it [is] proper to rely on federal precedent to interpret the California statute. [Citations.]” (Spurgeon v. Franchise Tax Board (1984) 160 Cal.App.3d 524, 528, 206 Cal.Rptr. 636.)
The federal tax regulations attempt to define what a partnership is in part by defining what it is not. “A joint undertaking merely to share expenses is not a partnership․ Mere coownership of property which is maintained ․ and rented or leased does not constitute a partnership. For example, if an individual owner, or tenants in common, of farm property lease it to a farmer for a cash rental or a share of the crops, they do not necessarily create a partnership thereby. Tenants in common, however, may be partners if they actively carry on a ․ venture and divide the profits thereof.” (26 C.F.R. § 1.761–1(a) (1994), italics added.)
Joint working interest owners are essentially tenants in common in an estate in real property, namely, the right to exploit oil and gas beneath a particular tract of land.9 (Pub.Resources Code, § 3316.11; Dabney–Johnston Oil Corp. v. Walden (1935) 4 Cal.2d 637, 649–650, 654–655, 52 P.2d 237.) Although joint working interest owners are tenants in common, the Internal Revenue Service has determined that working interest owners who develop properties under standard operating agreements do not share profits and therefore are not partners for tax purposes.
In 1948, the Commissioner of the Internal Revenue Service issued a ruling concerning the “[s]tatus for Federal income tax purposes of joint operating agreements commonly entered into between coowners of oil and gas properties or leaseholds.” (Int.Rev. Ruling I.T. 3930 (1948) 2 C.B. 126.) The operating agreements under review contained the following typical features: (1) costs were prorated among the parties in accordance with their respective interests; (2) the purchaser of the oil paid the working interest owners in proportion to their respective shares; (3) generally, the working interest owners could take their share of production in kind; (4) the parties had voting power proportionate to their interests to choose and advise the operator; and (5) the liabilities of the parties were separate, not joint. (Int.Rev. Ruling I.T. 3930, supra, 2 C.B. at pp. 126–127.)
In his ruling, the Commissioner determined that such operating agreements exhibited all of the hallmarks of a partnership except the objective of “joint profit.” The Commissioner observed: “Manifestly, profits arise not from mere extraction or from the processing of mineral, but from the sale thereof. Accordingly, it seems clear that if the joint objective is limited to development and the extraction and processing of mineral (at joint cost and expense to be met by contributions of the respective participants) for division in kind or for sale for the accounts of the several participants individually, the test of a joint venture for joint profit is not met․ As such agreements commonly allow the participants to take their shares of the mineral in kind (or provide for the sale of the shares of the respective participants for their individual accounts under revocable agency powers), the sale of the mineral, even though made by the operator, is a sale by or on behalf of the individual participants. In such cases there is no joint profit contemplated or realized by the associates.” (Int.Rev. Ruling I.T. 3930, supra, 2 C.B. at pp. 128–129.)
The Commissioner's reasoning applies with equal force to the operating agreements under consideration here. Under each operating agreement introduced in evidence, the working interest owners had the right to take their share of production in kind, rather than in cash. Taken as a whole, the objective of those agreements was “limited to [the joint] development and ․ extraction and processing of mineral ․ for division in kind or for sale for the accounts of the several participants individually․” As the Commissioner pointed out, it does not matter that the operator made the actual sales, as these sales are on behalf of the participants' individual accounts. (Int.Rev. Ruling I.T. 3930, supra, 2 C.B. at p. 129.)
The Commissioner's decision—which is directly on point—is sufficient to end the matter. However, there are two additional reasons why Richmond's operating agreements did not create partnerships for tax purposes. First, each of the operating agreements disclaimed an intent to create a partnership. Although this disclaimer is not binding on a court (Fishback v. United States (D.S.D.1963) 215 F.Supp. 621, 625), it is a factor for consideration (Commissioner v. Culbertson (1949) 337 U.S. 733, 742, 69 S.Ct. 1210, 1214, 93 L.Ed. 1659). This seems particularly appropriate where, as here, there is expert testimony that in the usual operating agreement the working interest owner's arrangement is with the operator directly. In the typical case, a working interest owner does not even know who the other owners are. Thus the disclaimer is not a mere smoke screen, but accurately describes the relationship between the working interest owners.
Second, the goal of the working interest/operating agreement arrangement is to address the particular risks involved in oil exploration and the concerns of those willing to accept those risks. This arrangement permits investors to spread the risk of exploring for hydrocarbons over a group, while at the same time permitting individual investors to limit their particular risks through the consent/nonconsent procedures those agreements contain. Thus, the working interest owner gains some of the benefits of a partnership (shared expenses) but minimizes the major drawback to a partnership (complete subservience to the will of the majority). We must treat such agreements for what they are, and not deem them as partnerships for the convenience of the taxing authorities.
In sum, we conclude that the operating agreements introduced at trial did not create partnerships for tax purposes. Consequently, the working interest/operating agreement arrangements are not subject to the special tax treatment accorded partnerships under the Division of Income Act. (Title 18, § 25137–1(a).) 10
2) Management of Fractional Working Interests Can Constitute a Trade or Business.
Having determined that fractional working interests do not constitute shares in partnerships, we consider the only remaining question: whether investing in and actively managing such fractional interests constitutes a “trade or business.” We conclude that it does.
Neither party has cited to a statutory or regulatory definition of “trade or business,” and we have not discovered one in our independent research. However, section 23101 defines “ ‘[d]oing business' ” as “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” (Italics added.) Title 18, section 23101, states that “ ‘[d]oing business' ” in this state “includes the purchase and sale of stocks or bonds․” Although these definitions arise in a slightly different context,11 they nevertheless indicate how broadly the term “business” is defined in the tax code.
More generally, Black's Law Dictionary defines “[b]usiness” as “[t]hat which habitually busies or occupies ․ the time, attention, labor, and effort of persons as a principal serious concern or interest or for livelihood or profit.” (Black's Law. Dict. (6th ed. 1990) p. 198, col. 2.) There is no question that Richmond's investments in its numerous working interests “habitually ․ occupie[d] ․ the time, attention, labor, and effort” of Richmond's employees as a “principal serious concern” and for “livelihood or profit.” Because Richmond's investments in its working interests constituted a business, it follows that income from that enterprise is presumptively business income, which is subject to unitary treatment. (Tit. 18, § 25120, subd. (a); see also Times Mirror Co. v. Franchise Tax Bd., supra, 102 Cal.App.3d at pp. 879–880, 162 Cal.Rptr. 630.)
C. Richmond Was Not Required to Prove That Each Working Interest Was Unitary With Its Food Operations.
The trial court stated that Richmond had failed to present evidence of the operating agreements controlling each of what the court determined to be 38 relevant wells. It based this determination on the Board's posttrial brief, which noted a discrepancy between the number of working interests Richmond had purchased (24) and the number of drilled wells (38). However, this analysis evidences a basic misunderstanding of how working interests operate. A working interest or operating agreement is not equivalent to a single well. Rather, multiple wells can be developed on a single working interest and pursuant to a single operating agreement. Thus, the number of working interests and wells is not necessarily the same.
According to Richmond, the operating agreements introduced at trial controlled all but two of the relevant wells. Richmond also contends that it can establish the loss attributable to each well for each tax year at issue, and can thus establish its precise tax liability even with exclusion of the two undocumented wells from its unitary business. That Richmond might not be able to produce the operating agreements for all of the wells at issue does not authorize the court to deny unitary treatment as to Richmond's entire oil operations.
It is true that a taxpayer must not only show that the tax assessment was incorrect, but must also produce evidence to establish the proper amount of tax. (Honeywell, Inc. v. State Bd. of Equalization (1982) 128 Cal.App.3d 739, 744, 180 Cal.Rptr. 479.) Here, Richmond claims that it can do so even with exclusion of two of the wells from the unitary calculations. Richmond should have an opportunity to prove which wells the operating agreements introduced at trial do cover, and which are thus clearly unitary with its food operations.
Finally, Richmond contends there is no need to remand this case, as “[i]t is a simple mathematical calculation to omit losses from the working interests that are not unitary and determine the proper refund.” However, in order to make this calculation, we would have to determine as a factual matter which oil wells the operating agreements introduced at trial do not cover. We are not prepared to make such factual determinations, nor are we prepared to apply the allegedly “simple mathematical calculation” in the absence of briefing from both sides.
This does not mean, however, that we must inevitably return this case to the trial court for an additional hearing. Instead, we remand to the trial court with directions to order the Board to apply the principles this opinion outlines to the evidence Richmond has provided and to calculate the appropriate refund. Richmond may accept the Board's calculations, and the trial court shall enter judgment accordingly. The trial court shall hold a further hearing on this matter if, and only if, the parties are first unable to agree on the appropriate refund.
The judgment is reversed. The matter is remanded to the trial court, which shall first order the Board to calculate the appropriate refund based on the principles outlined in this opinion and the evidence provided by Richmond. If Richmond accepts the Board's calculations, the court shall enter judgment accordingly. If the parties are unable to agree on the appropriate refund, the court shall hold a hearing at which it will take additional evidence, if necessary, and will itself calculate the appropriate refund.
Richmond is awarded costs on appeal.
1. For purposes of clarity, we refer to the oil and gas operations simply as the “oil operations.”
2. Unless otherwise noted, subsequent statutory references are to the Revenue and Taxation Code.
3. Subsequent references to title 18 are to the California Code of Regulations.
4. The trial court found that Richmond had invested in 38 “ventures” for speculative oil drilling. In its opening brief, Richmond contends it purchased working interests in 23 properties from 1979 to 1982.
5. We include this qualification because in its statement of decision the court determined that Richmond invested in a total of 38 “ventures” for speculative oil drilling, but produced only 24 operating agreements at trial. The court refused to make a finding that each venture was subject to certain clauses and requirements because it found Richmond had “not provided evidence in relation to each of the 38 ventures․” (Italics added. See post, p. 864.)
6. Dental Consultants concerned a unitary business composed of two enterprises that were at least as diverse as those under consideration here. In Dental Consultants, the Court of Appeal affirmed a finding that a parent corporation, the primary business of which was dental consulting, and its wholly owned subsidiary corporation, the primary business of which was farming, constituted a unitary business for franchise tax purposes. (Dental Consultants, supra, 1 Cal.App.4th at pp. 346–347, 1 Cal.Rptr.2d 757.)
7. Title 18, section 25101, provides in pertinent part: “․ When a taxpayer has income from sources within the state as well as income from sources outside this state, the division of income and the resulting determination of the portion of the taxpayer's entire net income which has its source in this state shall be determined pursuant to the allocation and apportionment provisions set forth in sections 25120 to 25139, inclusive. When the business, whether carried on by a single corporation or by a group of affiliated corporations, conducted both within and without California is unitary in nature, the portion of the business income from that unitary business which is ‘derived from or attributable to sources within this State’ must be determined by formula apportionment. In such cases, the first step is to determine which portion of the taxpayer's entire net income constitutes ‘business income’ and which portion constitutes ‘nonbusiness income.’ The various items of nonbusiness income are then directly allocated to specific states pursuant to the provisions of section 25124 to 25127, inclusive. The business income of the taxpayer is divided between the states in which the business is conducted pursuant to the property, payroll and sales apportionment factors [set] forth in sections 25128 to 25136, inclusive. The sum of (1) the items of nonbusiness income directly allocated to this state, plus (2) the amount of business income attributable to this state by the apportionment formula constitutes the amount of the taxpayer's entire net income which is subject to tax․”
8. Richmond framed the ultimate issue in a similar light: “If the court determines that [Richmond] is correct in its position that management of its working interest operations can constitute a portion of its unitary business, [Richmond's] appeal should be successful. If [the Board] is correct that [Richmond's] working interest operations are only an investment and that [Richmond] would have to control the entire well for its operations to constitute a portion of its unitary business, its appeal should be unsuccessful.”
9. The Board's suggestion that a working interest is actually an ownership interest in a particular well rather than in a tract of land is simply wrong, and evidences the Board's ignorance of the custom and practices in the oil business.In California, a “ ‘[w]orking interest’ ” is defined as “an interest held in lands by virtue of fee title, ․ a lease, operating agreement or otherwise, under which the owner of such interest has the right to drill for develop and produce oil and gas․” (Pub.Resources Code, § 3316.11, italics added.) Although the precise definition of working interest varies slightly from state to state, it is absolutely clear that a working interest is an estate in real property, not an interest in a particular well. (See, e.g., Oxy USA v. Colorado Interstate Gas Co. (1994) 20 Kan.App.2d 69, 883 P.2d 1216, 1224 [“The term ‘working interest’ is virtually synonymous with the term ‘leasehold interest.’ ( [Citation]; Williams and Meyers, Manual of Oil and Gas Terms, pp. 646, 1379 (8th ed. 1991).)”]; Garman v. Conoco, Inc. (Colo.1994) 886 P.2d 652, 656; Sackett Enterprises, Inc. v. Staren (1991) 211 Ill.App.3d 997, 156 Ill.Dec. 226, 229–230, 570 N.E.2d 702, 705–706.)Moreover, the Board's claim that some of Richmond's operating agreements do not involve “working interests” as defined above is specious. Most of Richmond's operating agreements are model form agreements used in the oil and gas industry for working interests. The Board has not pointed to a single operating agreement in evidence that does not involve a working interest.
10. Because we conclude the operating agreements did not create partnerships, we do not address Richmond's alternative argument that most of the operating agreements contained provisions specifically “elect[ing] out” of partnership treatment under federal regulations. (See 26 C.F.R. § 1.761–2(a)(3) (1994); tit. 18, former § 17921).
11. The term “ ‘[d]oing business' ” determines which corporations are subject to taxation in this state. All corporations “ ‘[d]oing business' ” in this state are subject to the corporate franchise tax. (Tit. 18, § 23101.)
CHIN, Presiding Justice.
MERRILL and CORRIGAN, JJ., concur.