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Court of Appeal, First District, Division 5, California.

ARKLA INDUSTRIES, INC., Plaintiff and Appellant, v. FRANCHISE TAX BOARD, Defendant and Respondent.


Decided: December 31, 1986

Lawrence V. Brookes, Valentine Brookes, Brookes and Brookes, San Francisco, for plaintiff and appellant. John K. Van de Kamp, Atty. Gen., Patricia Streloff, Deputy Atty. Gen., San Francisco, for defendant and respondent.

In this case, we hold that the intercorporate ties between the parent company and its subsidiary are insufficient to justify the treatment of the subsidiary as a unitary business.   Accordingly, we reverse the judgment.

Arkla Industries, Inc., (Arkla) a wholly owned subsidiary of Arkansas-Louisiana Gas Company (Ark Gas), appeals from a judgment affirming the decision of the Franchise Tax Board (the Board) denying its request for a refund of corporate income taxes paid for the years 1968 and 1969.   The trial court affirmed the Board's decision to treat Arkla and its out-of-state parent corporation and subsidiaries as a unitary business within the meaning of Revenue and Taxation Code section 25101,1 and apportion the income of the entire business pursuant to section 25120 et seq.   Arkla contends that there was insufficient interrelation between its own activities and operations and those of its parent corporation and its fellow subsidiaries to constitute a unitary business within the meaning of the statute.

Arkla filed its state tax return and paid the minimum tax of $100 in 1968 and $1,983.10 with interest in 1969.   The Board assessed additional franchise taxes against Arkla of $5,044 including interest for the 1968 tax year, and $3,936.68 including interest for the 1969 tax year, on the ground that the parent company and subsidiaries operated a unitary business.   In January 1979, Arkla filed a claim for a refund which was denied.   A complaint was filed in June 1979, and the trial court entered judgment for the Board on October 3, 1984.   This appeal followed.


 The case was tried on stipulated facts.   As such, the determination of whether the business was unitary presents a question of law.  (Anaconda Co. v. Franchise Tax Board (1982) 130 Cal.App.3d 15, 23, 181 Cal.Rptr. 640.)   Arkla, a Delaware corporation, whose home office and principal manufacturing plant are located in Evansville, Indiana, was authorized to do business in this state.   Arkla is comprised of two divisions:  Arkla Air Conditioning Company and Arkla Equipment Company.   The issue in this case concerns the degree to which Arkla was dependent upon its parent for materials, management and/or common operations which contribute to the realization of profits in this state.  (See Edison California Stores v. McColgan (1947) 30 Cal.2d 472, 479, 183 P.2d 16;  F.W. Woolworth v. Franchise Tax Bd. (1984) 160 Cal.App.3d 1154, 1160, 207 Cal.Rptr. 149;  Container Corp. of America v. Franchise Tax Bd. (1981) 117 Cal.App.3d 988, 994, 173 Cal.Rptr. 121.)   To make this determination, we examine the interrelationship of the operations and management functions between the two companies.

Arkla Air Conditioning Company

The air conditioning division was purchased from Servel, Inc., in 1957.   It manufactures and sells gas air conditioning equipment for home and industry under the registered trade name “Arkla-Servel All-Year.”   It also manufactures and sells natural gas outdoor lights and gas-fired barbecues.   The parent company made no significant changes in the operation or product line of the subsidiary after it purchased the company.   Its principal manufacturing plant is in Evansville, Indiana, the site of its home office.   It has another plant in Emmet, Arkansas.   Its general sales offices are located in Little Rock, Arkansas, and it has regional warehouses in Atlanta, Dallas, Washington, Houston and Los Angeles.   Products were sold throughout the nation, including California.   In California, Arkla leases warehouse space which houses an inventory of gas air conditioning units, gas lights and gas grills, as well as replacement parts.   It employs a sales force within the state.   It ships to purchasers in this state from both its California location and its factory in Evansville, Indiana.   Sales in California by the air conditioning division totaled $1,505,417 in 1968 and $2,543,610 in 1969.   This division was the only segment of the entire Arkla family to do business in California during the tax years in question.

Arkla Air Conditioning Company sold its products to its parent company for resale on the same terms as to any third party.   It also sold its products to competitors of the parent concern.   Sales to the parent in 1968 totaled $3,798,400 or 23 percent of total sales for that year.   Sales in 1969 totaled $3,030,896 or 12 percent of total sales.   Ark Gas also purchased similar appliances from competitors of the air conditioning division.

Arkla Equipment Company

Arkla Equipment Company, the other division of Arkla Industries, designs, manufactures and services natural gas compressors, air compressors and gas-operated engine units for the production of electricity.   It was acquired by Ark Gas in its purchase of Ingersoll Corporation in 1961.   Its manufacturing and sales offices are located in Shreveport, Louisiana, two miles from the parent company's headquarters.   The general manager of the division attended the weekly management meetings of Ark Gas at the Slattery Building in Shreveport.   It did no business in California, but it did make interstate sales of $4,734 and $6,930 to California customers in 1968 and 1969, respectively.   The equipment division's products were used in the parent company's operations.   Arkla Equipment Company division sold $524,135 of equipment to its parent in 1968 and $975,068 in 1969.   These amounts represented 25 percent and 35 percent of total sales for the years 1968 and 1969, respectively.

Arkla's equipment division did its own accounting and billing and kept most of its accounts and records separate for the air conditioning division.   The products of the two divisions are unrelated and were sold by separate sales staffs, using separate advertising, inventories and warehouses.   The divisions maintained separate office locations, manufacturing plants, machinery, equipment and raw materials.   The divisions operated with separate management groups and maintained separate personnel, purchasing, design, engineering and research departments.

The Arkansas-Louisiana Gas Company

Ark Gas, the parent company, is engaged in the extraction, production, purchase, transmission and distribution of natural gas in the five-state area of Arkansas, Louisiana, Texas, Oklahoma and Kansas.   Its principal offices and corporate headquarters are located in the Slattery Building in Shreveport.   Several of its corporate executives had offices in Little Rock, Arkansas.   It has never sold any of its gas in California and did no business in California during the years in question.

Ark Gas owned four other subsidiaries, Arkla Exploration Company, Arkansas-Louisiana Finance Corporation, Arkla Chemical Corporation and Arkansas Cement Corporation, none of which did business in California during the pertinent time.   None of these subsidiaries shared employees, sales staff, production equipment, offices, plants or other facilities with Arkla.   None of these subsidiaries contributed components or raw materials to Arkla or otherwise aided in the manufacturing of Arkla's products.


During the years in issue, Arkla shared key directors and officers with its parent and some or all of the subsidiaries.   The chairman of the board and president of Ark Gas was president of Arkla and a member of its board of directors.   He was also a director and president of three other subsidiaries.   The executive vice-president of Ark Gas and two other vice-presidents served either as officers and/or directors of Arkla.   The controller of Ark Gas also served as an officer of Arkla and other subsidiaries.   The secretary-treasurer of the parent served in a similar capacity with Arkla and the other four subsidiaries.   The vice-president and general manager of Arkla was employed by the parent company before being promoted to that position.   This was the only transfer of a key employee between Arkla and its parent during the years in issue.

These officers did not participate in the day-to-day management of Arkla, nor did they assert control over any departments within the subsidiary.   However, Arkla did submit production, sales and financial reports to its parent corporation for review on a weekly or more frequent basis.   Officers of the parent company reviewed Arkla's monthly and annual profit and loss statements, its cash requirements, its annual changes in employee compensation and its plan for executive compensation and bonuses.

Certain capital expenditures were submitted to the parent for review.   There were no formal guidelines as to when this would be appropriate.   Most of these expenditures were for amounts in excess of $30,000.   However, Arkla's general manager often would authorize expenditures up to $10,000 without first seeking approval.

Part of Ark Gas's executive overhead was allocated to and paid by Arkla.   The amounts totaled $54,300 and $54,100 in 1968 and 1969, respectively.

Each company maintained its separate accounting records, but the same accounting firm audited the records of the parent company and all five subsidiaries.   Tax administration for the parent and all the subsidiaries was performed by the assistant treasurer of the parent company.   The parent company and Arkla used the same advertising firm, but the accounts were handled by separate staffs.   The two entities also had common health and pension plans, and the parent company purchased liability and workers' compensation insurance for itself as well as for all its subsidiaries.   Ark Gas provided Arkla with computer services on a time share basis for Arkla's payroll and accounts receivable.

During the years in question, Ark Gas made 28 loans to Arkla, totaling $6,771,000.   These loans were at market rates and reflected 66 percent of the amounts Arkla borrowed during this period.   Arkla also borrowed from private lenders at prime rate.


Section 25101 provides:  “When the income of a taxpayer subject to the tax imposed under this part is derived from or attributable to sources both within and without the state the tax shall be measured by the net income derived from or attributable to sources within this state in accordance with the provisions of Article 2 (commencing with Section 25120 of this chapter).”

This tax is authorized since “ ‘contributions to income [of the subsidiaries] result[ed] from functional integration, centralization of management, and economics of scale.’  [Citation.]”  (F.W. Woolworth Co. v. Taxation & Revenue Dept. (1982) 458 U.S. 354, 364, 102 S.Ct. 3128, 3135, 73 L.Ed.2d 819;  see also Edison California Stores v. McColgan, supra, 30 Cal.2d at p. 479, 183 P.2d 16;  F.W. Woolworth Co. v. Franchise Tax Bd., supra, 160 Cal.App.3d at p. 1160, 207 Cal.Rptr. 149;  Container Corp. of America v. Franchise Tax Bd., supra, 117 Cal.App.3d at p. 994, 173 Cal.Rptr. 121.)   The general test is stated as follows:  “If the operation of the portion of the business done within the state is dependent upon or contributes to the operation of the business without the state, the operations are unitary.”  (Edison California Stores v. McColgan, supra, 30 Cal.2d at p. 481, 183 P.2d 16;  Chase Brass & Copper Co. v. Franchise Tax Bd. (1970) 10 Cal.App.3d 496, 501, 95 Cal.Rptr. 805.)

The seminal case on the subject, Butler Brothers v. McColgan (1941) 17 Cal.2d 664, 111 P.2d 334, sets forth a three-factor test for determining if the enterprise is unitary.   These factors are (1) unity of ownership, (2) unity of operation evidenced by central purchasing, management, advertising and accounting departments, and (3) unity of use in the centralized executive force and general system of operations.  (Id., at pp. 667–668, 111 P.2d 334.)   All three must be found to exist to justify a finding of unitary business.   (Chase Brass & Copper Co. v. Franchise Tax Bd., supra, 10 Cal.App.3d at p. 506, 95 Cal.Rptr. 805.)

A Unity of Ownership

There is no dispute that this unity was present.   Ark Gas owned all the stock of Arkla and the four other subsidiaries.

B Unity of Operation

The categories of unity of operation and unity of use are somewhat artificial, and precise distinctions are therefore impossible as they often overlap.   These descriptions are useful only to the extent they reflect the organizational and economic interrelation between the parent and subsidiary companies.   This interrelation must be significant in order to find a unitary business.   (Kessling & Warren, The Unitary Concept in the Allocation of Income (1960) 12 Hastings L.J. 42, 50–52.)


“Unity of Operation” is generally described as the sharing of “staff,” or management functions, whereas unity of use pertains to “line” functions, or the shared use of personnel and facilities.  (Container Corp. of America v. Franchise Tax Bd., supra, 117 Cal.App.3d at p. 995, 173 Cal.Rptr. 121;  Chase Brass & Copper Co. v. Franchise Tax Bd., supra, 10 Cal.App.3d at p. 502, 95 Cal.Rptr. 805.)

Unity of operation is characterized by a centralization of all the major income producing activities, i.e., management, purchasing, accounting, advertising, personnel, and research and development departments, to name a few.   A typical example is found in Edison California Stores v. McColgan, supra, 30 Cal.2d 472, 183 P.2d 16.   There, the taxpayer corporation operated retail shoe stores in 15 states, including California.   The parent company, headquartered in Georgia, exercised control over all its subsidiaries in the various states, making the purchasing, marketing and advertising decisions from its headquarters.   These officers and directors of the parent company constituted all the officers and directors of the subsidiaries.   These centralized departments determined the operating policies and kept the main accounting records of all the subsidiaries.   The subsidiaries paid a proportionate amount to the parent for these services.   In effect, the subsidiaries were extensions of the parent company.   In reversing the judgment awarding a refund, the court concluded that all three unities were present.   (Id., at pp. 479–480, 183 P.2d 16.)   The activities of the business as a unit contributed to the earning of a common income, no portion of which can be segregated and assigned to any one of the activities.  (See Butler Brothers v. McColgan, supra, 17 Cal.2d at pp. 668–669, 111 P.2d 334;  also Cal.Admin.Code, tit. 18, § 25120, subd. (b)(1).)

In Butler Brothers, the taxpayer was engaged in the operation of seven department stores in seven states, including California.   The head office was located in Chicago, Illinois, where the activities of the different stores were strictly managed and supervised.   The company maintained centralized purchasing, accounting and advertising departments.  (Id., at pp. 668–669, 111 P.2d 334.)   The cost of operating these centralized departments was allocated among the different stores.   The court found a unitary business existed because of the interdependence of each unit for the production of income.  “By its large scale purchasing activity, appellant concededly is able to buy at lower prices than would otherwise be possible, thus realizing a purchasing saving.   But it is able to buy in large quantities only because it is able to sell in large quantities, so that it is apparent that the purchasing saving is made possible only because of the sales.”   (Ibid.)

None of the departments in Arkla, e.g., advertising, accounting, marketing, purchasing, or legal, were controlled by, nor were any department's services paid for by the parent company.   Arkla did use the same advertising firm as the parent, but there is no indication that the parent was required to approve or fund Arkla's advertising campaign.   The parent company purchased liability and workers' compensation insurance for Arkla and the other subsidiaries and they all shared the same pension and retirement plans.   Also, the parent company provided Arkla with computer services to be time shared among the different subsidiaries.   We do not know if Arkla paid a proportionate share of the cost of these insurance policies and services.   Even if the services were given gratis by the parent, this contribution does not establish the necessary financial or operational interdependence to consider the business unitary.


During the tax years in question, Arkla borrowed over $6.7 million from its parent at prime rate for capital expenditures and accounts payable.   This amounted to 66 percent of the total amount borrowed during this period.   Plaintiff argues that since this was at prime rate, no additional significance should be given this fact.   A significant amount of intercompany financing is considered to be substantial evidence of unity of operation.  (See Container Corp. of America v. Franchise Tax Bd., supra, 117 Cal.App.3d at p. 996, 173 Cal.Rptr. 121;  also Anaconda Co. v. Franchise Tax Board, supra, 130 Cal.App.3d at p. 26, 181 Cal.Rptr. 640;  Chase Brass & Copper Co. v. Franchise Tax Bd., supra, 10 Cal.App.3d at p. 503, 95 Cal.Rptr. 805.)   However, loans, by themselves, have not been sufficient to transform two separate companies into a unitary business.   In the cases cited above, there was substantial evidence of either vertical or horizontal integration between the parent company and its subsidiary, which is not present here.

C Unity of Use

This factor is characterized by a centralized executive force and general system of operation.  (Edison California Stores v. McColgan, supra, 30 Cal.2d at pp. 478–479, 183 P.2d 16;  Chase Brass & Copper Co. v. Franchise Tax Bd., supra, 10 Cal.App.3d at p. 504, 95 Cal.Rptr. 805.)

Arkla shared several top level executives with its parent.   The chairman of the board and president of the parent, three vice-presidents of the parent, the controller and the secretary-treasurer of the parent all were officers and/or directors of Arkla.   None of these officers managed the daily activities of Arkla or supervised the income producing departments.  (Cf. Edison California Stores v. McColgan, supra, 30 Cal.2d at pp. 479–480, 183 P.2d 16;  Butler Brothers v. McColgan, supra, 17 Cal.2d at pp. 668–669, 111 P.2d 334.)   It is true that executives of the parent company reviewed production, sales and financial reports of Arkla.   They also approved expenditures in excess of $10,000 and were responsible for setting the executive compensation rates.   But this type of review is no more than could be expected between any parent company and a wholly owned subsidiary.  (See F.W. Woolworth Co. v. Franchise Tax Bd., supra, 160 Cal.App.3d at p. 1161, 207 Cal.Rptr. 149.)   After all, the parent company has an obligation to its stockholders to assess the operations of its subsidiary and make corrections if needed.   The parent's ultimate authority over the subsidiary in the corporate hierarchy, in this case, does not materially contribute to Arkla's income producing activities.   Arkla did not rely on these officers for managerial assistance in the operation of the company.   Before we can conclude that these separate business entities constitute a single business, the savings and advantages to the subsidiary must be substantial in relation to the income involved.  (See Kessling & Warren, The Unitary Concept in the Allocation of Income, supra, 12 Hastings L.J. at p. 52.)


Relying on Container Corp. of America v. Franchise Tax Bd., supra, 117 Cal.App.3d 988, 173 Cal.Rptr. 121, defendant Board argues that there is sufficient sharing of the departments to constitute a unity of operation.   We disagree.   There, the parent and the subsidiaries were engaged in the same business, paperboard packaging.   Although there was no exchange of raw materials, the parent assisted its subsidiaries in procuring paper, personnel and equipment.   The parent also loaned its subsidiaries over $18 million during the three tax years in question and guaranteed one-third of the subsidiaries' other loans.  (Id., at p. 996, 173 Cal.Rptr. 121.)   Executives of the parent company served as officers of the subsidiaries.   They gave directions to the subsidiaries for compliance with the parent's standard of professionalism, profitability and ethical practices.   These executives reviewed financial reports of its subsidiaries and, in general, exerted close control and gave directions to management of the subsidiaries.  (Id., at p. 998, 173 Cal.Rptr. 121.)

Arkla, on the other hand, was not engaged in the same business with its parent.   Moreover, Arkla did not share personnel or depend on its parent for purchasing and brokerage ties, as did the subsidiaries in Container Corp. of America.  (Id., at p. 996, 173 Cal.Rptr. 121.)   Further, the parent company in that case exerted more control and supplied significantly more direction to the subsidiaries in order to maintain quality control of the single line of products produced.   We do not have similar high level management involved in the case at bar.  (Compare Anaconda Co. v. Franchise Tax Board, supra, 130 Cal.App.3d 15, 181 Cal.Rptr. 640 [the parent company and its affiliates were all engaged in the same business, mining and processing copper and metal by-products].)

Chase Brass & Copper Co., also relied upon by defendant, is likewise distinguishable.   Chase Brass & Copper Company, which manufactured brass and bronze products, was vertically integrated with its parent company, Kennecott Copper Corporation, which mined and refined copper ore.   Except for a common retirement plan, there was no sharing of purchasing, advertising, accounting or legal departments.   Chase borrowed $10 million from its parent to repair flood damage.   There was also the usual interlocking directors and officers.   Also, Chase purchased about 20 percent of its copper from its parent.   The interrelation brought about by a strong centralized management is absent.   However, this is more than compensated for by the parent company's control over a component necessary to production, which is characteristic of vertically integrated companies.   In fact, the Legislature used this company model as an example of a unitary business.  (See Cal.Admin.Code, tit. 18, § 25120, subd. (b)(1).)

 Arkla is not vertically or horizontally integrated with its parent nor with the other subsidiaries.   In the absence of both strong centralized management and vertical integration, the requisite dependence upon the parent company is missing.


The sales of the air conditioning division represented 23 percent of total sales in 1968 and 12 percent of total sales in 1969.   The equipment division's sales to the parent represented an even larger share, 35 percent in 1968 and 25 percent in 1969.   This flow of goods between parent and subsidiary is of some relevance.  (See Anaconda Co. v. Franchise Tax Board, supra, 130 Cal.App.3d at p. 27, 181 Cal.Rptr. 640;  Chase Brass & Copper Co. v. Franchise Tax Bd., supra, 10 Cal.App.3d at p. 505, 95 Cal.Rptr. 805.)   The intercompany sales, while substantial, cannot be said to create such an advantage to Arkla that it could not have realized similar sales to competitors of the parent company.   In Chase Brass & Copper Co., the parent company sold 20 percent of its copper production to its subsidiary.   However, there was an industry-wide copper shortage and the benefit to Chase was obvious.   (10 Cal.App.3d at p. 505, 95 Cal.Rptr. 805.)   Moreover, Chase is a classic example of vertical integration, a factor which is not present in this case.

The instant case is similar to F.W. Woolworth Co. v. Franchise Tax Bd., supra 160 Cal.App.3d 1154, 207 Cal.Rptr. 149.   There, as here, the subsidiaries operated their own departments autonomously and independently of the parent.   There was no rotation of personnel.   Each company had separate advertising, accounting, marketing, purchasing and legal departments from its parent.   Each company had typical managerial links with its respective parent company, including interlocking boards of directors, and frequent in-person and telephonic communication between the upper levels of management, all of which are expected in the operation of a wholly owned subsidiary by a large parent company.  (Id., at p. 1161, 207 Cal.Rptr. 149.)

Clearly, the Legislature intended something more than the usual parent-subsidiary relationship in order to constitute a unitary business.   The Franchise Tax Board in section 25120, title 18 of the California Administrative Code requires a “strong centralized management,” where “the central executive officers are normally involved in the day-to-day operations of the various divisions and there are centralized offices which perform for the divisions the normal matters which a truly independent business would perform for itself, such as accounting, personnel, insurance, legal, purchasing, advertising and financing.”  (Subd. (b)(3).)   This interdependence is not present here.


At oral argument, plaintiff made reference to the Multistate Tax Compact (§ 38001).   Even assuming this issue is properly before us, which it is not, we do not see how this act affects the threshold inquiry whether the two companies operated as a unitary business.   For these reasons, we decline to address this contention.

We conclude that the advantages Arkla received from the few shared administrative services and executive involvement by the parent company were minimal and did not significantly contribute to the production of income in this state.   Since its purchase as an ongoing concern, Arkla operated as a separate business, distinct from the operations of its parent company and the other subsidiaries, and its income should have been computed separately.

The judgment denying the tax refund is reversed.


1.   Unless otherwise noted, all section references are to the Revenue and Taxation Code.

LOW, Presiding Justice.

KING and HANING, JJ., concur.