BUTLER BROS v. McCOLGAN (1940)

This action was brought to recover the sum of $4,143.10, being the amount of taxes and interest thereon paid to respondent under protest. Judgment was entered in favor of respondent, and plaintiff appealed therefrom.

The cause was submitted upon an agreed statement of facts which may be summarized as follows:

Plaintiff and appellant, Butler Brothers (herein called “the Company”), is an Illinois corporation, having its principal corporate office at Chicago. It is engaged in the wholesale dry goods and general merchandise business, purchasing from manufacturers and others, and selling to retailers only. It operates seven distinct wholesale houses at Chicago, Jersey City, Baltimore, Minneapolis, St. Louis, Dallas and San Francisco. Each of these houses serves a separate trade territory. At each house stocks of goods are maintained, from which sales are made in its territory. Each house handles its own sales, and all solicitation, credit and collection arrangements in connection therewith, and keeps books of account showing the operations of the house. All sales in California were made from the San Francisco house and all receipts credited thereto.

The greater part of the operating expense of the houses is directly and exclusively incurred at the respective houses, including such items as labor, rentals, etc. There are, however, some common expenses such as executive salaries and corporate overhead and the expense of operating a central buying division and a central advertising division. These expenses are apportioned to the respective houses on bases which, it is agreed, are in accord with recognized accounting practice, and the accuracy and propriety of such bases of apportionment are here conceded. The aggregate of such common expenses so charged to the San Francisco house for the year 1935 was $100,091, of which, it is agreed, approximately 75 per cent would have been incurred whether or not the San Francisco house were operated. Except for such common expenses, each house is operated independently of each other house.

Through a central buying agency goods required for resale in the various houses are ordered, but such goods are shipped directly from the manufacturer to the houses, where the cost thereof, with transportation charges thereon, is entered on the books of the house. No charges are made against any house for the benefit of the company, or any other house by reason of such centralized purchases, but the actual cost of operating the central buying division is allocated to the houses as stated in the preceding paragraph. By reason of the volume of purchases so made, more favorable prices are obtained than would be obtainable in respect to purchases for the account of any individual house, but addition or subtraction of purchases in the volume made for the San Francisco house would have no effect on the prices obtainable for the remaining houses.

The accounts of the San Francisco house, computed by deducting from the gross receipts from all sales made therefrom (which includes all sales made and business done in California) the actual cost of merchandise and other direct expenses, and the apportioned share of common expenses previously described, showed for the year 1935 a loss of $82,851. Within the time allowed by law a report showing this loss was made and the minimum tax of $25 was paid for the year 1936. During the year 1935 the operations of all houses of the company produced a profit of $1,149,677. The commissioner subsequently assessed an additional tax of $3,798.43, which, with interest amounting to $344.67, was paid under protest on September 16, 1938. The additional assessment was predicated on the allocation to California of 8.1372 per cent of the company's total income derived from all sources. This percentage was a mathematical average of the percentages which the value of the tangible property, payroll and gross sales attributable to California bore to the corresponding items of all houses of the company. If an allocation is proper, use of the particular percentage here used is not questioned.

The tax in question was levied under the provisions of section 10 of the Bank and Corporation Franchise Tax Act (General Laws, Act 8488, vol. 2, p. 3851.) That section provides: “If the entire business of the bank or corporation is done within this State, the tax shall be according to or measured by its entire net income; and if the entire business of such bank or corporation is not done within this State, the tax shall be according to or measured by that portion thereof which is derived from business done within this State. The portion of net income derived from business done within this State, shall be determined by an allocation upon the basis of sales, purchases, expenses of manufacturer, pay roll, value and situs of tangible property, or by reference to these or other factors, or by such other method of allocation as is fairly calculated to assign to the State the portion of net income reasonably attributable to the business done within this State and to avoid subjecting the taxpayer to double taxation. *”

It is contended by appellant that the method by which the tax was fixed and computed was unauthorized and unlawful, and that such method had the effect of taxing plaintiff on, and in respect to income derived from sources beyond the jurisdiction of the state. This resulted, it is contended, in a denial of due process of law, and of the equal protection of the law, in violation of the Fourteenth Amendment of the Constitution of the United States.

On the other hand, respondent contends that the tax was levied upon income from business derived from within this state; that such business was unitary in character; and that the state was therefore justified in applying the formula method in arriving at the net income of appellant.

The sole question presented is whether the franchise commissioner should have adopted the separate accounting method in computing the franchise tax, or whether it was proper and legal for him to have used the formula system. If the first method is used, only the minimum tax of $25 would be due. Under the second method, which was actually applied here, the tax amounted to $3,798.43. The first method shows a loss in the California operations of appellant amounting to $82,851. Under the second, respondent showed that appellant enjoyed and received a net income from the business done in California amounting to $95,000. In respect to net income, the two methods are some $177,851 apart. Both methods are described in the stipulated facts above. The first is obviously based upon strict and accurate accounting procedure, while the second is the application of a set formula which has been approved in many jurisdictions in those cases where interstate operations are carried on, and where, from the nature of such operations, income cannot be properly allocated by separate accounting methods. Plain instances which justify the application of the formula method would be telegraph, telephone, railroad and express companies. If there is any evidence to sustain a finding that the operations of appellant in California, during the year 1935, contributed to the net income derived from its entire operations in the United States, it would seem as though the method used was a proper one. Such income would be within the purview of the statute quoted above—“The portion of net income derived from business done within this State”. Where the formula method is adopted by the taxing power, the burden of proof is upon the taxpayer to show that such method has been applied unreasonably and arbitrarily. Hans Rees' Sons v. State of North Carolina, 283 U.S. 123, 51 S.Ct. 385, 75 L.Ed. 879.

Appellant earnestly contends that the evidence is insufficient to justify the imposition of the formula. It points out that there is nothing in the stipulated facts which would justify a finding that it was doing a unitary business, and even if there were such evidence, the method used operated arbitrarily and unreasonably in respect to appellant's business. It is agreed by all parties that the formula of allocation to California of a portion of appellant's income from all sources, is proper, if the facts of the case justify the application of a formula. The question is not whether the formula used is fair and proper, but whether, under the facts here, there should be any allocation at all.

The factual structure of the case is relatively simple. Appellant is engaged in buying merchandise from manufacturers and others, and selling to retailers only. It does no manufacturing. It maintains a central buying division, but goods are shipped directly from the manufacturer to the houses in the several states, where the cost thereof and transportation charges are entered upon the books of the house. Further facts appear in the summary given above.

It is fundamental that jurisdiction to tax is dependent upon jurisdiction of the person or transaction sought to be taxed and that for a state to tax property on transactions beyond its jurisdiction is a denial of due process of law and of the equal protection of the laws. Frick v. Pennsylvania, 268 U.S. 473, 45 S.Ct. 603, 69 L.Ed. 1058, 42 A.L.R. 316. Where, however, property located in two or more states derives a value from its unity of use, allocation of the composite value on a fair and reasonable basis will be sustained. The familiar illustration of this principle is in the assessment of railroad property. State Railroad Tax Cases, 92 U.S. 575, 23 L.Ed. 663. Referring to a unitary business, “That term is simply descriptive, and primarily means that the concern to which it is applied is carrying on one kind of business—a business, the component parts of which are too closely connected and necessary to each other to justify division or separate consideration, as independent units.” Maxwell v. Kent–Coffey Mfg. Co., 204 N.C. 365, 168 S.E. 397, 399, 90 A.L.R. 476. It has further been held that unity of use is something more than mere unity of ownership. Adams Express Co. v. Ohio, 165 U.S. 194–222, 17 S.Ct. 305, 41 L.Ed. 683. The allocation may be made by the application of a formula, which is based upon certain factors. The following excerpt from the stipulated facts describes the formula used and the manner of its application: “In the year 1935, the operations of all houses of the Company produced a profit of $1,149,677. The additional tax assessed by the Franchise Tax Commissioner was predicated on the allocation to California of 8.1372% of the total income of the Company derived from all sources, such percentage having been determined by mathematical average of the percentages which (a) value of real and tangible personal property, (b) wages, salaries, commissions and other compensation of employees, and (c) gross sales, less returns and allowances, attributable to the San Francisco house bore to the corresponding items of all houses of the Company.”

The fact that a corporation does business in more than one state does not necessarily justify the application of a formula to ascertain the tax. In Hans Rees' Sons v. State of North Carolina, supra, the court held [283 U.S. 123, 51 S.Ct. 389, 75 L.Ed. 879]: “But the fact that the corporate enterprise is a unitary one, in the sense that the ultimate gain is derived from the entire business, does not mean that for the purpose of taxation the activities which are conducted in different jurisdictions are to be regarded as ‘component parts of a single unit’ so that the entire net income may be taxed in one state regardless of the extent to which it may be derived from the conduct of the enterprise in another state.”

Where, however, a business is unitary in character, that is, where its separate parts cannot be fairly considered by themselves, and where the whole business in the several states derives a value from the unity of use, allocation of income upon a reasonable formula has been sustained. Bass, Ratcliff & Gretton v. State Tax Commission, 266 U.S. 271, 45 S.Ct. 82, 69 L.Ed. 282; Underwood Typewriter Co. v. Chamberlain, 254 U.S. 113, 41 S.Ct. 45, 65 L.Ed. 165. Aside from the question as to the propriety of applying a formula here, and paramount over all other considerations, is the question whether or not it reasonably appears that a portion of the total net income of appellant was “derived from business done within this State”. Sec. 10 of Act 8488—fully quoted above.

The only factor called to our attention by respondent which might point to a unitary business is the central buying power exercised by the headquarters of appellant in Illinois. The state argues that even though the California house lost money during the year 1935, the operations conducted during that year actually brought a profit to the corporation. They contend that the disposal of some $5,000,000 worth of merchandise during the time mentioned, increased the purchasing power of appellant, and thus permitted it to buy for its other houses, through volume purchases, at a price lower than it otherwise would have secured. It appears, however, that the parties have stipulated otherwise. We quote from the agreed facts: “A reduction in the volume of purchases in an amount equal to the purchases made for the San Francisco house would result in no less favorable prices being obtainable in respect of the purchases which would be made for the remaining houses of the Company.”

Most of the cases cited by respondent, with one exception, involve corporations which are engaged in manufacturing. In those instances a manufacturing profit was made by the corporation before the merchandise was shipped to another state. This is true of the Underwood case, supra. Here, none of the merchandise was manufactured by appellant. It was engaged solely in buying and selling. There are cases where a corporation engaged in buying and selling has been held subject to the payment of income taxes in one of the states where it has been doing business. In International Elevator Co. v. Thoresen, 58 N.D. 776, 228 N.W. 192, a company which bought and sold grain was held liable for the payment of an income tax in the state of North Dakota. It bought grain in that state and shipped it for resale in other states. The corporation filed a return showing only income derived from sales in North Dakota. It failed to account for sales outside the state, and contended that only transactions within the state should be considered in fixing its income. It showed that it had lost some $85,000 on transactions within the state. Its net profit from all its operations in several states amounted to $249,515.11. A tax of $2,937.98, computed by a formula, was upheld. The case was clearly one where a separate accounting system did not disclose the income received from shipment and sale of grain outside the state. The return by the elevator company included only income received from sales at North Dakota elevators. The case of Montgomery Ward & Co. v. Kansas Tax Commission, 151 Kan. 159, 98 P.2d 143, throws little light upon the question. No attempt was there made by the state to base a tax upon the net income of the corporation outside the state of Kansas. The only question was whether or not the corporation was entitled to charge against its Kansas income a proportionate share of certain expenses incurred outside the state. The court held in the affirmative.

Appellant relies strongly upon the case of Standard Oil Co. v. Wisconsin Tax Commission, 197 Wis. 630, 223 N.W. 85, 88. Wisconsin taxes corporations on a basis very similar to our Bank and Corporation Franchise Tax Act and provides for allocation of income in a manner very like section 10. A company engaged in the production, refining and sale of petroleum products but engaged only in selling within Wisconsin was taxed on the basis of a statutory allocation of income from the entire operation. In that case it was shown that accurate accounting of the operations of the various branches existed. The court there held: “In the enactment of the statute relating to the allocation of income of persons doing business within and without the state, the declared legislative purpose is to make a reasonable and equitable distribution of the taxpayer's income to the end that that part of the income justly assessable in the state of Wisconsin may be ascertained. The statute does not enjoin upon the commission the use of that method which will produce the largest amount of taxable income but rather that method which will most justly apportion the income properly taxable in Wisconsin. Here it appears conclusively that it is possible to ascertain the income derived from business transactions in Wisconsin by the application of proper accounting methods. * There are some operations which from their very nature produce an income which cannot be properly allocated by separate accounting methods, instances of which are the telegraph, telephone, and express companies. They stand ready to serve whoever may apply for service and the entire operation constitutes a unit of service. That is not the case with the manufacturing and sales business, particularly so where the accounts are so kept as to be readily separable.”

We regard the foregoing case as very persuasive authority to the effect that a separate accounting method should be applied in the instant case.

We therefore conclude that the stipulated facts show that the company actually incurred a loss in California; that its California earnings could have been accurately ascertained without the necessity of recourse to any arbitrary formula, and that the use of such formula results in the imposition of a tax on income not earned in California, and therefore not subject to its taxing power.

The facts found do not support the judgment, and it is ordered that the judgment be reversed, with directions to the trial court to enter judgment in favor of appellant.

Mr. Justice TUTTLE delivered the opinion of the court.

We concur: PULLEN, P.J.; THOMPSON, J.