VALLEY SPORTSWEAR MFG CO INC v. FRANCHISE TAX BOARD (1991)

INTRODUCTION

This appeal concerns the meaning of “unitary business” for purposes of franchise taxation by defendant and appellant Franchise Tax Board (the Board).   The Board appeals the judgment in favor of plaintiff and respondent Valley Sportswear Mfg. Co., Inc. (Valley) in its claim for refund of California corporation franchise taxes for the income year which ended June 30, 1973.

We affirm the judgment.

FACTUAL AND PROCEDURAL BACKGROUND

Valley is part of a corporate group which includes CSI Corporation (CSI), the corporate parent (initially a California corporation reorganized as a Delaware corporation);  Lee Mar Corporation (Lee Mar), a California corporate subsidiary of CSI engaged in the manufacture of women's clothing;  Valley, a California corporate subsidiary providing contract labor to Lee Mar;  and Sunbeam Lighting Co. (Sunbeam), a California corporate subsidiary of CSI engaged in the manufacture of lighting fixtures and systems (collectively, the CSI group).

The trial court concluded that CSI and its subsidiaries, including Valley, conducted a unitary business for the fiscal year ending June 30, 1973.¹

The facts are not in dispute.   The evidence before the trial court consisted of a stipulation of facts, trial exhibits, and testimony.

CSI ² acquired a controlling stock ownership of Sunbeam in 1969.   Sunbeam's operations resulted in substantial losses, a net operating loss for federal tax purposes of $5,851,886 as of June 30, 1972.   During the period of ownership, CSI advanced Sunbeam a total of $6,302,512 as of June 30, 1972, and $7,634,747 as of June 30, 1973.

Lee Mar had been engaged in manufacturing and selling women's shirts, blouses and tops in California with sales offices both within and outside of California since 1953.   Lee Mar incorporated Valley as its subsidiary in 1970.

As of June 30, 1972, CSI was in default of its long-term obligations, including a promissory note in the amount of $5,000,000 to the Prudential Insurance Company of America (Prudential).   CSI had two major assets:  $900,000 in cash and a “tax loss carry forward” which could be preserved.

In 1972, CSI developed a reorganization plan through Prudential and Athlone Industries, Inc. (Athlone), another major creditor, “to reduce Sunbeam's aggregate debt, stabilize the company and, at the same time, acquire the profitable Lee Mar/Valley business.”   CSI acquired all the stock of Lee Mar and Valley from the stockholders Henry T. Kramer and Leon Frieden pursuant to a purchase agreement executed on October 4, 1972 which recited an effective date of June 30, 1972.   The agreement provided, “This Agreement sets forth the terms and conditions pursuant to which, at a Closing (the ‘Closing’) taking place simultaneously with the execution of this Agreement (but as of the close of business of June 30, 1972, since which time the businesses of Lee Mar and Valley have been operated for the benefit of CSI)․”   The purchase price was $5 million plus 50 per cent of pretax earnings over a five-year period from June 30, 1972, forward.   A portion of the purchase price incurred by CSI in connection with the acquisition of Lee Mar's stock (an amount based on the earnings of Lee Mar, not to exceed $8 million) was guaranteed by Lee Mar.   The restructure resulted in debt reduction of about $3 million.

In January 1973, the name and assets of Sunbeam were sold to Keene Corporation.   Sunbeam's operations for the income year up to January 2, 1973 resulted in a separate California tax loss of $2,278,406.

In May 1973, CSI filed a registration statement with the SEC but it was subsequently withdrawn because of economic and market conditions.

At the beginning of the tax year, CSI had a single officer/director, H.J. Miller.   In October, a new board of directors and slate of officers were established.   H.T. Kramer and R. Hirsch of Valley/Lee Mar became directors and president and executive vice president respectively.   Rose Grad, bookkeeper of Lee Mar, became an officer of CSI.   Traitel of Sunbeam was placed on CSI's board and became vice president/secretary.   Loughran of Sunbeam became vice president/assistant treasurer/assistant secretary.   D.J. Lyons of Athlone was named to the board of directors and became vice president/assistant secretary.   An employee of Athlone, McLean, became vice president/treasurer of CSI and later became the chief financial officer of Lee Mar.   There were revisions to the board and slate of officers during the year, and near the end of the tax year in issue, June 16, 1973, Lyons became president and Kramer, Hirsch, Traitel and Loughran were no longer officers or directors of CSI.

D.J. Lyon, an officer and director of CSI, testified that his job was to “manage and make certain that Lee Mar did exactly what it was supposed to do, which was to make the earnings, manufacture, make the earnings that they said that they could do.”   He was not there to interfere with day-to-day operations, such as “to decide whether they should cut some red fabric or blue fabric.”   Lyon, as manager, discussed with Kramer, president of Lee Mar, his idea to go into a new product line, and they agreed not to do it.   CSI, however, approved a new line of clothing under a separate label.   Under Lyon's direction, Lee Mar effected change in its accounts receivable factoring.

CSI was the operating group and the head office.   At all times after November 1972 the books and records of CSI and Lee Mar were maintained in one central location.   Through an intercompany account, cash flowed back and forth between Lee Mar and CSI.   CSI had two sources of cash:  Lee Mar and payments by Keene for Sunbeam.   Lee Mar advanced $70,000 on a note to CSI.

Alan Shaw, vice-president and secretary of CSI during the tax year in issue, was a licensed attorney and supervised all legal matters involving any of the three CSI companies.   There was one primary law firm for Lee Mar at the time of restructuring and that firm took up the accounts for CSI and Sunbeam following the restructuring.   The accountants for Lee Mar/Valley took on accounting responsibility for the entire CSI group, including the preparation of monthly financial reports to the board of directors and shareholders of the affiliates and the preparation and filing of tax returns for the group.   Internal accounting procedures for the group were centralized under the direction of Rose Grad.   Common signatories were maintained for the bank accounts of the operating subsidiaries.   There was common insurance as to workers' compensation and general liability.   A proposed stock option plan would have included all employees, but did not materialize because the public offering was aborted.

According to CSI's tax return, during the income year, Lee Mar/Valley's separate activities resulted in a taxable income of $2,167,213, Sunbeam had a loss of $2,278,406 and CSI had a loss of $342,938.

After a court trial, judgment was entered in favor of Valley to recover from the Board a refund in the principal sum of $70,809.96 plus interest.   In rendering the judgment, the trial court did not prepare findings because the hearing had taken less than four hours.   However, the judge stated Valley had shown all of the elements necessary to demonstrate that this was a unitary operation by more than a preponderance of the evidence.

The Board appeals.³

ISSUE AND CONTENTIONS

The sole issue is whether CSI and its subsidiaries, including Valley, constituted a “unitary business” during the tax year ending June 30, 1973, for purposes of California corporate franchise taxation.

The Board contends that in order to be a unitary business there must be “substantial functional integration” and that Valley and CSI were not unitary, and even if they were, they were not unitary with Sunbeam.   It further contends that CSI did not provide strong central management to Valley and because CSI did not perform substantial operations, it was not unitary with Sunbeam.

Valley contends all factors to establish unitary status under traditional tests are present in this case.   It also contends a taxpayer is entitled to unitary status even where the corporate parent is inactive or operating subsidiaries have diverse product lines.   Valley contends that administrative regulations create a presumption of unitary status where strong central management exists and that the Board's new functional integration test is a misstatement of the law and has been rejected by the courts.

DISCUSSION

1. The “Unitary Business” Concept

The “unitary business” concept arises out of the problem of assigning the appropriate amount of income to each state in which the multijurisdictional corporate taxpayer conducts business activities.   Income attributable to activities within California is subject to the California Bank and Corporation Tax.  (Rev. & Tax.Code, § 25101.)   For purposes of calculating this tax, “business income is attributed to California corporate activities either by means of a statutory apportionment formula or by a method that is commonly known as separate accounting.”  (“Application of the Unitary Business Concept to Diverse Businesses:  Light at the End of the Tunnel or the Impossible Dream?”   18 Pac.L.Rev. 1161 (1987) (footnotes omitted).)   For apportionment purposes, California currently uses a method involving a three factor formula based on gross sales, payroll, and property.  (Cal.Code of Regs., tit. 18, §§ 25101, 25128–25136.)

a. The United States Supreme Court's Definition of “Unitary Business”

The state's ability to tax extrajurisdictional business income is constrained by constitutional principles of due process and commerce clause considerations.   The United States Supreme Court has held that apportionment as a means to determine income is not permissible unless the activities within the state are part of a unitary business.   The “unitary-business principle” is the “linchpin of apportionability.”  (Mobil Oil Corp. v. Commissioner of Taxes (1980) 445 U.S. 425, 439, 100 S.Ct. 1223, 1232, 63 L.Ed.2d 510.)   “․ [O]ut-of-state activities of the purported ‘unitary business' [must be] related in some concrete way to the in-state activities.   The functional meaning of this requirement is that there be some sharing or exchange of value not capable of precise identification or measurement—beyond the mere flow of funds arising out of a passive investment or a distinct business operation—which renders formula apportionment a reasonable method of taxation.”   (Container Corp. v. Franchise Tax Bd. (1983) 463 U.S. 159, 166, 103 S.Ct. 2933, 2940, 77 L.Ed.2d 545, citations omitted.)

In the early case of Butler Bros. v. McColgan (1942) 315 U.S. 501, 62 S.Ct. 701, 86 L.Ed. 991, affirming 17 Cal.2d 664, 111 P.2d 334 (1941), the Court recognized that the unitary business principle could apply, not only to vertically integrated enterprises, but also to a series of similar enterprises operating separately in various jurisdictions but linked by common managerial or operational resources that produced economies of scale and transfers of value.  (Id., 463 U.S. at p. 166, 103 S.Ct. at p. 2940.)

Rejecting the notion of adopting a “bright-line rule” requiring “ ‘a substantial flow of goods,’ ” the Supreme Court has declared, “The prerequisite to a constitutionally acceptable finding of unitary business is a flow of value, not a flow of goods.   As we reiterated in F.W. Woolworth [Co. v. Taxation & Revenue Department, 458 U.S. 354, 102 S.Ct. 3128, 73 L.Ed.2d 819 (1982) ], a relevant question in the unitary business inquiry is whether ‘ “contributions to income [of the subsidiaries] result[ed] from functional integration, centralization of management, and economies of scale.” ’   458 U.S., at 364 [102 S.Ct., at 3135], quoting Mobil, 445 U.S., at 438 [100 S.Ct., at 1232].  ‘[S]ubstantial mutual interdependence,’ F.W. Woolworth, supra [458 U.S.] at 371 [102 S.Ct., at 3139], can arise in any number of ways;  a substantial flow of goods is clearly one but just as clearly not the only one.”  (Container Corp. v. Franchise Tax Bd. (1983) 463 U.S. 159, 178–179, 103 S.Ct. 2933, 2947, 77 L.Ed.2d 545.)

In regard to the flow of capital resources from the parent corporation to its subsidiaries through loans and loan guarantees, the Court noted, “․ [C]apital transactions can serve either an investment function or an operational function.   In this case, appellant's loans and loan guarantees were clearly part of an effort to ensure that ‘[t]he overseas operations of [appellant] continue to grow and to become a more substantial part of the company's strength and profitability.’  [Citation.]”  (Id., at p. 180, fn. 19, 103 S.Ct. at p. 2948, fn. 19.)

The Board, emphasizing the Supreme Court's use of the phrase, “functional integration,” equates it with “operational interconnections,” and asserts the trial court failed to consider this factor in finding a unitary business in this case.⁴  The Board seems to suggest that diverse businesses by their very diversity cannot be unitary.  “They were intuitively separate, legally separate business operations.”

b. California's Definition

The California Supreme Court decision in Butler Bros. v. McColgan (1941) 17 Cal.2d 664, 111 P.2d 334, affirmed in Butler Brothers v. McColgan, supra, 315 U.S. 501, 62 S.Ct. 701, 86 L.Ed. 991, is the source of the frequently cited “three unities test” for determining whether a unitary business exists.

“․ [T]he unitary nature of appellant's business is definitely established by the presence of the following circumstances:  (1) unity of ownership;  (2) unity of operation as evidenced by central purchasing, advertising, accounting and management divisions;  and (3) unity of use in its centralized executive force and general system of operation.”  (Id., 17 Cal.2d at p. 678, 111 P.2d 334.)   The court found a foreign corporation engaged in wholesale merchandising and distributors located in different states formed a unitary business.

In Edison California Stores v. McColgan (1947) 30 Cal.2d 472, 183 P.2d 16, the court employed another test as well:  whether the business done within California is “dependent upon or contributes to” the operation of the business done outside the state.  (Id., at p. 481, 183 P.2d 16.)

These traditional tests do not require intercompany flow of goods.   (Superior Oil Co. v. Franchise Tax Board (1963) 60 Cal.2d 406, 34 Cal.Rptr. 545, 386 P.2d 33;  Honolulu Oil Corp. v. Franchise Tax Board (1963) 60 Cal.2d 417, 34 Cal.Rptr. 552, 386 P.2d 40.)   Nor do the companies have to be engaged in the same businesses.   In Chase Brass & Copper Co. v. Franchise Tax Bd. (1970) 10 Cal.App.3d 496, 95 Cal.Rptr. 805, the court held vertically integrated businesses were unitary.   In Hugo Neu–Proler Internat. Sales Corp. v. Franchise Tax Bd. (1987) 195 Cal.App.3d 326, 240 Cal.Rptr. 635, the court held that a dummy corporation created for purposes of federal tax advantages, owned by a partnership comprised of two corporations was not a new separate entity for tax purposes but was a part of the original unitary business.

Recently, in Mole–Richardson Co. v. Franchise Tax Bd. (1990) 220 Cal.App.3d 889, 269 Cal.Rptr. 662, the Court of Appeal stated:  “A general test to determine whether a business is unitary is ‘ “[i]f 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, ․” ’  (Superior Oil Co. v. Franchise Tax Bd. (1963) 60 Cal.2d 406, 412 [ ], [34 Cal.Rptr. 545, 386 P.2d 33];  Chase Brass & Copper Co. v. Franchise Tax Bd., supra, 10 Cal.App.3d 496, 501 [95 Cal.Rptr. 805], cert. den. 400 U.S. 961 [91 S.Ct. 365, 27 L.Ed.2d 381].   A three-part test was set out in Butler Bros. v. McColgan [supra] 17 Cal.2d 664, 678 [ ] [111 P.2d 334], affirmed 315 U.S. 501 [ ] [62 S.Ct. 701, 86 L.Ed. 991], and remains viable today:  ‘[T]he unitary nature of appellant's business is definitely established by the presence of the following circumstances:  (1) unity of ownership;  (2) unity of operation as evidenced by central purchasing, advertising, accounting and management divisions;  and (3) unity of use in its centralized executive force and general system of operation.’ ”  (Id., 220 Cal.App.3d at p. 895, 269 Cal.Rptr. 662.)

In Mole–Richardson, a California corporation, owned by family trusts and engaged in lighting equipment operations for motion picture and television studios and still photographers, was held a unitary business with a second California corporation, owned by the same family, engaged solely in the ownership of real property in California and Colorado.   A wholly owned subsidiary of the second corporation engaged in the rental of motion picture lighting equipment produced by the first corporation.   The Board had determined that there were two unitary businesses, a “light group” and a “farm group,” and assessed them separately.

In affirming the trial court's judgment that they were a unitary business, the court stated:

“[The Board's view] seems to be based on the view that ‘functional integration’ refers to a new and different concept with which a business enterprise must be evaluated to justify unitary treatment.   Although the term is not specifically defined in the cases cited, a review of the analyses employed makes it clear that the determinative factors are the same as those set forth in title 18, California Code of Regulations, section 25120, as well as the earlier California cases of Butler Bros. v. McColgan, supra, 17 Cal.2d 664 [111 P.2d 334], affirmed 315 U.S. 501 [62 S.Ct. 701, 86 L.Ed. 991], Superior Oil Co. v. Franchise Tax Bd., supra, 60 Cal.2d 406 [34 Cal.Rptr. 545, 386 P.2d 33], and Honolulu Oil Corp. v. Franchise Tax Bd. (1963) 60 Cal.2d 417 [ ] [34 Cal.Rptr. 552, 386 P.2d 40].   Those factors are ‘strong central management, coupled with the existence of centralized departments for such functions as financing, advertising, research, or purchasing’ (Cal.Code Regs., tit. 18, § 25120, subd. (b)) and ‘unity of ownership’;  ‘unity of operation as evidenced by central purchasing, advertising, accounting and management divisions';  and ‘unity of use in its centralized executive force and general system of operations.’  (Butler Bros. v. McColgan, supra, 17 Cal.2d at p. 678 [111 P.2d 334].)”   (Id., 220 Cal.App.3d at p. 898, 269 Cal.Rptr. 662.)

In support of its conclusion that the corporations had strong centralized management, the court cited evidence that all major business decisions were made by one person, based in the Hollywood office;  and accounting, payroll, insurance, pension plans, primary banking, major purchasing and advertising for the Colorado business as well as the California business were conducted at the Hollywood offices, realizing cost savings, resulting from economies of scale.   Also, real property in Hollywood was mortgaged to fund improvement of the ranch property in Colorado, and one California attorney acted as general counsel.  (Ibid.) ⁵

2. Application of the Tests

The Board contends no functional integration existed between Valley and the other entities.

In regard to Valley and Sunbeam, the Board argues that there was no operational interconnections, due to the fact they were in diverse businesses.   The Board also contends that there was no common ownership except for a maximum of three months of the income year, as CSI did not acquire Valley until October 4, 1972, and then Sunbeam was sold on January 2, 1973.

In regard to Valley and CSI, the Board asserts the only “alleged connections, other than a single $70,000 loan and minor economies of scale resulting from common bookkeeping and a $480 rental expense were the ‘management’ services provided to [Valley] by CSI.”   The Board argues that these management services “lack unitary significance because such activities are merely the activities which any parent exercises over its investment subsidiary,” citing F.W. Woolworth Co. v. Franchise Tax Bd. (1984) 160 Cal.App.3d 1154, 1161, 207 Cal.Rptr. 149.   It also argues that CSI was “essentially inactive, and thus literally incapable of providing any operational services to anyone.” ⁶

The Board also argues that because CSI was not an operating entity, it could not be combined with Sunbeam.

a. The Three Unities Test

Pursuant to the test set forth in Butler Bros. v. McColgan, supra, 17 Cal.2d 664, 678, 111 P.2d 334, and declared viable in Mole–Richardson v. Franchise Tax Bd., supra, 220 Cal.App.3d 889, 269 Cal.Rptr. 662, the CSI group is a unitary business.   Although not of common ownership throughout the income tax year, apparently there was common ownership at the relevant times, when income was earned and losses were incurred.⁷  There is no question that Sunbeam was owned by CSI before 1972.   The losses claimed were for Sunbeam operations for the income year up to the date its assets and name were sold.

There was unity of use as there was a significant overlap between the board of directors and key officers of the group.   CSI served as a head office, and CSI's president and executive vice president were the former owners of Valley and Lee Mar and continued to serve as president and vice president of Lee Mar.   Contrary to the implication of the Board's repeated reference to Lyon as an employee of Athlone, Lyon, who oversaw Lee Mar, was a director and vice president of CSI.   Indeed, it is apparent that the reorganization resulted in a directorship and slate of officers from the various entities.

Finally, there was considerable unity of operation by way of intercompany financing.   The entire restructuring program required the coordination of intercompany finances and involved loans, loan guarantees, debt refinancing and a substantial, $8 million, debt reduction.   Additionally, the CSI group shared attorneys, accountants, financial reporting, insurance programs and use of facilities.

b. The Contribution or Dependency Test

Again, by design of the restructuring plan, the various entities of the CSI group contributed to the operation of and were dependent upon the other entities within the group.  (See, Edison California Stores v. McColgan, supra, 30 Cal.2d 472, 183 P.2d 16.)   That this dependency was primarily in the financial areas, rather than in materials or expertise, does not diminish the fact that there was significant “flow of value” among CSI, Sunbeam and Lee Mar/Valley.  (Container Corp. v. Franchise Tax Bd., supra, 463 U.S. 159, 178–179, 103 S.Ct. 2933, 2947, 77 L.Ed.2d 545.)

c. The Board's Administrative Regulations

The regulations of the Board reflect the law as expressed by the traditional tests.  Section 25120, subdivision (b) of the California Code of Regulations, title 18, (formerly the California Administrative Code) provides in pertinent part as follows:

“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 general, the activities of the taxpayer will be considered a single business 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.   The following factors are considered to be good indicia of a single trade of business, and the presence of any of these factors creates a strong presumption that the activities of the taxpayer constitute a single trade or business:

“․

“(3) Strong centralized management:  A taxpayer which might otherwise be considered as engaged in more than one trade or business when there is a strong central management, coupled with the existence of centralized departments for such functions as financing, advertising, research, or purchasing.   Thus, some conglomerates may properly be considered as engaged in only one trade or business when the central executive officers are normally involved in the 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 or financing.”  (Emphasis added.)

CSI presented substantial evidence of centralized management for functions specifically enumerated in the regulation, thereby triggering the “strong presumption.”   Although not a conclusive presumption, the trial court, in light of the evidence before it, did not err in concluding that CSI and its subsidiaries, including plaintiff and appellant Valley, constituted a unitary business for purposes of franchise taxation for the income year ending June 30, 1973.  (See Mole–Richardson Co. v. Franchise Tax Bd., supra, 220 Cal.App.3d 889, 895–899, 269 Cal.Rptr. 662.)

DISPOSITION

Judgment affirmed.

HINZ, Associate Justice.

DANIELSON, Acting P.J., and CROSKEY, J., concur.