How the Envirodyne
Decision May Impact the Unitary Business Determination
By
Scott D. Smith
Sharlene Amitay
The unitary business principle and combined reporting are cornerstones of multistate corporate income taxation.[1] Likewise, the tools most frequently employed to measure unity, the “three unities”[2] and “dependency/contribution”[3] tests, have dominated unitary case law for decades. As such, it is seldom that new ground is broken in the area of unitary combined reporting jurisprudence. The unitary decisions handed down from year to year typically involve application of a particular taxpayer’s very detailed facts to these well-settled rules. Yet, a recent decision issued by the United States Court of Appeal for the Seventh Circuit, Envirodyne v. Industries, Inc. v. Illinois Department of Revenue, presents a fresh perspective on the boundaries of unity.[4] The decision essentially stands for the proposition that unity among affiliates should not be presumed solely based on unity between various affiliates and their common parent. The court uses a metaphor to illustrate its holding: that of a wheel (the parent) with spokes (the subsidiaries). Pursuant to the court’s theory, if the wheel has a “rim,” unity may be established; however, if there is no rim uniting the various spokes, those spokes cannot avail themselves of or be forced into a combined report.
This article examines the implications of the Envirodyne decision. Following a brief overview of the decision, the article evaluates the court’s rationale, from an academic perspective, as compared to Illinois law and existing case law in Illinois and other states. The article then analyzes the practical effect, if any, of this decision on multistate unitary taxpayers both in Illinois and other states. Finally, the article presumes a hypothetical environment in which the Envirodyne rule is controlling and examines the mechanical impact that application of such a rule would have on the combined reports of multistate taxpayers.
In Envirodyne, the United States Court of Appeal for the Seventh Circuit held that an affiliated group’s food packaging segment was not unitary with the group’s steel manufacturing segment.[5] The court acknowledged that both groups were unitary with their common parent but, nevertheless, found that under Illinois law, the groups were not unitary with each other.[6] The court’s rationale was that the two groups were not integrated, and there was no dependency and contribution between them, notwithstanding that the groups were united by common ownership through their parent. The decision has garnered attention, in large part, because the court’s analysis represents somewhat of a departure from the majority of unitary decisions.
Several circumstances of the decision were noteworthy. First, unlike most unitary decisions, Envirodyne was issued by a federal court.[7] While the legal analysis was based on Illinois state law (and constitutional principles), the matter was heard in a federal tribunal because the taxpayer was in bankruptcy. The litigation resulted from an appeal by the Illinois Department of Revenue (the Department), as a creditor, from a rejected claim in bankruptcy court. The taxpayer wished to include the steel affiliates in its Illinois unitary group because the steel affiliates had net operating losses. Conversely, the Department, in an effort to increase its bankruptcy claim for outstanding taxes, argued that the steel group’s losses should not be combined with the food packaging group’s income.
The court conceded that the parent corporation established functional integration through active management of both groups. However, it focused on the lack of several commonalities among the parties, including pension plans, welfare plans, an employee handbook, and joint advertising, in finding that the two groups were not unitary.[8] The court found that the absence of such central functions created a nonunitary corporate structure that was analogous to a hub with spokes, rather than a unitary wheel with a rim.[9] The court did not require that the spokes engage in intercompany transactions as a condition of establishing unity (i.e., operational interdependence). What the court appeared to be looking for, instead, were common programs, policies, or functions used by both the food packaging and steel groups that would support a finding that the two lines of business were unitary. The court did identify one such integrated activity: legal and accounting services provided in preparation of the group’s consolidated federal tax return. However, the court discounted the significance of this factor.[10]
Although Envirodyne is technically a taxpayer loss, this particular taxpayer’s loss may well prove to be a gain for the taxpayer community as a whole. The Department’s arguments in Envirodyne and the court’s holding may be used instead by taxpayers seeking to exclude profitable affiliates from their unitary groups, particularly when all intragroup contacts are routed through a common parent. The court itself appeared to recognize the potential opportunities raised by its interpretation of Illinois law, noting that Illinois’ unitary laws were “shortsighted” because they made it more difficult for the state to tax out-of-state entities.[11]
When a legal decision deviates from the norm, it is reasonable to question whether the court “got it right.”[12] In Envirodyne’s case, this analysis requires a comparison of the court’s rationale to a variety of authorities and perspectives, including Illinois law, Illinois case law, and the corresponding standards in other states.
Illinois Law – According to Envirodyne, unity, as measured by integration, dependency, and contribution, requires interrelationships among the various members of a group rather than a series of parallel relationships between subsidiaries and a common parent. Sufficient interrelationships may be established through substantial intercompany transactions among subsidiaries. However, such transactions are often absent or minimal in diverse business situations (i.e., where operating affiliates are not engaged in the same line of business). In Container Corp., the U.S. Supreme Court recognized that the concept of flow of value was not limited to intercompany transactions but, rather, embodied the value created by centralized management, functional integration, and economies of scale.[13] In Envirodyne, the court sought evidence of central programs and policies in evaluating whether the taxpayer’s diverse businesses constituted a unitary group. The court illustrated its reasoning through an example, noting that combination would be inappropriate if, instead of an unprofitable Wisconsin steel company, the affiliate at issue in Envirodyne was a “money-losing rickshaw operator in Mandalay.”[14] The court’s exaggerated example is intended to convey the point that diverse entities under common ownership may lack the integration required to establish a unitary business group, absent strong centralized management.
Illinois’ statutory definition of a unitary business group also supports the court’s theory. Unlike other unitary states, Illinois statutorily incorporates the dependency and contribution test as a required element of a unitary business group. The statute defines a unitary business group in terms of three mandatory criteria: 1) persons related through common ownership; 2) whose business activities are integrated with each other; and 3) who are dependent upon and contribute to each other.[15] The statute also notes that unity can ordinarily be illustrated where entities are functionally integrated through strong centralized management. However, unlike the dependency/contribution test, this portion of the definition appears to be an example rather than mandatory criteria. Thus, even in situations where functional integration exists, the dependency and contribution test must still be satisfied to establish a unitary group in Illinois.[16] Furthermore, the statute refers to dependency and contribution with respect to “each other.” While this language may be subject to differing interpretations, the theory that unity is required among the various members of a unitary group is not an unreasonable interpretation of the statute.
Thus, based on the statutory language alone, there is some support for the court’s theory. However, when the other relevant authorities are introduced into the analysis, the issue becomes murkier. The regulation that interprets the unitary business group statute contains additional language that, at the same time, both supports and challenges the court’s position. The administrative interpretation of unity requires that the members be “dependent upon or contribute to the activities of one or more of the other persons” in the group.[17] The regulation thus could be read to support the scenario that was rejected by the Envirodyne court—that each subsidiary must satisfy the dependency/contribution only with respect to one other member of the group, including a common parent.
Does this mean that the Envirodyne rationale is inconsistent with the regulation? Not necessarily. The court did not categorically rule out unity through a common parent. Rather, it indicated that in order for a common parent to establish unity, it must provide sufficient integration to create a unitary “rim.” Such integration, the court suggested, could be manifested through common functions in which all members of the group participated (e.g., commingled funds, joint marketing and advertising, etc.), even if the members did not otherwise interact among themselves. On the other hand, in the view of the court, unity may not be appropriate if the common parent merely exercised managerial control over its subsidiaries.
The regulation contains an example that is seemingly on point.[18] The example involves a diversified group of corporations engaged in four distinct, autonomously operated lines of business. There is no flow of goods between the various “spokes” in the example. The common parent maintains overall control; approves expenditures over $500,000, budgets, and financing arrangements; supervises the tax function; and maintains a central warehouse and accounting system. In the example, the companies are deemed to be engaged in a unitary business.
Both sides in Envirodyne claimed this example as support for their respective positions. The taxpayer pointed to the lack of interaction between the spokes in the example and the fact that the subsidiaries are still considered unitary, while the court and the Department found that the example contained several integrated functions that were not present in Envirodyne. The court focused on the central warehouse and accounting system mentioned in the regulation, noting that if “all these functions” had been present in Envirodyne’s case, unity may have been established. This appears to illustrate the court’s point that common programs with group participation would be sufficient to establish the rim necessary to connect the spokes of the wheel and, thus, establish unity. However, aside from the few factors emphasized by the court, the example bears a striking resemblance to the taxpayer’s facts. Moreover, the U.S. District Court’s lower court ruling in Envirodyne explicitly cited this example as authority for its ruling that the taxpayers were unitary.[19]
Judicial Authority – It is difficult to draw the comparison between Envirodyne and established case law. This is partially attributable to the fact that the relevant decisions are not directly on point; they are largely concerned with unity between a parent and subsidiaries rather than the subsidiary-to-subsidiary relationship. In Envirodyne, the parent-subsidiary unity was stipulated, and (although not explicitly stated) the remaining issue was whether there were one or two unitary groups.[20] In addition, the Envirodyne court focused on the dependency/contribution element of the unitary business statute. The Illinois decisions involving unity, by and large, skip over this test and focus on the statutory/regulatory language, which provides that unity can be established by functional integration as exhibited by strong centralized management.[21] An analysis that focuses on centralized management is obviously relevant to issues involving parent-subsidiary unity, as evidenced by the court’s acknowledgement that Envirodyne was unitary with both its food packaging and steel manufacturing subsidiaries through management and control. However, the presence of strong centralized management may also be sufficient to establish subsidiary-subsidiary (i.e., peer-to-peer) unity in a diverse business setting.
Overall, Illinois’ large body of unitary jurisprudence provides less support for the Envirodyne holding than the statutory and regulatory authorities.[22] Interestingly, all of the decisions cited by the Department in support of decombination were issued by other states’ tribunals, whereas all decisions cited by the taxpayer in support of unity were Illinois decisions. This alone does not mean that Illinois’ case law is in conflict with Envirodyne. Unitary analyses are extremely fact-specific, and each decision is unique. However, the court did expend significant efforts distinguishing and dismissing the Illinois decisions cited by the taxpayer, while at the same time remaining silent with respect to the non-Illinois decisions cited by the Department.
The court focused, in particular, on the Illinois Supreme Court’s decision in Citizens Utilities, in which a unitary business group was found to exist.[23] Although subsidiary-subsidiary unity was not directly at issue in Citizens Utilities, there were parallels to the Envirodyne fact pattern. The parent corporation owned 24 subsidiaries, all engaged in similar aspects of the water treatment business and none of which appeared to have much interaction with each other. In distinguishing the decision, the Envirodyne court identified several aspects of the parent-subsidiary relationship in Citizens Utilities that it agreed established unity, including: approval of purchases, legal assistance, a financing system where the parent had full access to the subsidiaries’ bank accounts, review of engineering projects, complex central accounting functions, and similar lines of business.[24]
Comparing Envirodyne to Citizens
Utilities, a clearer picture begins to emerge as to how a common parent may
establish the functional integration necessary to create a unitary business
group of related corporations under the Envirodyne
rationale. However, upon closer examination, Envirodyne and Citizens
Utilities may not be so different after all. The District Court decision in
Envirodyne contained certain facts
that were not mentioned in the Seventh Circuit’s decision and that would appear
to narrow the gap between the two decisions. In particular, the District
Court’s Envirodyne decision noted use
of the same legal and accounting firms, oversight of significant purchasing
decisions, and even interactions
between the steel group and other Envirodyne
subsidiaries (other than food packaging subsidiaries).[25]
This raises questions about the Seventh Circuit’s decision and the degree of
integration necessary to establish unity. How much intercompany integration is
required to create a rim that unites the spokes of a wheel? Moreover, in
distinguishing Citizens Utilities, the
court focused on “complex accounting functions, including preparation of the
taxpayer’s income tax returns” but, at the same time, discounted the
significance of tax preparation in Envirodyne.
Finally, the Envirodyne court noted
that the parent in Citizens Utilities
could access its subsidiaries’ accounts. Yet in an organizational structure
that involves wholly owned subsidiaries, it could be argued that such an
arrangement is superfluous.
Nevertheless, Envirodyne does create a persuasive
argument for the creation of separate unitary groups where diverse businesses
are bound by nothing more than high-level management oversight by a common
parent. This was illustrated by the court’s dismissal of the A.B. Dick and Borden decisions. The court claimed that these decisions
incorrectly equated common management to functional integration.[26]
The court suggested that, if the unitary business theory was based solely on
the rationale of these decisions, states would be permitted to
unconstitutionally tax extraterritorial income in some cases.[27]
Yet while common management alone should not necessarily be determinative of
unity, the U.S. Supreme Court has recognized the application of the unitary
business principle to “similar enterprises operating separately in various
jurisdictions but linked by common managerial or operational resources.”[28]
The boundaries are thus unclear. However, the distinction may be influenced by
the degree to which affiliates are engaged in diverse lines of business.[29]
In any event, the court’s analysis in Envirodyne
provides a thoughtful argument for excluding separately operated, diverse
affiliates from a unitary group.
Other States – The wheel and spokes issue has also been addressed in California, where the Monsanto appeal and subsequent rulings stand for the proposition that affiliates under common control will generally be included in the same unitary group.[30] Monsanto itself did not actually involve the issue of unity among subsidiaries. Rather, in Monsanto, a taxpayer/parent attempted to exclude a subsidiary (which had become a division by the time of the appeal) from its California unitary group on the grounds that the subsidiary did not satisfy the dependency and contribution test with regard to the taxpayer’s California operations. The State Board of Equalization (SBE) found that the subsidiary was unitary with the taxpayer based on significant personnel transfers, intercompany loans, and dependence by the subsidiary on the taxpayer as the sole source of crucial raw materials. The taxpayer argued that none of those connections were related to its California activities. However, the SBE rejected the taxpayer’s attempt to create a geographic division for its unitary group.[31] The SBE’s reasoning was consistent with the underlying philosophy of the unitary business principle—that the income of a genuinely integrated, multistate enterprise cannot be attributed to any one single state.[32]
While Monsanto did not address unity among subsidiaries, the “Monsanto doctrine” has since been applied to such a situation. In Appeal of Aimor Corp., the SBE held that Japanese- and U.S.-based subsidiaries of a common Japanese parent were unitary with each other.[33] The U.S. subsidiary served as the Japanese parent’s U.S. distributor of stereo equipment. The Japanese subsidiary manufactured car stereos, which it sold to its parent corporation in order to avoid export commissions. None of the Japanese subsidiary’s products were sold to or by the U.S. subsidiary. However, the SBE concluded that the dependency and contribution standard was satisfied with respect to the entire group through the extensive intercompany product sales from the Japanese subsidiary to the common parent, despite the fact that there were no intercompany sales between the two subsidiaries. The SBE cited Monsanto for the proposition that it is not necessary for each part of a unitary business to be directly related to each other part.[34]
The California Multistate Audit Technique Manual (MATM) cites both Monsanto and Aimor in a section entitled “Direct Integration Between Each Subsidiary Unnecessary.”[35] The MATM provides a brief description of both decisions and notes that, in Monsanto, even though the subsidiary had no connections with its parent’s California operations, it did have connections with its parent’s divisions outside California. Likewise, the MATM notes that the U.S. and Japanese subsidiaries were found to be unitary in Aimor due to their ties with the Japanese parent. Citing these decisions as examples, the MATM instructs that a taxpayer’s activities in California need not be directly integrated with each other in order to be included in a California combined report.
While Monsanto and Aimor both involve affiliates engaged in the same general lines of business, the issue of unity for diverse lines of business has been addressed in numerous California decisions as well. In Mole-Richardson and Dental Insurance Consultants, California appellate courts ruled, respectively, that a lighting equipment company and dental insurance consultants were unitary with farm subsidiaries owned by each.[36] The taxpayers in both decisions demonstrated strong centralized management. In Mole-Richardson, all major business decisions were made by the same person, and all bookkeeping, purchasing, advertising, accounting, payroll, pension, and insurance activities were conducted at the taxpayer’s California headquarters. In Dental Insurance Consultants, in which the taxpayer purchased farms in a deliberate effort to diversify its operations, unity was established through similar common activities (accounting, purchasing, insurance, check writing, intercompany financing). However, the impact of these decisions may be tempered by the fact that, unlike Envirodyne, the organizations in Mole-Richardson and Dental Insurance Consultants were closely held corporations controlled by a single or a few individuals.
The issue was addressed with respect to a large diverse organization in Tenneco West. In that decision, similar to Envirodyne, an appellate court held that a large conglomerate could not include non-core subsidiaries in its unitary business group.[37] The court found that the centralized management established by the taxpayer was not strong enough to support a finding of unity. The taxpayer had a corporate policy and procedure manual, some common pension and compensation programs, and some centralized legal and accounting functions. At the same time, however, there was no common advertising, purchasing, or research; intercompany sales were minimal; and subsidiaries filed many of their own tax returns. Weighing the factors, the court determined that the parent’s involvement with the diverse subsidiaries “did not extend significantly beyond the normal review and oversight by a parent over its subsidiaries.”[38] It is difficult to discern where the line is crossed between parental oversight and centralized management. Mole-Richardson and Dental Insurance Consultants involved small, diverse businesses, whereas Tenneco West involved a very large conglomerate. These decisions suggest that as the size of a corporate enterprise increases, the strength of the evidence supporting centralized management must increase proportionately.
How should the Envirodyne and California rationales be reconciled? The Monsanto doctrine appears to reject the wheel and spokes theory espoused in Envirodyne. At the same time, there is strong support in California case law for the Envirodyne court’s position that centralized management may create a hub to unite the spokes of a diverse wheel—if the centralization of the management is strong enough. Conversely, applying the Envirodyne rationale to the California controversies, if, for example, Aimor was considered by the Envirodyne court, the result may not necessarily be reversed. Based on the Envirodyne court’s analysis of Citizens Utilities, it is possible that unity would be found on the grounds that the subsidiaries in Aimor were engaged in closer lines of business than the subsidiaries in Envirodyne. The diversity of operations remains an integral factor in application of the unitary business principle.
In Arizona, support for the Envirodyne proposition can be found in the state’s seminal decision involving unity, State ex rel. Arizona Dep’t of Revenue v. Talley Industries, Inc.[39] Talley involved a fact pattern similar to Envirodyne. The Talley group consisted of a parent corporation and 25 wholly owned subsidiaries engaged in various lines of business. As in Envirodyne, the taxpayer was the party seeking to file a combined report in order to combine profitable and unprofitable affiliates. Likewise, the court held that the lack of substantial interrelationship among the subsidiaries (which was conceded by the taxpayer) precluded the filing of a combined report, despite the parent’s extensive centralized control over the various subsidiaries. Indeed, the Talley decision appears to be even narrower than the Envirodyne court’s position. Faced with the contacts identified in Talley, it is possible that even the Envirodyne court would have found that sufficient integration/common programs existed to include the steel group in the Illinois combined report.[40]
Turning the focus from the academic to the practical, the issue arises as to whether Envirodyne breaks significant new ground in the field of unitary jurisprudence or, alternatively, if it is merely an anomaly with limited practical impact. Given the right set of facts, the ability to exclude highly profitable corporations from an affiliated group could serve as a powerful tool. If the Envirodyne “doctrine” were to be applied as a general tenet of the unitary business principle, taxpayers may even be inclined to structure intercompany services and transactions in such a way as to comport with the parameters set by that decision.
Envirodyne essentially stands for the proposition that, under Illinois’ statutory definition of a unitary business group, the dependency and contribution test is not satisfied unless related entities are integrated with each other, directly or through significant common programs/functions. The Seventh Circuit’s decision does not appear to be in direct conflict with any state case law.[41] However, there are several appellate decisions (issued by the Illinois Supreme Court or the Appellate Court of Illinois) that, if applied to Envirodyne’s facts, may have resulted in a finding that Envirodyne’s food packaging and steel groups were unitary. In fact, the court explicitly dismissed two such decisions (A.B. Dick and Borden) that found functional integration through common management.[42]
How, then, does an Illinois taxpayer reconcile these authorities? And what is the likelihood that the Envirodyne argument would be successful before a state tribunal?[43] A state court is not required to follow a federal decision involving a construction of state law, but such a decision may serve as persuasive authority in that state.[44] If application of Envirodyne is entirely discretionary, why, then, would a tribunal follow the decision, particularly at the assessment or administrative appeal level? There are actually a few reasons why the state might consider the Envirodyne decision. For one thing, the decision was written by Judge Richard Posner, one of the most renowned and senior federal appellate court judges in this country.[45] Despite the infrequency with which federal courts tackle unitary business issues, a decision issued by this court and authored by Judge Posner will capture the attention of state tribunals. Furthermore, it was the Department itself seeking to throw the unprofitable steel group out of Envirodyne’s combined report that first raised the argument that led to the court’s “wheel and spokes” theory.[46] As noted by the court, “what is sauce for the goose is sauce for the gander.”[47] The Department may find it difficult to refute its own philosophies when they are instead asserted against the state by taxpayers.
Beyond Illinois, what is the likely impact of the Envirodyne decision in other states? In California, in an audit situation at least, the Monsanto doctrine will be applied, which permits combination without regard to the extent of direct integration between each member of the group.[48] Furthermore, unlike Illinois, dependency and contribution is not required to establish a California unitary business group. Unity may be established on the basis of any of the various tests applied in California and constitutional case law, including the three unities test.[49] Most other unitary combined reporting states, like California, rely on more than one test to define a unitary business group or do not adopt the dependency/contribution test. However, the decision may be influential in Montana and Arizona, both of which incorporate dependency and contribution into their legal definitions of a unitary business group.[50] The rationale of Envirodyne may also be applied in Kansas, which uses dependency/contribution to measure unity.[51] In the absence of vertical or horizonal integration, a diverse business organization may be engaged in a unitary business in Kansas if there is centralized management and centralized departments for certain administrative functions.[52] This is compatible with Envirodyne.
Application of the “Wheel and
Spokes” Theory to Unitary Combined Reporting
Setting aside the question of whether various jurisdictions will follow Envirodyne, this section examines the potential tax return implications of a combined reporting regime in which Envirodyne is the controlling rationale. What are the potential benefits and corresponding issues raised by application of the “wheel and spokes” metaphor?
If unity was measured based on Envirodyne, diverse organizations could be transformed from one single unitary business group to several different groups, depending on the corporate infrastructure, the extent of subsidiary-subsidiary transactions, and the degree of integration created by a common parent. Taxpayers would have reason to revisit the composition of their unitary groups, paying particular attention to the nature of the relationship between parents and their subsidiaries. If diverse business lines were presumed unitary based on the ownership or oversight of a common parent, but there was little or no integration, it may be possible to subdivide the unitary group. A similar result might be achieved if a subsidiary used a parent for administrative services that it could just as easily provide in-house. Furthermore, in the context of an acquisition, an acquirer could benefit from taking these principles into account as it formulated decisions about integrating a newly purchased target. If the target already had an infrastructure in place to administer the types of services and programs provided by the parent to its other subsidiaries, the purchasing company might wish to weigh the effects of streamlining administrative functions against those of maintaining a buffer between the target and the existing unitary group.
Envirodyne also has potential implications with respect to taxpayers’ investment/treasury functions. Illinois prohibits the inclusion of a “financial organization” in a combined report with non-financial organizations.[53] However, over the years, the potential opportunity associated with this peculiarity in Illinois law has diminished as the definition of a financial organization has been narrowed, first judicially and then by regulation, to clarify that in-house, investment-type subsidiaries will not generally qualify as excludable financial organizations.[54] Nevertheless, under Envirodyne, there may be an argument supporting the exclusion of such companies from an Illinois combined report based on the “wheel and spokes” theory. Even if the investment capital comes from the parent (itself or via other subsidiaries), as long as the funds represent excess working capital rather than capital required to finance the unitary business, there may be a position to exclude the investment subsidiary/treasury organization from the unitary group.[55]
This issue has been addressed in other jurisdictions. In Louis-Dreyfus Corp. v. Huddleston, a Tennessee appellate court held that the bond trading group of an agricultural commodities organization was not unitary with the dealer and its six commodity trading groups.[56] The court noted that the bond group used none of the common services shared by the dealer and the other groups. Despite commingled accounts (the bond group’s excess funds were swept into a common cash management account on a nightly basis), the court found that the bond group’s transactions were passive investments. Moreover, this decision was cited by the Department in Envirodyne to support exclusion of the steel group from the combined report.[57]
While application of Envirodyne would create taxpayer opportunities, there are also issues associated with application of this rule. The Envirodyne decision resulted in the creation of two unitary groups, with the parent corporation a member of both groups. This raises the issue of how the parent’s income and factors should be accounted for in each group. Presumably, some equitable bifurcation system would be employed. However, the state offers no guidance as to how such a bifurcation should be achieved.[58]
Furthermore, in a situation where unity is based on intercompany relationships between spokes rather than activities of the common parent, the unitary relationship might fluctuate. For instance, if unity between brother-sister companies was based on intercompany sales, what would happen if, in a particular tax year, intercompany sales decreased dramatically or the affiliate began to go outside the group for its products? Compared to unity based on integrated policies/processes administered by a common parent, intercompany sales would appear to be a more volatile barometer of the unitary relationship.
Finally, apportionment issues should be considered. In particular, the benefits of excluding a related member from a unitary group must be offset by the denominator reduction that may result from removing that entity’s factors from the combined report.
Is Envirodyne groundbreaking? Probably not. It is persuasive rather than controlling authority in Illinois; Illinois has conflicting or, at least incompatible, precedents; and many other unitary states, including California, may apply different rules. Nevertheless, in an environment where unitary case law is dominated by lengthy examinations of functional integration, this decision represents a fresh perspective. In most unitary decisions, great emphasis is placed on the activities of the parent corporation. What often gets lost in the shuffle is the fact that affiliated corporations may have very little in common, particularly in a diverse organization. Even if dependency among subsidiaries is not constitutionally significant, from a theoretical perspective it is arguably a relevant, or at least reasonable, factor. Accordingly, taxpayers may wish to consider following the Illinois Department of Revenue’s lead and the Seventh Circuit’s rationale in excluding diverse affiliates from a unitary group where there is no rim to unite the spokes of the organizational wheel.
[1] Mobil Oil Corp. v. Commissioner of Taxes of Vt., 445 U.S. 425 (1980). See, also, F.W. Woolworth Co. v. Taxation & Revenue Dep’t, 458 U.S. 354 (1982); ASARCO, Inc. v. Idaho State Tax Comm’n, 458 U.S. 307 (1982); Exxon Corp. v. Wisc. Dep’t of Revenue, 447 U.S. 207 (1980).
[2] Butler Bros. v. McColgan, 315 U.S. 501 (1942).
[3] Edison Cal. Stores, Inc. v. McColgan, 183 P.2d 16 (Cal. 1947).
[4] 354 F.3d 646 (7th Cir. 2004) (note that due to LEXIS pagination issues, the pinpoint cites contained throughout the article begin with page “1,” rather than page “646”).
[5] Id. The food packaging segment involved in the controversy consisted of the unitary Envirodyne parent and seven subsidiaries. The steel manufacturing segment that incurred the losses at issue consisted of five subsidiaries and a holding company.
[6] Id. at 5.
[7] The
federal Tax Injunction Act, 28 U.S.C. 1341, generally bars federal courts from
hearing state tax controversies. Bankruptcy, however, is a notable exception to
this prohibition.
[8] Envirodyne at 6.
[9]
Id.
[10] Id. at 9.
[11] Id. at 7.
[12]
This section of the article critiques Envirodyne
from a purely academic/theoretical perspective, by comparing and
contrasting the decision to other authorities dealing with the unitary business
principle. The practical implications of the decision, such as whether the
decision is precedential, binding, or persuasive authority, is addressed
in “The
Practical Impact of Envirodyne,” section of this article.
[13] Container Corp. of America v. Franchise Tax Bd., 463 U.S. 159, 178-179 (1983).
[14] Envirodyne at 8.
[15] 35 Ill. Comp. Stat. 5/1501(a)(27) (emphasis added).
[16] This is noteworthy because, in most other unitary states, a combined report is permitted and/or required if any one of the established tests for unity is satisfied. See FTB Legal Ruling 92-4 (Cal. Fran. Tax Bd. 1992). Of course, the tests are not necessarily mutually exclusive, and under the facts of many unitary controversies more than one test will be satisfied (e.g., three unities and dependency/contribution).
[17] Ill. Admin. Code tit. 86, § 100.3010(c)(1) (emphasis added).
[18] Ill. Admin. Code tit. 86, § 100.3010(c)(4)(D).
[19] 2002 U.S. Dist. LEXIS 2403 (U.S. Dist. Ct. N. Dist. Ill., E. Div. 2002), infra note 25 and accompanying text.
[20] While this issue was not stated in the Seventh Circuit’s opinion, it was the explicit argument of the Department in the underlying District Court decision for which this appeal was taken. Id. at 17.
[21] 35 Ill. Comp. Stat. 5/1501(a)(27).
[22] Citizens Utilities Co. v. Department of Revenue, 488 N.E.2d 984 (Ill. 1986); Caterpillar Tractor Co. v. Lenckos, 417 N.E.2d 1343 (Ill. 1981); PPG Industries, Inc. v. Dep’t of Revenue, 765 N.E.2d 34 (Ill. App. 2002); Hormel Foods Corp. v. Zehnder, 738 N.E.2d 145 (Ill. App. 2000); Borden, Inc. v. Illinois Dep’t of Revenue, 692 N.E.2d 1335 (Ill. App. 1998); A.B. Dick Co. v. McGraw, 678 N.E.2d 1100 (Ill. App. 1997).
[23] 488 N.E.2d 984 (Ill. 1986).
[24] Envirodyne at 10-11.
[25] 2002 U.S. Dist. LEXIS 2403 at 4-5.
[26] Envirodyne at 14-15.
[27] Id. The court cautioned that if these decisions are taken literally, “since wholly owned subsidiaries of the same parent corporation are normally considered under common management [this] would imply unconstitutionally that all such affiliated groups were unitary business enterprises.”
[28] Container Corp., 463 U.S. 159 at 166; Butler Bros. v. McColgan, 315 U.S. 501 (1942).
[29] The entities at issue in Container were all engaged in the same general line of business. Id. at 171.
[30] Appeal of Monsanto Co., 1970 Cal. Tax LEXIS 13 (Cal. St. Bd. of Equal. 1970).
[31] “The argument misconceives the unitary business concept. All that need be shown is that . . . . [the company] formed an inseparable part of the appellant’s unitary business wherever conducted.” Id. at 11 (emphasis added).
[32] See, e.g., Ariz. Admin. Code R15-2D-401(c) (“The main reason for defining a business as unitary is that its components in various states are so tied together at the basic operational level that it is difficult to determine the state in which profits are earned.”). Likewise, the SBE, in Monsanto, ruled that “[b]y attempting to establish a dichotomy between appellant’s California operations and [the company], appellant would have us ignore other parts of appellant’s business which cannot justifiably be separated from [the company] or the California operations.” Monsanto at 11.
[33] Appeal of Aimor Corp., 1983 Cal. Tax LEXIS 42 (Cal. St. Bd. of Equal. 1983).
[34] Id. at 8 (“It is not necessary for each part of a unitary business to be directly related to each other part.”). See, also, Appeal of Grolier Society, Inc. 1975 Cal. Tax LEXIS 23 at 17-18 (Cal. St. Bd. of Equal. 1975) (“A determination that a business is unitary does not require an interdependence between one segment of that business and every other segment of it.” (addressing unity between four Canadian and four Latin American subsidiaries of a common parent)); FTB Legal Ruling 95-8 (“It is well established that there does not need to be a direct unitary relationship between each corporation in a combined report. It is sufficient if the relationship is indirect.”).
[35] California Multistate Audit Technique Manual, § 3010 (updated Dec. 2002).
[36] Mole Richardson Co. v. Franchise Tax Board, 220 Cal. App. 3d 889 (Ct. App. Cal., 2nd Dist., Div. 4 1990); Dental Insurance Consultants, Inc. v. Franchise Tax Board, 1 Cal. App. 4th 343 (Ct. App. Cal., 1st Dist., Div. 5 1991).
[37] Tenneco West, Inc. v. Franchise Tax Board, 234 Cal. App. 3d 1510 (Ct. App. Cal. 4th Dist., Div. 1 1991).
[38] Id. at 1530.
[39] 893 P.2d 17 (Ariz. App. 1994) (this was actually a clear reflection of income decision with the taxpayer arguing for combined reporting as an alternative apportionment method).
[40] The relevant facts established that Talley controlled all operations of the 25 subsidiaries; prepared their tax returns; administered general accounting, operating, and personnel policies; centralized financing activities, salary guidelines, and accounting manuals; and set insurance requirements, common benefit plans, training, and technology needs. Id. at 19.
[41] Indeed, the court agreed that Citizens Utilities was correctly decided but distinguished that decision, finding that Envirodyne’s facts did not rise to the level of the unitary relationship present in Citizens Utilities. Moreover, note that, if the holding had been directly contrary to Citizens Utilities, it would have been invalid. Johnson v. Fankell, 520 U.S. 911, 916 (1997) (“Neither this court nor any other federal tribunal has any authority to place a construction on a statute different from the one rendered by the highest court of the state.”).
[42] Supra notes 26-27 and accompanying text.
[43] Recall that while Envirodyne is a federal court decision, the holding was based entirely on state law.
[44] 20 Am. Jur. 2d Courts, § 169.
[45] Judge Posner has sat on the Seventh Circuit Court of Appeal for more than 20 years, 7 of them as chief judge, and according to his University of Chicago faculty biography, has authored more than forty books among numerous other achievements.
[46] 2002 U.S. Dist. LEXIS 2403, at 18. On appeal from the bankruptcy court order denying the Department’s claim, the Department argued before the U.S. District Court that the “lack of unitizing factors” between the steel and food packaging subsidiaries resulted in two unitary groups.
[47] Envirodyne at 7.
[48] Supra notes 30-35 and accompanying text.
[49] FTB Notice No. 92-4 (Cal. Fran. Tax Bd. 1992).
[50] Mont. Code Ann. § 15-31-301(2) (“A business is unitary when the operation of the business within the state is dependent upon or contributory to the operation of the business outside the state or if the units of the business within and without the state are closely allied and not capable of separate maintenance as independent businesses.”); Ariz. Admin. Code R15-2D-401(c) (“An entity, group of entities, or components of an entity [are] not a unitary business for apportionment purposes unless there is actual substantial interdependence and integration of the basic operations of the business carried on in more than one taxing jurisdiction.”).
[51] See, In re Tax Appeal of A.M. Castle & Co., 783 P.2d 1286, 1289 (Kan. 1989).
[52] Kan. Admin. Regs. 92-12-72.
[53] 35 Ill. Comp. Stat. 5/1501(a)(27).
[54] Automated Data Processing, Inc. v. Illinois Dep’t of Revenue, 729 N.E.2d 897 (Ill. App. 2000); Ill. Admin. Code tit. 86, § 100.9710(d)(11).
[55] See Home Interiors & Gifts v. Dep’t of Revenue, 741 N.E.2d 998 (Ill. App. 2001) (although Home Interiors involved a question of allocation versus apportionment, the designations of working capital and excess working capital as operational and investment-function income could be useful to the taxpayer in this context to establish that an investment subsidiary was not integrated with the unitary group).
[56] 933 S.W.2d 460 (Ct. App. Tenn. 1996).
[57] Envirodyne at 8.
[58] This is not a hypothetical issue in Illinois. Although 35 Ill. Comp. Stat. 5/1501(a)(27) prohibits combination of general corporations and financial organizations, a financial organization “holding company” may be combined with a unitary general corporation, thus potentially creating two unitary business groups.