R.R. Donnelley & Sons Co. v. Arizona Department of Revenue

Citations: 229 P.3d 266; 224 Ariz. 254; 581 Ariz. Adv. Rep. 53; 2010 Ariz. App. LEXIS 64Docket: 1 CA-TX 08-0007

Court: Court of Appeals of Arizona; April 29, 2010; Arizona; State Appellate Court

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The Arizona Court of Appeals case 229 P.3d 266 (2010) involves R.R. Donnelley & Sons Company and its subsidiaries challenging the Arizona Department of Revenue (ADOR) regarding corporate income tax assessments for tax years 1990 to 1999. The Arizona Tax Court had granted summary judgment favoring R.R. Donnelley, allowing it to exclude two subsidiaries, Receivables and Caslon, from its combined Arizona tax return, while requiring the inclusion of another subsidiary, Heritage. 

R.R. Donnelley, a Delaware corporation with operations in Arizona, along with its subsidiaries—Receivables (a Nevada corporation involved in factoring), Caslon (a Delaware corporation providing investment management), and Heritage (a South Carolina corporation managing trademarks)—filed combined tax returns excluding these subsidiaries. Following an audit, ADOR assessed additional taxes, arguing that the subsidiaries were part of a unitary business and should be included in the tax return under the Arizona Uniform Division of Income for Tax Purposes Act (UDITPA).

The tax court determined that the income from Receivables and Caslon could not be attributed to R.R. Donnelley, while Heritage's income could. The court subsequently awarded R.R. Donnelley $30,000 in attorneys' fees. Both parties appealed aspects of the decision, with R.R. Donnelley cross-appealing the requirement to include Heritage. The appellate court affirmed the tax court's ruling.

The tax court's ruling on summary judgment is reviewed de novo, and its interpretation of statutes is also subject to de novo review. The case examines whether two subsidiaries, Receivables and Caslon, are not part of a unitary business, while Heritage is considered part of such a business. Arizona law mandates that every corporation's entire taxable income be taxed, and corporate taxpayers operating in Arizona must file a tax return. For affiliated corporations with multistate operations, the unitary-business principle is applied to assess whether a corporation has sufficient connection to Arizona for its income to be included in the tax base.

An out-of-state corporation must be part of a unitary business, which operates within and outside Arizona, to justify including its income in the tax base. If a unitary business exists, a combined Arizona tax return is required, with business income apportioned using a single formula under UDITPA. The standard for determining unitary business status in Arizona was established in the 1994 Talley Industries case, where the taxpayer sought combined reporting to reduce taxable income by utilizing subsidiary losses. In contrast, the current case involves the Department aiming to classify the subsidiaries as a unitary business to increase taxable income attributed to the Taxpayer.

In Talley, the court analyzed the criteria for determining whether a business is unitary, referencing a range of approaches from broad tests in California to narrower tests in Louisiana and Mississippi. It identified a "rational compromise" in an intermediate approach, as recommended by the Hellerstein treatise and adopted in Pennsylvania. This approach emphasizes that a business is not unitary unless there is substantial interdependence among its affiliates or branches. Minor transactions do not suffice for unitary treatment. Talley’s arguments for its unitary status—such as centralized management and shared resources—were rejected due to a lack of substantial interrelationships between its subsidiaries. The court noted no significant transfers or operational ties among subsidiaries, particularly emphasizing the distinction between "basic operations" and "accessory functions." Talley highlighted that the unitary business doctrine was developed to address accounting challenges faced by horizontally and vertically integrated enterprises. However, this doctrine does not extend to centralized services like management and financing, which can be accounted for separately without the same complications.

The determination of whether services are accessory and distinct from core business operations hinges on their absence from the product itself and its delivery to customers. Accessory services do not undermine the functional independence of subsidiaries, emphasizing the need for combined reporting of net income to accurately reflect taxable income. Arizona regulations outline three essential characteristics for entities to be considered a unitary business: common ownership/control of over 50% voting stock, shared management, and reconciled accounting systems. However, merely meeting these criteria is insufficient without evidence of significant operational integration, which may include shared business activities, product development stages, asset sharing, and centralized operations. The presence of various integration factors, such as centralized employee training and advertising, further supports the unitary classification. Not all integration factors must be present for a unitary business designation. The analysis will examine if Receivables, Caslon, and Heritage constitute part of the Taxpayer's unitary business, with the burden of proof resting on the Department to substantiate Taxpayer's tax liability.

Receivables operated by purchasing and factoring accounts receivable, primarily for Taxpayer, under a 1987 agreement. Engaging in factoring without recourse qualifies as a financing business, as established in Manhattan Factoring Corp. v. Orsburn. During the audit period, Receivables derived 90% of its factoring income from Taxpayer but also generated substantial revenue from third-party transactions, totaling over $6.7 million in 1997, $6.4 million in 1998, and $6.2 million in 1999. Despite its operations, Receivables' activities were less extensive than those evaluated in the Talley case, which failed to demonstrate a unitary business due to insufficient interdependence of operations.

The Department argued that certain businesses could be classified as unitary based on operational interdependence, even if intangible services were involved. However, it emphasized that such services must be integral to the core business, not merely supplementary, which was the case for Receivables. The Department did not differentiate Receivables’ factoring services from those offered to other companies, noting that many businesses utilize third-party factors without establishing a unitary relationship.

Taxpayer’s arrangement with Receivables would not imply a unitary business if an unrelated factoring company had been contracted instead. The Department acknowledged that transactions between Receivables and Taxpayer occurred at fair market prices, yet the relationship did not satisfy the criteria for a unitary business established in Talley, which focuses on the necessity of combined reporting for accurately reflecting taxable income. Consequently, the services provided by Receivables were deemed ancillary, and the undisputed facts indicated that Receivables did not meet the unitary business standard as outlined in Talley, negating the need for further analysis of other regulatory factors.

Caslon's activities during the audit period, which involved buying and selling investment assets, receiving passive income, and engaging in arm's length borrowing and lending, did not fulfill the criteria established in the Talley case for being considered part of a unitary business. Caslon primarily held intangible personal property investment assets and operated independently from Taxpayer, lacking shared employees or centralized services. Similar to Receivables, Caslon's activities were classified as accessory services rather than core operational functions. The Talley court's precedent indicated that intercompany financing and related activities are merely accessory to business operations, a stance supported by additional case law such as Louis Dreyfus Corp. v. Huddleston and Cent. Nat'l-Gottesman, Inc. v. Dir. Div. of Taxation, which affirmed that investment divisions often do not constitute a unitary relationship with operational divisions. Consequently, the tax court correctly ruled that Caslon was not part of the unitary business.

In a related matter, Taxpayer established Heritage as a subsidiary in 1995 to manage its trademarks, transferring the trademarks to Heritage and entering a licensing agreement that granted Taxpayer a non-exclusive license in exchange for royalties. Heritage employed one individual for trademark management and did not license the trademarks to any other entities. The tax court concluded that Heritage should be included in Taxpayer’s combined return, arguing that the trademarks are inherently linked to their original holder. However, this reasoning was flawed, as the law allows trademark licensing to third parties regardless of historical use, provided the licensor maintains quality control over the licensed goods and services.

The licensee's use of the trademark benefits the trademark owner, aligning with the Restatement (Third) of Unfair Competition. Trademark rights can be acquired and maintained through a controlled licensee's use, even if the licensee is the sole user of the mark. There is no inherent or operational connection between a trademark and the underlying property. The court can uphold a judgment based on different grounds than those cited by the trial court, as demonstrated in Ness v. W. Sec. Life Ins. Co. 

In applying the Talley test, the distinction between "basic operations" and "accessory" functions is crucial. Talley identified certain services provided by a parent company to its subsidiaries as accessory, not integral to product delivery. In contrast, the trademarks in question are integral to Taxpayer's operations, as they are prominently displayed on shipping labels, invoices, and promotional materials, essential for product identification and delivery. This use is not an accessory function but a core aspect of Taxpayer's business.

Additionally, the Talley test requires that accessory functions do not undermine the subsidiary's functional independence. The text notes a trend where corporations form intangible holding companies (IHCs) to manage trademarks and other intangibles, which allows for tax benefits. Heritage functioned as Taxpayer's IHC, licensing trademarks back to Taxpayer for a royalty, impacting state income tax calculations.

Hellerstein critiques the use of an intangibles holding company (IHC) as a strategy by corporations to minimize taxable income by transferring trademarks to the IHC and licensing them back for royalties. He suggests that states should implement combined reporting to neutralize this tactic by eliminating the associated royalty expenses and income. While acknowledging that taxpayers can legally arrange their affairs to reduce taxes, the document emphasizes that the creation of a separate corporation, like an IHC, does not exclude it from being part of a unitary business if it is functionally interdependent with the parent company. The financial data indicates significant royalty revenues flowing from Taxpayer to Heritage, along with minimal employee expenses at Heritage, illustrating their functional interdependence during the years 1995 to 1999. Unlike in the Talley case, the level of interdependence here does not undermine the functional independence of Heritage. Although Heritage's structure is scrutinized up until 1999, there is no indication that it could not become independent later. The analysis concludes that during the relevant period, Heritage was part of Taxpayer's unitary business, having not marketed trademarks to third parties. Additionally, the assertion that intangible assets do not constitute a transfer of materials under applicable regulations is addressed, referencing specific regulatory language that pertains to the definition of a unitary business.

Regulation R15-2D-401 (G) characterizes a unitary business based on significant transfers of tangible items, yet both the court and the Arizona Supreme Court have determined that intangibles are comparable to tangibles. In the case of Walter E. Heller W. Inc. v. Arizona Department of Revenue, the court ruled that out-of-state borrowing used to provide loans to Arizona consumers must be included in the sales factor ratio, equating the costs of procuring money to the costs a retailer incurs in obtaining inventory. The context of transactions is critical in defining what constitutes a 'sale.' In M.D.C. Holdings, the sale of money to homebuyers in exchange for fees and secured promises to repay was treated similarly to the sale of a tangible product in Arizona.

The court concluded that trademarks could be regarded as tangible products under the unitary business standard, supported by the purpose of combined reporting and various factors outlined in Department regulations for assessing operational integration. The Taxpayer claimed that none of these factors applied to Heritage, but the court disagreed, noting multiple applicable factors, including similar business operations, vertical product development, and transfers of goods and technological processes. The Taxpayer's assertion that Heritage was not involved in commercial printing was countered by the court, which emphasized Heritage's integral role in the delivery of Taxpayer's products and services. Unlike Home Depot, which licensed its trademarks extensively, Heritage had only been used by Taxpayer, further supporting its operational integration within Taxpayer's business. The court affirmed that intangibles, such as trademarks, qualify for consideration under the operational integration factors.

Factor 14 addresses sales or leases between components, noting a non-exclusive licensing agreement rather than an "exclusive sales-purchase agreement" as outlined in factor 12. The term "leases" is interpreted to encompass licenses, thus not excluding them from consideration. Factor 15 highlights significant integration between Heritage and Taxpayer, as Heritage operated as an IHC solely with its parent entity. The Department's regulations allow for Heritage to be viewed as part of Taxpayer's unitary business, aligning with the analysis in Hellerstein, which emphasizes that a unitary business includes the flow of "operational intangibles." Hellerstein's framework suggests that substantial exchanges of materials or services across business segments, including intangibles like trademarks, are crucial for defining unity. In this case, the trademark intangibles were functionally equivalent to tangibles, with Taxpayer reliant on Heritage for trademark usage, and Heritage having no other customers or licensing agreements. There was a significant flow of operational intangibles between the two entities. Therefore, Heritage is determined to be part of Taxpayer's unitary business. The tax court's judgment regarding Receivables, Caslon, and Heritage is affirmed, with no fees awarded on appeal, but Taxpayer is entitled to costs as it prevailed in two of three subsidiary matters.

Common ownership, management, and reconciled accounting systems are essential for a business to qualify as a single unitary business, but these alone are insufficient without evidence of substantial operational integration. Key factors indicating such integration include: similar business activities among components; vertical and horizontal product development; transfer of materials and data; sharing of assets and employees; centralized training and purchasing; development and distribution of technology; use of common trademarks; exclusive sales agreements; price differentials with unrelated businesses; and inter-component sales or leases. Not all factors must be present, but substantial integration at the operational level must be demonstrated. Additionally, Intangible Holding Companies (IHCs) may also be known as trademark holding, passive holding, intangible property, or passive investment companies.