Butler Bros. v. McColgan

This action was brought to recover an additional assessment made by the defendant as Franchise Tax Commissioner under authority of the Bank and Corporation Franchise Tax Act (Stats. 1929, chap. 13, as amended) for the taxable year 1936, based upon income for the year 1935, paid by plaintiff under protest. Judgment was entered in favor of defendant, and plaintiff appealed therefrom.

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

Plaintiff, 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 wholesale distributing 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.

Part of the operating expense of the houses is directly and exclusively incurred at the respective houses, including such items as labor, rentals, etc. The remainder consists of certain items of common expense such as executive salaries and corporate overhead and the expense of operating a central buying division and a central advertising division. These expenses are allocated 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. For the year 1935 the amount of such allocated expense charged to the San Francisco house was $100,091, of which, it is agreed, approximately seventy-five per cent would have been incurred even though the San Francisco house was not operated. Except for such common expenses, each house is operated independently of each other house.

The company maintains a central buying division through which goods for resale are ordered, but such goods are shipped

The company computed its income from the operation of the San Francisco house by deducting from the gross receipts from sales of merchandise in California the costs of such merchandise, the direct expenses of the San Francisco house, and the apportioned share of common expenses previously described. According to this computation the San Francisco house operated at a loss of $82,851 for the year 1935. 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. In the year 1935 the operations of all houses of the company produced a profit of $1,149,677. The Franchise Tax 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 total income of the company derived from all sources, such percentage having been determined by 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 is not questioned.

The tax in question was levied under the provisions of section 10 of the Bank and Corporation Franchise Tax Act (Deering’s Gen. Laws, Act 8488, vol. 2, p. 3858; Stats. 1929, p. 19; amended by Stats. 1931, p. 2226; Stats. 1935, p. 965), which, so far as here involved, reads as follows:

“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 claimed 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 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 the operations of the company are unitary in character, and that the formula for allocation of income used by the Franchise Tax Commissioner was lawful and proper in arriving at the net income of appellant from business done in California—computed to be approximately $95,000.

The sole question to be determined on this appeal is whether it is lawful and proper for the respondent, as Franchise Tax Commissioner, to insist upon use of the formula for allocation of income in a case such as this, or whether the company is entitled to use the separate accounting of its San Francisco house to determine its net income in the State of California. The answer to this question depends entirely on the nature of the business conducted within and without the state by appellant, a foreign corporation. It is only if its business within this state is truly separate and distinct from its business without this state, so that the segregation of income may be made clearly and accurately, that the sepa

Preliminary to analysis and discussion of the cases cited by the parties as bearing on the issue involved in the instant case, we shall review briefly the relatively simple factual structure as it is logically reflected in the modus operandi of appellant’s business. The company is engaged in buying merchandise from manufacturers and selling to retailers only. It maintains a central buying department outside the state. By its large scale purchasing activity, appellant concededly

The Supreme Court of the United States has repeatedly held that companies whose income has resulted from a series of transactions beginning with manufacture in one state and sales in another were unitary businesses. (Underwood Typewriter Co. v. Chamberlain (1920), 254 U. S. 113 [ 41 Sup. Ct. 45 , 65 L. Ed. 165 ]; Bass, Ratcliff & Gretton, Ltd., v. State Tax Com. (1924), 266 U. S. 271 [ 45 Sup. Ct. 82 , 69 L. Ed. 282 ].) While it is not clear from the record whether appellant manufactured any of its goods in the State of Illinois or elsewhere, it is conceded that appellant purchased most of its goods through the Illinois central purchasing arrangement. This central purchasing factor is completely analogous and comparable to the manufacturing activities in the Underwood Typewriter and Bass Ale cases, supra, wherein we find recognition of the principle that income from sales is attributable to the series of transactions from which the income is derived. Since these two leading cases involve the validity of allocation by applying a percentage formula to the entire income in order to determine the income taxable in a state where the business is only partly carried on, we shall consider them in some detail.

In Underwood Typewriter Co. v. Chamberlain, supra, the company manufactured its typewriters in Connecticut and sold them generally throughout the country. Using a statutory method of allocation (by assigning to the state that portion of the total income which the value of real and tangible personal property within the state bore to the total value of such property within and without the state), Connecticut determined that 47 per cent of the company’s net income was derived from property and transactions within the state. The company objected to the method of apportionment on the ground that only a little over 3 per cent of its net receipts was collected in Connecticut. The court upheld the Connecticut allocation for the reasons expressed in the following excerpt from the opinion at pages 120, 121:

“ . . . The profits of the corporation were largely earned by a series of transactions beginning with manufacture in Connecticut and ending with sale in other States. In this it was typical of a large part of the manufacturing business conducted in the State. The legislature in attempting to put

upon this business its fair share of the burden of taxation was faced with the impossibility of allocating specifically the profits earned by the processes conducted within its borders. It, therefore, adopted a method of apportionment which, for all that appears in this record, reached, and was meant to reach, only the profits earned within the State. ‘The plaintiff’s argument on this branch of the case, ’ as stated by the Supreme Court of Errors, ‘carries the burden of showing that 47 per cent, of its net income is not reasonably attributable, for purposes of taxation, to the manufacture of products from the sale of which 80 per cent, of its gross earnings was derived after paying manufacturing costs. ’ The corporation has not even attempted to show this; and for aught that appears the percentage of net profit earned in Connecticut may have" been much larger than 47 per cent. There is, consequently, nothing in this record to show that the method of apportionment adopted by the State was inherently arbitrary, or that its application to this corporation produced an unreasonable result. ’ ’

Here we have clear and concise expression of the only limitation on the use of a formula in the allocation or apportionment of income of a unitary business, to wit, the formula must not be intrinsically arbitrary, and it must not produce an unreasonable result.

Bass, Ratcliff & Gretton, Ltd., v. State Tax Com., supra, involved a British corporation engaged in brewing and selling Bass’ ale. Its brewing was done and a large part of its sales were made in England, but it had imported a portion of its product into the United States, which it sold in branch offices maintained in New York and Chicago. During the income year in question, the entire business was operated at a substantial profit, but the company, for federal income tax purposes, reported no income for that year from its business within the United States. Presumably this result was reached by computing its income under the separate accounting-method. The Tax Commission of the State of New York assigned to New York that portion of the total net income which the value of certain specified classes of assets within New York bore to the total value of such assets within and without the state. The company resisted the tax on the ground that it derived no income from New York and that the action of the commission was an attempt to assign to

“So in the present ease we are of the opinion that, as the Company carried on the unitary business of manufacturing and selling ale, in which its profits were earned by a series of transactions beginning with the manufacture in England and ending in sales in New York and other places—the process of manufacturing resulting in no profits until it ends in sales—the State was justified in attributing to New York a just proportion of the profits earned by the Company from such unitary business. In Wallace v. Hines, 253 U. S. 66 , 69 [ 40 Sup. Ct. 435 , 64 L. Ed. 782 ], it was recognized that a State, in imposing an excise tax upon foreign corporations in respect to doing business within the State, may look to the property of such corporations beyond its borders to ‘get the true value of the things within it, when they are part of an organic system of wide extent, ’ giving the local property a value above that which it would otherwise possess, and may therefore take into account property situated elsewhere when it ‘can be seen in some plain and fairly intelligible way that it adds to the value of the (property) and the rights exercised in the State. ’ This is directly applicable to the carrying on of a unitary business of manufacture and sale partly within and partly without the State. ’ ’

Thus, it is apparent from the language of this case that with respect to a unitary business, income from the taxing state as determined by an allocation formula was controlling, where the statutory method of apportionment was not shown to be arbitrary or unreasonable.

In support of its argument that respondent’s application of the formula would tax income from transactions taking place beyond the jurisdiction of California, appellant relies heavily upon Hans Rees’ Sons v. State of North Carolina (1931), 283 U. S. 123 [ 51 Sup. Ct. 385 , 75 L. Ed. 879 ]. Bufan examination of the facts and legal principles involved therein reveals that there is nothing in that decision to support appellant’s argument. The corporation was engaged in the business of tanning, manufacturing and selling leather products, and its principal manufacturing and supply house was

The latest expression of the Supreme Court of the United States on this subject brought to our attention is North American Cement Corp. v. Graves (1936), 269 N. Y. 507 [ 199 N. E. 510 ]; 243 App. Div. 834 [ 278 N. Y. Supp. 920 ]; 299 U. S. 517 [ 57 Sup. Ct. 311 , 81 L. Ed. 381 ], wherein it is significant to note that Bass, Ratcliff & Gretton, Ltd., v. State Tax Com., supra, was cited in support of its holding that income from the taxing state as determined by an allocation formula was controlling, although the taxpayer showed that by separate accounting much less income would be allocated to the taxing state. The United States Supreme Court and the New York courts from which the taxpayer appealed all decided the case with memorandum opinions, so the facts must be obtained from the record in the ease (vol. 2253, United States Supreme Court Becords). The taxpayer, a foreign corporation, owned

The significance of this decision on two points involved in the instant case is readily apparent: (1) It holds that the operations of four separate manufacturing plants, one of them making a different product from different materials than the others, are so interrelated as properly to be treated as unitary; (2) it holds that separate accounting in accordance with recognized accounting practice is insufficient evidence to disprove the propriety and presumption of fairness of formula allocation. On both points this decision is contrary to Standard Oil Co. v. Wisconsin Tax Com. (1929), 197 Wis. 630 [ 223 N. W. 85 ], on which appellant strongly relies in asserting that the results of its separate accounting must be accepted by respondent as tax administrator. However, careful examination of the factual situation in this Wisconsin case reveals a peculiar distinguishing allocation factor which undoubtedly exerted a strong influence on the result reached by the court there.

In Standard Oil Co. v. Wisconsin Tax Com., supra, the plaintiff company produced, refined, transported and marketed petroleum products in eleven mid-western states, and its property within Wisconsin consisted principally of tanks

The unitary character of the buying and selling business has been recognized in International Elevator Co. v. Thoresen (1929), 58 N. D. 776 [ 228 N. W. 192 ], and Great Atlantic & Pacific Tea Co. v. Grosjean (1937), 301 U. S. 412 [ 57 Sup. Ct. 727 , 81 L. Ed. 1193 , 112 A. L. R. 293 ]. In the Thoresen case, supra, plaintiff company operated a line of grain elevators, about half of which were in Montana and the other half in North Dakota.. The company’s income was derived chiefly from the sale, outside the state, of grain bought within North Dakota, and the question was whether North Dakota could assess a tax upon any part of the income from the sales outside the state. Like appellant here, the plaintiff company there tried to apportion its income by separate accounting. That procedure was held improper and allocation of income was sanctioned to North Dakota wholly out of proportion to the receipts within North Dakota. On the mere basis of accounting figures the instant case is less extreme than the North Dakota case, where the net income allocated to the taxing state by the formula exceeded the gross income allocated to the state by separate accounting; yet, in such situation because of the unitary nature of the business, the Supreme Court of North Dakota held that the transactions of buying constituted an essential part of the transactions from which the income collected outside the state was derived.

The Great Atlantic & Pacific Tea Co. case, supra, dealing with a state chain store tax act, bears on the instant issue in that it was there held that the out-of-state stores and central buying and advertising of the buying and selling corporation gave the within-the-state stores advantages which they otherwise would not have had and justified a chain store tax on the within-the-state stores which would otherwise have been, from the constitutional viewpoint, discriminatory. The

The formula method of allocating or apportioning income in the ease of a unitary business was approved by this court in Matson Nav. Co. v. State Board of Equalization, 3 Cal. (2d) 1 [ 43 Pac. (2d) 805 ]; affirmed 297 U. S. 441 [ 56 Sup. Ct. 553 , 80 L. Ed. 791 ]. In that case it was established that the power of California to tax foreign corporations measured by their net income and the provisions of section 10 of the Bank and Corporation Franchise Tax Act are co-extensive in scope, and in this connection this court there held that section 10 measures the tax by income from California and excludes from the measure “income from business done entirely outside the State . . . ”. ( 3 Cal. (2d) 1 , 8.) In such case as the instant one, allocation of income to the various states in which the business is done by means of a formula that gives weight to the various factors such as property, services of employees and sales, which are responsible for the earning of income, appears entirely reasonable. To rebut the presumption that the formula produced a fair result, “the burden is on the taxpayer to make oppression manifest by clear, cogent evidence”. (Norfolk & Western Ry. Co. v. North Carolina (1936), 297 U. S. 682 , 688 [ 56 Sup. Ct. 625 , 80 L. Ed. 977 ].) In considering the implications of the formula in the last-mentioned case, the Supreme Court of the United States, speaking through Mr. Justice Cardozo, also said at page 688: “ ... a taxpayer does not escape the application of the statute by evidence directed to only one of the related terms. The evidence to be effective must be directed to each of them alike, for only thus can the assumed relation between them be proved to be unreal. ...” In the case at bar appellant has not furnished any explanation of why its California business differs so from the average that the formula produced an erroneous result. Here there has been only an assertion that a loss was incurred in this state. As appellant has failed to show a variance from normal in either the California sales, property or payroll, or in either expenses or revenues, it is our conclusion that appellant has not upheld its burden of proof, for in order to overthrow a formula the taxpayer must introduce such evidence and the evidence must go to

In accordance with the foregoing analysis it is our opinion that the 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. The reasonable and equitable character of this state’s formula, based on factors properly reflecting the relative contribution of the activities in the various states to the production of the total unitary income so as not to contravene the restrictions implicit in the Fourteenth Amendment against taxing property outside the state, was recognized in Matson Nav. Co. v. State Board of Equalization, supra. Accordingly, respondent correctly applied the formula method of apportionment to determine California’s portion of appellant’s income from the business carried on within and without the state.

Judgment affirmed.

Gibson, C. J., Shenk, J., and Carter, J., concurred.

Traynor, J., took no part in the consideration or decision of this ease.

Appellant’s petition for a rehearing was denied April 17, 1941. Traynor, J., took no part in the consideration or decision of this matter.