The Alaska Supreme Court has held that the taxation of a petroleum company's worldwide income, including the income of its out-of-state subsidiaries, by applying formulary apportionment did not violate the Due Process or Commerce Clauses of the U.S. Constitution because the company's business was unitary.1 Also, the Court determined that the company did not have standing to challenge the internal consistency of Alaska's apportionment scheme providing two possible three-factor formulas because the company did not show that it had suffered harm. Furthermore, application of the alternative three-factor apportionment formula to the company was reasonable.2
Background
The taxpayer, a petroleum company headquartered in Texas, had 33 subsidiaries that were organized into five business segments: (i) the Exploration and Production (E&P) segment based in Texas and Bolivia; (ii) the Retail and Marketing (R&M) segment based in Alaska; (iii) the Marine Services segment based in Louisiana and Texas; (iv) the Corporate segment based in Texas; and (v) the Finance segment based in Texas.
From the time the taxpayer began doing business in Alaska in 1969 until 1994, it filed its tax returns as a unitary business. To compute taxable income, the taxpayer used the standard three-factor apportionment formula with property, payroll and sales factors. In 1995, the taxpayer purchased a pipeline company that serviced its Alaska refinery and became subject to a statutory alternative apportionment formula for companies that transport oil or gas by pipeline.3 The taxpayer took the position on its 1995 tax return that the pipeline company was not unitary with the taxpayer's other business segments. As a result, the taxpayer apportioned the pipeline company's income using the alternative formula and the income from its other subsidiaries using the standard formula. For the 1996 and 1997 tax years, the taxpayer further asserted that its Finance segment was not unitary with the other subsidiaries and was not subject to Alaska tax.
As a result of an audit of the tax returns for 1994 and 1995, the Department determined that all of the taxpayer's subsidiaries were unitary and subject to the statutory alternative apportionment formula. The taxpayer subsequently filed its 1998 tax return and asserted that the pipeline company and subsidiaries within R&M were not unitary with the other subsidiaries.4 The Department audited the tax returns for 1996 through 1998 and again determined that all of the subsidiaries were unitary. During the interval between the audits, the Alaska Attorney General issued an opinion that questioned the constitutionality of the statutory alternative apportionment formula as applied to businesses that produce oil or gas in Alaska but transport it out of state. The Department responded with an advisory letter5 explaining its intention to use discretionary authority to allow a taxpayer that both produces and transports oil or gas in any jurisdiction to use the alternative threefactor formula based on property, sales and extraction.6
After challenging the assessments during informal conferences with the Department, the taxpayer filed appeals before an administrative law judge and then the superior court. At each stage, the adjudicator agreed with the Department that: (i) the taxpayer was a single unitary business; and (ii) the alternative three-factor formula applied to the taxpayer produced a constitutionally and statutorily fair apportionment of its income.
Alaska Apportionment of Income
Alaska generally uses a three-factor apportionment formula with equally-weighted payroll, property and sales factors.7 The Department may make adjustments if the statutory apportionment formula does not "fairly represent the extent of the taxpayer's business activity in this state."8 Alaska has three different alternative apportionment provisions for taxpayers that produce or transport by pipeline oil or gas in the state.9 A taxpayer that only transports oil or gas in Alaska is subject to a two-factor formula based on property and sales.10 In contrast, a taxpayer that only produces oil or gas in Alaska is subject to a two-factor formula based on property and extraction.11 Finally, a taxpayer that both transports and produces oil or gas in Alaska is subject to a three-factor formula based on property, sales and extraction.12
Constitutional Challenge to Apportionment
Under the Due Process and Commerce Clauses of the U.S. Constitution, a state "may not tax value earned outside its borders."13 For multistate companies, a unitary business concept and formula apportionment method is used to divide income among the taxing states.14 A taxing state first identifies the unitary business and then apportions its income to the taxing state according to a set formula. The Alaska Supreme Court held that the taxpayer was a unitary business subject to formula apportionment and lacked standing to contest the internal consistency of the alternative three-factor apportionment formula.
Single Unitary Business
The Court held that the taxpayer failed to prove that its business was not unitary. In reaching its conclusion, the Court determined that: (i) the taxpayer's subsidiaries were functionally integrated; (ii) the taxpayer centrally managed its subsidiaries; and (iii) the taxpayer's business exhibited economies of scale.
After thoroughly considering applicable case law, including U.S. Supreme Court precedents, the Court concluded that the taxpayer's subsidiaries were functionally integrated. The Court rejected the taxpayer's argument that the subsidiaries within the E&P and R&M segments were not functionally integrated because there was no horizontal integration between them. The relevant case law did not support the taxpayer's restrictive interpretation of the functional integration concept. In these cases, the courts held that functional integration existed due to the services the parent companies provided to their subsidiaries.15 According to the Court, the taxpayer in the instant case "provided services to its subsidiaries to a greater degree than did the taxpayers in all of these cases combined." Similar to the taxpayers in these cases, the taxpayer provided its subsidiaries with both loans and loan guarantees. However, the taxpayer's involvement in financing the subsidiaries went beyond merely loaning them money because it exercised nearly complete control over the funding of subsidiary operations. The taxpayer also provided guidance on personnel matters.
The Court held that the taxpayer centrally managed its subsidiaries through its very active board of directors. Specifically, the board made all major financial and operational decisions for the subsidiaries and considered projects that were based in Alaska. Furthermore, the taxpayer's business exhibited economies of scale by providing its subsidiaries with centralized services. The elimination of administrative redundancies saved the taxpayer $2.24 million a year. Also, the taxpayer and its subsidiaries had saved $30 million in interest over the five audited years by using shared credit facilities.
No Standing to Challenge Internal Consistency
The Court held that the taxpayer lacked standing to challenge the internal consistency of Alaska's tax scheme because it failed to show that it was injured by any inconsistency. Because the taxpayer did not have standing, it could not argue that the Department's apportionment methodology violated the Due Process and Commerce Clauses of the U.S. Constitution by being internally inconsistent. As explained by the Court, the test for internal consistency considers a situation where every jurisdiction applies the tax at issue. The test determines whether more than 100 percent of the taxpayer's income would be subject to tax in these circumstances. The taxpayer argued that Alaska's tax scheme is unconstitutional because it could result in more than 100 percent of a taxpayer's income being taxed by potentially applying the two different apportionment formulas.
The taxpayer based its internal consistency argument on an example that illustrated the apportionment factors for a hypothetical taxpayer subject to tax in Alaska, California and Texas. The taxpayer in this example was subject to the property, sales and extraction formula in Alaska and Texas, and was subject to the property, sales and payroll formula in California where it neither produced nor transported oil or gas. The choice between the alternative formulas caused 106.7 percent of the hypothetical taxpayer's income to be taxed, but the example only showed how the tax structure could result in double taxation, not how the tax structure in fact resulted in double taxation to the taxpayer.
Alternative Apportionment Formula Was Reasonable
The Court held that the Department's alternative apportionment formula was reasonable as applied to the taxpayer. As discussed above, Alaska law allows the Department to apply an alternative apportionment formula provided it is reasonable.16 The Department applied the alternative property, sales and extraction formula to apportion the taxpayer's income.
The property and sales factors were reasonable as applied to the taxpayer. The taxpayer made three challenges to the Department's calculation of the property factor. First, the taxpayer argued that because R&M subsidiaries invested in massive infrastructure in Alaska, while the E&P subsidiaries' out-of-state property holdings were leased land and partially owned equipment, the property factor overvalued the taxpayer's activities in Alaska. Second, the taxpayer argued that the Department's calculations of the property factor undervalued its out-of-state assets by calculating their value at cost rather than fair market value. Third, the taxpayer argued that the property factor was distortive because it excluded intangible property. The Court rejected all of these arguments and found that there was no evidence of unreasonable distortion of the property factor.
The Court also disagreed with the taxpayer's argument that the sales factor was unreasonable because it used gross receipts rather than net profits. According to the Court, the taxpayer "quarrels with universally accepted taxing practice." The Court rejected the argument because it concluded that a taxpayer's in-state activity may be fairly measured by the amount of goods or services that consumers purchase in the state regardless of whether the business later turns a profit or loss on those purchases.
The taxpayer was not successful in arguing that unreasonable distortion could be seen in the disparity between the income subject to tax under the alternative apportionment method and the income that would be subject to tax under separate accounting.17 The U.S. Supreme Court has declined to hold formula apportionment unreasonable even when presented with a large disparity between income that would have been taxed under separate accounting and the income actually taxed under formula apportionment.18
Commentary
This is a thorough decision that provides guidance on making unitary business determinations as well as the constitutionality and reasonableness of alternative apportionment methods. Undoubtedly, the fact that the taxpayer had consistently filed unitary tax returns for many years prior to the years in dispute made it more difficult to argue that the businesses were not unitary. During the past several years, there has been a growing trend of revenue departments requiring out-of-state taxpayers to use alternative apportionment methods to accurately reflect their income in the state. In making a constitutional argument, taxpayers must show that they incurred actual, rather than merely hypothetical, injury from the apportionment method employed. If a taxpayer is unable to prove actual harm, a court will not consider its internal consistency argument.
Although the Court did not make a determination regarding which party bore the necessary burden of proof to invoke the use of an alternative apportionment method, it noted that the Department met such burden. As the growing trend towards use of alternative apportionment methods continues, knowing which party bears the burden of proof could become increasingly important.
Footnotes
1 Tesoro Corp. v. Department of Revenue, Alaska Supreme Court, Docket No. S-14326, Opinion No. 6838, Oct. 25, 2013.
2 The Court also affirmed the imposition of failure-to-pay and negligence penalties against the taxpayer.
3 As discussed below, a taxpayer that transports oil or gas in Alaska is subject to a two-factor apportionment formula based on property and sales. A taxpayer that both transports and produces oil or gas in Alaska is subject to a three-factor formula based on property, sales and an "extraction" factor. See ALASKA STAT. § 43.20.144(c).
4 The 1998 return treated only the pipeline companies and the R&M subsidiaries as subject to Alaska tax.
5 Advisory Letter addressed to all oil and gas taxpayers, Alaska Dept. of Revenue, Nov. 19, 1999.
6 The Court termed this the "remedial formula." For the 1996 through 1998 tax years, the Department applied this alternative three-factor formula to the taxpayer.
7 ALASKA STAT. § 43.19.010, art. IV, § 9. Note that Alaska has adopted the Uniform Division of Income for Tax Purposes Act (UDITPA) and the Multistate Tax Compact.
8 ALASKA STAT. § 43.19.010, art. IV, § 18.
9 ALASKA STAT. § 43.20.144.
10 ALASKA STAT. § 43.20.144(c)(1).
11 ALASKA STAT. § 43.20.144(c)(2).
12 ALASKA STAT. § 43.20.144(c)(3).
13 ASARCO Inc. v. Idaho State Tax Commission, 458 U.S. 307 (1982).
14 Container Corp. v. Franchise Tax Board, 463 U.S. 159 (1983).
15 In Container Corp., the U.S. Supreme Court held a paperboard company to be unitary with its subsidiaries where the parent provided the subsidiaries with loans and guarantees, occasional assistance in obtaining equipment and fulfilling personnel needs, and general oversight and guidance. In Alaska Gold Co. v. Department of Revenue, 754 P.2d 247 (Alaska 1988), the Alaska Supreme Court upheld a finding of functional integration where the parent approved capital expenditures greater than $100,000, handled salaries and payroll for executives and guaranteed the lease obligations of the subsidiaries. In Earth Resources Co. v. Department of Revenue, 665 P.2d 960 (Alaska 1983), the Alaska Supreme Court upheld a unitary business finding where the parent provided the subsidiary with loans and loan guarantees, a uniform pay scale, salary guidelines and a uniform retirement plan.
16 ALASKA STAT. § 43.19.010, art. IV, § 18.
17 The taxpayer cited Hans Rees' Sons, Inc. v. North Carolina, 283 U.S. 123 (1931) for the proposition that a state's apportionment should be struck down if there is a large disparity between the income taxed under separate accounting and the income taxed under the state's apportionment formula.
18 See Trinova Corp. v. Michigan Department of Treasury, 498 U.S. 358 (1991); Butler Brothers v. McColgan,
315 U.S. 501 (1942).
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