Case Name: Rho Company, Inc., Respondent, v. The Department of Revenue, Petitioner
Court: Washington Supreme Court
Jurisdiction: Washington
Decision Date: 1989-10-31
Citations: 113 Wash. 2d 561
Docket Number: No. 55569-9
Parties: Rho Company, Inc., Respondent, v. The Department of Revenue, Petitioner.
Judges: 
Reporter: Washington Reports
Volume: 113
Pages: 561–591

Head Matter:
[No. 55569-9.
En Banc.
October 31, 1989.]
Rho Company, Inc., Respondent, v. The Department of Revenue, Petitioner.
Kenneth 0. Eikenberry, Attorney General, and Mary E. Fairhurst, Assistant, for petitioner.
Joseph D. Holmes, Jr., and Philip A. Talmadge (of Karr, Tuttle, Campbell), for respondent.

Opinion:
Durham, J.
Rho Company, Inc. (Rho) contends that WAC 458-20-111—which excludes certain "pass through" payments from gross income for purposes of business and occupation taxes—applies to its business, which supplied temporary engineering personnel to client companies. Rho regularly received payments from its clients that it then passed on to the temporary personnel as wages, per diem and repayment of travel expenses. The Board of Tax Appeals (Board) found the regulation inapplicable to Rho, and included these payments in determining the taxpayer's gross income. In so ruling, the Board relied exclusively on provisions found in the contracts underlying Rho's transactions. We reverse. We hold that the contractual labeling of the parties' relationships, although an important factor, is not solely determinative of the regulation's applicability.
I
Facts
Rho is a Washington corporation which supplies local manufacturing and engineering firms with temporary workers having technical engineering skills. Rho conducts most of its Washington business by providing personnel for the Boeing Company, but Rho also conducts business with Westinghouse Hanford Company, Crown Zellerbach and Western Gear Machinery Corporation.
According to all of Rho's contracts—including both those entered into with the technical personnel and those with its corporate clients—the contract personnel were employed by Rho. These contracts repeatedly state not only that Rho employed the contract personnel, but also that Rho acted as an independent contractor in dealing with the corporate clients. Although most of the contracts were silent as to the creation of an agency relationship between Rho and the clients, at least one of the contracts expressly disavowed the existence of any such relationship.
Under these contracts, the corporate clients did not directly compensate the contract personnel, but instead they sent money to Rho, who then assumed responsibility as an employer for paying the personnel, paying employer taxes, and for withholding the appropriate amount of the employees' paycheck for tax purposes. Labeling the workers as Rho's employees was an essential part of the service that Rho provided.
By establishing Rho as the employer of the temporary workers, the clients were able "to avoid costs and liabilities attendant to hiring technical personnel as their own employees."
When one of Rho's clients had a temporary need for engineers, the client provided Rho with a purchase order listing the number of workers needed and basic job qualifications. Rho checked its resume bank for suitable personnel, and if none seemed to match the client's requirements, it advertised in various newspapers. Rho then forwarded suitable resumes to the client, who decided which workers would receive offers. The client contacted Rho with offers of employment at a given salary, and Rho communicated this information to the workers. The worker either accepted the offer or countered with a higher proposed salary. In this manner, with Rho acting as intermediary, the worker and the client arrived at a final agreement as to salary, and if the worker did not live in the immediate area, the negotiations would also cover the possible payment of a per diem amount and reimbursement of relocation expenses.
Once the worker reported to the client's work facility, he was subject to the exclusive guidance of the client. The client determined the worker's job assignment and the duration of his employment. The client supervised the worker and evaluated his performance. Rho played no role in this supervision, and the only regular contact that Rho had with the workers once they were on the job was the mailing of paychecks. The client furnished the tools and materials for the contract personnel to use. Requests for raises were submitted. to the client either by Rho or by the worker directly. The client decided when to terminate a worker, and the procedures called for Rho to inform a worker of his firing once the client so decided. In practice, however, the client often informed the worker that he was fired without going through Rho.
Rho billed the clients based on each worker's hourly wage and hours worked. Rho then paid the workers' wages and any applicable per diem and travel expenses. Rho also withheld the appropriate taxes from the workers' wages and was responsible for reporting and paying withholding, FICA, FUTA and unemployment insurance contributions to the appropriate governmental agencies. The amount that Rho collected from the client as its own profit and payment of overhead expenses was calculated either as a fixed amount per employee or as a fixed percentage of the worker's salary.
The Department of Revenue (Department) assessed Rho's tax liability for the years 1979 through 1983 at $657,940. Rho contended that WAC 458-20-111 (Rule 111), by excluding the reimbursements it received for paying the workers' wages, travel and per diem, reduced its liability to only $142,461. Alternatively, Rho argued that it should have been assessed the lower rate established for "processors for hire", which would have reduced its liability to $270,087.
The Board agreed with the Department's position that because Rho's contracts showed that it was not acting as an agent in employing the workers, Rule 111 was not applicable. The Board also concluded, without further explanation, that Rho had not presented sufficient evidence to establish that it was taxable as a processor for hire. The Board's decision was affirmed on appeal to the King County Superior Court.
The Court of Appeals reversed the decisions below. Rho Co. v. Department of Rev., 52 Wn. App. 196, 758 P.2d 553 (1988). The court determined that the Board committed an error of law when it "confined its inquiry to the form of the transaction and not its substance." Rho, at 207. The court stated that proper resolution of the issues required going beyond the contracts to determine which party actually employed the contract personnel. In this regard, the court decided that the record was inadequate for it to decide the employment question, and it remanded for further fact-finding on the question of the right of control over the contract personnel. Rho, at 206-07. Finally, the court held that the Board's dismissal of Rho's "processor for hire" argument was arbitrary and capricious, and remanded for further consideration of this issue. Rho, at 207. This court granted the Department's petition for review.
II
Applicability of Rule 111
B&O taxes are assessed at different rates depending on the type of business the taxpayer conducts. The statutes categorize a number of different business activities and specify the tax rate to be applied to each. The Department determined in this case that Rho fit within the "catch-all" category of "other business or service activities", for which the tax rate currently is 1.5 percent of the gross income generated by the business. See RCW 82.04.290.
Because the tax is based on gross income rather than net income, a business is taxed on the entire gain it accrues from its transactions, and no deduction is allowed for the expenses involved in conducting the business. RCW 82.04-.080. Therefore, as a general rule, the base amount from which the B&O tax is calculated does not allow for deductions for the expenses of conducting business.
Even though business expenses generally are not deductible, the Department has adopted an administrative rule recognizing that certain "pass through" expenses should not be included in determining gross income. Rule 111 excludes from the definition of "gross income" certain "advances" and "reimbursements" for which the taxpayer assumes solely agent liability.
Rule 111 reads as follows, with the heart of the rule being stated in the fourth paragraph:
The word "advance" as used herein, means money or credits received by a taxpayer from a customer or client with which the taxpayer is to pay costs or fees for the customer or client.
The word "reimbursement" as used herein, means money or credits received from a customer or client to repay the taxpayer for money or credits expended by the taxpayer in payment of costs or fees for the client.
The words "advance" and "reimbursement" apply only when the customer or client alone is liable for the payment of the fees or costs and when the taxpayer making the payment has no personal liability therefor, either primarily or secondarily, other than as agent for the customer or client.
There may be excluded from the measure of tax amounts representing money or credit received by a taxpayer as reimbursement of an advance in accordance with the regular and usual custom of his business or profession.
The foregoing is limited to cases wherein the taxpayer, as an incident to the business, undertakes, on behalf of the customer, guest or client, the payment of money, either upon an obligation owing by the customer, guest or client to a third person, or in procuring a service for the customer, guest or client which the taxpayer does not or cannot render and for which no liability attaches to the taxpayer. It does not apply to cases where the customer, guest or client makes advances to the taxpayer upon services to be rendered by the taxpayer or upon goods to be purchased by the taxpayer in carrying on the business in which the taxpayer engages.
(Italics ours.) WAC 458-20-111.
This court has summarized the operation of Rule 111 by stating that the rule allows an exclusion from income for a "pass through" payment when the following three conditions are met: (1) the payments are "customary reimbursements for advances made to procure a service for the client"; (2) the payments "involve services that the taxpayer did not or could not render"; and (3) the taxpayer "is not liable for paying the associate firms except as the agent of the client." Christensen, O'Connor, Garrison & Havelka v. Department of Rev., 97 Wn.2d 764, 769, 649 P.2d 839 (1982); see Walthew, Warner, Keefe, Arron, Costello & Thompson v. Department of Rev., 103 Wn.2d 183, 186, 691 P.2d 559 (1984).
There is no dispute as to the applicability of the first two conditions. The clients customarily paid Rho for procuring the engineering services rendered by the technical personnel, and Rho did not itself perform these services. The facts described above clearly reveal that Rho itself did not supervise or otherwise become involved in the rendering of the engineering services. Indeed, it appears from oral argument that Rho was not even licensed to render such services. On appeal, the parties have focused solely on the third condition—whether Rho's liability for paying the technical personnel is solely that of an agent.
The third condition has been addressed in two of this court's recent opinions. Because the facts of each of these cases differs from those of the present case, however, they provide limited help in resolving our issue. In Christensen, the taxpayer was a law firm which had advanced money to out-of-state attorneys and foreign patent professionals for services performed for the law firm's clients. In that case, however, both parties stipulated that the service providers understood that they were working directly for the law firm's clients and, consequently, the taxpayer had no liability for paying the providers, rendering applicable Rule 111. Christensen, at 769-70. Walthew involved similar facts, in that a law firm had advanced money to court reporters, process servers and physicians on behalf of its clients. The court held that because rules on attorney discipline prevent attorneys from advancing the costs of litigation for the client unless the client remains ultimately liable for those costs, the law firm was liable only as an agent of its client. Walthew, at 188.
In the present case, the third condition is not so easily analyzed as it was in Christensen and Walthew, there being no stipulation between the parties as to ultimate liability and no rules preventing Rho from assuming liability for paying the contract personnel. Accordingly, we turn to the rules of agency for guidance.
The question that the parties have primarily addressed in this regard is: Who employed the contract pérsonnel, Rho or Rho's corporate clients? If Rho is the employer, then Rho is liable in its own right for the payment, and Rule 111 does not apply. If, however, the clients are deemed to be employers, then Rho is more easily characterized as the clients' paymaster agent in paying the personnel.
Because the contracts show that Rho employed the personnel, the Department argues that Rho was primarily liable—not just as an agent—for paying the workers. Rho, on the other hand, argues that the clients actually employed the personnel, and Rho's payment of the personnel was actually an advance or reimbursement for which Rho was liable only as the clients' agent. According to Rho, the Department's exclusive reliance on the contracts improperly exalts form over substance. The Court of Appeals adopted this form versus substance analysis. Rho, at 203, 206, 207.
While there is support for this approach in the law, the extent to which a taxpayer is allowed to invoke the doctrine is far from settled. Furthermore, the parties have not thoroughly addressed this issue. Fortunately, this case can be resolved without resorting to substance/form analysis. Rho's argument that the contractual labels are not determinative has merit under well-accepted principles of agency.
Determination of an agency relationship is not controlled by the manner in which the parties contractually describe their relationship. See Matsumura v. Eilert, 74 Wn.2d 362, 368, 444 P.2d 806 (1968); Busk v. Hoard, 65 Wn.2d 126, 134, 396 P.2d 171 (1964); see generally 3 Am. Jur. 2d Agency § 21, at 526 n.36 (1986). An agency relationship generally arises when two parties consent that one shall act under the control of the other. See Uni-Com Northwest, Ltd. v. Argus Pub'g Co., 47 Wn. App. 787, 737 P.2d 304, review denied, 108 Wn.2d 1032 (1987). The requisite consent need not be expressed between the parties, but can be implied from their actions:
An agency relationship, of course, may arise without an express understanding between the principal and agent that it be created. It does not depend upon an express undertaking between them that the relationship exists. Petersen v. Turnbull, 68 Wn.2d 231, 412 P.2d 349 (1966). If, under the circumstances, the parties by their conduct have created an agency in fact, then it exists in law.
Matsumura, at 368.
In this regard, agency is a legal concept that depends on the manifest conduct of the parties; it "does not depend upon the intent of the parties to create it, nor their belief that they have done so. . . . [A]n agency exists although the parties did not call it agency and did not intend the legal consequences of the relation to follow." Restatement (Second) of Agency § 1, comment b (1958), quoted in Busk v. Hoard, supra at 129. It follows that an agency can be implied, if the facts so warrant, not only if the contracts are silent as to agency, but even if the parties execute contracts expressly disavowing the creation of an agency relationship. See Fernander v. Thigpen, 278 S.C. 140, 143, 293 S.E.2d 424 (1982).
Therefore, although it reasoned differently, the Court of Appeals correctly concluded that the Board committed an error of law by restricting its analysis to the parties' contracts. We remand to the Board for consideration of the parties' relationship which takes into account the factors we discuss in this opinion, one such factor being the contractual labeling of the parties' relationship.
On remand, the Board will have to determine whether Rho acted as the clients' agent in paying the technical personnel, and if so, whether Rho's liability to the personnel was solely that of an agent.
This first issue involves application of traditional agency principles. The Board will have to decide whether Rho and its clients consented—either expressly or impliedly—that Rho would act under the clients' control. Along these lines, we disagree with the overly broad language from a Court of Appeals opinion stating that "a different test is applied to the agency concept in tax cases than in tort or contract cases." Boise Cascade Corp. v. State, 3 Wn. App. 78, 87, 473 P.2d 429 (1970). In Boise Cascade, the Court of Appeals concluded that in tax cases, courts must look not just at the issues of consent and control, but also to (1) whether the parties' contracts actually designate one party as the agent of the other, and (2) whether one party has become so "assimilated" or "incorporated" into the other party's structure as to become its "instrumentality" or one of its "constituent parts". Boise Cascade, at 88, 90.
These extra requirements in Boise Cascade are not applicable to agency issues in the context of Rule 111 cases. Boise Cascade's support for these extra requirements comes only from cases addressing whether the federal government's immunity from state taxation should be extended to private contractors of the federal government. See E.I. Du Pont de Nemours & Co. v. State, 44 Wn.2d 339, 267 P.2d 667 (1954); see also Kern-Limerick, Inc. v. Scurlock, 347 U.S. 110, 98 L. Ed. 546, 74 S. Ct. 403 (1954); United States v. Boyd, 378 U.S. 39, 12 L. Ed. 2d 713, 84 S. Ct. 1518 (1964). The analysis of constitutional tax immunity in these older cases combined analysis of the agency factors of consent and control with nonagency factors, such as the extent to which one party was assimilated into the other's structure. A recent Supreme Court case has recognized as much and stated that "a finding of constitutional tax immunity requires something more than the invocation of traditional agency notions: to resist the State's taxing power, a private taxpayer must actually 'stand in the Government's shoes.'" United States v. New Mexico, 455 U.S. 720, 736, 71 L. Ed. 2d 580, 102 S. Ct. 1373 (1982) (quoting Detroit v. Murray Corp. of Am., 355 U.S. 489, 503, 2 L. Ed. 2d 441, 78 S. Ct. 458 (1958)). Therefore, these cases should not be interpreted as adding additional requirements to the definition of "agent" in tax cases involving different issues.
Moreover, in Christensen and Walthew, which dealt with law firm/client relations, agency was found under Rule 111 even though there was no indication that a contract expressly established an agency relationship and even though neither law firm was so incorporated into their clients' structure as to be one of their constituent parts.
Accordingly, we hold that the standard definition of agency should be used in analyzing Rule 111, absent any specific legislative or regulatory statement to the contrary.
If an agency relationship is found on remand, then the Board will also have to determine if Rho's obligation to pay the technical personnel constituted solely agent liability. Resolution of this issue will require analysis of the control over the contract personnel that was exercised by Rho and by the clients. If the clients' control over the personnel was so pervasive that it should be deemed the employers of the personnel for purposes of B&O taxation, and Rho's control consisted of little more than paying the personnel once they were hired, then Rho should be deemed to be a mere paymaster who pays the personnel only as an agent for the clients. The areas in which control will be important will include hiring, compensation, work assignment, supervision and termination.
And finally, as our previous discussion makes clear, the Board will have to look beyond the contractual labels placed on the parties' relationships in determining these issues.
Ill
"Processor for Hire" Classification
Rho presented an alternative argument to the Board. Its position was that if the Board ruled against it as to the applicability of Rule 111, then it should be taxed not as a service provider but as a processor for hire. See RCW 82.04.280; WAC 458-20-136.
The Court of Appeals held that the Board's handling of this issue was arbitrary and capricious. Rho Co. v. Department of Rev., 52 Wn. App. 196, 207, 758 P.2d 553 (1988). In its petition for review, the Department challenges this conclusion by arguing that Rho waived this issue by not presenting evidence on this issue to the Board and by not arguing it until its closing statement. We decline to address this argument because the Department has presented no argument or authority to support its position. See Transamerica Ins. Group v. United Pac. Ins. Co., 92 Wn.2d 21, 29, 593 P.2d 156 (1979).
The case is remanded to the Board of Tax Appeals for further proceedings consistent with this opinion.
Callow, C.J., and Brachtenbach, Dolliver, Pearson, Andersen, and Smith, JJ., concur.
Rho also engages in business in California and other western states.
As the Court of Appeals indicated, appellate review of this case is controlled by Washington's administrative procedure act, RCW 34.04:
The standard of review for a formal hearing before the Board is governed by RCW 34.04.130. UPS, Inc. v. Department of Rev., 102 Wn.2d 355, 687 P.2d 186 (1984). The standard is error of law and under this standard the reviewing court may substitute its judgment for that of the administrative body, though substantial weight is accorded the agency's view of law. UPS, Inc. v. Department of Rev., supra; Franklin Cy. Sheriff's Office v. Sellers, 97 Wn.2d 317, 646 P.2d 113 (1982), cert. denied, 459 U.S. 1106 (1983). Agency findings of fact will be reviewed under the clearly erroneous standard, Hitchcock v. Department of Retirement Sys., 39 Wn. App. 67, 71, 692 P.2d 834 (1984), review denied, 103 Wn.2d 1025 (1985), or under the arbitrary and capricious standard. Northern Pac. Transp. Co. v. State Utils. & Transp. Comm'n, 69 Wn.2d 472, 418 P.2d 735 (1966).
(Italics ours.) Rho, at 201.
The party invoking the doctrine is usually not the taxpayer but the taxing authority. In such instances, courts generally are willing to elevate substance over form. See B. Bittker, Federal Taxation of Income, Estates and Gifts ¶ 4.3.3, at 4-36 (1981). Courts disagree, however, on the extent to which taxpayers should be allowed to invoke this doctrine. Some courts state that taxpayers can never invoke the doctrine, reasoning that taxpayers should be bound by the form that they chose for their transactions. Other courts hold that the doctrine can be freely invoked by either the taxpayer or the taxing authority. See B. Bittker, at ¶ 4.3.6. Finally, some courts take a middle position and allow taxpayers to invoke the doctrine only if the taxpayers can satisfy an elevated standard of proof. See B. Bittker, at ¶ 4.3.6.
The dissenting opinion is based on the premise that we hold that Rho is not hable on its contracts with its engineers. To the contrary, we are remanding for a determination of the nature of Rho's liability on these contracts.
Nothing in Seattle v. Paschen Contractors, Inc., 111 Wn.2d 54, 758 P.2d 975 (1988) should be interpreted to the contrary. Although we used a general cite to E.I. Du Pont de Nemours & Co. v. State, 44 Wn.2d 339, 267 P.2d 667 (1954) in support of our holding that the transaction did not constitute a "pass through" payment, the case should not be interpreted as expanding the definition of "agent" for purposes of Rule 111. The holding of Paschen Contractors turns on the conclusion that the money actually belonged to the contractor rather than passing through to the State, and the citation to E.I. Du Pont de Nemours & Co. v. State, supra, merely provided general support because of its somewhat similar facts.
We note that Washington's tax regulations have placed additional restrictions on the definition of "agent" at least for one category of taxpayers. Taxpayers who buy or sell tangible personal property on behalf of another will not be treated as agents unless they have a contract expressly creating an agency relationship and their records indicate that the transactions were entered into in the name of the principal. WAC 458-20-159. This regulation, however, is expressly limited to cases involving tangible personal property and therefore is not applicable to the current case involving personal services.