Title: Webb Resources v. McCoy
Citation: 194 Kan. 758, 401 P.2d 879
Docket Number: 44,062
State: Kansas
Issuer: Kansas Supreme Court
Date: May 15, 1965

194 Kan. 758 (1965)
401 P.2d 879
WEBB RESOURCES, INC., formerly known as ANSCHUTZ DRILLING COMPANY, INC., Appellee,
v.
WAYNE E. McCOY, Kansas State Director of Revenue, Appellant. (In the Matter of Webb Resources, Inc., formerly known as Anschutz Drilling Company, Inc., and the Deficiency Income Tax Assessment levied on such company for the fiscal year 1958).
No. 44,062

Supreme Court of Kansas.
Opinion filed May 15, 1965.
Dean Burkhead, of Topeka, argued the cause, and C.A. Arterburn, also of Topeka, was with him on the brief for the appellant.
Mark H. Adams, II, of Wichita, argued the cause, and Mark H. Adams, Charles E. Jones, Wm. I. Robinson, J. Ashford Manka, Clifford L. Malone, John S. Seeber and Phillip L. Bowman, all of Wichita, were with him on the brief for the appellee.
The opinion of the court was delivered by
SCHROEDER, J.:
This is an appeal by the director of revenue from an adverse ruling in the lower court under the Kansas income tax law as applied to a multi-state corporation whose gross income is derived from property located and business transacted in part within and in part without the state of Kansas.
*759 The principal question involves the proper method of determining the corporation's income allocable to Kansas for income tax purposes.
In accordance with the facts hereafter stated, the director of internal revenue of the state of Kansas assessed additional income tax to the appellant for the fiscal year 1958. This assessment was approved by the board of tax appeals, and the taxpayer appealed to the district court. In the district court the parties agreed upon and read a stipulation of facts into the record. The stipulation, with some omissions, reads:
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The foregoing facts, as stipulated by the parties, were accepted by the trial court as true and correct and adopted as its findings of fact. It thereupon made the following conclusions of law:
*763 CONCLUSIONS OF LAW
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Under Kansas law an income tax is levied upon corporations whose income is derived from property located and business transacted within the state of Kansas during the tax year. The statute applicable to the facts in the instant case is G.S. 1957 Supp., 79-3203, which reads in part as follows:
Where a corporation does business in more than one state, the problem is to determine what portion of the corporation's income is derived from property located and business transacted within the state of Kansas during the tax year in question. Constitutionally, *764 the state may only tax the income from the taxpayer's business within a state. It cannot attempt to tax income earned in another state, nor by the same token is it required to allow a taxpayer to attribute income earned in this state to its out-of-state activities, nor is it required to allow as a deduction losses or other deductions incurred in other states.
The legislature has given attention to the method of determining what income and expenses are attributable to the taxpayer's operations in Kansas by enacting two statutes. The first, hereafter referred to as the direct method of income allocation, is contained in G.S. 1949, 79-3217 (repealed L. 1963, ch. 485, § 24). It reads:
The second, hereafter referred to as the apportionment or formula method of income allocation, is set forth in G.S. 1957 Supp., 79-3218 (repealed L. 1963, ch. 485, § 24). Insofar as the statute is material to the present discussion it provides where the nature of the business is such as to render direct allocation impracticable, or where the books of account and records do not clearly reflect the net income subject to tax, the net income allocated to Kansas shall be computed by taking the arithmetical average of the following factors: (1) The ratio of costs of Kansas property to costs of property everywhere used in connection with the business carried on; (2) the ratio of costs of Kansas manufacturing or selling to the costs of manufacturing or selling everywhere during the taxable year; and (3) the ratio of Kansas gross sales or revenue to gross sales or revenue everywhere in connection with the business carried on during the taxable year. By applying the arithmetical average ratio or percentile thus obtained to the net income of the entire business, the income attributable to Kansas is determined.
The two statutes in question leave much to be desired, and this perhaps accounts for their repeal by the legislature in 1963. These statutes were before the court in Crawford Manufacturing Co. v. State Comm. of Revenue and Taxation, 180 Kan. 352, 304 P.2d 504. There the manufacturing company allocated its net income *765 to Kansas by the direct method, and the director of revenue assessed an additional tax against the company on the theory that it was required to report its income under the formula method of allocation. It was ultimately determined on appeal to this court that the taxpayer did not sustain the burden of showing that the formula method, ordered by the director to be applied, did not clearly reflect a just and equitable allocation of net income to Kansas.
Basic considerations in appealed cases of this type were stated in the Crawford decision. In the opinion the court said:
In Crawford it was also held in computing the net income of a multi-state corporation whose gross income is derived from property located and business transacted in part within and in part without the state of Kansas, the direct method of allocating income prescribed by 79-3217, supra, could not be employed if the business is of a unitary character. Where the business is unitary in character net income should be determined by the application of the formula method set forth in 79-3218, supra, thus giving weight to the different factors responsible for earning the income so as to apportion it from the entire business among the states in which it was earned.
*766 It was said a multi-state business is a unitary business for income tax purposes when the operations conducted in one state benefit and are benefited by the operations conducted in another state or states. If its various parts are interdependent and of mutual benefit so as to form one integral business rather than several business entities, it is unitary.
It was further said whether a multi-state business is separate or unitary depends upon the manner in which its business is conducted. The essential test to be applied is whether or not the operation of the portion of the business within the state is dependent upon or contributory to the operation of the business outside the state. If there is such relationship, the business is unitary.
The trial court held, in effect, the action of the director in the instant case, in allocating the income of the taxpayer (appellee) under the direct method (79-3217, supra,), was arbitrary, capricious and unlawful.
We must look to the stipulated facts to determine as a matter of law whether the trial court's conclusion on this point is correct.
Authorities in other states which have addressed themselves to allocation of income from oil and gas production for income tax purposes are not uniform in their holding as to which method is to be employed in allocating income of a multi-state corporation to the state.
On facts substantially similar to those presented in the instant case the state of California has held the business of a corporation, engaged in the exploration for, and extraction and sale of oil and gas in fifteen states and the Dominion of Canada, was unitary in nature and thereby entitled to compute state franchise taxes by the formula method in allocating a portion of the overall income of the business to the taxing state. (Honolulu Oil Corp. v. Franchise Tax Bd., 60 Cal. 2d 417, 34 Cal. Rptr. 552, 386 P.2d 40; and Superior Oil Co. v. Franchise Tax Bd., 60 Cal. 2d 406, 34 Cal. Rptr. 545, 386 P.2d 33.) These decisions may be attributable to the narrow issue presented. In Superior it was said:
*767 The Honolulu case, immediately following Superior in the California official reports, followed the holding in the Superior case. Within the foregoing issue the question was whether the taxpayer's operations in several jurisdictions, including California, were unitary in nature and thus subject to local taxation on a basis which allocated a portion of the overall net income to California (citing the statute) or whether, on the other hand, the local operations were sufficiently separate to justify local taxation on the net income derived from such separate, local operations.
The taxpayer (appellee) relies on these decisions as "bay horse" cases and controlling, while the director contends they are based strictly upon the California statute and, therefore, distinguishable.
The Supreme Court of Louisiana in Texas Company v. Cooper, 236 La. 380, 107 So. 2d 676, held an oil company conducting operations on a world-wide scale was not of such a unitary nature that it was impossible and inequitable to attribute any direct profit to its Louisiana production operations, which consisted solely of the gathering of crude oil for shipment outside the state. Hence the separate accounting method for state income tax purposes was held feasible.
Similarly, the Supreme Court of Oklahoma in Magnolia Petroleum Co. v. Oklahoma Tax Com., 190 Okla. 172, 121 P.2d 1008, held an income tax assessable to a foreign corporation producing crude oil in the state, and shipping the same to itself and others in other states, based upon direct allocation of gross profit determined by costs of production and market price at time of shipment was held to be a practicable method for the assessment of net income derived from oil. There the Oklahoma tax commission sought to assess the tax under the formula method. In the opinion the court said:
The Oklahoma statutes are substantially the same as the Kansas statutes here in question.
Other cases holding the direct method of allocating income proper are Standard Oil Co. v. Wisconsin Tax Comm., 197 Wis. 630, 223 N.W. 85; Standard Oil Co. v. Thoresen, 29 F.2d 708 (8th Cir.); and Fisher v. Standard Oil Co., 12 F.2d 744 (8th Cir.). (See, also, Skelly Oil Company v. Commissioner of Taxation, 131 N.W.2d 632 [Minn. 1964]; and Rock Island Ref. Co. v. Oklahoma Tax Com., 194 Okla. 349, 147 P.2d 1000.)
The taxpayer's Kansas income tax return for the fiscal year 1958 was admitted in evidence by stipulation of the parties. On the basis of this return, computed under the formula method, 34% of the taxpayer's property is located in Kansas; 25% of its manufacturing costs are incurred in Kansas; and its sales in Kansas constitute 43% of its total. Also, during the tax year involved the taxpayer sold an oil payment which burdened 80% of all its properties. Under the existing law the sale of such oil payment constitutes income in the year of sale. The taxpayer's return shows that 71% of the oil payment would be obtained from Kansas properties. The taxpayer's return under the formula method discloses 34% of the taxpayer's income and deductions is attributable to this state, in spite of the fact that 43% of its gross income is earned in Kansas, while only 29% of its direct costs is incurred in this state.
*769 It must be conceded that Kansas, having the right to collect a tax imposed on net income, has the right to determine what that income is in relation to the business transacted within the state, if it meets the test of being just and equitable. This is true even though the net income by the direct accounting method is more than what would be the state's aliquot portion of the earnings based on the formula method of income allocation.
The United States Supreme Court has held the entire net income of a corporation, generated by interstate as well as intrastate activities, may be fairly apportioned among the states for tax purposes by formulas utilizing instate aspects of interstate affairs; and that the commerce clause and the due process clause are not violated by state statutes levying nondiscriminatory net income taxes on that portion of a foreign corporation's net income earned from and fairly apportioned to business activities within the taxing state, even though these activities are exclusively in furtherance of interstate commerce. (Northwestern Cement Co. v. Minn., 358 U.S. 450, 3 L. Ed. 2d 421, 79 S. Ct. 357, 67 A.L.R.2d 1292 [1959].) Where the direct method of income allocation can be employed, all suspicion of unconstitutional taxation is dispelled. (Magnolia Petroleum Co. v. Oklahoma Tax Com., supra.)
When the provisions of 79-3203(b), supra, are construed with 79-3217 and 3218, supra, it is apparent the direct method of allocation or accounting is the favored one. It is first mentioned in the statutory scheme and corresponds most nearly to 79-3203(b), supra, which imposes the tax. The formula method of allocation may only be used where "the nature of the business is such as to render direct allocation impracticable or where the books of account and records do not clearly reflect the net income subject to tax by this act." Where direct accounting is employed it assigns to this state the actual income from property owned and business transacted within this state as required by 79-3203(b), supra.
On the facts the instant case is stronger than the Magnolia case because it was stipulated that all of the oil produced in Kansas by the taxpayer was and is sold to other companies; and that no oil which it produced within the state of Kansas was moved by it across Kansas borders.
Whether the taxpayer's multi-state business is a unitary business for income tax purposes under the test laid down in Crawford requires attention.
*770 On the facts in Crawford the director levied an additional income tax against the manufacturing company by applying the formula method for allocating income to Kansas. The taxpayer used the direct method. In the instant case the situation is reversed. In Crawford the director's action was held to reasonably attribute income allocable to property owned and business transacted within this state, and met the test of being just and equitable. He was said to be free from arbitrary, unreasonable or capricious action in applying the formula method. Under these circumstances, it was simple to expound on the unitary character of a taxpayer's business. But application of the definition in accordance with the test to determine whether the business of a multi-state corporation is unitary, as there stated, must be tempered by the foregoing basic construction of the statutes involved (79-3203[b]; 79-3217 and 79-3218, supra), and the facts which gave rise to its pronouncement. This, of necessity, restricts its application to businesses which are clearly unitary.
In Texas Company v. Cooper, supra, it was said:
A text discussing the subject is Altman and Keesling, Allocation of Income in State Taxation (1946) at pages 74 and 102.
In our opinion on the facts here presented, the portion of the taxpayer's business conducted within the state of Kansas is not dependent upon or contributory to the operation of the taxpayer's business outside the state. Whether the taxpayer could conduct its wildcatting operations in other states without the profits derived from the production of oil and gas in Kansas is not the question or the test.
In our opinion the director of revenue acted well within the scope and intent of the statutes here involved in allocating income of the taxpayer pursuant to the direct method of accounting. Within the meaning of 79-3217, supra, direct allocation of income was practicable on the books of account and records of the taxpayer, together with the deductions applicable thereto, and such method clearly reflects the net income of the taxpayer attributable to Kansas. It cannot be said the business of the taxpayer of exploring for, drilling *771 for, finding, producing and selling oil and gas and other liquid hydrocarbons is of such a unitary character in its multi-state operations as to require application of the formula method of income allocation to Kansas under 79-3218, supra.
It was specifically stipulated that the direct method of allocation for reporting income tax to the state of Kansas was used in the returns filed by the taxpayer within the state for the years 1955, 1956 and 1957. Further, the gross revenues, drilling costs and operating costs could be determined by state lines from supplemental records of the taxpayer. It was stipulated the taxpayer can determine its gross income by state lines in that it knows the exact number of barrels of oil produced from each well; it knows the location of each well; the taxpayer can also determine the exact cost of drilling and the exact cost of equipping each well, as well as the direct costs of operation within the geographical area of Kansas.
The only part of the taxpayer's Kansas business which is conducted beyond the borders of this state is the management functions of the home office in Denver, wherein are located its geologists, land men, production supervisors, company officers and clerical staff. Hence, the decision making and bookkeeping transactions are maintained without the state. These expenses are ordinarily considered to be general or overhead type of expenses which are required in any type of business which crosses state lines.
Kansas Income Tax Regulation 92-4-85 (revoked January 1, 1964) provides that in the use of separate accounting methods, separate records must be kept of sales, cost of sales and expenses for Kansas business as distinct from the remainder of the business. Overhead items of income and expense, which cannot be directly allocated on the books and records as provided in 79-3217, supra, must then be allocated to the business within and without Kansas. It further provides the method of allocating these overhead items of income by types of businesses.
The taxpayer argues its total income for fiscal year 1958 under the federal return was $114,642.99. Using the formula method of income allocation the total income assessable by the various states in which its operations are conducted for income tax purposes would represent 100% of such total income. On this basis there would be allocated to the state of Colorado 11.43%; to Montana 13.52%; to North Dakota 8.07%; to Utah 5.55%; to Wyoming and Nebraska (no income tax) 26.88%; and to Kansas 34.55%.
*772 Under the direct method of allocating income to Kansas, the taxpayer argues the total income, as adjusted, attributable to Kansas is $157,172.29, which amounts to 137.10% of its total income as computed under the federal return. By using the formula method in other states, income taxable by such other states would be $75,034.98 which amounts to 65.45% of its total income. It is therefore argued the total income being taxed under the direct method as proposed by the director of revenue in the instant case is $232,207.27, which amounts to 202.55%.
This argument, of course, has some fallacies. Wyoming and Nebraska, which impose no income tax, have attributed to them 26.88% of the income. Furthermore, under the stipulation, the taxpayer's profitable business is located within the state of Kansas by reason of the fact that it has 110 producing wells in Kansas. This is in proven fields and where oil production has been or is being developed. Its expense figures show that its wildcatting or exploration expenses are being incurred primarily in other states. Obviously, under these circumstances other states where income tax returns must be filed do not object when the taxpayer files its return under the formula method in their state. Other fallacies in the argument have already been touched upon.
In conclusion we hold as a matter of law upon the stipulated facts that each and every conclusion of law made by the district court is erroneous.
The judgment of the lower court is reversed.