Opinion ID: 1861696
Heading Depth: 1
Heading Rank: 1

Heading: question # 1: were the taxpayer's wisconsin operations an integral part of a unitary business within the meaning of sec. 71.07 (2), stats. (1967)?

Text: This case brings into play several sections of ch. 71, Stats. (1967): 71.01. Imposition of tax; exempt income. ... (2) FRANCHISE TAX ON CORPORATIONS. For the privilege of exercising its franchise or doing business in this state in a corporate capacity every domestic or foreign corporation, except corporations specified in sub. (3), shall annually pay a franchise tax according to or measured by its entire net income of the preceding income year at the rates set forth in s. 71.09 (2am). Every corporation organized under the laws of this state shall be deemed to be residing within this state for the purposes of this franchise tax. All provisions of chs. 71 and 73 relating to net income taxation of corporations shall apply to franchise taxes imposed under this subsection, unless the context requires otherwise. The tax imposed by this subjection on national banking associations shall be in lieu of all taxes imposed by this state on national banking associations to the extent it is not permissible to tax such associations under federal law. 71.07. Situs of income; allocation and apportionment. (1) For the purposes of taxation income or loss from business, not requiring apportionment under sub. (2), (3) or (5), shall follow the situs of the business from which derived. Income or loss derived from rentals and royalties from real estate or tangible personal property, or from the operation of any farm, mine or quarry, or from the sale of real property or tangible personal property shall follow the situs of the property from which derived. Corporation income from personal services performed by employes of corporations shall be deemed business income and shall follow the situs of the business. Income from personal services and from professions of resident individuals shall follow residence. Income from personal services of nonresident individuals, including income from professions, shall follow the situs of the services. All other income or loss, including royalties from patents; income or loss derived from land contracts, mortgages, stocks, bonds and securities or from the sale of similar intangible personal property, shall follow the residence of the recipient, except as provided in s. 71.07 (7). For the purposes of taxation, interest received on state and federal tax refunds when the tax refunded was on business income or property shall be deemed income from business and shall follow the situs of the business from which derived. (2) Persons engaged in business within and without the state shall be taxed only on such income as is derived from business transacted and property located within the state. The amount of such income attributable to Wisconsin may be determined by an allocation and separate accounting thereof, when the business of such person within the state is not an integral part of a unitary business, provided, however, that the department of taxation may permit an allocation and separate accounting in any case in which it is satisfied that the use of such method will properly reflect the income taxable by this state. In all cases in which allocation and separate accounting is not permissible, the determination shall be made in the following manner: There shall first be deducted from the total net income of the taxpayer such party thereof (less related expenses, if any) as follows the situs of the property or the residence of the recipient; provided, that in the case of income which follows the residence of the recipient, the amount of interest and dividends deductible under this provision shall be limited to the total interest and dividends received which are in excess of the total interest (or related expenses, if any) paid and allowable as a deduction under section 71.04 during the income year. The remaining net income shall be apportioned to Wisconsin on the basis of the ratio obtained by taking the arithmetical average of the following 3 ratios: ... The purpose of these sections is to determine what portion of a taxpayer's income is attributable to activities in the state of Wisconsin, since the opening sentence of sec. 71.07 (2) states: Persons engaged in business within and without the state shall be taxed only on such income as is derived from business transacted and property located within the state. The two methods  separate accounting and formula apportionment  were described in Keesling and Warren, The Unitary Concept, 12 Hastings Law Journal 42, 43 (1960) as follows: In the apportionment of business income two methods have been devised which have come to be known as the `separate accounting' method and the `formula' method, respectively. Under the separate accounting method, as the name implies, the business within the state is treated separately and distinctly from the business outside the state and the income is computed in much the same manner as it would be if the taxpayers' activities were confined solely to the taxing state. The gross income from the business activities within the state is first determined. The allowable deductions are then subtracted. The remaining net income is attributed in its entirety to the taxing state. Under the formula method the business activities within the state are considered to be an inseparable part of a business carried on both within and without the state. The total gross income from the entire business is determined. The allowable deductions are then subtracted and the remaining net income is apportioned within and without the state by means of an allocation formula consisting of various factors which are thought to be relevant in the production of income, such as property, payroll, and sales. [1] The term unitary has been variously defined. The definition applied in Interstate Finance Corp. v. Dept. of Taxation, 28 Wis.2d 262, 269, 137 N.W.2d 38 (1965), and relied on by the trial court in the instant case, borrows from the text authority Altman & Keesling, Allocation Of Income In State Taxation, (2d ed.), p. 101: ... the essential test 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 a relationship the business is unitary. This is the definition to which we continue to adhere. [2, 3] Sec. 71.07 (2), Stats. (1967) requires that the apportionment method be used by a taxpayer engaged in business within and without the state when the taxpayer's Wisconsin business is an integral part of a unitary business. Celon Co. v. Dept. of Taxation, 269 Wis. 372, 377-78, 69 N.W.2d 453 (1955). The statute sets forth ratios for the apportionment method but gives the department considerable latitude in adopting a formula which will most accurately reflect a reasonable and equitable tax on the income earned in Wisconsin. Interstate Finance Corp., supra at 271-272. This court has held that the latitude of the statute itself is not unconstitutional as arbitrary or unreasonable or taxing extraterritorial income, although the application of the statute in some instances might be. Id. at 272. The trial court below characterized some of the findings of the Tax Appeals Commission as erroneous conclusions of law, rather than findings of fact. Those findings were: 1) that Humble's three main functional operating departments  exploration and production, marketing, and refining  were each unitary businesses; 2) that there was no economic dependence between Humble's Wisconsin marketing operations and the exploration and production function, and 3) that there was no economic dependence between Humble's marketing operations and the refining function. Judge Currie, when a Wisconsin Supreme Court Justice wrote the opinion of this Court in Pabst v. Dept. of Taxation, 19 Wis.2d 313, 120 N.W.2d 77 (1963), wherein this Court pointed out that courts use two conflicting methods of administrative review where the issue is whether the administrative agency has correctly applied a statute to certain facts. The first is the so-called analytical approach whereby the court decides which part of the agency's determination presents a question of fact and which part a question of law. The second is the practical or policy approach which tries to avoid allocation of functions merely on the literal meaning of the terms `fact' and `law.' When this practical approach is used, the court holds that, `The judicial function is exhausted when there is found to be a rational basis for the conclusions approved by the administrative body.' On the other hand, Davis notes that when the court deems the question presented to be suitable for judicial determination, it feels free to substitute its own judgment for that of the agency. When the court substitutes its own judgment, however, it would appear that it in effect finds the agency's decision without rational basis in law or treats the issue analytically as a question of law for the court. Id. at 322-23. [4] While this court has held that ch. 227, Stats. requires that courts employ the analytical approach when reviewing agency decisions, this court will give deference to agency determinations, where the agency has particular expertise, rational basis exists in law for the agency's interpretation, and it does not conflict with the statute's legislative history, prior decisions of this court, or constitutional prohibitions. Id. at 323-24. [5, 6] When mixed questions of law and fact are presented to this court, there are really two component questions which must be answered. The first question is what, in fact, actually happened; the second question is whether those facts, as a matter of law, have meaning as a particular legal concept. Comment, The Scope of Judicial Review of Administrative Agency Decisions in Wisconsin, 1973 Wis. L. Rev. 554 (1973). The question of whether the facts fulfill a particular legal standard is itself a question of law. See Cheese v. Industrial Comm., 21 Wis.2d 8, 15, 123 N.W.2d 553 (1963). Thus, for example, in Cheese, supra, the court substituted its judgment for that of the Industrial Commission on whether particular conduct by the claimant constituted misconduct connected with his employment. In Pabst, supra, the court concluded that the question of whether a trust was administered in Wisconsin was a question of law. In Globe-Union, Inc. v. Dept. of Taxation, 20 Wis. 2d 213, 219, 121 N.W.2d 894 (1963), the court treated as a question of law, whether various sales had been made in Wisconsin for purposes of corporate income tax apportionment. [7] This court accepts the view of the circuit court in this case that the question of whether Humble constituted a unitary operation is a question of law. The manner in which Humble conducted its business requires a series of factual determinations; the legal significance of those business arrangements is a judicial question subject to review by this court. Further, in its findings, the Tax Appeals Commission only stated that there was no economic dependence between the Wisconsin marketing operations and the refining and exploration and production functions of Humble. The full test requires a determination of whether the operation of the portion of the business is dependent upon or contributory to the operation of the business outside the state. Interstate Finance Corp., supra, 28 Wis.2d at 269. (Emphasis added.) For the years in question, Humble's corporate organization consisted of three parts: corporate management, coordination and services management, and operations management. Corporation management was the highest level of management in the company. In this review, the court is concerned only with operations management which was responsible for directing the operating activities of the individual functional segments of the company. Each functional segment was organized into a separate department which operated independently of the other operating segments. The individual functional segments under Operations Management consisted of Exploration and Production, Refining, Marketing, Marine, Coal and Shale Oil, Minerals, Land Management. Exploration and Production was further broken down into exploration, production, and natural gas. The three major departments were Exploration and Production, Refining, and Marketing. Each operating department had its own separate management responsible for the proper conduct of the operation. Each had a separate profit center which provided a means for recording transactions involving expense and revenue so that a profit for each function could be determined. Each department was considered a separate investment center by the company. It was the management philosophy of Humble to have each department independently responsible for its performance in order to measure the performance of each department. Under this system, each department is in competition with the other departments for available funds for investment. Each functional department was also in competition with other members of the industry operating the same function. There was no requirement that crude oil produced by the Production department flow through the marketing outlets in the form of Humble refined products. The company had extensive dealings with third parties for the acquisition of raw materials and products sold. It was company policy that the transfer of products and raw materials between departments be based on competitive wholesale market prices. Thus, crude oil produced and transferred to the refining department was accounted for at posted industry prices. As a result the refining department paid the same price for Humble-produced crude as it would pay for crude oil from any other supplier. Products transferred from the refining department to the marketing department were also based on wholesale market prices or some alternate value. Where there was no readily available wholesale market value for a product, Oral Luper, an Exxon senior vice president testified that the representatives of our Marketing Department and our Refinery Department with both of their knowledge of the market, knowledge of the products, negotiate with each other on an arm's length basis in an adversary position to try to negotiate the appropriate transfer value to the best of their ability, market orientated. Significantly, Luper also testified as to the reasons for organizing the separate operating departments under one corporate entity. ... [I]n any industry which is highly capital intensive, such as the petroleum industry, the fixed operating costs are highly relative to total operating costs, and for this reason the profitability of such an industry is very sensitive and directly related to the full utilization of the capacity of the facilities. So, in the case of the petroleum industry ... where you have high capital investments in refineries, the existence of an assured supply of raw materials and crude is important and the assured and stable outlet for products is important, and therefore when there are  when these segments are under a single corporate entity, it provides for some assurance that the risk of disruptions in refining operations are minimized due to supply and demand imbalances that may occur from time to time. Luper also stated that putting the individual operating segments under one corporate entity provided greater profit stability for the company, spread risks, and enabled corporate staff to provide services on a corporate-wide basis more efficiently and effectively. The existence of a stable and assured market outlet is directly related to the refining investment. Luper testified that as an officer of the company, he is concerned directly with the overall profits of the entire company. The profits of each of the individual functional segments go into a determination of the overall corporate profits. Humble has a uniform credit card system used nationwide which is a valuable marketing tool. It is administered centrally in Houston, Texas, with accounting and collection carried out at two or three credit card centers. Humble promotes its products by uniform packaging and brand names. The overall plan for distribution of products is developed in Houston. Promotional display equipment is designed by the engineering staff at headquarters marketing. Key employees of the company are transferred from one department to another frequently. The factors determining whether Humble produced crude oil will be sold to third parties or transferred to the Humble refinery include the distance from the point of production to the refinery and the quality of the crude. Once Humble-produced crude enters the pipeline system, it moves to the most desirable market, and in some cases, that is to a Humble refinery. There is no way of identifying the origin of the crude oil after it has entered the pipeline. It is undisputed that Humble carried on no production or refining functions in Wisconsin. The only activities in the state related to marketing of the product. The gasoline and fuel oil sold in Wisconsin by Humble did not originate in Humble's oil wells. They came into the state as a result of an exchange agreement Humble had with Pure Oil Company at Lemont, Illinois. The products exchange portion of the agreement was set up at a time when Humble was expanding in the Midwest market. Pure Oil had more refining capacity than marketing requirements in the Midwest and wanted to find a way to get products to the East coast. The major purpose of any exchange agreement of this type is to reduce the cost of transporting the product from the source of production to the point where it is sold. The exchange contracted was negotiated by Humble's Supply and Refining Departments. The gasoline received by Humble in the exchange is either refined according to Humble's specifications or meets certain basic criteria before it is accepted by Humble for exchange. For Humble-refined gasoline, additives developed by Humble are mixed into the gasoline at the refinery. For gasoline acquired through exchange, the Humble additives are injected into the gasoline at the point of exchange. Seasonal variations in weather must be taken into account so that a different gasoline is manufactured for winter than is manufactured for summer. Quality control starts at the time of refining and continues through transportation to insure that the quality of gasoline delivered at the service station is the same as that produced at the refinery. Motor oils, greases, and other packaged products were produced and manufactured by Humble outside of Wisconsin and shipped into the state for sale from Humble's central warehouse facilities in Chicago, Illinois, and other out-of-state locations. Tires, batteries and accessories were centrally purchased by Humble's purchasing office in Houston, Texas and shipped from out-of-state locations into Wisconsin for sale. What emerges from this pattern of organization is that Humble's production and refining functions depended upon the marketing operation to provide an outlet for its products. Wisconsin was a part of Humble's marketing system. In a high capital investment industry such as the petroleum industry, the existence of a stable and assured marketing system is important for the full utilization of refining capacity. This was the testimony of a top Exxon executive who admitted that the profits of the overall corporation depend on the profits of each of the individual functional segments. [8] The United States Supreme Court has held that the enterprise of a corporation which manufactures and sells its manufactured product is ordinarily a unitary business, and all the factors in that enterprise are essential to the realization of profits. Butler Brothers v. McColgan, 315 U.S. 501, 508 (1942); Hans Rees' Sons v. North Carolina, 283 U.S. 123, 133 (1931). The Oregon Tax Court, in a case dealing with the identical taxpayer, faced a factual pattern virtually indistinguishable from the one before this court. Humble's operations in Oregon were almost exclusively concerned with marketing. It had no manufacturing or refining facilities in Oregon, nor any sale of crude oil or natural gas. Although it was engaged in exploration for crude oil in Oregon during the years in question, there was no production. All of the refined petroleum products and related automotive accessories sold in Humble's service stations in Oregon were acquired by purchase from third party suppliers, except for oils and greases which were supplied centrally by Humble from its plants and refineries throughout the United States. These centrally supplied items amounted to about five percent in value of the total products marketed in Oregon. Humble's books, maintained on a separate accounting basis, showed a net operating loss for the Oregon operations. The Oregon Tax Court determined that Humble was a unitary business and that the apportionment method of accounting was proper because it most fairly and accurately reflected the net income of the taxpayer attributable to Oregon. The court also made the following comments: Humble Oil & Refining Company is a large vertically integrated corporation engaged nationwide in all phases of the petroleum industry, from discovery through production and manufacture to marketing. It has unity of ownership, operations, management, control and products; and strong centralized credit, purchasing, advertising, accounting and legal services. All segments of plaintiff's business have a great deal in common and contribute to and are dependent upon each other. The plaintiff is actually a single interrelated unitary business operation. The component parts, including those in Oregon, are too closely connected and necessary to each other to be considered as independent units. Producing in one state and selling in another depends upon a multitude of interdependent operations, and although the petroleum Humble sold in Oregon was not its own production but that of a third party, the sales nevertheless were made possible by the company's own production. If plaintiff wasn't producing it wouldn't be selling, and what plaintiff did in Oregon was not due solely to conditions here, but was dependent upon the market elsewhere and upon plaintiff's production and manufacturing elsewhere. The marketing in Oregon was an integrated part of plaintiff's nationwide business and undoubtedly was beneficial to the corporation as a whole. It was not a completely separate, independent or local endeavor. Plaintiff's production and refining conform to the demands of the nationwide market, and the court believes plaintiff expanded into Oregon to increase demand for its products so that it could increase production and refining and thus increase profits and its stature in the industry. There certainly was more to plaintiff's decision to operate service stations in Oregon than the mere hope the stations might show a profit. The purpose of marketing here was to increase over-all marketing strength for the benefit of all phases of plaintiff's business. Costs incurred here led to profits elsewhere, and the primary measure of success of Oregon activities was not the profit or loss shown on the income statements of the local service stations, but rather it was the contribution the stations made to plaintiff's over-all operations and growth that really counted. The plaintiff bought its Oregon inventory of gasoline from third parties because it was more economical to do so, and whether an outlet sold Humble production or that of another company was a central management decision based on over-all economic considerations. Each activity of the company was carried on in whatever locality was most economically feasible. Plaintiff was so organized and vertically integrated that its separate parts, geographical and structural, could not be fairly considered by themselves. Humble Oil & Refining Company v. Dept. of Revenue, 4 OTR 284, 292-93 (1971). That Humble reported losses for its Wisconsin operations for the disputed years is immaterial. The same question was addressed in Butler Brothers v. McColgan, supra . In that case, Butler Brothers was a wholesale merchandising company whose home office was in Illinois, and which had branches in seven different states. It attempted to show that its California branch operated at a $70,000 loss as reflected in a separate accounting return, and that an income tax calculated on an apportionment basis was unconstitutional because it taxed extraterritorial values. The Supreme Court commented: It is true that appellant's separate accounting system for its San Francisco branch attributed no net income to California. But we need not impeach the integrity of that accounting system to say that it does not prove appellant's assertion that extraterritorial values are being taxed. Accounting practices for income statements may vary considerably according to the problem at hand. Sanders, Hatfield & Moore, A Statement of Accounting Principles (1938), p. 26. A particular accounting system, though useful or necessary as a business aid, may not fit the different requirements when a State seeks to tax values created by business within its borders. Cf. Hamilton, Cost as a Standard for Price, 4 Law & Contemporary Problems 321. That may be due to the fact, as stated by Mr. Justice Brandeis in Underwood Typewriter Co. v. Chamberlain, 254 U.S. 113, 121, that a State in attempting to place upon a business extending into several States `its fair share of the burden of taxation' is `faced with the impossibility of allocating specifically the profits earned by the processes conducted within its borders.' Furthermore, the particular system used may not reveal the facts basic to the State's determination. Bass, Ratcliff & Gretton, Ltd. v. Tax Commission, supra, p. 283. In either aspect of the matter, the results of the accounting system employed by appellant do not impeach the validity or propriety of the formula which California has applied here. 315 U.S. at 507-508. [9] We hold that the taxpayer's Wisconsin operations were an integral part of a unitary business within the meaning of sec. 71.07 (2), Stats. (1967). Thus, its income was subject to apportionment under the statutory formula. The constitutionality of this apportionment will be discussed below together with our consideration of the situs income exclusion.