Opinion ID: 3156371
Heading Depth: 3
Heading Rank: 3

Heading: Functional Integration

Text: ¶ 30. Another important factor identified by the Department’s regulations and the Supreme Court is the degree of functional integration. Functional integration refers to the extent to which a subsidiary is integrated into the parent’s business outside the state. Under the U.S. Supreme Court’s jurisprudence, functional integration occurs where business segments pool resources or have integrated processes that affect the operations of the segments. See F.W. Woolworth Co., 458 U.S. at 364-65. Functional integration can include centralization of processes and controlled interaction. Exxon Corp. v. Wis. Dep’t of Revenue, 447 U.S. 207, 224 (1980); see Malpass, 833 N.W.2d at 282 (describing functional integration as “the extent to which business functions are blended to promote a unitary relationship”). Several of the factors in the Unitary Combined Reporting regulations relate to functional integration. These include: operations in the same line of business; the extent the entities are different steps of a vertically structured business; the existence of non-arm’s-length pricing between entities; the existence of benefits from joint purchasing or common activities; the extent that joint activities benefit the income-producing activities of the unitary business; and the exercise of control by one entity over another. Unitary Combined Reporting § 6(c)(1), (2), (6)-(9). 14 ¶ 31. In Woolworth, the Supreme Court addressed the issue of functional integration. In that case, New Mexico sought to tax a portion of dividends that parent Woolworth received from its subsidiaries. Woolworth was engaged in a retail business through chains of department stores selling a wide range of goods. The subsidiaries were engaged in retail business of purchasing wholesale goods and selling directly to customers. The Court determined that there was little functional integration between Woolworth and its subsidiaries. The Court relied on the facts that “no phase of any subsidiary’s business was integrated with the parent’s”; the subsidiaries independently sited stores, advertised and did accounting; and there was no centralized manufacturing or warehousing. 458 U.S. at 365. Further, there was no centralized training, and the subsidiaries obtained their own financing. Id. at 364-66. ¶ 32. Here, the facts demonstrate a similar lack of integration. AIG and MMC operate in different lines of business. They are not part of a vertically integrated business. The entities do not engage in joint purchasing or other common activities. MMC does its own advertising and does not share offices or services with AIG. AIG held ten conferences and events at MMC in 2006, but AIG paid market prices for these events. In addition, AIG employees received discounted resort services at MMC. Other than provision of those services there was no exchange of goods or services between MMC and other AIG unitary group members. ¶ 33. The main integration found by the Commissioner was that MMC received substantial financial assistance from AIG. MMC had no operating revenue in excess of its operating expenses and therefore no ability to fund capital improvements or borrowing through its routine operations. AIG was MMC’s only lender, and all of MMC capital and borrowing decisions required approval by AIG senior management. In 2006, AIG provided lines of credit to MMC equal to about $32 million, which exceeded 150% of MMC’s gross operating revenue for the year of about $20 million. During 2006, the rates varied from 4.296% to 5.289%, and were 15 based on the LIBOR rate4 plus three basis points. The Commissioner described these loans as made at “remarkably favorable interest rate” when compared to the prime rate at the time. ¶ 34. Certainly, AIG’s influx of funds was important to MMC; the question is whether this funding is sufficient to indicate that the two entities had unitary operations. In Container Corp., the U.S. Supreme Court explained the distinction between capital transactions that serve an investment purpose and those that are related to an operational function. 463 U.S. at 180 n.19. In that case, the parent held or guaranteed half of the subsidiaries’ long-term debt, and the Court concluded that because the investments were part of an effort to grow the overseas operations, they related to operations. Id. In addition, the financing was accompanied by other indicators of unitary operations. The parent and the subsidiaries were engaged in the same kind of business, and the Court emphasized that the parent “provided advice and consultation regarding manufacturing techniques, engineering, design, architecture, insurance, and cost accounting” and “assisted its subsidiaries in their procurement of equipment.” Id. at 173. Thus, the financing was coupled with an integration of functions and operations. ¶ 35. We conclude that the financing provided by AIG to MMC served an investment rather than operational function. The financing was not part of an AIG operational goal to grow part of its business. Further, there is no operational integration between AIG’s insurance and financial businesses and the ski resort operated by MMC. Because the companies engage in different lines of business there was no common purchasing of goods, advertising, or use of facilities. See BIS LP, Inc. v. Dir., Div. of Taxation, 26 N.J. Tax 489, 500 (N.J. Tax Ct. 2011) (concluding there was no functional integration or economies of scale because entities engaged in different businesses); Maytag Corp. v. Dep’t of Revenue, 12 Or. Tax 502, 508-09 (T.C. 1993) (explaining that because companies made different products there was no functional integration because there was “no common manufacturing facilities, engineering functions or research and 4 The Commissioner’s decision explains that LIBOR is the London Inter-Bank Offered Rate. 16 development activities”). Where intercompany financing is not also accompanied by an overlap in operational function or a lending of expertise, courts have concluded that the operations are not unitary. See Tenneco West, Inc., 286 Cal. Rptr. at 365-66 (concluding that parent’s financing was nonunitary because it served investment function not operational function); Gen. Mills, 795 N.E.2d at 564-65 (concluding parent’s services to subsidiary served investment rather than operational function where lines of business not integrated); Nabisco Brands, Inc. v. Dep’t of Revenue, No. TC-MD 010109A, 2003 WL 21246425, at  (Or. T.C. Mag. Div. Apr. 3, 2003) (holding that investment into subsidiaries did not amount to functional integration sufficient to create unitary relationship where no other indicators were present). ¶ 36. Diverse lines of business can form a unitary business group where other indications of unitary operations and use are present. See Dental Ins. Consultants, Inc. v. Franchise Tax Bd., 1 Cal. Rptr. 2d 757, 760-61 (Ct. App. 1991) (holding that insurance consulting company and framing subsidiary were unitary business despite diverse business lines given sharing of operational functions and “[s]ubstantial intercompany loans”); Mole-Richardson Co. v. Franchise Tax Bd., 269 Cal. Rptr. 662, 667-68 (Ct. App. 1990) (concluding that two businesses with diverse business enterprises were unitary given strong centralized management, sharing of offices and services, and fact that property of one company was mortgaged to fund improvement of other company). But such is not the case here. ¶ 37. Further, the Commissioner’s description of this financing as “non-arm’s-length loans,” lacks support in the record. The loans were not interest-free; MMC paid interest on these loans, and that interest rate was variable, set at the LIBOR rate plus three basis points. Although the Commissioner characterized this as a favorable interest rate, this inference was based on the Commissioner’s comparison of the loan interest rate to the Commissioner’s own research of the U.S. prime rate at the time, and not on evidence in the record of what market interest rates were for other types of similar loans. Without this type of evidence there is no support for the 17 Commissioner’s findings that “an arm’s-length lender” would not have provided MMC with the kind of credit or interest rate provided by AIG. Therefore, we must view these loans as arm’s- length transactions.5 ¶ 38. The Commissioner also found that there was functional integration because AIG used MMC’s resort to build its brand and “build broker and other business relations to drive AIG business.” These findings would be significant if supported by the evidence since it would demonstrate the type of “substantial mutual interdependence” between the parent and the subsidiary that is indicative of unitary operations. F.W. Woolworth Co., 458 U.S. at 371. However, none of the evidence demonstrates that AIG used MMC as a tool for enhancing its brand or building its business. ¶ 39. As to the brand, the Commissioner described how AIG executives testified that after the federal bailout AIG needed to rebuild its brand and adopted several strategies in support of this goal. The Commissioner found that MMC was used as a part of this strategy to enhance AIG’s brand. The shortcoming of this reasoning, however, is that the relevant tax year is 2006 and the federal government bailout occurred in 2008. The evidence does not show that prior to 2008 AIG was working on rebranding or that MMC was a part of that. ¶ 40. Further, the evidence does not support the Commissioner’s finding that AIG used MMC to build its broker relations and fuel growth. The evidence indicated that AIG held conferences at MMC, and AIG employees received discounts at MMC. There was no evidence that this benefitted AIG. AIG paid market rates for the events held at MMC and there was no evidence that the events generated business for AIG or contributed to AIG’s operations. There was also no evidence that the employee discounts contributed to hiring or growing AIG’s brand. 5 AIG filed a motion seeking permission for leave to submit a surreply brief in response to arguments in the Department’s reply brief that AIG’s evidence did not clearly show that MMC paid any of the principal on the loans it had with AIG. The Department then filed a motion for permission to file a brief in response. The motions are denied. Issues may not be raised for the first time in a reply brief. Bigelow v. Dep’t of Taxes, 163 Vt. 33, 37-38, 652 A.2d 985, 988 (1994). Therefore, we do not reach this issue and we do not consider the additional briefing. 18 Although we defer to the Commissioner’s findings, where there is no evidence in the record to support this finding, we must reverse. Travia’s Inc., 2013 VT 62, ¶ 12 (stating that Commissioner’s factual findings will be affirmed “unless clearly erroneous”). Therefore, in assessing whether functional integration existed, we do not consider this fact. ¶ 41. In sum, MMC met its burden of demonstrating that its operations were not unitary with AIG. MMC operated in a different line of business than AIG. AIG had a role in appointing members to MMC’s board and oversaw some financing, but there was no direct operational control. There was no overlap of officers between the entities, and AIG did not exercise strong centralized management over MMC. Although AIG provided financing to MMC, this served more of an investment than an operational function insofar as AIG did not use its financing to achieve an operational goal and there is no evidence that the financing was at a below-market rate. MMC’s activities were not functionally integrated with AIG, and there were no economies of scale realized through the businesses’ separate operations. AIG realized no benefit from its involvement with MMC. Therefore, we conclude that MMC was not part of the AIG unitary group for tax reporting purposes.