Domestic holding companies with no foreign property, payroll, or operations can be excluded from a Colorado water’s-edge group, the state high court has affirmed in rulings that could cost the state hundreds of millions of dollars.
In May 28 decisions in Department of Revenue v. Agilent Technologies Inc. and Department of Revenue v. Oracle Corp., the Colorado Supreme Court also held that the DOR could not use its discretionary authority to reallocate income because the holding companies at issue were created for legitimate business purposes and no tax abuse was committed.
The decisions affirm November 2017 lower-court summary judgments for Agilent and Oracle and come less than two months after oral arguments, during which counsel for the DOR told justices that the cases would determine “whether combined reporting will remain mandatory or become optional for corporate taxpayers.”
The decisions also come one week after the legislature sent to Gov. Jared Polis (D) a measure that would clarify that only holding companies with 80 percent or more of their property and payroll based outside the United States are excluded from a combined return. The bill, S.B. 233, which at press time was pending on the governor’s desk, also addresses when a partnership’s activities are treated as the activity of a member of an affiliated group of corporations.
At press time, the Colorado DOR had not responded to a request for comment, nor had counsel for the companies. Irwin Slomka of Morrison & Foerster argued on behalf of Agilent, while Neil Pomerantz of Silverstein & Pomerantz LLP argued on behalf of Oracle.
Background
In both cases, Agilent and Oracle included in their corporate structures a domestic holding company that served as a U.S. shareholder for controlled foreign corporations. The domestic holding companies at issue received subpart F income from foreign subsidiaries, and then transferred all of that income as dividends to the U.S. parent doing business in Colorado.
The taxpayers argued that Colorado does not have a traditional unitary combined reporting regime. In 1985 the state enacted its “3-of-6” bright-line tests for determining which entities can be included in a combined return. Lawmakers knew that these tests would limit combined groups, the companies argued, but sought to provide taxpayers with a more objective and predictable combined reporting regime.
Agilent claimed $13.72 million in refunds on $1.7 billion in transfers of dividends and subpart F income from its domestic holding company that it argued was excludable. Oracle claimed $22.26 million in refunds on more than $6.4 billion of income from the sale of stock received by its domestic subsidiaries that it argued is excluded from its Colorado combined returns.
Separate divisions of the Colorado Court of Appeals agreed with the multinationals that because the domestic holding companies at issue had no property or payroll of their own, they did not meet the state’s statutory definition of a corporation includable in the combined return, because 20 percent or more of their property or payroll factors could not be assigned to locations in the United States.
At oral argument, Assistant Attorney General Noah C. Patterson said that an entity must have foreign property or payroll to even be considered for exclusion under the state’s water’s-edge statute. Patterson said that if the supreme court accepts the interpretation of the multinationals, then any company could choose where in its corporate chain it wants to cut off Colorado taxation — and not only could every holding company in the United States be excluded from the Colorado combined return, but so could every subsidiary of every holding company.
“Help me understand why that’s crazy,” Justice Richard L. Gabriel responded.
Gabriel went on to write both May 28 opinions. The court was not persuaded by any of the state’s arguments.
The Decisions
In the 20-page Agilent decision, the supreme court concluded that the holding company at issue does not meet the state’s definition of an “includable C corporation” under the statutory 3-of-6 test for combination or the definition of an affiliated group that must be included in a combined return.
Section 39-22-303(12)(a) defines “affiliate group,” and includes a reference to the definition of “includable C corporations” under section 39-22-303(12)(c): “any C corporation which has more than twenty percent of the C corporation’s property and payroll as determined by factoring pursuant to [the state’s apportionment formula provisions], assigned to locations inside the United States.”
The supreme court found that the Agilent holding company “has no property or payroll as determined by the requisite factoring inside the United States,” and thus cannot be included in Agilent’s combined return. The court here referred to the DOR’s longstanding regulation, which provides: “Since corporations that have no property or payroll factors of their own cannot have twenty percent or more of their factors assigned to locations in the United States, such corporations, by definition, cannot be included in a combined report.”
“In our view, this regulation is directly on point because it unambiguously provides that if a corporation has no property or payroll of its own, then it may not be included in a combined return,” Gabriel wrote in the opinion, later adding, “We are unpersuaded by the Department’s assertion that the aforementioned regulation is inapplicable because it was intended to apply solely to foreign sales corporations. The regulation does not express any such limitation, and when the language of a regulation is clear and unambiguous, we must apply it as written.”
The court also was not persuaded by the DOR’s assertion that the holding company has domestic property because it used the tangible property of its parent. Thus, the court found no error in the lower court’s determination that the holding company had no property factors.
Regarding the DOR’s discretionary authority, the court said the statutory section containing the state’s 3-of-6 test determines when combination is required — and thus, in this instance, supersedes the DOR’s authority under section 303(6) to reallocate income. Concluding otherwise would render the bright-line tests meaningless “because the Department could always override the result dictated by the objective tests set forth therein merely by making a subjective determination that such an override is necessary to avoid abuse and to clearly reflect income,” the court said.
Even if the DOR could invoke its discretionary authority under section 39-22-303(6), the court said no reallocation would be necessary to avoid abuse or clearly reflect income. The court also took issue with the DOR’s arguments that abuse is a broad concept that could extend to a taxpayer that adheres to the text of a statute while contradicting the statute’s intent. “In the Department’s view, then, a corporate structure may constitute abuse even if that structure serves a legitimate business purpose,” the court said.
In his 13-page opinion in Oracle, Gabriel said the court reached the same conclusions based on its reasoning in Agilent.
Consequences
Under the rulings against the state, Colorado would owe Agilent and Oracle a combined $36 million in refunds, but the total potential estimated revenue loss to the state is already in the hundreds of millions of dollars.
According to Larson Silbaugh, an economist with the state’s Legislative Council who addressed lawmakers in April, Colorado would owe $215 million more in about 20 tax protests involving taxpayers that have filed amended returns. Silbaugh did not have an estimate of the potential revenue impact going forward but told lawmakers that the state could lose between $80 million to $100 million annually if taxpayers altered their behavior — though S.B. 233 would prevent further revenue losses in future years, he said.
“This could be a very expensive mistake,” said Darien Shanske, a University of California, Davis, law professor who signed an amicus brief in support of the DOR. “It goes without saying that not every taxpayer will be able to use this holding to its advantage, either in the future or in the past, but many will, and so I think the projected significant revenue losses are realistic.”
Shanske said that he would have advised the legislature “to explain that its statute is meant to clarify the existing law. Also, I would recommend revising the language of the antiabuse provision as well, also clarifying that the changes are meant to clarify existing law.”
Shanske credited the lawyers for Oracle and Agilent as having done a fine job arguing their cases. The decisions, however, were “sparsely reasoned or poorly reasoned” in many places. “The court’s narrow interpretation of the applicable remedial provision is a striking example,” Shanske said.
University of Connecticut law professor Richard Pomp, who served as an expert witness on behalf of Agilent, said the court correctly read the law in these cases.
“Even the state’s expert witness in Agilent did not claim that the single-purpose entities were formed for a nontax reason,” Pomp said. “If they were, the state has antiavoidance rules to combat this.”
Pomp added that legislation is on the governor’s desk that would deal with holding companies in a combined report. “The ultimate answer, of course, is mandatory worldwide combined reporting,” Pomp said.
University of Richmond assistant law professor Hayes Holderness, who also signed an amicus brief in support of the state, said the decisions “lay bare an unfortunate loophole in the Colorado combined reporting regime that will hopefully be quickly closed" by S.B. 233.
“Despite the court’s insistence that the plain meaning of the includable corporation’s definition mandated the results, the court seemed most convinced by the department’s regulations interpreting the Colorado tax law,” Holderness said.
Holding companies that have no apportionment factors present difficult challenges, Holderness said, "because the math can’t get a clear result; dividing by zero has no meaning. So the statutory language leads to some ambiguity here, and it would have been nice to see the court acknowledge that ambiguity rather than cut off the analysis by referring to the regulations," which he said might or might not be the correct approach.
"Given the context of water’s-edge combined reporting as a political compromise between the states and the federal government which was meant to head off concerns about the taxation of foreign entities, Colorado’s statute could have fairly been read to include domestic holding companies," Holderness said. "In the end, the department’s own regulations put it in a hole too deep to climb out of."
The DOR has provided notice that taxpayers should not rely on Rev. Reg. 39-22-303(12)(c) while the cases are pending, and that it will await a final ruling from the courts before considering further action on the regulation.