IN THE SUPREME COURT OF THE STATE OF KANSAS
No. 86,277
In the Matter of the Appeal of PANHANDLE EASTERN
PIPE LINE CO. and NATIONAL HELIUM CORP., et al.,
from a Denial of Refund of KANSAS CORPORATE INCOME TAX.
SYLLABUS BY THE COURT
1 In an appeal from an order of the Board of Tax Appeals (BOTA), K.S.A. 77-621 controls an appellate court's scope of review.
2. BOTA is considered the paramount, lawfully constituted taxing authority in Kansas. Kansas statutory and case law mandate that, on appeal, the Kansas Department of Revenue (Department) bears the burden of showing BOTA's decision was invalid.
3. In K.S.A. 74-2437, the legislature granted BOTA the authority to hear appeals from the Director of Taxation and the Director of Property Valuation.
4. The hearing before BOTA shall be a de novo hearing unless the parties agree to submit the case on the record made before the Department. The definition of a de novo hearing is a decision of the matter anew, giving no deference to findings and conclusions previously made.
5. Under K.S.A. 79-32,141, which controls combined reporting, the Director of Taxation may allocate gross income, deductions, credits, or allowances between two or more organizations, trades or businesses (whether or not incorporated, or organized in the United States or affiliated) owned or controlled directly or indirectly by the same interests, if the director determines such allocation is necessary to prevent evasion of taxes or to clearly reflect income of the organizations, trades or businesses.
6. The determination of whether the activities of the taxpayer constitute a single trade or business or more than one trade or business will turn on the facts in each case. In general, the activities of the taxpayer will be considered a single business if there is evidence to indicate that the segments under consideration are integrated with, dependent upon, or contribute to each other and the operations of the taxpayer as a whole.
7. The authority of the Department is subject to review in that the legislature has conferred upon BOTA the authority to hear appeals of decisions of the Secretary of Revenue or the Secretary's designee. BOTA is the paramount, lawfully constituted taxing authority in Kansas and, as such, functions independently of the Secretary of Revenue in matters of administrative judgment and decision.
8. BOTA bears an independent responsibility to review a decision of the Department; this responsibility is foreign to the concept of deference. BOTA need not defer to the Department's interpretation of a statute.
9. In tax law the concept of a unitary business arises when a corporation has one or more subsidiaries or divisions which are dependent upon, or contribute to, the parent corporation or other subsidiaries or divisions so, in essence, to constitute a homogenous enterprise. When such an entity exists it may be described as a unitary business, and in determining the tax liability of the given subsidiary or division, the taxing authority may consider the entire income of the unitary business and apportion taxes on the basis of the income attributable within its jurisdiction.
10. A unitary business is characterized by functional integration, centralization of management, and economies of scale.
11. For purposes of Kansas state income tax, interrelated multijurisdictional corporations may be taxed on a unitary basis if the parent and the subsidiary share such an interdependent relationship so as to form one integral business rather than several business entities.
12. Whether a multistate business is separate or unitary depends upon the manner in which its business is conducted. The essential test to be applied is whether 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. Stated another way, the test is whether a business' various parts are interdependent and of mutual benefit so as to form one business rather than several business entities and not whether the operating experience of the parts is the same in all places. Various portions of a business may be carried on exclusively in different states without destroying its unitary character if the integral parts are of mutual benefit to one another.
13. Kansas has adopted the dependency/contribution test as the appropriate test to be applied in determining whether two or more business entities are unitary for taxation purposes.
14. Under K.S.A. 79-32,141, the term "controlled" includes any kind of control, direct or indirect, whether legally enforceable, and however exercisable or exercised. It is the reality of the control which is decisive, not its form or the mode of its exercise.
15. Under K.S.A. 79-32,141, a strict requirement of more than 50 percent ownership is not necessary to demonstrate control in a unitary business relationship.
Appeal from the Board of Tax Appeals. Opinion filed January 25, 2002. Affirmed.
John Michael Hale, of Kansas Department of Revenue, Legal Services Bureau, argued the cause and was on the briefs for appellant.
Paul H. Frankel, of Morrison & Forester LLP, of New York, New York, and Jack Glaves, of Glaves, Irby and Rhoads, of Wichita, argued the cause, and Donald J. Horttor, of Cosgrove, Webb & Oman, of Topeka, and Dennis Ng, of Dennis Ng & Associates, of Houston, Texas, were with them on the brief for appellees.
The opinion of the court was delivered by
ABBOTT, J.: The Kansas Department of Revenue (Department) appeals the Board of Tax Appeals' (BOTA) final order finding that Panhandle Eastern Pipe Line Co. (Panhandle) and National Helium Corp. (Helium) were a unitary business under K.S.A. 79-32,141. At stake in this appeal is a corporate tax refund, including interest, of approximately $26 million. The Department appealed pursuant to K.S.A. 2000 Supp. 74-2426 and K.S.A. 77-621. The matter is before this court pursuant to a K.S.A. 20-3018(c) transfer.
The Department attempts to insert the red herring issue of whether its bright line test is rationally related to the controlling statute for unitary businesses, K.S.A. 79-32,141. The bright line test is that before the Department will consider whether two or more businesses are operating as a unitary business, one entity must show it owns more than 50% of the other entity. This rule is not reflected in the language of the Kansas statutes, case law, or even in the Department's published regulations. The issue is a red herring because (1) the bright line test is only a rule of thumb used by auditors, not a published regulation or policy; (2) the test may not have been in use during the time period in question; and (3) BOTA's standard of review of the Department's decision was de novo, not a mere rationality review. As the paramount tax agency in the state of Kansas, BOTA need not defer to the Department's findings or an unpublished bright line test (with no basis in the Kansas statutes or case law). While the Department argues that BOTA should have deferred to its bright line rule, BOTA did not address this issue or make any findings in regard to its validity.
On July 22, 1986, Panhandle and Helium requested permission from the Department to amend corporate tax returns and to file a combined report as a unitary business for tax years 1981-1984. On September 10, 1987, the Department denied Panhandle's request to file a combined return including Helium, rejected its amended returns, and denied Panhandle's refund claim. The Department's position was that 50 percent ownership of Helium by Panhandle was insufficient for a unitary business determination for the purpose of combined reporting. Thereafter, Helium requested a hearing on the matter.
A prehearing conference was conducted on February 21, 1994, before Alisa M. Dotson. Three days later, Dotson issued an order directing the Department to file a motion for summary judgment. On December 15, 1994, Dotson authored an order granting in part and denying in part the Department's motion for summary judgment. Dotson concluded that (1) the Department failed to establish that more than 50 percent ownership of a corporation's voting stock was required as a matter of law to make a unitary business determination; (2) that an issue of fact remained as to whether Helium was unitary with Panhandle; and (3) that Panhandle should be allowed to present arguments at an evidentiary hearing.
The Department moved to vacate Dotson's order, however. On October 3, 1995, the acting Secretary of Revenue, Karla J. Pierce, vacated the order to the extent that it purported "to define controlling Kansas law regarding the ownership requirement for combined reporting." Pierce noted that Dotson's order "failed to give due consideration to whether the department's standard of requiring more than 50 percent ownership was reasonable," and "concluded the order should be vacated in its entirety and that the matter should proceed to formal hearing on all issues of fact and law."
At an informal conference on February 11, 1998, Panhandle presented witness testimony. On September 4, 1998, Pierce issued her final determination finding that, as a matter of law, Panhandle and Helium could not be unitary "because Panhandle's ownership of Helium [was] not more than 50%." In short, Pierce ruled that without ownership of more than 50 percent of the stock of Helium, Panhandle could not establish, as a matter of law, the right to file a combined return; hence, there was no necessity to look into the facts.
Pursuant to K.S.A. 2000 Supp. 74-2438, Panhandle filed an appeal with BOTA on September 22, 1998. BOTA conducted a 3-day trial on September 15 through 17, 1999.
Kenneth Kalen, who had served in the capacity of vice president, president, and chief operating officer of Panhandle, and vice chairman of the board of Helium, testified at the BOTA hearing regarding the history and interrelationship of Panhandle and Helium.
Kalen stated that Panhandle began as a small intrastate gas system in eastern Kansas around 1930, but developed into one of the larger gas transmission companies, serving customers in Kansas, Missouri, Illinois, Indiana, Ohio, Michigan, and Canada. Panhandle owned extensive gathering systems in western Kansas, Oklahoma, and Texas, which company officials refer to as the "West End" gathering systems. Kalen explained that these systems converge at Liberal, Kansas, where the mainline compressor station compresses the gas which is sent east through the pipeline to Panhandle customers. Following the passage of the Helium Act Amendments of 1960, see 50 U.S.C. § 167 et seq. (1994 ed.), Kalen said representatives from the federal government contacted Panhandle to encourage the company to build a facility to extract helium from gas taken from the Hugoton Gas Field. According to Kalen, Panhandle discussed the possibility of constructing a helium extraction facility with its "sister" corporation, National Distillers and Chemical Corporation (Distillers).
Stanley Wilbers, who worked as senior auditor and accountant for Panhandle and later became the vice president/treasurer and controller of Helium in 1976, testified that Helium was formed in 1960. Wilbers testified that "Helium agreed to supply helium to the United States government in the amount of $15,200,000 a year and, based on the initial contract price of eleven seventy-eight an Mc.f., the quantity amounted to 1.3 billion cubic feet of helium."
Kalen noted that Panhandle's chief executive officer and the chief executive officer of Distillers served on each other's board of directors. James Crozier, who served as a vice president and general manager for a division of Distillers called UFI, as well as on Helium's board of directors, testified at the hearing that Panhandle owned at least 9 percent of Distiller's outstanding shares and was its single largest stockholder from 1981 to 1984.
Kalen stated that top level managers of Panhandle and Distillers agreed to build the helium plant as a joint project and worked together during the development and construction of the facility. Each company invested equity investments of $2.6 million (520 shares each) in Helium, and the balance of the $25 million cost was financed with five different banks by Panhandle's financial personnel. The helium extraction facility was constructed on land purchased by Helium from Panhandle, adjacent to Panhandle's compressor station. During construction, Panhandle provided on-site project engineers at its own expense.
Although Helium had legal title to the facilities and retained control over hiring and firing employees, Panhandle owned 50 percent of its stock and Distillers owned 50 percent. Panhandle and Distillers agreed to restrict the sale of stock, and there was a letter agreement to a first right of refusal between the parties.
According to Kalen, because Panhandle's entire gas stream coming into the Liberal compressor station would be processed by Helium, Panhandle had a vested interest in protecting the integrity of its pipeline system. During contract negotiations between Panhandle, Distillers, and Helium, Panhandle inserted clauses in the contract giving it the right to approve the design of piping in and out of the helium plant and to review maintenance procedures. Panhandle retained the right to "inspect the plant from time to time for the purpose of satisfying itself as to the adequacy of operation and maintenance."
Initially, 5 of the 10 officers of Helium were chosen from Panhandle's staff, and the vice president of transmission with Panhandle, F.J. McElhatton, was named president of Helium. The chairman of Panhandle, William Maguire, became chairman of Helium, and Panhandle's general counsel also served as general counsel for Helium. During the 1981 to 1984 period, Helium had 10 officers; 5 from Panhandle, 3 from Helium, and 2 from Distillers.
Panhandle employees were given an opportunity to go to work for Helium at its inception. Helium employees enjoyed the same benefit package as Panhandle employees and Helium employees belonged to Panhandle's employees' credit union. When a job came up for bid at either Panhandle or Helium, the employees of both companies were given the opportunity to bid on it. No employees from Distillers transferred to Helium after its incorporation, however.
Wilbers and Kalen both testified that the president of Helium reported directly to Kalen, then president of Panhandle. Panhandle furnished Helium with daily forecasts of its gas volumes so Helium could adjust its operations to accommodate the expected volumes. Crozier's testimony confirmed that Panhandle exercised control over the day-to-day operations of Helium. By contrast, Wilbers and Kalen testified that Distillers was not active in the day-to-day operations of Helium, and only met annually with Helium to review budgets and declare dividends.
Kalen agreed that the operations of Panhandle and Helium were functionally integrated and centrally managed by Panhandle so it could maintain the integrity of its pipeline system. Moreover, he acceded that the Panhandle-Helium operating relationship could be characterized as different steps in a large vertically structured enterprise.
For example, Panhandle was the sole supplier of natural gas to Helium. The consumption requirements of Panhandle's customers dictated what gas would be available for processing at Helium. In addition, Panhandle was Helium's sole source of legal, tax planning, and preparation services and helped with Helium's employee stock option plan. Helium did pay Panhandle a service fee of a quarter of a million dollars a year for those services. As Helium processed the gas, certain ancillary products such as butane and propane were produced and captured. Century Refining Company, a wholly owned subsidiary of Panhandle, was primarily responsible for marketing the butane and propane for Helium.
According to Kalen, the operations of Helium were intertwined with Panhandle because it was "absolutely necessary that the helium plant compressors continued to function, as our own compressors function every day, ever hour; and it just was an integral part of the total operations." In addition, "the helium plant was in effect preparing the gas for quality control to meet [Panhandle's] mainline tariff specifications . . . [by removing] the water content and hydrocarbon content . . . ."
In addition, the emergency shutdown systems of the two companies were tested at the same time because each operation was dependent on the other. Panhandle performed engineering studies for Helium and provided welders and other workers when needed. Laboratory services were provided to Helium by Century Refining. Helium management had full use of Panhandle's airplanes and travel services department. The Panhandle employee newsletters included information concerning notices of employee transfers, retirements, deaths, service awards, and other announcements at Helium.
Wilbers noted that there was an ongoing exchange of Helium employees to Panhandle and its subsidiary, Anadarko. When Panhandle built its plant in Lake Charles, Louisiana, to process liquefied natural gas, an electrician, maintenance supervisor, and two operators were transferred there from Helium. According to Wilbers, all employee benefits, retirement privileges, and vacation time were also transferred.
Kalen stated that after about 10 years, the government prematurely canceled its contract for the purchase of helium. In 1997, Distillers ultimately divested itself of its Helium stock by selling it to Panhandle.
At the BOTA hearing, Panhandle presented testimony of expert witnesses J. Thomas Johnson, Walter Hellerstein, J.D., Richard D. Pomp, and Dr. Richard E. Olson.
Johnson, a partner in charge of state and local tax practice for the Chicago firm of KPMG, LLP, formerly served as Illinois Director of Revenue. Johnson testified that the purpose for the language in K.S.A. 79-32,141 "owned or controlled directly or indirectly by the same interests," is to
"really look at how did the ownership really exist, because if you didn't include 'indirect,' there would be all kinds of opportunity to avoid the ownership attribution. The reason why you have both 'direct and indirect' in most state laws is so that a taxpayer would not be able to manipulate the facts to avoid the consequences of the ownership and control that really exists economically . . . ."
Furthermore, Johnson stated:
"I don't think there is a threshold requirement of ownership in the statute. It says controlled or owned, as I understand, so, I mean, you could have a situation where there is no or a very small percentage, ownership and if you controlled the company through debt instrument or some other way you would still meet that test."
Johnson then testified that, in light of his experience as tax commissioner, "there's no question that the unitary relationship existed, not only for the audit period, but, in all likelihood, probably existed far before that audit period . . . ."
Hellerstein, a University of Georgia law professor and author of a well-recognized treatise on state taxation, testified "in my judgment, this is just a very easy case on the question of whether or not these two entities are unitary." Hellerstein said:
"[A]s a matter of substance, you have a single operational enterprise here from, I'm going to say, the wellhead to the gas pump. Here, you have the gas flowing, so you can actually watch the product flow back and forth and the essentialness of one company's operation to the other.
"Obviously, Helium couldn't extract liquids unless they got the gas, and they got the gas from Panhandle; and Panhandle couldn't have sold the gas unless they had the liquid removed; and that's what Helium did.
"So you couldn't ask for more operational interdependence. Dependency and contribution, flow of value, flow of goods, whatever your test is, it's met here."
In addition, Hellerstein stated that although the Secretary of Revenue was given the discretion to define "ownership or control" under K.S.A. 79-32,141, "clearly the Secretary does not have the discretion to issue a regulation inconsistent with the statutory mandate." Hellerstein's expert report concluded: "[T]he evidence is clear that 'the actual exercise of control' [of Helium] rested with Panhandle."
Pomp, a University of Connecticut Law School professor and visiting Harvard law professor in the area of federal, state, and local corporate income taxation, testified that, in essence, the Panhandle-Helium relationship was a vertically integrated operation. According to Pomp, "a vertically integrated manufacturing activity is the quintessential of a unitary business for which a combined report is needed."
Pomp noted that the wording of K.S.A. 79-32,141 parallels language found in 26 U.S.C. § 482 (1994 ed.) allowing the Internal Revenue Service (IRS) Commissioner "to distribute, apportion or allocate gross income, deductions, credits, or allowances between businesses . . . 'owned or controlled, directly or indirectly, by the same interests.'" (Emphasis added.) An IRS/Treasury regulation defines "controlled" for 26 U.S.C. § 482 to mean: "'any kind of control, direct or indirect, whether legally enforceable or not, and however exercisable or exercised, including control resulting from the actions of two or more taxpayers acting in concert or with a common goal or purpose. It is the reality of the control that is decisive, not its form or the mode of its exercise.'" See 26 C.F.R. § 1.482-1(i)(4), p. 538 (2001). Pomp further related to the hearing panel that federal case law interpreting 26 U.S.C. § 482 had relaxed the requirement of majority stock ownership. Quoting an unidentified commentator, Pomp read a footnote discussing 26 U.S.C. § 482 cases: "'While, in some early cases, the courts were reluctant to find control of a corporation absent actual ownership of a majority stock interest, this position has long since been overruled.'"
Olson, a professor and former Dean of Washburn University School of Business, noted that under securities law, more specifically the Williams Act, 15 U.S.C. § 78m(g) (2000 ed.), the threshold percentage of stock ownership that could demonstrate control of a corporate entity is 5 percent. Therefore, Olson agreed that the 9 percent interest Panhandle had in Distillers would be considered significant, requiring Panhandle to file reports with the Security and Exchange Commission.
Olson testified that in his opinion, in economic terms, the United States Supreme Court's and the Kansas Supreme Court's dependency/contribution test meant that companies were unitary "if they are essentially interwoven or intertwined, [and could not] operate very well independently, or could not operate well without each other." Olson stated the two companies were completely integrated functionally. He concluded that "Panhandle treated Helium as pretty much as a company of its own . . . and they did control the day-to-day operation."
At the hearing, other witnesses were questioned as to whether the Secretary of Revenue had disseminated an agency definition of "ownership or control" under K.S.A. 79-32,141 to mean more than 50 percent direct control during the 1981-1984 reporting period.
Alan Corey, who worked for the Department as a revenue audit manager from September 1979 to March 1992, testified on behalf of the Department. Corey confirmed that audit managers and members of the Legal Services Bureau at the Department had discussed the facts of this case. Corey said the discussion dealt with whether 50 percent ownership was sufficient, and he stated he did not believe there necessarily was a clear policy established for 50 percent ownership at that time.
Earl Agent, a corporate auditor for the Department since the fall of 1986 or 1987, testified on behalf of the Department that from the time he began his initial training, the policy for combined reporting was that there had to be "'more than 50 percent' ownership." He admitted on cross-examination, however, that he did not have anything in writing confirming that policy, and stated, "That has been my interpretations [sic] from the instructions that I have been given since I started with the department, doing corporate income taxes."
Carol Ireland also testified on behalf of the Department. Ireland said she had worked for the Department since June 1, 1978, and since 1987 had worked in the capacity of an audit manager. She did not recall any time approving combined reporting for entities who owned 50 percent or less of another entity, and that her understanding of this policy came from training out in the field. On cross-examination, Ireland confirmed that taxpayer's Exhibit 22 appeared to be the official policy of the Department at the time.
Karen Warner, C.P.A., testified on behalf of Panhandle that Department policies given to her in early 1986 during her training as a corporate income tax auditor contained a specific provision concerning ownership percentage for combined reporting. According to Warner, taxpayer's Exhibit 22 was used during Department training sessions in 1986. The first page of that exhibit is entitled "Corporate Training Outline." In that document, the Department policy on required percentage of ownership for combined reporting states: "Combined stock return includes only those corporations engaged in the unitary business and connected through at least 50% stock ownership." (Emphasis added.)
On October 9, 2000, BOTA filed an order finding that (1) Panhandle and Helium were engaged in the same general line of business; (2) were vertically integrated; (3) shared management; (4) that Panhandle had over 50% control of Helium through direct and indirect means; and (5) were unitary. Therefore, BOTA determined that Panhandle and Helium were entitled to file combined income tax reports. The Department filed a petition for reconsideration on October 23, 2000, which was denied by BOTA on November 7, 2000.
On December 6, 2000, the Department filed a timely notice of appeal with BOTA and the clerk of the appellate courts. The matter is before this court pursuant to a K.S.A. 20-3018(c) transfer.
I. STANDARD OF REVIEW
The Department appeals BOTA's final determination finding that Panhandle and Helium were a unitary business under K.S.A. 79-32,141. In an appeal from an order of BOTA, K.S.A. 77-621 controls this court's scope of review. See K.S.A. 2000 Supp. 74-2426(c) (stating that actions of BOTA are subject to review in accordance with the Act for Judicial Review and Civil Enforcement of Agency Actions, K.S.A. 77-601 et seq.).
Within the Act for Judicial Review and Civil Enforcement of Agency Actions, K.S.A. 77-621(a) provides that unless "this act or another statute provides otherwise: (1) The burden of proving the invalidity of agency action is on the party asserting invalidity." Additionally, K.S.A. 77-621(c) specifies that this court may grant relief from an order of BOTA only if we determine that:
"(1) The agency action, or the statute or rule and regulation on which the agency action is based, is unconstitutional on its face or as applied;
"(2) the agency has acted beyond the jurisdiction conferred by any provision of law;
"(3) the agency has not decided an issue requiring resolution;
"(4) the agency has erroneously interpreted or applied the law;
"(5) the agency has engaged in an unlawful procedure or has failed to follow prescribed procedure;
"(6) the persons taking the agency action were improperly constituted as a decision-making body or subject to disqualification;
"(7) the agency action is based on a determination of fact, made or implied by the agency, that is not supported by evidence that is substantial when viewed in light of the record as a whole, which includes the agency record for judicial review, supplemented by any additional evidence received by the court under this act; or
"(8) the agency action is otherwise unreasonable, arbitrary or capricious."
We note that under K.S.A. 77-621, this court's standard of review for an appeal from a BOTA decision is "somewhat broader than the traditional three-pronged scope of review as set forth in Kansas State Board of Healing Arts v. Foote, 200 Kan. 447, Syl. ¶ 1, 436 P.2d 828 (1968)." In re Tax Appeal of A.M. Castle & Co., 245 Kan. 739, 741, 783 P.2d 1296 (1989). In Foote, this court noted that in reviewing the decision of an agency, a district court could not, on appeal, substitute its conclusion for that of the administrative tribunal, but was confined to the traditional three-part determination of whether, as a matter of law, "(1) the tribunal acted fraudulently arbitrarily or capriciously, (2) the administrative order is substantially supported by evidence, and (3) the tribunal's action was within the scope of its authority." 200 Kan. 447, Syl. ¶ 1.
BOTA is considered the paramount, lawfully constituted taxing authority in Kansas. Wirt v. Esrey, 233 Kan. 300, 314, 662 P.2d 1238 (1983). Kansas statutory and case law mandate that, on appeal, the Department bears the burden of showing BOTA's decision was invalid. See K.S.A. 77-621(a)(1); see also In re Tax Appeal of Scholastic Book Clubs, Inc., 260 Kan. 528, 536, 920 P.2d 947 (1996) (stating that the party challenging an action taken by BOTA has the burden of proving it erroneous).
A. BOTA's standard of review
The Department first asserts that because the action of denying Panhandle's request for combined reporting was within its grant of statutory authority to administer and enforce K.S.A. 79-32,141, its final decision was presumptively valid and therefore, under the doctrine of operative construction, was entitled to judicial deference by BOTA. In addition, the Department maintains that under the statutory language of K.S.A. 79-32,141, only the Director of Taxation may determine whether to allow a taxpayer to file income tax returns on a combined basis; thus, without a finding that the Director's decision was arbitrary, capricious, or unreasonable, BOTA's decision is simply a wrongful substitution of its own interpretation of the statute for that of the Director.
In essence, the Department asks this court to find that, in conducting its evaluation of the Department's final determination, BOTA failed to employ the correct standard of review. The Department asserts that "the Board's inquiry was limited solely to whether the director's discretion was arbitrary, capricious or unlawful."
We first look to t