Handlery v. Franchise Tax Board

• Citation: 26 Cal.App.3d 970,103 Cal.Rptr. 465
• Court: California Court of Appeals
• Decision Date: 31 July 1972
• Parties: Paul R. HANDLERY et al., Plaintiffs and Appellants, v. FRANCHISE TAX BOARD, Defendant and Respondent. Civ. 30084.

Page 465

103 Cal.Rptr. 465

26 Cal.App.3d 970

Paul R. HANDLERY et al., Plaintiffs and Appellants, v. FRANCHISE TAX BOARD, Defendant and Respondent.

Civ. 30084.

Court of Appeal, First District, Division 1, California.

July 31, 1972.

As Modified on Denial of Rehearing Aug. 29, 1972.

Hearing Denied Oct. 5, 1972.

Athearn, Chandler & Hoffman, Theodore P. Lambros, Donald H. Maffly, San Francisco, for appellants.

Evelle J. Younger, Atty. Gen. of State of California, Ernest P. Goodman, Asst. Atty. Gen., John J. Klee, Jr., Deputy Atty. Gen., San Francisco, for respondent.

ELKINGTON, Associate Justice.

The plaintiffs appeal from a judgment denying a refund of taxes paid on their income to defendant State of California Franchise Tax Board for the years 1962, 1963 and 1964.

It is a basic principle of income taxation law that an individual or corporation shall pay a tax measured by his or its own income. (See Hoeper v. Tax Commission, 284 U.S. 206, 52 S.Ct. 120, 76 L.Ed. 248.) California's Supreme Court has said: 'It is a fundamental premise of tax law that each taxpayer is accountable and taxable only upon its own income . . ..' (Great Western Financial Corp. v. Franchise Tax Bd., 4 Cal.3d 1, 5, 92 Cal.Rptr. 489, 490, 479 P.2d 993, 994.) California's tax statutes provide that every corporation doing business within the state shall pay 'a tax according to or measured by its net income'. (Rev. & Tax.Code, § 23151.) Where such a corporate enterprise is conducted wholly within the state its net income ordinarily is readily found upon its books.

But when the business is conducted in several states, often the true income derived from within a given state is difficult or even impossible of measurement. A perhaps oversimplified illustration: A corporate enterprise manufactures goods in one state which it sells at substantial profit to its subsidiary corporation in another. The second corporation because of its high wholesale costs retails the goods at a loss, thus earning no taxable income. Yet the combined enterprise operated at a profit, an undetermined amount of which is obviously attributable to the subsidiary's operations. Considerations such as this have given rise to the 'unitary business,' 'separate business,' and 'formula' concepts of state income tax law.

If the operation of a business within the state is dependent upon or contributes to the operation of the business without the state, the operation is a 'unitary business.' If there is no such dependency or contribution the intrastate operation is generally considered as one or more 'separate businesses.' (See Edison California Stores v. McColgan, 30 Cal.2d 472, 481, 183 P.2d 16.)

When one or more operations within a state are treated as 'separate businesses' by the state taxing authority, generally each is required to pay a tax on its own income derived from sources within the state, without regard to the profit or losses of any related operation. In the case of a 'unitary business' the enterprise files a combined report, and the income from its operations within the state is determined by a formula. Under this formula in California, and generally elsewhere, the intrastate income is considered to be the same proportion of the total (intrastate and interstate) income, as the intrastate payroll, property and sales bears to the total payroll, property and sales.

It was said in John Deere Plow Co. v. Franchise Tax Bd., 38 Cal.2d 214, 222, 238 P.2d 569, 573, that the formula of payroll, property, and sales 'has been recognized as embracing factors sufficiently diversified to reflect 'the relative contribution of the activities in the various states to the production of the total unitary income' so as to allocate to California, its just proportion of the profits earned from a unitary business.' The court also stated (p. 223, 238 P.2d p. 574): '(T)he unitary income is derived from the functioning of the business as a whole, to which the activities in the various states contribute; and that by reason of such interrelated activities in the integrated overall enterprise, the business done within the state is not truly separate and distinct from the business done without the state so as reasonably to permit of a segregation of income under the separate accounting method rather than use of the formula method in assigning to the taxing state its fair share of taxable values. . . .'

Care must be taken that no more than the unitary business income fairly allocable to a state be taxed by that state. Any greater tax runs afoul of the due process and interstate commerce clauses of the United States Constitution. (See Butler Bros. v. McColgan, 315 U.S. 501, 506--510, 62 S.Ct. 701, 86 L.Ed. 991; Hans Rees' Sons v. State of North Carolina, 283 U.S. 123, 129--135, 51 S.Ct. 385, 75 L.Ed. 879.) California's unitary business and formula practice has been found reasonable and in constitutional compliance. (Butler Bros. v. McColgan, supra, 315 U.S. at pp. 506--510, 62 S.Ct. 701, 86 L.Ed. 991; Butler Bros. v. McColgan, 17 Cal.2d 664, 111 P.2d 334.)

It may accordingly be said that the 'formula' apportionment of unitary business income has not only been found to be constitutionally permissible, but that it is often the only reasonable and practical manner in which a state may levy and collect taxes to which it is constitutionally entitled. It might be described as a sort of rule of necessity, having its origin in the accommodation of a state's constitutional right to tax income derived from within the state, to constitutional due process of law and interstate commerce provisions.

The action below was tried on stipulated facts.

Harry Handlery, now deceased (but whom for convenience we shall describe as a plaintiff) and his wife, plaintiff Rose Handlery, were residents of California. They directly owned or controlled over half of the voting stock of plaintiffs Handlery Hotels, Inc., Casa Hamilton Corporation, Georgian-Merritt Corporation, Hotel Monarch, Inc. and El Cortez Sky Room. Plaintiff Handlery Hotels, Inc. directly owned or controlled over half of the voting stock of plaintiffs Bret Harte Inn, Inc. and Camino Del Rio Properties, Inc. Plaintiff Camino Del Rio Properties, Inc., directly owned or controlled over half of the voting stock of plaintiff Stardust County Club.

The individual and corporate plaintiffs conducted all of their activities, and derived all of their income from sources, within California. All corporate plaintiffs were California corporations. In all cases the corporate entities were observed. Separate books and records were maintained for the individual and corporate plaintiffs according to accepted accounting principles. There was no basis for treating the incorporation of any of the plaintiffs as a sham.

Each of the business of the several plaintiffs was dependent upon and contributed to the operations of the other businesses. The ownership, control and operation of the businesses were such that if one or more of the corporate plaintiffs had conducted similar activities outside of California, then the Franchise Tax Board would have considered and treated their California operations, or at least the California corporate operations, as a unitary business.

The plaintiffs separately reported on their income tax liability to the Franchise Tax Board for the years 1962, 1963 and 1964. Some of the returns showed profit, and taxable income. Others showed losses. These losses were not offset against the profits of the more successful plaintiffs. Had such losses been so offset the overall taxes owed and paid by plaintiffs would have been $30,252 less.

Contending that they were entitled to have been treated as a unitary business, plaintiffs filed claims for a refund of $30,252 with the Franchise Tax Board. The claims were denied and this action followed.

On their appeal plaintiffs contend that although their businesses and income sources were purely intrastate in nature, nevertheless since each of them was concededly dependent upon and contributed to the operations of the others, they were Required to report and pay taxes on their income as a unitary business. They describe themselves as an 'intrastate unitary business.' (Emphasis added.)

It seems desirable at this point to emphasize the meaning and coverage of the term under consideration. Insofar as we can determine, 'unitary business' has always been used to denote the activity of one or more corporations or businesses as a 'unit,' In two or more states or jurisdictions. It is a technical expression peculiar to the area of state taxation. Research discloses no application of the term to one or more businesses operating in any manner solely within a single state. (See generally, Words and Phrases (perm. ed.), vol. 43.) Nor, apart from plaintiffs' briefs have we found anywhere, mention of an 'intrastate' unitary business.

Defining the principle under discussion the court in Edison California Stores v. McColgan, supra, 30 Cal.2d 472, 481, 183 P.2d 16, 21, stated: 'If the operation of the portion of the business done within the state is dependent upon or contributes to the operation of the business without the state, the operations are Unitary; otherwise, if there is no such dependency, the business within the state may be considered to be Separate.' (Emphasis added.)

In an article entitled 'The Unitary Concept in the Allocation of Income' (Keesling and Warren, Hastings L.J., vol. 12 (1960), pp. 42, 46--47), the authors state: 'For example, a company is engaged in the operation of a number of different businesses each of which is conducted partly within and partly without a particular taxing state. In such a case, the term Separate may be employed to indicate that each business is a distinct business and not simply a portion of one or more of the others. ( ) As used, however, in contradistinction to Unitary, the designation of a business as separate means simply that it is conducted wholly within a...