IN RE APPEAL OF THE KROGER CO.

• Decision Date: 03 November 2000
• Docket Number: No. 83,927.,83,927.
• Parties: In the Matter of The Appeal of The Kroger Co., from an Order of the Division of Taxation on Assessment of Corporate Income Tax.
• Court: Kansas Supreme Court

270 Kan. 148

12 P.3d 889

In the Matter of The Appeal of The Kroger Co., from an Order of the Division of Taxation on Assessment of Corporate Income Tax.

No. 83,927.

Supreme Court of Kansas.

Opinion filed November 3, 2000.

John H. Wachter, of Wright, Henson, Somers, Sebelius, Clark & Baker, L.L.P., of Topeka, argued the cause and Charles N. Henson, of the same firm, was with him on the brief for appellant The Kroger Co.

James Bartle, of Kansas Department of Revenue, argued the cause and was on the brief for appellee.

The opinion of the court was delivered by

LOCKETT, J.:

Multistate taxpayer appeals the Board of Tax Appeals' (BOTA) order disallowing as an apportionable business expense an interest expense incurred to fight a hostile takeover. BOTA classified the expense as a nonbusiness expense, which was allocated to the taxpayer's state of commercial domicile. Taxpayer appealed, claiming its interest expense was a business expense, apportionable to Kansas.

The taxpayer, The Kroger Co. (Kroger), and the Department of Revenue (KDR) stipulated that late in 1988, Kroger, an Ohio corporation operating retail food and grocery stores in Kansas and numerous other states, was the target of hostile takeover attempts by two separate groups. In response to these threats, Kroger's board of directors determined it was in the best interest of the company and its shareholders to defend against the hostile takeover. To avoid the takeover, Kroger declared a special dividend to its shareholders. To finance the special dividend, Kroger borrowed $4.1 billion. The borrowing of $4.1 billion required Kroger to pay large amounts of interest for the tax years ending December 30, 1989, through January 2, 1993 (the audit period). The interest expenses were declared by Kroger pursuant to the Internal Revenue Code, 26 U.S.C. §162 (1994), as ordinary and necessary business expenses and deducted by Kroger on its federal income tax return.

KDR determined that Kroger's interest cost associated with the 1988 restructuring was a nonbusiness expense and not apportionable to Kansas. As a result, KDR assessed Kroger additional Kansas income tax of $5,145,161, with interest of $4,095,734 and a penalty of $1,286,294, for a total assessment of $10,527,189. KDR's assessment was based on its determination that Kroger's claimed interest expense resulting from borrowing to deter a hostile takeover was not an apportionable business expense arising from an activity in the regular course of Kroger's business.

The Kansas Income Tax Act, K.S.A. 79-3201 et seq., provides that the Act shall be administered by the Secretary of Revenue or the Secretary's designee for the purpose of ascertaining the correctness of any return. See K.S.A. 79-3233. Kroger protested KDR's assessment by filing a request for hearing with the Secretary of KDR. The Secretary issued a written determination, finding that Kroger's interest expense associated with defending against the hostile takeover bid was not a business expense incurred in the regular course of Kroger's operations; therefore, the interest expense of Kroger's $4.1 billion debt was a nonbusiness expense.

Kroger appealed the Secretary's determination to BOTA. BOTA found that the regular course of Kroger's business is the retail sale of groceries and that fending off a hostile takeover was not an activity associated with the selling of groceries. By a 4 to 1 majority, BOTA concluded that the interest expense was nonbusiness in nature and should be allocated to Kroger's state of domicile. BOTA later denied Kroger's request for reconsideration. Kroger appealed to the Court of Appeals, and its motion for transfer to the Supreme Court was subsequently granted. Our jurisdiction is pursuant to K.S.A. 20-3017.

Kroger seeks review under the Kansas Act for Judicial Review and Civil Enforcement of Agency Actions (KJRA), K.S.A. 77-601 et seq., claiming BOTA erroneously interpreted the Kansas Income Tax Act or misapplied the law. See K.S.A. 77-621(c)(4). The KJRA provides that the party challenging BOTA's action has the burden to prove that the action by BOTA was erroneous. K.S.A. 77-621(a). See In re Tax Appeal of Scholastic Book Clubs, Inc., 260 Kan. 528, 536, 920 P.2d 947 (1996).

Under the doctrine of operative construction, the interpretation of a statute by an agency charged with its enforcement is entitled to judicial deference. Blue v. McBride, 252 Kan. 894, Syl. ¶ 7, 850 P.2d 852 (1993). Despite the deference given to an agency's interpretation of the law it administers, if the court finds that the administrative body's interpretation is erroneous as a matter of law, the court will take corrective steps. In re Tax Appeal of Univ. of Kan. School of Medicine, 266 Kan. 737, 749, 973 P.2d 176 (1999). Whether an agency has erroneously interpreted a statute is a question over which an appellate court has unlimited review. Wasson v. United Dominion Industries, 266 Kan. 1012, 1018, 974 P.2d 578 (1999).

Statutory Construction of Tax Laws

First, Kroger contends that KDR does not have the statutory authority to disallow the interest expense as a business expense. Kroger notes that the principles and rules of statutory construction of tax laws place the burden on KDR to cite to clear and unequivocal terms within the tax statutes. The principles have been established by the court because of the general nature of the imposition and collection of taxes. Although courts have uniformly recognized that the power to levy taxes is inherent in the power to govern, the exercise of that power is dependent on the existence of legislation creating the tax. Nothing is taxable unless clearly within a taxing statute. Robbins-Leavenworth Floor Covering, Inc. v. Leavenworth Nat'l Bank & Trust Co., 229 Kan. 511, 512, 625 P.2d 494 (1981). Tax laws are statutory and do not exist apart from the statute and, as such, they must be strictly construed. American Home Life Ins. Co. v. Board of Shawnee County Comm'rs., 22 Kan. App.2d 18, 23, 913 P.2d 1211,rev. denied 258 Kan. 857 (1995). Where there is a reasonable doubt as to the meaning of a taxing statute, the statute will be construed most favorably to the taxpayer. Fleming Co. v. McDonald, 212 Kan. 11, Syl. ¶ 1, 509 P.2d 1162 (1973). KDR argues that K.S.A. 79-3272 and K.S.A. 79-3274 encompass expenses as a component of net income.

Because corporations may earn income in their state of domicile as well as other states, many states, including Kansas, adopted the Uniform Division of Income for Tax Purposes Act (UDITPA), K.S.A. 79-3271 et seq. Neither the Kansas statutes nor the regulations of the KDR define a "nonbusiness expense." However, K.S.A. 79-3272 provides that "net" business and nonbusiness income shall be allocated and apportioned according to UDITPA. The Multistate Tax Compact, K.S.A. 79-4301 et seq., adopted in Kansas in 1967, defines "income tax" as a tax imposed on or measured by an amount arrived at by deducting expenses from gross income. K.S.A. 79-4301, Art. II (4). Furthermore, K.S.A. 79-3274 provides that allocable nonbusiness income shall be limited to the total nonbusiness income received which is in excess of any related expenses which have been allowed as a deduction during the income year. Expenses, therefore, are a factor in the derivation of net income, and a statutory basis, implicit in the determination of "net" income, exists for making a determination regarding whether a multistate corporation may apportion certain expenses to the various states where it does business. Kroger apportioned part of its interest cost to its Kansas income based upon the UDITPA, the Internal Revenue Code, and its interpretation of the relevant Kansas tax statutes.

Classification of Interest Expense

The borrowing of $4.1 billion to defeat the hostile takeover required Kroger to pay large amounts of interest during the audit period. The calculation of the taxes owed to Kansas by a corporation begins with the corporation's federal taxable income; that income is then subject to modification as specified in K.S.A. 79-32,138. UDITPA provides that a corporation's business income is apportioned between the states in which it does business and its nonbusiness income is allocated to its state of domicile. K.S.A. 79-3272. "Business income" is defined in K.S.A. 79-3271(a) as "income arising from transactions and activity in the regular course of the taxpayer's trade or business and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations." "Nonbusiness income" is "all income other than business income." K.S.A. 79-3271(e). The question we must answer is whether Kroger's interest expenses on the loans used to finance its defense of a hostile takeover are an apportionable business expense or allocable nonbusiness expense.

Both parties agree that only the transactional test applies to determine whether Kroger's expense during the audit period is a business or nonbusiness expense. BOTA found the interest expenses to be nonbusiness expenses by applying the transactional test adopted in Western Natural Gas Co. v. McDonald, 202 Kan. 98, 446 P.2d 781 (1968). The controlling factor in the transactional test for the determination of business income is the nature of the particular transaction giving rise to the income. To be business income, the transaction and activity must have been in the regular course of the taxpayer's business operations. 202 Kan. at 100.

Kroger argues that the restructuring expense was an operational business expense to retain financial management of the corporation's assets, rather than an investment. For support, Kroger points out that the interest was deducted on its federal income tax return as a business expense and that the expense was also within the general rules for deductible business expenses set out in Commissioner v. Lincoln...