Surtees v. Vfj Ventures, Inc.

• Decision Date: 08 February 2008
• Docket Number: 2060478.
• Citation: 8 So.3d 950
• Parties: G. Thomas SURTEES, in his official capacity as commissioner of the Alabama Department of Revenue, and the Alabama Department of Revenue v. VFJ VENTURES, INC., f/k/a VF Jeanswear, Inc.
• Court: Alabama Court of Civil Appeals

8 So.3d 950

G. Thomas SURTEES, in his official capacity as commissioner of the Alabama Department of Revenue, and the Alabama Department of Revenue v. VFJ VENTURES, INC., f/k/a VF Jeanswear, Inc.

2060478.

Court of Civil Appeals of Alabama.

February 8, 2008.

Troy King, atty. gen., and Jeff Patterson, deputy atty. gen., Montgomery, for appellants.

Joseph B. Mays, Jr., Bruce P. Ely, Christopher R. Grissom, and Marc James Ayers of Bradley Arant Rose & White, LLP, Birmingham for appellee.

Bruce J. Fort, Washington, D.C., for amicus curiae MultiState Tax Commission, in support of the appellants.

Susan E. Kennedy and Pamela B. Slate of Slate Kennedy LLC, Montgomery, for amici curiae Alabama Education Association, Auburn University, and the Board of Trustees of the University of Alabama, in support of the appellants.

THOMPSON, Presiding Judge.

VFJ Ventures, Inc. ("VFJ"), f/k/a VF Jeanswear, Inc., filed an appeal in the Montgomery Circuit Court ("the trial court") pursuant to § 40-2A-7(b)(5)b., Ala. Code 1975, challenging a decision of the Alabama Department of Revenue assessing against VFJ an amount representing additional corporate income tax purportedly owed the State; it also named the commissioner of the Department as a defendant.¹ We refer to the two named defendants collectively as "the Department."

The Department responded, arguing that the assessment should be upheld. The Department later filed a motion for a partial summary judgment, which the trial court denied. The trial court conducted a lengthy trial at which evidence was presented ore tenus and numerous exhibits submitted. The trial court also accepted posttrial briefs from the parties. On January 24, 2007, the trial court entered a judgment in favor of VFJ. The Department timely appealed to this court pursuant to § 12-3-10, Ala.Code 1975.

VFJ manufactures and sells jeanswear sold under the Lee® and Wrangler® brand names in the United States. VFJ has two distribution facilities and a "cutting" facility in Alabama. Those facilities employ approximately 600 people. In 2001, the tax year at issue in this case, VFJ's gross sales were approximately $2.1 billion; only a portion of VFJ's gross sales were attributable to its activities in Alabama. "Under both the Due Process and the Commerce Clauses of the [United States] Constitution, a state may not, when imposing an income-based tax, `tax value earned outside its borders.'" Container Corp. of America v. Franchise Tax Bd., 463 U.S. 159, 164, 103 S.Ct. 2933, 77 L.Ed.2d 545 (1983) (quoting ASARCO, Inc. v. Idaho State Tax Comm'n, 458 U.S. 307, 315, 102 S.Ct. 3103, 73 L.Ed.2d 787 (1982)). Thus, only that part of VFJ's income that was fairly attributable to its presence in Alabama is subject to taxation in this state.

When a corporation such as VFJ has manufacturing facilities or operating facilities or performs activities in more than one state, a formula known as an "apportionment factor" is used to determine how much income is attributable to each state. The apportionment factor is used to determine the portion of the corporation's income that is subject to income tax in each of the states in which the corporation has activity. See Allied-Signal, Inc. v. Director, Div. of Taxation, 504 U.S. 768, 778, 112 S.Ct. 2251, 119 L.Ed.2d 533 (1992) ("Because of the complications and uncertainties in allocating the income of multistate businesses to the several States, we permit States to tax a corporation on an apportionable share of the multistate business carried on in part in the taxing State."). In this case, the Department and VFJ seem to have agreed on the application of a common three-part apportionment factor that has been approved by the United States Supreme Court. See Container Corp. of America v. Franchise Tax Bd., 463 U.S. at 170, 103 S.Ct. 2933 ("[N]ot only has the three-factor formula met our approval, but it has become ... something of a benchmark against which other apportionment formulas are judged.").

Alabama, like a number of other states, has adopted the apportionment factor referenced in Container Corp. of America v. Franchise Tax Bd., supra, for determining the portion of a multistate corporation's income that may be taxed in this state. The apportionment factor is set forth in § 40-27-1, Art. IV, ¶ 9, Ala.Code 1975, as a part of Alabama's adoption of the Multistate Tax Compact. The Multistate Tax Compact creates a uniform system for taxing entities such as VFJ, who have operations or are active in more than one state. State Dep't of Revenue v. MGH Mgmt., Inc., 627 So.2d 408, 408-09 (Ala.Civ.App. 1993) ("The [Multistate] Tax Compact provides for the allocation and apportionment of income of taxpayers doing business in more than one state in such a manner as to avoid duplicative taxation.").

In opening statements during the trial of this matter, one of the attorneys accurately summarized Alabama's apportionment factor for the trial court as follows:

"You take the ratio of the property in the state to the property out of state, a ratio of the sales in the state to the sales out of the state, a ratio of the payroll in the state to the sales [sic] out of the state, add them together and divide by three, and that average is your apportionment factor."

For the 2001 tax year, VFJ's apportionment factor for Alabama was 13.9299%. Using that factor, VFJ reported approximately $13,702,000 in income to be apportioned to Alabama on its state corporate income-tax return for the 2001 tax year.

VFJ is a subsidiary of VF Corporation ("VF"), a parent holding company comprising hundreds of subsidiaries worldwide. VF's corporate headquarters is located in Greensboro, North Carolina. Among VF's subsidiaries are numerous intangible management companies ("IMCOs") that own and manage trademarks, most of which are used by other VF subsidiaries. All the IMCOs are Delaware corporations.

A treatise on state taxation has explained the function of IMCOs like those in the VF corporate family as follows:

"One of the standard tax-planning devices corporations employ to reduce taxable income in states where they conduct their operations is to transfer their trademarks or trade names to an intangibles holding company ([IMCO]) and license back the trademarks or trade names for a royalty. The royalty, which is deductible to the operating company, reduces its income in the states where it carries on its business. The [IMCO], on the other hand, ordinarily pays no tax on its royalty income because it is taxable — or at least taxpayers so contend — only in a state that does not tax such income (e.g., Delaware)."

J. Hellerstein & W. Hellerstein, State Taxation ¶ 9.20[3][j] (2007 Cum.Supp.).

Two of the IMCOs in the VF corporate family are the H.D. Lee Company, Inc. ("Lee"), and the Wrangler Clothing Corporation ("Wrangler"), which own and manage trademarks for Lee® and Wrangler® brands, respectively. Lee and Wrangler license their respective trademarks to VFJ and other VF subsidiaries, as well as to third parties. It is undisputed that VFJ and the other subsidiaries of VF, including Lee and Wrangler, are "related members" as that term is defined for the purpose of determining Alabama's corporate income tax.² Testimony at trial indicated that Lee and Wrangler generally charge a 5% royalty rate to both related-member and third-party licensees. In 2001, the tax year at issue, approximately 78% of Lee's income came from licensing agreements with related members. For that same year, approximately 97% of Wrangler's licensing income was derived from licensing agreements with related members.

In Delaware, IMCOs such as Lee and Wrangler are subject to taxation only under limited circumstances. See Del.Code Ann. tit. 30, § 1902. Because the royalty payments are generally deductible expenses as to the licensee operating companies, the royalty payments made by related-member licensees that comprise the corporate income of the IMCOs escape taxation on the state level. Accordingly, the creation of the Delaware IMCOs created significant state-tax savings for VFJ and other subsidiaries of VF by effectively shifting income out of states that do impose corporate income tax to a state that does not impose such a tax.

To illustrate this process, the record indicates that in 2001 VFJ paid Lee $36,220,000 in licensing royalty fees for its use of the Lee® trademarks on its products, and it paid Wrangler $66,420,000 for the use of its Wrangler® trademarks. On its 2001 federal income-tax return, VFJ deducted those royalty payments as ordinary and necessary business expenses, see 26 U.S.C. § 162, thereby reducing the amount of its federal taxable income. Because federal taxable income is the starting point for the calculation of taxable income in Alabama, see § 40-18-33, Ala. Code 1975, the deduction of those royalty payments as business expenses also served to reduce VFJ's taxable income in Alabama. Thus, the royalty payments VFJ made to Lee and Wrangler for the use of their trademarks in its operating facilities in Alabama and other states worked to transfer funds out of this state, which has a corporate income tax, to the Delaware IMCOs, thereby ensuring that those royalty payments could not be subjected to taxation on the state level. In the 2000 tax year, the use of the practice of making royalty payments to the related-member IMCOs resulted in a total state-tax savings for VFJ (for its total operations, not just those in Alabama) of approximately $5.5 million. VFJ's 2001 state-tax savings as a result of royalty payments to the related-member IMCOs was approximately $6 million.

The payment of royalty fees to a related member located in a jurisdiction that does not impose a state corporate income tax works to avoid state taxation only in states known as "separate-entity" or "separate-reporting" states. In those states, including Alabama, each entity in a corporate group that has activity in the state must file a separate corporate...