Question

Use California Publication 1061 (2017) to identify the various tests California used to determine whether two or more entities are part of a unitary group.

Answer 1

Both Butler Bros. and Edison California Stores, discussed previously, set forth tests to be used in determining whether the activities of several divisions or corporations should be considered unitary. In Butler Bros., the court held that a “unitary business” exists where there is: (1) unity of ownership; (2) unity of operation as evidenced by central divisions for functions such as purchasing, advertising, accounting, and management; and (3) unity of use in its centralized executive force and general system of operations. In Edison California Stores, the court held that if the operation of the portion of the business done within the state is dependent upon or contributes to the operation of the business outside the state, the operations are unitary.

The three unities test and the contribution or dependency test have been applied by the California courts in a variety of cases. (See, e.g., Superior Oil Co. v. Franchise Tax Board (1963) 60 Cal.2d 406, 411-412; Honolulu Oil Corp. v. Franchise Tax Board (1963) 60 Cal.2d 417, 423-424; John Deere Plow Co. v. Franchise Tax Board (1951) 38 Cal.2d 214, 221-222; Container Corporation of America v. Franchise Tax Board (1981) 117 Cal.App.3d 988, 994-1001, aff’d 463 U.S. 159, (1983); Chase Brass & Copper Co. v. Franchise Tax Board (1970) 10 Cal.App.3d 496, 501-502.) If either the three unities test or the contribution/dependency test is satisfied, the businesses are unitary (A.M. Castle & Co. v. Franchise Tax Board (1995) 36 Cal. App. 4th 1794.)

The United States Supreme Court has also referred to a unitary business as one that exhibits “contributions to income resulting from functional integration, centralization of management, and economies of scale.” (Mobil Oil Corp. v. Comm’r of Taxes of Vt. (1980) 445 U.S. 425, 438; F. W. Woolworth Co. v. Taxation and Revenue Dep’t of the State of N.M. (1982) 458 U.S. 354, 366; Allied Signal v. Director, Taxation Division (1992) 504 U.S. 768.) That court further noted that, “The prerequisite to a constitutionally acceptable finding of a unitary business is a flow of value, not a flow of goods.” (Container Corp. of America v. Franchise Tax Board (1983) 463 U.S. 159, 178.) The United States Supreme Court has stated that for commonly controlled activities to be nonunitary, they must be part of “unrelated business activity which constitutes a ‘discrete business enterprise.’ (Mobil Oil Corp., supra, 445 U.S. at 439-440.)

Cal. Code Regs., tit. 18 section 25120 provides additional rules and examples regarding what constitutes a unitary business. The regulation: (1) recognizes that a single taxpayer may have more than one “trade or business”; and (2) sets forth three factors, the presence of any one of which creates a “strong presumption” that the activities of the taxpayer constitute a single trade or business. Cal. Code Regs., tit. 18 section 25120 provides in pertinent part

(b) Two or More Businesses of a Single Taxpayer. A taxpayer may have more than one “trade or business.” In such cases, it is necessary to determine the business income attributable to each separate trade or business. The income of each business is then apportioned by an apportionment formula which takes into consideration the in-state and out-of-state factors, which relate to the trade or business, the income of which is being apportioned.

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. The following factors are considered to be a good indication of a single trade or business, and the presence of any of these factors creates a strong presumption that the activities of the taxpayer constitute a single trade or business:

(1) Same type of business – This factor applies when all of a taxpayer’s activities are in the same general line, such as in the operation of a chain of retail grocery stores.

(2) (2) Steps in a vertical process – An example of this factor would be a taxpayer that explores for and mines copper ores; concentrates, smelts, and refines the copper ores, and fabricates the refined copper into consumer products

(3) ) Strong centralized management – A taxpayer that might otherwise be considered as engaged in more than one trade or business is properly considered as engaged in one trade or business when there is a strong central management, coupled with the existence of centralized departments for such functions as financing, advertising, research, or purchasing.

For court decisions that discuss strong centralized management and the application of the unitary concept to diverse businesses, see Mole-Richardson Co. v. Franchise Tax Board (1990) 220 Cal.App.3d 889, 894; Tenneco West, Inc. v. Franchise Tax Board (1991) 234 Cal.App.3d 1510 and Dental Insurance Consultants, Inc. v. Franchise Tax Board (1991) 1 Cal. App.4th 343. For application of the unitary tests to passive holding companies, see FTB Legal Rulings 95-7 and 95-8, dated November 29, 1995.

As noted above, the activities of a single corporation or group of commonly owned corporations do not always constitute a single unitary business. If a taxpayer has two or more trades or businesses that are not unitary with one another, separate combined report computations must be made to compute business income and apportionment factors for each trade or business and to apportion to California the business income of each.

California law classifies income as either “business” or “nonbusiness.” Business income is income arising from transactions and activity in the regular course of the taxpayer’s trade or business. Business income includes income from tangible property and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations. Business income is assigned through formula apportionment, R&TC Section 25120(a). Nonbusiness income is all other income, R&TC Section 25120(d), and is generally allocated to a particular jurisdiction (R&TC Sections 25123- 25127). Regulations under R&TC Section 25120 also provide guidance for distinguishing between business and nonbusiness income. For further discussion and examples of business and nonbusiness income, get the instructions for Schedule R.