MARY F. WALRATH, Bankruptcy Judge.
The issues presented by the summary judgment motions before the Court are (1) whether the FTB
Through operating company subsidiaries, the Debtors owned and operated the largest chain of family buffet restaurants in the United States. The Debtors' restaurants included HomeTown Buffet, Old Country Buffet, Roadhouse Grille, and Tahoe Joe's. The Debtors maintained restaurants and distribution centers throughout the United States during the relevant taxable years (the "Treasury Years").
On January 22, 2008, the Debtors (and several of their affiliates) filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code in this Court. On July 10, 2008, the FTB filed proofs of claim against the Debtors for corporate franchise taxes. On April 13, 2009, the Debtors commenced this adversary proceeding seeking a determination that they did not owe the additional corporate franchise taxes asserted by the FTB. Motions for summary judgment were filed by the FTB and the Debtors, have been fully briefed, and are ripe for decision.
The Court has core jurisdiction over the motions for summary judgment, which essentially involve the allowance of the FBE's claims. 11 U.S.C. § 505(a)(1); 28 U.S.C. §§ 157(b)(1)(B) & 1334. See, e.g.,
In considering a motion for summary judgment under Rule 56,
The movant bears the burden of establishing that no genuine issue of material fact exists. See Matsushita Elec. Indus. Co. v. Zenith Radio Corp., 475 U.S. 574, 585 n. 10, 106 S.Ct. 1348, 89 L.Ed.2d 538 (1986); Integrated Water Res., Inc. v. Shaw Envtl., Inc. (In re IT Group, Inc.), 377 B.R. 471, 475 (Bankr.D.Del.2007). A fact is material when it could "affect the outcome of the suit." Anderson, 477 U.S. at 248, 106 S.Ct. 2505.
The parties in this case agree that there are no genuine issues of material fact and that the issues presented are legal. Therefore, the Court may enter summary judgment. See Matsushita, 475 U.S. at 587, 106 S.Ct. 1348.
The Debtors' treasury department, in Eagan, Minnesota, provided treasury services for the Debtors' unitary business. The treasury department invested cash in U.S. commercial paper and money market funds (collectively the "Treasury Investments") on behalf of the unitary business. The treasury department derived gross receipts from these Treasury Investments. The investment activities ensured that the Debtors' working capital earned maximum returns while still being readily available for use in the restaurant business. The Debtors' treasury operations gave rise to business income and expenses occurring in Minnesota.
During each of the Treasury Years, the Debtors treated the income generated by their Treasury Investments as business income subject to apportionment. The Debtors included the gross receipts from their Treasury Investments in the formula for determining the California franchise tax for the Treasury Years. The FTB audited the Debtors' California franchise tax returns for the Treasury Years and issued Notices of Proposed Assessments asserting additional California franchise tax and interest was due. For each Notice,
The issue in this adversary involves a dispute over the proper amount of the Debtors' gross receipts from Treasury Investments, if any, to be included in the formula for calculation of franchise taxes for the Treasury Years under California Revenue and Taxation Code (the "CRTC") sections 25120(e) and 25134. Section 25134 provides as part of the formula that: "The sales factor is a fraction, the numerator of which is the total sales of the taxpayer in this state during the taxable year, and the denominator of which is the total sales of the taxpayer everywhere during the taxable year." Cal. Rev. & Tax.Code § 25134. Section 25120(e) provides that for taxable years beginning before January 1, 2011, "sales" means all gross receipts of the taxpayer not allocated under sections 25123 to 25127, inclusive. Cal. Rev. & Tax.Code § 25120.
The FTB argues that including the Treasury Gross Receipts
Cal. Rev. & Tax.Code § 25137. Here, the FTB recommends, as an alternative method of apportionment, including in the formula only the interest income or gain from Treasury Investments and not the return-of-principal amounts of the Treasury Gross Receipts.
Under section 25137, the FTB is statutorily authorized to use an alternative method of apportionment if it can prove by clear and convincing evidence that: (1) the standard formula results in an apportionment of the Debtors' income to California that does not fairly represent the extent of the Debtors' California business activities, and (2) the FTB's alternative method of apportionment is reasonable. Microsoft Corp. v. Franchise Tax Bd., 39 Cal.4th 750, 47 Cal.Rptr.3d 216, 139 P.3d 1169, 1178 (2006).
The Debtors argue that the FTB has not established by clear and convincing evidence that the inclusion of the Debtors' Treasury Gross Receipts in the formula under sections 25120 and 25134 does not fairly represent the extent of the Debtors' business activity in California.
In Microsoft, the California Supreme Court formulated a two-prong test for deciding whether to apply an alternative
With regard to the second prong, the court in Microsoft examined three factors: 1) the quantitative difference between the treasury margin and non-treasury margin; 2) the quantitative difference between the income produced by treasury activities and the gross receipts generated by treasury activities; and 3) the overall quantitative difference between applying the standard formula with and without the full gross receipts included. Id.
The Debtors argue that qualitative distortion cannot be established here because their treasury functions were "directly related and indispensable" to their non-treasury activities and far different from the cash management activities in other cases. The Debtors support this contention by emphasizing that the Debtors' restaurant business did not maintain a large reserve of working capital and that the cash invested, and the revenue produced, by its treasury department was critical to its daily operations.
The California Court of Appeals, however, has made it clear that "whether or not this revenue is used to complement the company's primary business is not the test imposed by Microsoft." The Limited Stores, Inc. v. Franchise Tax Bd., 152 Cal.App.4th 1491, 62 Cal.Rptr.3d 191, 197 (2007) (stating that "[i]t [will] almost always [be] true that a treasury department's revenue production will be utilized to support or enhance the company's primary business."). The court in The Limited stated that if consideration were given to this factor then the qualitative test required by Microsoft would become illusory. Id.
Therefore, the Court rejects the Debtors' argument, because it is simply not an appropriate factor to consider in determining whether a taxpayer's treasury functions are qualitatively different from its main line of business. The Court finds instead that the FTB has met its burden of proving by clear and convincing evidence that the Debtors' treasury functions "were qualitatively different from [their] principal business." In Microsoft, the California Supreme Court found that the operation of a large treasury department unrelated to the taxpayer's main line of business represented a "paradigmatic example" of circumstances that warranted the application of section 25137. Microsoft, 47 Cal.Rptr.3d 216, 139 P.3d at 1179 (emphasis added) (citing In re the Appeal of Crisa Corp., 2002 Cal. Tax. LEXIS 269 (Cal. St. Bd. Of Equal. June 20, 2002)). In reaching this conclusion, the court noted that the State Board of Equalization (the "SBE") included in a nonexclusive list of circumstances that warrant the application of Section 25137 that "[o]ne or more of the standard factors is biased by a substantial activity that is not related to the taxpayer's main line of business. For example, the taxpayer continuously reinvests a large pool of `working capital,' generating large receipts that are allocated to the site of the investment activity. However, the investments are unrelated to the services provided by the taxpayer as its primary business." Id.
In Microsoft, the California Supreme Court found that "Microsoft's treasury
Unlike the taxpayer in Merrill Lynch, the Debtors in this case do not provide investment services to participants in the securities industry. Rather, like the taxpayers in Microsoft and The Limited, the Treasury Investments of the Debtors' treasury department merely provide support to the Debtors' business of operating restaurants. As a result, the Court finds that the Debtors' treasury functions were qualitatively different from their principal business.
The Debtors contend that to meet this factor there must be "several orders of magnitude" in difference between the Debtors' treasury margin and non-treasury margin, in a strict mathematical sense. Specifically, the Debtors contend that there cannot be quantitative distortion unless the non-treasury margin ranges from two to three orders of magnitude, or 100 to 1,000 times greater than the treasury profit margin. See, e.g., Microsoft Corp., 47 Cal.Rptr.3d 216, 139 P.3d at 1180 (finding that Microsoft's investment activities had a marginal rate of return of less than 0.2 percent, while its non-treasury activities had a margin of more than 31 percent, roughly 155 times greater); The Limited, 62 Cal.Rptr.3d at 198-99 (finding that The Limited's investment activities had a marginal rate of return of less than.1 percent, while its non-treasury activities had a margin of more than 46 percent, roughly 460 times greater).
In this case, for the six Treasury Years, the average margin for the Debtors' investment activities was approximately .08 percent, while the average margin for the Debtors' restaurant operations was 4.25 percent, or 53 times greater. The Debtors argue that this difference (53x) is substantially less than the difference in Microsoft (155x) and The Limited (460x) where quantitative distortion supported the application of section 23157.
In two recent cases, however, California courts have found quantitative distortion in circumstances much closer to the facts of this case. In Square D, the Superior Court held that a difference of 74x was sufficient to prove quantitative distortion. Square D Co. v. Franchise Tax Bd., CGC 05-442465 (Cal.Sup.Ct. Apr. 11, 2007). In Microsoft II, the Superior Court of California held that a difference of 34x and 42x in two separate tax years was sufficient to prove quantitative distortion. Microsoft Corp. v. Franchise Tax Bd., CGC 08-471260 (Cal.Sup.Ct. Feb. 17, 2011). The Debtors' margin difference (53x) fits well within the range of quantitative differences which the California courts have found
In evaluating the quantitative level of distortion in Microsoft, the Supreme Court observed that Microsoft's inclusion of the full price from the redemption of its marketable securities in computing the gross receipts for the sales factor had the effect of grossly distorting the extent of its business activity in California. Microsoft Corp., 47 Cal.Rptr.3d 216, 139 P.3d at 1178-79. The court illustrated the distortional impact of Microsoft's practice by noting that, for tax year 1991, its short-term treasury investments produced 73 percent of its gross receipts but less than 2 percent of the company's income. Id. at 1178 n. 17. Similarly, in The Limited, the Court of Appeals found that the taxpayer's short-term investments produced less than 1 percent of the company's business income in the relevant tax years, but over 62 percent and over 52 percent of its gross receipts in those years. The Limited, 62 Cal.Rptr.3d at 198.
During the Treasury Years at issue here, the Debtors' treasury activities generated an average of 77 percent of the Debtors' gross receipts, but only an average of 5.4 percent of the Debtors' income. This range falls within ranges in Microsoft and The Limited. Therefore, the Court concludes that the FTB has established this factor.
Rote application of the standard formula would treat an average of 77 percent of the Debtors' total sales as occurring in Minnesota and would treat an average of over 38.5 percent of the Debtors' income as though it were apportioned to Minnesota solely because the Debtors' three-person treasury department was located there. The distortional impact on income in this case (38.5 percent) is even greater than in Microsoft (24 percent) or The Limited (9.25 percent). Microsoft Corp., 47 Cal.Rptr.3d 216, 139 P.3d at 1178-1179; The Limited, 62 Cal.Rptr.3d at 198. See also Square D Co., CGC 05-442465 (finding apportionment of 15 percent of the enterprise's income to the state where its treasury department was located was distortive.) Thus, this factor supports the application of section 23157.
Further, by using the standard formula, the income apportioned to California is reduced on average 40 percent, and the Debtors' California franchise tax liability is reduced on average 44 percent across the six Treasury Years. While the reduction of income attributable to California in this case is lower than that in Microsoft (50 percent) it is even greater than that in The Limited and Square D (23.5 percent and 18 percent, respectively). Thus, the reduction of income attributable to California, when viewed in comparison with the situations in Microsoft, The Limited and Square D, supports the application of section 23157.
Given the previously stated income attribution rate and reduction of income attributable to California, the Court finds that the overall quantitative difference in applying the standard formula supports the application of section 23157.
The Debtors argue, however, that the FTB has not established by clear and convincing evidence that its proposed alternative apportionment formula is reasonable. The Court disagrees. In Microsoft, the Supreme Court of California approved an identical proposal. Microsoft Corp., 47 Cal.Rptr.3d 216, 139 P.3d at 1182. The Court in Microsoft found that including only the net receipts from treasury activities
In Microsoft, the net receipts from its treasury activities was $10.7 million, while its non-treasury activities produced income of $659 million and gross receipts of $2.1 billion. Id. at 1180. Here, for the Treasury Years, the Debtors' net receipts from treasury activities was $15.1 million, while its non-treasury activities produced income of $233 million and gross receipts of $5.5 billion. Like in Microsoft, the Debtors' net receipts from treasury activities are quite small in comparison to its non-treasury income and gross receipts.
Accordingly, the Court concludes that the FTB's proposal to include in the formula only the net receipts from the Debtors' Treasury Investments is reasonable.
Section 23649 provides an income tax credit to "qualified taxpayers" who incur qualified costs in the purchase of qualified property to be used primarily in any stage of manufacturing in California. Cal. Rev. & Tax.Code § 23649. Section 23649(c)(1) defines a "qualified taxpayer" as any taxpayer "engaged in those lines of business described in Codes 2011 to 3999, inclusive, . . . of the Standard Industrial Classification (SIC) Manual published by the United States Office of Management and Budget, 1987 edition." Cal. Rev. & Tax.Code § 23649(c)(1). Codes 2011 to 3999 collectively constitute SIC Division D ("manufacturing") in the SIC Manual. Cal. Rev. & Tax.Code § 23649(c)(1). The parties dispute whether the Debtors were "qualified taxpayers" for purposes of the MIC during the years when it was available.
The Debtors argue that their activities, which include the manufacture of prepared meats, salad dressings and other sauces, various bakery items, frozen desserts and other products are specifically defined in SIC Division D.
The FTB does not dispute the nature of the Debtors' activities. Instead, the FTB contends that the Debtors' restaurant and food preparation processing activities during the MIC Years do not qualify as manufacturing activities under Regulation 23649-3,
The Debtors respond that Regulation 23649-3 has been determined to be invalid as inconsistent with the statutory language of section 23649. Appeal of Save Mart Supermarkets, Op. on Rehearing 2002-SBE-002, 2002 Cal. Tax LEXIS 80 (Cal. St. Bd. of Equal., Feb. 6, 2002) (holding by the State Board of Equalization (the "SBE") that Regulation 23649-3 "alters and enlarges on the words of the statute, and is thus invalid.").
In Save Mart, the business seeking the MIC was a grocery store which had a full service bakery and meat department. Id. at *3. The FTB in Save Mart asserted that while the bakery and meat department might have qualified as manufacturing under SIC Division D, the SIC manual requires that if the taxpayer is "primarily" engaged in retail trade under SIC Division G, it is not engaged in business under SIC Division D. Id. at *6. The SBE rejected the FTB's argument, because it concluded that the MIC should be interpreted liberally in favor of taxpayers. Id. at *10. The SBE found that Section 23649's use of the words "described in" meant only to reference the SIC Manual's SIC Division D and not the entire manual. Id. at *11-12. According to the SBE, the legislature has in the past, and could have utilized more expansive wording if it wanted to incorporate the entire manual. Id.
After finding Regulation 23649-3 invalid, the SBE found that the language of the statute did not require that the taxpayer be "primarily" engaged in the business of baking or meat processing. Id. at *12 (finding that despite the taxpayer's retail grocery store operations being "described in other portions of the SIC Manual seemingly to the exclusion of its manufacturing activities, [the taxpayer] does engage in activities described in Division D of the SIC Manual. . . .").
The FTB asserts that the SBE in Save Mart lacked authority to invalidate a regulation duly promulgated by the FTB. Cal. Rev. & Tax.Code § 19333. Rather, such a determination should be left to the courts, who "bear the ultimate responsibility for construing the statute." Citicorp N. Am., Inc. v. Franchise Tax Bd., 83 Cal.App.4th 1403, 100 Cal.Rptr.2d 509, 522 (Cal.Ct.App. 2000). The FTB, however, admits that the SBE's decision is entitled to some deference in interpreting the statute. Id.
The Debtors respond that the SBE is explicitly authorized to determine the validity of the Regulation, because it is within its duty to determine appeals from actions of the FTB. Cal. Rev. & Tax.Code §§ 19045-19048, 19333. Even if the SBE could not completely invalidate the Regulation, the Debtors assert that the SBE's determination in Save Mart is still "highly persuasive." See, e.g., Hoechst Celanese Corp. v. Franchise Tax Bd., 25 Cal.4th 508, 524-25, 106 Cal.Rptr.2d 548, 22 P.3d 324 (Cal.2001) (stating that the amount of deference given to an administrative agency, like the SBE, depends upon "the thoroughness evident in its consideration, the validity of its reasoning, its consistency with earlier and later pronouncements, and all those factors which give it power to persuade, if lacking power to control.") (quoting Yamaha Corp. of Am. v. State Bd.
The Court finds that the SBE's decision in Save Mart is persuasive. The statute does not require that the food manufacturing or processing be the only business of the taxpayer, only that some of its activities fit in that section of the SIC Manual. The entire SIC Manual is not incorporated in Section 23649, but only Division D. Therefore, the Court rejects the FTB's arguments and concludes that because the Debtors "back of the house" activities are properly classified under SIC Section D, they qualify for the MIC credit.
For the foregoing reasons, the Court finds that the FTB has established that application of the standard formula does not fairly represent the extent of the Debtors' California business activity. The Court further finds that the FTB has proven that its proposed alternative apportionment formula is reasonable. Therefore, the Court concludes that the FTB used an appropriate method to apportion the share of the Debtors' unitary business income that is taxable to California when calculating its amended claims.
The Court, however, concludes that the Debtors were engaged in a line of business covered by section 23649 and therefore may claim the MIC Credit during the MIC Years.
An appropriate order is attached.
