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Jamie C. Yesnowitz
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On Jan. 4, 2019, the Kentucky Court of Appeals held that a parent corporation could not file a consolidated income tax return with its wholly-owned subsidiary because the parent corporation did not qualify as an “includible corporation.”1
In doing so, the Court first concluded that the parent corporation was subject to two statutory exceptions in the definition of “includible corporation” for taxpayers with de minimis
or zero apportionment factors in the state. The Court then rejected the argument that the parent corporation qualified as an includible corporation under a different subsection in the consolidated return statute that defines “affiliated group.” As a result, the Court affirmed the denial of the corporation’s refund claim.
The taxpayers were a parent corporation (“Parent”) based in South Carolina, and its wholly-owned subsidiary (“Subsidiary”), a corporation that operated over 70 stores that provide consumer loans and tax preparation services in Kentucky. For the tax years ending March 31, 2007, through March 31, 2010, Subsidiary originally filed separate returns. After filing these returns, Parent determined that it also conducted some business activities in Kentucky consisting of an employee working in the state and the receipt of management fees from Subsidiary. Parent believed that it was required to file consolidated corporate income tax returns with Subsidiary. Prior to filing consolidated returns, Parent asked its third-party tax advisor to request an anonymous letter ruling from the Kentucky Department of Revenue to provide guidance. Based on the provided facts, the Department issued a letter concluding that a consolidated return was required.
Subsidiary amended its prior returns and filed consolidated returns with Parent for the relevant tax periods. Because the returns reflected tax overpayments, the taxpayers requested refunds of more than $1.3 million. The Department denied the refunds because Parent did not meet the statutory definition of an includible corporation required to file consolidated returns. Parent requested that its case be forwarded to the Department’s Division of Protest Resolution and that a conference be held to discuss the case. Following the hearing, the Department issued a letter maintaining its position that Parent was not an includible corporation because it satisfied the statutory exclusions for corporations that: (i) realize a net operating loss (NOL) and have de minimis
apportionment factors; or (ii) have apportionment factors with a sum of zero. Parent argued that the apportionment factor tests did not apply because it qualified as an includible corporation under a separate statutory subsection that defines an “affiliated group.” The Department issued a final ruling that Parent was not an includible corporation but did not address the taxpayers’ affiliated group argument.
In response to Parent’s appeal of the Department’s final ruling, the Kentucky Board of Tax Appeals upheld the Department’s determination that Parent was not entitled to a refund because it was not authorized to file a consolidated return with Subsidiary. Also, the Board determined that the anonymous letter ruling issued by the Department was not binding because the actual facts were different than the factual scenario presented to the Department in the letter ruling request.
Parent appealed the Board’s decision to the Franklin Circuit Court. In initially reversing the Board and holding that the Department improperly denied the refund request, the Circuit Court accepted Parent’s argument that it was an includible corporation because it met the ownership requirements of the “affiliated group” statute. The Department filed a motion to alter, amend or vacate. In response, the Circuit Court issued an opinion and order granting the Department’s motion, vacating its prior opinion and order, and affirming the Board. The opinion explained that the Court’s previous order was based on an erroneous analysis of the relevant statute and determined that the Department’s interpretation of the statute was correct. The taxpayers subsequently appealed.
Consolidated return statute
The Kentucky consolidated return statute provides in relevant part that every corporation doing business in Kentucky must, for each taxable year, file a separate return unless the corporation was, for any part of the taxable year: (i) an includible corporation in an affiliated group; or (ii) a common parent corporation doing business in the state.2
An affiliated group, whether or not filing a federal consolidated return, must file a consolidated return that includes all includible corporations.3
The Department relied on the statutory subsection that defines “includible corporation” as any corporation that is doing business in Kentucky except for nine specified types of corporations.4
For purposes of this case, the relevant exceptions are for: (i) any corporation that realizes an NOL whose Kentucky property, payroll and sales apportionment factors are de minimis
or (ii) any corporation for which the sum of the property, payroll and sales factors is zero.6
The taxpayers relied on a statutory subsection that defines “affiliated group” as one or more chains of includible corporations connected through stock ownership with a common parent corporation which is an includible corporation if: (i) the common parent owns directly stock meeting the statutory ownership requirements in at least one other includible corporation; and (ii) stock meeting the statutory ownership requirements in each of the includible corporations, excluding the common parent, is owned directly by one or more of the other corporations.17
Under the statutory ownership requirements, the stock must encompass at least 80 percent of the voting power of all classes of stock and have a value equal to at least 80 percent of the total value of all stock.8
“Common parent corporation” is defined as a member of an affiliated group that meets these ownership requirements.9
Kentucky Court of Appeals opinion
The Kentucky Court of Appeals affirmed the Circuit Court’s final opinion and held that Parent was not an “includible corporation” that could file a consolidated return with Subsidiary. In reaching its decision, the Court was required to carefully analyze the exact language of the Kentucky consolidated return statute. In presenting its case, the taxpayers did not argue against the application of the de minimis
and zero apportionment exceptions from the term “includible corporation.” Instead, the taxpayers alleged that they satisfied an alternative definition of “includible corporation” provided in the “affiliated group” statutory subsection. The Court acknowledged that the consolidated return statute “is anything but a model of clarity,” but it could not accept the taxpayers’ interpretation of the statute.
The Court began its analysis by confirming that all corporations are considered includible unless they fall within one of the nine exceptions specified in the “includible corporation” definition. The Department successfully argued that Parent fell within two of the exceptions because: (i) it realized an NOL and its apportionment factors were de minimis
; and (ii) the sum of its apportionment factors was zero. Therefore, Parent could not be considered an “includible corporation in an affiliated group” that files a consolidated return.10
Although Parent was affiliated with Subsidiary, it was not a defined includible corporation.
The Court then carefully examined the statute providing that a separate return is not required for a common parent doing business in the state.11
As discussed above, a “common parent” is a member of an affiliated group that meets the statutory ownership requirements.12
The taxpayers argued that Parent’s satisfaction of the ownership requirements meant that it conformed to an “alternative” definition of “includible corporation” contained within the “affiliated group” definition. Specifically, the taxpayers cited the following language in the “affiliated group” definition: “one or more chains of includible corporations connected through stock ownership with a common parent corporation which is an includible corporation if
” certain conditions are met.13
In rejecting this argument, the Court explained that it did not believe the Kentucky legislature intended to place a separate and entirely alternative definition of “includible corporation” within the subsection defining “affiliated group.” Because the statute is organized in subsections to provide separate definitions, the Court “must look to those subsections exclusively when a defined term is used elsewhere in the statute.” The Court noted that the legislative history of the statute also supports this interpretation.
Following a detailed statutory analysis, the Court concluded that the contested statute only defines “affiliated group” and does not define any other terms. As the Circuit Court determined, an affiliated group must contain an includible common parent. The determination of whether a corporation is includible is made using the statutory definition of “includible corporation” rather than the ownership requirements of the “affiliated group” definition. Because Parent fell within the exceptions for an includible corporation, it could not file a consolidated return with Subsidiary.
The Court rejected the taxpayers’ argument that the Department was bound by its earlier letter ruling in response to the anonymous inquiry. The additional and differing facts that became apparent following the initial letter ruling made it non-controlling and non-binding. The Court also disagreed with the taxpayers’ argument that the denial of the refund violated the contemporaneous construction doctrine. Under this doctrine, an administrative agency may not change its long-standing interpretation of an ambiguous statute. According to the Court, two letter rulings14
over a five-year span did not constitute a long-standing policy that falls within the doctrine. Finally, the Court summarily rejected the taxpayers’ argument that the Department’s actions violated Kentucky constitutional provisions governing separation of powers between branches and departments of state government.15
This case attempts to provide clarity regarding Kentucky’s complex consolidated return statute. In particular, the Kentucky Court of Appeals agreed with the Department that the statutory subsection defining “includible corporation” is the only subsection in the statute that may be used to determine whether an entity is an “includible corporation.” Thus, parent corporations that meet the ownership requirements provided in the “affiliated group” definition may be required to file separate returns if they meet one of the exceptions in the “includible corporation” definition. There seems to be some uncertainty concerning the interpretation of the consolidated return statute. As discussed above, the Circuit Court originally found for the taxpayers but subsequently vacated its decision and issued a new opinion that agreed with the Department’s interpretation of the statute. Based on the Court of Appeals decision, taxpayers may want to re-evaluate whether they are required (or even allowed) to file a consolidated return.
The taxpayers’ reliance on a letter ruling issued by the Department, and the narrow factual path on which the taxpayers tried to obtain relief from filing on a nexus consolidated basis serves as a cautionary tale. Rulings from a state tax authority on a specific set of facts often are extremely helpful to taxpayers looking to determine whether to take a tax position (or whether to change it through an amended return). However, the facts have to be verifiable, and relatively innocuous changes in the facts could void the provided guidance. As far as the facts in this case, the taxpayers tried to emphasize Parent’s substance in Kentucky through physical presence as a way to change their Kentucky filing method. But the Department, and eventually the Court, concluded that the minimal physical presence of an entity with NOLs was not enough to allow the entity to offset income from its subsidiary as a means to structure a favorable result from a change in filing method. The change in facts from what had been represented in the letter ruling request to what actually occurred made it somewhat easier for the Court to decide in favor of the Department purely from an equitable perspective.
Kentucky enacted legislation last year that substantially changed group filing requirements. For tax years beginning on or after Jan. 1, 2019, Kentucky is requiring combined reporting for members of a unitary business group. Groups may, however, elect to file a consolidated return with all members of the affiliated group. While the applicability of this case may be somewhat limited in the future, the ability to comfortably rely on the Department’s letter rulings may be impacted, especially in situations where the facts as relayed to the Department in the ruling request are different than originally represented.
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