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ASHLAND OIL, INC. (1979)(TRC)(Corp)2

Topic Code: B160, D171Dividends, I041Income - Determination of (I), R306Royalty Income, B160, D171Dividends, I041Income - Determination of (I), R306Royalty Income          Document Reference:

IN THE MATTER OF: ASHLAND OIL, INC. P.O. Box 14000 Lexington, KY 40512

Department of Revenue and Finance

iowadrf

90-24-2-0109

PROPOSED DECISION AS AMENDED

STATEMENT OF THE CASE

On February 28, 1990, Ashland Oil, Inc. filed a Protest to the assessment of corporate income tax for the taxable periods ending September 30 of 1985, 1986, 1987 and 1988, based on the inclusion in apportionable income of certain dividends and capital gains. The Iowa Department of Revenue and Finance filed its Answer on April 8, 1991; and on April 17, 1991, a Notice of Time, Place and Nature of Hearing was issued, scheduling an evidentiary hearing for October 23, 1991.

On motions filed by Protestor, this matter was continued and rescheduled for February 25, 1991; and an Amended Statement of Issues was issued on July 10, 1991. On February 13, 1992, Protestor filed a second motion to amend the statement of issues was filed on February 25, 1992.

On February 20, 1992, the Department filed a motion seeking a continuance or a bifurcated hearing; and on February 24, 1992, an order was issued continuing the hearing as regards those issues to be decided by the United States Supreme Court in a pending appealKraft General Foods, Inc. v. Iowa Department of Revenue and Finance, (No. 90- 1918), 60 U.S.L.W. 4582 (U.S. 6-18-92)., and ordering that the hearing set for February 25, 1992, be limited to consideration of the issue of the business income treatment of the capital gains and dividendsIssues No. 1 and 2, Second Amended Statement of Issues based on Iowa statutes.

This matter proceeded to a hearing on February 25, 1992, before Elizabeth Duncan, Administrative Law Judge. Appearing at the hearing on behalf of Ashland Oil, Inc. were attorneys Burns Mossman, William R. Buzo, Sean T. Crimmins and M. Ray Pace, along with C.P.A.s Jerome M. Colvin and Kenneth B. Denton, and Assistant Secretary for Protestor, John McD. Ross. Appearing on behalf of the Department were Assistant Attorneys General Marcia Mason and Valencia McCown, along with Jim McNulty, C.P.A. and Revenue Examiner IV, Audit Services Section.

During the course of the hearing Jerome L. Colvin, Kenneth Denton, and Jim McNulty testified; and the parties presented the following exhibits:

Protestor's Exhibits

Exh. 1 - Copy of Shareholders Agreement.

Exh. 2 - 1988 Annual Report of Ashland Coal, Inc.

Exh. 3 - Copy of Services and Employee Benefits Agreement.

Exh. 4 - Copy of Protestor's Schedule of Dividend and Gain Income From Non-Unitary Companies.

Exh. 5 - Copy of Department's Adjustment Summary of 2-1-90.

Exh. 6 - Copy of Protestor's Corporation Income Tax Return - FYE 9-30-85.

Exh. 7 - Department's Answers to Protestor's Interrogatories No. 1 -5.

Exh. 8 - Department's Response to Protestor's Request for Admissions (1 12).

Exh. 9 - Copy of Claim for Refund and cover letter filed by Protestor on about July 25, 1988.

Exh. 10 - Schedule of Services (Ashland Oil, Inc.)

Department's Exhibits

Exh. A - Protestor responses 1 -145 to the Department's interrogatories.

Exh. B, C, D, E - Copies of Ashland Oil, Inc.'s Annual Reports for 1985, 1986, 1987 and 1988, respectively.

Exh. F, G, H, I - Copies of SEC Form 10-Ks of Ashland Oil, Inc. for year ended Sept. 30, 1985, 1986, 1987 and 1988, respectively.

Exh. J - Copy of Protestor's Supplemental Response to Department's First Set of Interrogatories.

Exh. K - Copy of Protestor's letter to Department providing additional response to Department's Interrogatories.

Exh. L - Copy of Protestor's responses 1 - 26, to Department's Second Set of Interrogatories.

Exh. M - Copy of Protestor's responses 1 - 26 to Department's Request for Admissions.

Exh. N - Copy of Protestor's letter confirming the services agreement with subsidiary, Ashland Chemical Co.

Exh. O - Copy of Capital Gains and Losses form filed by Protestor for 1985.

Exh. P - Copy of Iowa Corp. Inc. Tax Return for 1988 filed by Protestor.

Written briefs were filed in accordance with a briefing schedule proposed by the parties and subsequent extension order; and this matter was deemed submitted for a decision on September 16, 1992. Now having considered the entire record presented in this matter along with the parties written arguments, I make the following findings, conclusions and decision.

FINDINGS OF FACT

Protestor, Ashland Oil, Inc. ("Ashland Oil"), is a Kentucky corporation with its principal place of business and commercial domicile in Kentucky. The Protestor is a diversified energy company with operations in petroleum refining, transportation and wholesale marketing; retail gasoline marketing; motor oil and lubricant marketing; chemicals; and oil and gas exploration and production. The Protestor is also an investor in the coal industry. The Protestor's business operations in Iowa were limited to the marketing of petroleum and chemical products.

Ashland Coal, Inc. ("Ashland Coal") was incorporated in 1975 as a wholly owned subsidiary of Ashland Oil. Ashland Coal is a producer and marketer of low sulfa coal in the Appalachian region. Ashland Coal conducts no business activities within the State of Iowa.

Ashland Oil owned 100% of Ashland Coal until 1981. In 1981, a German coal company acquired a 25% interest in Ashland Coal; and in 1982 a Spanish coal company acquired a 10% equity interest in Ashland Coal, leaving Ashland Oil with 65% of the outstanding shares of Ashland Coal. On August 11, 1988, Ashland Coal became a public company; and during its initial public offering, Ashland Oil sold a portion of its stock investment in Ashland Coal, reducing its ownership therein from 65% to 46%.

Ashland Oil realized a gain of $58,019,669 on the sale of the Ashland Coal stock; and these gains are now under consideration. During FYE September 30, 1985, 1986, 1987 and 1988, Ashland oil received $6,127,004 in dividends from Ashland Coal and eleven other dividend paying companies. The other dividend paying companies are involved in various activities, some of which are similar to Protestor's activities and some of which are not. Ashland Oil owned 50% or less of the stock in each of the other dividend paying companies. (Exh. 4).

Protestor sold the stock of Ashland Coal in order to increase its shareholder's value by decreasing Protestor's ownership interest in Ashland Coal from that of a majority shareholder in a nonpublic company to that of a majority shareholder in a publicly traded company and to simultaneously raise a substantial amount of cash. (Exh. L #5). In its Annual Report for 1988, Protestor stated:

Maintaining a strong financial position while accomplishing our goals will require careful planning. We believe our goals are achievable, but it may require alternate forms of financing, such as the recent initial public offering of Ashland Coal ....

(Exh. E p. 5).

Protestor also stated that "[b]ecause refining has been volatile in the 1980s, Ashland also has sought to diversify earnings by investing heavily in its non-refining businesses. The third part of its strategy is to maintain a strong financial condition." (Exh. E inside cover). Protestor's "strong financial position enables it to maintain an 'A' bond rating from both major agencies and obtain capital for its financing needs." (Exh. E p. 42). Increasing the coal operations was an "important part of [Protestor's] strategy since 1981." (Exh. D p. 2).

Ability To Exercise Ownership Rights

Ashland Oil's ability to exercise ownership rights in Ashland Coal was governed by a 1981 Shareholder's Agreement between Ashland Oil, Ashland Coal and the German coal company. The agreement and corporate bylaws, as amended and in effect during the years in issue, provided for "super-majority" voting provisions. These provisions set forth the voting rights for Ashland Coal's shareholders and board of directors on business matters that substantially affected Ashland Coal's business operations including, but not limited to, the annual operating budget, capital budget, capital lease transactions, sales of capital assets, marketing agreements, and the appointment of independent auditors. These were all matters which Ashland Oil could not individually approve based on its majority stock ownership. Protestor did, however, have "veto power" such that Ashland Coal could not engage in any of these activities without Protestor's consent, for Protestor could individually disapprove of and prevent Ashland Coal from engaging in these activities. (Exh. 1, testimony, Denton.)

Common Officers And Directors

Prior to the sale of Ashland Coal stock on August 11, 1988, Ashland Oil's stock ownership in Ashland Coal entitled it to elect five (5) of eight (8) directors; and Ashland Oil exercised this right and elected five (5) out of eight (8) directors which comprised Ashland Coal's board of directors. Additionally, Ashland Coal's 1982 bylaws provided that its officers had to be elected by a majority of Ashland Coal's directors, although at least one (1) director (and in some instances two (2) directors) could not be elected by Ashland Oil. (Exh. 1).

Prior to the 1988 sale of Ashland Coal stock, five (5) of Ashland Coal's eight (8) directors were key officers of the Protestor. (Exh. M #4; Exh. A #37). One vice-president of Protestor was a director of Ashland Coal and the President of Ashland Coal. (Exh. A #15). A Senior Vice-President of Ashland Oil, Paul Chellgren, was the Chairman of the Board of Ashland Coal both before and after the August 11, 1988 sale. (Exh. A #15). His primary duties pertained to Ashland Oil's regular trade or business activities, and he reported directly to Ashland Oil's Chief Executive Officer. (Exh. L #14). He was also a member of Ashland Oil Core Group and Protestor's Chief Financial Officer; and Ashland Oil did financial planning in formulating how its employees serving on Ashland Coal's board of directors would carry out their responsibilities as directors. (Exh. L #13; M #25).

Kenneth B. Denton was an administrative vice-president and controller, and principal accounting officer of Ashland Oil, during the audit period; and he was a director of Ashland Coal from 1981 until August of 1988. As a director of Ashland Coal, he also represented shareholder Ashland Oil; and he participated with other directors in the managing and setting of guidelines and the review of critical decisions of Ashland Coal. Ashland Coal's management "and the directors to whom they report" had direct responsibility for the day-to-day operations of Ashland Coal - and five (5) of these eight (8) directors were officers of Ashland Oil. (Exh. M #4; Exh. A #37; Testimony, Denton).

Consolidated Reports

Protestor's Annual Reports and SEC Form 10-Ks included information about Ashland Coal's operations; and coal production and marketing appears as an "industry segment" in the annual reports and 10-Ks, with specific discussion of the activities of Ashland Coal. (Exhs. M #6, #7; H). Ashland Coal did not produce a separate Annual Report until it became a public company in 1988. (Exh. M #8). Ashland Coal was included in Protestor's consolidated financial statement for FYE Sept. 30, 1985, 1986 and 1987; (Exh. J #67); and it was not deconsolidated until 1988. (Testimony, Denton).

Transactions Between Ashland Oil And Ashland Coal

Ashland Coal's sales (principally coal) made to Ashland Oil and affiliates totaled $207,000 in 1988, $29,000 in 1987 and $9,000 in 1986. Ashland Coal also earned interest and other income through transactions with Ashland Oil of $91,000 in 1988, $82,000 in 1987 and $93,000 in 1986. In addition, Ashland Coal paid Ashland Oil interest of $8,000 in 1988, $358,000 in 1987 and $271,000 in 1986 in connection with a line of credit. Ashland Coal purchases petroleum, oil and other products from Ashland Oil. Payments from Ashland Coal to Ashland Oil for such purchases were $5,341,000 in 1988, $4,135,000 in 1987 and $3,736,000 in 1986 (Exh. 2, p. 19).

Ashland Coal has an uncommitted line of credit with Ashland Oil providing for borrowings up to $30,000,000 with the interest rate based on money market rates. (Exh.2, p. 23).

Control By Protestor Of Ashland Coal's Operating And Capital Budgets

Ashland Coal used Protestor's guidelines on investment of excess monies. To the extent that Ashland Coal's investment policy differed from these guidelines, prior approval from Protestor's financial management was obtained. (Exhs. M #9, A #87). Ashland Coal was required to follow major personnel policies and procedures set by Ashland Oil. (Exhs. M #10, A #95). Ashland Oil and Ashland Coal had uniform policies and procedures for hiring. There are common pre-employment tests and screening procedures between the two, but they are common industry pre-employment procedures. (Exhs. M #26, A #88). Prior to 1986, Ashland Coal used a modified version of the Ashland Oil Chart of Accounts. (Exh. A #65).

Intercompany Accounting

Up to March 1, 1984 Ashland Oil had been furnishing internal auditing services to Ashland Coal; and on that date the two parties entered into a formal services agreement memorializing in writing their agreement with respect to these services: Ashland Oil agreed to provide to Ashland Coal and Ashland Coal agreed to pay for Ashland Coal's requirements for internal auditing services (Attachment, Exh. J). Prior to the 8/11/88 sale of Ashland Coal stock, Ashland Oil's internal audit division audited all activities of Ashland Coal and its affiliated companies to prevent theft, fraud, waste or other abuses. After the sale, the internal audit services provided by Ashland Oil ceased. (Exh. J #66).

Intercompany Insurance Planning

Protestor had guidelines and policies regarding insurance coverage limitations, deductibles, etc. for Ashland Coal. (Exh. M #12; Exh. A. #76). Protestor made and/or approved major insurance policy decisions and engaged in insurance planning affecting Ashland Coal. (Exh. M #12; Exh. A #77). Insurance for Protestor and Ashland Coal was maintained and administered through a captive insurance company, and Ashland Coal paid its proportionate share of the cost of insurance. (Exh. M #13, 15; Exh. A #78). Protestor also acquired certain other insurance for Ashland Coal, with Ashland Coal paying its proportionate share of the cost of the insurance. (Exh. A #78). Protestor and Ashland Coal maintained common insurance or insurance policies. (Exh. J. #73). Protestor filed Ashland Coal's insurance claims. (Exh. M #14, Exh. A #74).

Ashland Coal participated in Protestor's executive compensation plans, incentive compensation plans, performance unit plans, stock options, and salary review programs. (Exh. M #23; Exh. A #96). Protestor maintained the employee benefit plans or programs in which Ashland Coal employees participated. (Exh. 3 p. 22). Ashland Coal did not have a separate retirement program until October, 1986, or a separate 401(K) plan until October, 1988. (Exh M #23). Employees who transferred from Protestor to Ashland Coal use their service time with Protestor and Ashland Coal and their average salary at Ashland Coal at retirement in determining their pension benefits. (Exh. M #22; Exh. A #89). The terms regarding fringe benefits, salary, etc. are different for transfers of personnel between Protestor and Ashland Coal than they would be if the two companies were unrelated corporations. (Exh. A #89). For the fiscal years 1985-1988 there were a total of 37 employees who transferred from Ashland Coal to Protestor, and a total of 8 employees who transferred from Protestor to Ashland Coal. (Exh. A #89).

Intercompany Financing

Ashland Coal had a line of credit with Protestor which provided for borrowing up to $30 million, with the interest rate based on money market rates. (Exh. M #16; Exh. 2 p. 23). From time to time, Ashland Coal did borrow money from Protestor. The interest rate was generally set at the average of what Protestor could earn on overnight investments with other parties and what Ashland Coal could borrow overnight from other parties. The loans only occurred "when there was a mutual benefit to both parties". (Exhs. A #82, J #83, Testimony, Denton). Ashland Coal paid Ashland Oil interest in 1986, 1987 and 1988 totaling $637,000 in connection with the line of credit. (Exh. 2, p. 19).

Protestor was contingently liable under guarantees of certain debt and lease obligations of Ashland Coal. (Exh. J #83; Tr. 58). On September 30, 1988, such obligations had a current value of approximately $21,600,000. (Exh. E p. 56).

In the case of certain debentures of Protestor, all assets of Protestor, including its stock in Ashland Coal, were security for the indebtedness. (Exh. A #22). During the audit period, Ashland Coal managed its own funds through its Treasury Department. (Testimony, Denton).

Centralized Purchasing And Services

Protestor did centralized purchasing of office supplies for Protestor and Ashland Coal, resulting in the benefits of volume purchasing. (Exh. M #18; Exh. A #112). Office supplies provided by Protestor to Ashland Coal at the request of, or to accommodate Ashland Coal, were billed to Ashland Coal at Protestor's actual cost. (Exh. 3 pp. 13-14).

Protestor and Ashland Coal entered into certain agreements whereby each party performed designated services for the other. The respective party was billed at an hourly rate which equated to the employer's cost, including benefits, for the services of the employees involved, regardless of which company rendered the services and which company was the recipient of the services. (Exh. M #20).

Services rendered for Protestor by Ashland Coal principally included salaries and expenses of personnel involved in Protestor projects. Charges from Ashland Coal to Protestor for salaries and expenses of personnel were $141,000 in 1988, $121,000 in 1987 and $118,000 in 1986. (Exh. 2 p. 19).

Services provided by Protestor to Ashland Coal included air transportation, building maintenance, printing, office supplies, data processing, telecommunications, insurance, payroll and personnel administration, internal auditing and tax services. Management/service fees were charged for some of those services in accordance with a May 1981 Service Agreement. (Exh. M #19; Exh. 2 p. 19). Protestor prepared Ashland Coal's payroll and employee benefit plan tax returns and was compensated for such under the Services Agreement. (Exh. A #60). Services performed for Ashland Coal under the Agreement were provided at Protestor's costs. (Exh. 3 p. 5; Testimony, Denton). The agreement sets forth formulas to reflect Protestor's "cost of providing the Services." (Exh. 3 p. 5). It also sets forth agreements as to the procedure for requesting and providing the services in order "[t]o facilitate mutual cooperation and coordination of the affairs and activities of both Ashland Oil and Ashland Coal." (Exh. 3 p. 15). During the audit years, the services of Protestor that were billed to Ashland Coal at cost represented from 5.9 to 7.45 percent of Ashland Coal's selling, general and administrative costs. (Exh. 10; Testimony, Denton). Total charges from Ashland Oil to Ashland Coal for services rendered were $705,000 in 1988, $629,000 in 1987 and $750,000 in 1986. (Exh. 2 p. 19).

Employees from different departments of Ashland Oil were involved in providing services to Ashland Coal. (Exh. 3, Schedules I and II, Exh. M #21). Ashland Oil made its fleet of aircraft available to Ashland Coal on an "as available" basis; and Ashland Coal paid for the services at the prevailing rates charged by the Aviation Department. Ashland Oil's Aviation Department provided pilot services and customary maintenance and repair for Ashland Coal's helicopter; and Ashland Coal reimbursed Protestor for such services.

The Services Agreement states that Ashland Coal had the right to use all ideas, concepts, know-how and techniques related to the documents and computer systems provided by the agreement. It also had the right to copies of the computer programs used by Protestor in providing services to Ashland Coal. (Exh. 3 pp. 20-21). Protestor agreed to make its personnel available to Ashland Coal employees for on-the-job training in using the computer systems and know-how transferred to Ashland Coal, with Protestor to be reimbursed for its expenses. (Exh. 3 pp. 21-22).

The amount which Ashland Coal paid to Protestor for Ashland Coal's use of Protestor's offices and a secretary in New York and in Washington, D.C. and for the use of Protestor's computers reflected only Protestor's cost. (Exh. 3 pp. 5, 7-10).

Ashland Coal used Protestor's Government Relations staff, for which Protestor received a monthly charge. Protestor's staffs in Washington, D.C., Ashland, Kentucky, and Charleston, West Virginia worked on issues which affected Ashland Coal. (Exh. A #129).

Intercompany Trademarks And Names

Ashland Coal used the name "Ashland" and related trademarks and tradenames until August 11, 1993. (Exh. M #24). Protestor received no fee for Ashland Coal's right to use Protestor's logo. (Exh. A. #107).

CONCLUSIONS OF LAW

The Iowa Department of Revenue and Finance has jurisdiction of this matter under the provisions of Iowa Code 422.28 made applicable by 422.41. All subsequent references to the Iowa Code are to the 1987 Code, and, unless otherwise indicated, these identical provisions were in effect at all times relevant to the audit period under consideration - FYE September 30, 1985, 1986, 1987 and 1988.

The issues presented for consideration are twofold:

1.          Whether the Department erred in including certain dividends received during the Protestor's 1985 through 1988 fiscal years in income subject to apportionment by the state of Iowa.

2.          Whether the Department erred in including the entire gain realized by Protestor on its sale of a portion of the equity interest which Protestor held in Ashland Coal, Inc.

The taxpayer has the burden of proving that income should be excluded from the tax base, Super Valu Stores v. Dept. of Revenue, 479 N.W.2d 255, 258 (Iowa 1991), citing Richards v. Iowa Dept. of Revenue, 360 N.W.2d 830, 831 (Iowa 1985) (assessment of income tax presumed to be correct; taxpayer has burden of proof of error).

I. PROTESTORS INVESTMENT INCOME WAS SUBJECT TO APPORTIONMENT

Iowa Code 422.33 sets forth the method for taxing the net income of corporations in Iowa. The statute categorizes the net income of corporations as either business or nonbusiness income. If the corporation's trade or business is carried on partly within and partly without Iowa, the business income is apportioned by use of a single factor formula consisting of gross receipts. Nonbusiness income is allocated to sources within Iowa or to sources without Iowa depending on the type of income and/or the commercial domicile of the taxpayer.

Under Iowa Code 422.33(b)(1), investment income such as dividends, interest, rents and royalties is subject to apportionment under rules adopted by the Director. Pursuant to Rule 701 IAC 54.2(422), such income is apportioned as business income to the extent the income was earned as a part of a corporation's unitary business, a portion of which was conducted in Iowa. The rule cites as authority, for including investment income as business income subject to apportionment, the following United States Supreme Court cases: Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425 (1980); ASARCO, Inc. v. Idaho State Tax Commission, 458 U.S. 307 (1982); F. W. Woolworth Co. v. Taxation and Revenue Dept., 458 U.S. 354 (1982); Container Corporation of America v. Franchise Tax Board, 463 U.S. 159 (1983).

Accordingly, the dividend and gain issues in the instant case can be resolved by determining whether the Protestor was engaged in a unitary business relationship with Ashland Coal and the other dividend paying companies. If the Protestor was engaged in a unitary business relationship with Ashland Coal and the other dividend paying companies, the dividend and gain income at issue is business income apportionable within and without Iowa. On the other hand, absent a unitary business relationship, the dividend and gain income at issue is nonbusiness income allocable without Iowa.

The prerequisite to a constitutionally acceptable finding of unitary business is a flow of value (not a flow of goods). Container, 463 U.S. at 561. As stated in F. W. Woolworth, 458 U.S. at 364, a relevant question in the unitary business inquiry is whether " 'contributions to income [of the subsidiaries] result[ed] from financial integration, centralization of management, and economies of scale.' " 458 U.S. at 364, quoting Mobil, 445 U.S. at 438."[S]ubstantial mutual interdependence," F. W. Woolworth, supra at 371, can arise in any number of ways; a substantial flow of goods is clearly one but just as clearly not the only one." What is required is "that the out-of-state activities of the purported 'unitary business' be related in some concrete way to the in-state activities.

If the unitary business principles discussed in the U.S. Supreme Court cases are satisfied, then the definition of "unitary business" in Iowa Code 422.32(5) will also be met. Section 422.32(5) defines "unitary business: as "a business carried on partly within and partly without a state where the portion of the business carried on within the state depends on or contributes to the business outside the state." If there is a flow of value between two parts of the business, due to such things as centralized management, functional integration or economies of scale, then the portion of the business carried on within the state will depend on or contribute to the business outside the state.

Although Rule 701 IAC 54.2 does not address capital gains, it is well settled in Iowa that capital gains are treated in the same manner as investment income. In Super Valu Stores, Inc. v. Department of Revenue and Finance, 479 N.W.2d 255, (1991) the Iowa Supreme Court held that Super Valu's gain on the sale of its subsidiary's stock was business income to apportionment because Super Valu and its subsidiary were engaged in a unitary business operation.

THE GAIN ON THE SALE OF ASHLAND COAL STOCK AND THE DIVIDENDS RECEIVED FROM ASHLAND COAL WERE PROPERLY INCLUDED IN APPORTIONABLE INCOME, BECAUSE THERE WAS A UNITARY RELATIONSHIP BETWEEN PROTESTOR AND ASHLAND COAL.

Protestor argues that under the principles enunciated in ASARCO, Inc. v. Idaho State Tax Commission, 458 U.S. 307, 73 L.Ed.2d 787, 1025, Ct. 3103 (1982), the Protestor was not engaged in a unitary business operation with Ashland Coal and the other dividend paying companies. In ASARCO, the Supreme Court found that there was no unitary relationships between the parent corporation and its subsidiaries, some of which sold to or purchased from the parent substantial amounts of products. The prices paid for the products were fairly negotiated and no different than if unrelated parties had made the same transaction. While there were management links between ASARCO and subsidiaries, ASARCO's majority interest was never exercised and ASARCO exercised no control over the management of the subsidiaries. The Court articulated the principle that actual exercise of control of a subsidiary, as distinguished from the legal right to control the company, is a sine qua non of a unitary business relationship, and found that while ASARCO had the control potential to manage its subsidiaries, no claim was made that it had done so; and that while the dividend paying subsidiaries added to the riches of ASARCO, they were "discrete business enterprises" that in any business or economic sense had nothing to do with the business activities of ASARCO in Idaho.

In ASARCO some of the subsidiaries sold to or purchased from the parent substantial amounts of products, but the products were fairly negotiated in the same manner as if the parties were unrelated. In addition, the parent exercised no control over the management of the subsidiaries, did not provide any financing to them, and the few services rendered were negotiated as to price which included a profit element, the same as if the subsidiaries had dealt with an unrelated third party. Although engaged in similar businesses, the parent and the subsidiaries operated independently of each other. Under these circumstances, the Supreme Court found that the parent and subsidiaries lacked any unitary relationship. Therefore, dividends paid by the subsidiaries to the parent and interest and capital gains associated with subsidiary stock and debentures were held to be nonunitary income.

The facts presented in ASARCO are substantially different than those presented by Ashland Oil. ASARCO appointed only 6 of Southern Peru's 13 directors and 8 votes were required to pass any resolution. Neither Southern Peru nor the other subsidiaries sought or were given direction or approval from ASARCO on major decisions, and ASARCO did not "control Southern Peru in any sense of that term."

In contrast to ASARCO, the facts in this case show that Protestor controlled or managed much of Ashland Coal's business. Five of Ashland Coal's eight directors were key officers of Protestor. The Chairman of Ashland Coal's Board of Directors reported directly to Protestor's Chief Executive Officer, and his primary duties pertained to Protestor's regular trade or business. The President of Ashland Coal was an officer of Protestor. As directors of Ashland Coal, officers of Protestor set guidelines and reviewed critical decisions of Ashland Coal. Ashland Oil's officers and Director could and did control Ashland Oil. Protestor could individually disapprove of and prevent Ashland Coal from engaging in objectionable activities.

In Container, 463 U.S. at 562, 77 L.Ed.2d at 563 n. 19, the Court observed that the mere decentralization of day-to-day management responsibility and accountability cannot defeat a finding of a unitary business, and provided, "The difference lies in whether the management role that the parent does play is grounded in its own operational expertise and its overall operational strategy." Protestor's management of Ashland Coal clearly was grounded in its own operational expertise and its overall operational strategy.

In F. W. Woolworth Co. v. Taxation and Revenue Dept. of the State of New Mexico, 458 U.S. 354, 73 L.Ed.2d 819, 102 S.Ct. 3128 (1982), the court considered a situation where the taxpayer parent corporation owned four foreign subsidiaries. New Mexico apportioned Woolworth's income for taxing purposes and included in such income dividends paid by subsidiaries. On appeal of the New Mexico Supreme Court's approval of this action, the United States Supreme Court's applied the unitary business principle and found the subsidiaries to be separate business entities. It determined, as in ASARCO, that the mere potential to control is insufficient to find a unitary business. Moreover, mere financial advantage achieved from dividends does not warrant a finding that a subsidiary is part of a unitary business.

The Court in Woolworth concluded that the contributions to income did not result from functional integration nor centralization of management. Functional integration was absent since the subsidiaries did all their own purchasing, staffing and training. Further, there was no centralized management. The subsidiaries had separate and distinct management personnel and training systems for such personnel. They made their own management decisions, determined their own policies and obtained financing from sources other than parent. With one exception, none of the subsidiaries' officers during the year in question was a current or former employee of the parent; Woolworth did not rotate personnel or exchange personnel; and each subsidiary had its own complete accounting department and financial staff. The situation presented by Ashland Oil is substantially different from all of the foregoing Woolworth facts.

It should be noted that the ASARCO and Woolworthcases were decided by the United States Supreme Court in 1982. In 1983, the court issued a decision sustaining the finding of a unitary business in Container Corp. of America v. Franchise Tax Bd., 463 U.S. 159, 77 L.Ed.2d 545, 103 S.Ct. 2933. During the tax years under consideration, Container owned controlling interest in 20 foreign corporations that were, by and large, engaged in essentially the same line of business as the taxpayer - parent, the manufacture and distribution of packaging. The operation of Container is vertically integrated and includes the production of paperboard from raw timber and waste paper, plus the composition into the finished products ordered by customers.

Factors that the Container court relied on to conclude that Container and its foreign subsidiaries constituted a unitary operation included the following: taxpayer made sales of raw material to subsidiaries; taxpayer used a senior vice president and four other officers to oversee operations of subsidiaries, and these officers established general standards of professionalism, profitability and ethical practices; Container had a large number of its officers and directors on the boards of the subsidiaries (although they did not play an active role in management decisions); taxpayer provided financing, technical assistance, advice, technical services, insurance and cost accounting; procurement of equipment; and the interplay of the taxpayer and subsidiaries in the area of corporate expansion.

The facts in the instant case are strikingly similar to Container. As in the Container case, Protestor, through its stock ownership, exercised control over its subsidiary, Ashland Coal; and there was a substantial flow of value or contributions to income that resulted from centralization of management, functional integration and economies of scale.

CENTRALIZED MANAGEMENT

The facts in this case show that Protestor controlled or managed much of Ashland Coal's business. Five of Ashland Coal's eight directors were key officers of Protestor. The Chairman of Ashland Coal's Board of Directors reported indirectly to Protestor's Chief Executive Officer, and his primary duties pertained to Protestor's regular trade or business. The President of Ashland Coal was an officer of Protestor. As directors of Ashland Coal, officers of Protestor set guidelines and reviewed critical decisions of Ashland Coal.

Ashland Coal began as a wholly-owned subsidiary of Protestor, and at the time of the sale resulting in the gains at issue Protestor still owned 65% of the stock of Ashland Coal. There was managerial integration or centralization of management, and Ashland Oil's management of Ashland Coal was grounded on its own operational expertise and its overall operational strategy. Protestor did financial planning in formulating how its employees serving on Ashland Coal's Board of Directors would carry out their responsibilities as Directors. To the extent that Ashland Coal's investment policy differed from Protestor's guidelines on investment of excess monies, prior approval from Protestor's financial management was obtained. Ashland Coal was required to follow personnel policies and procedures set by Protestor. Ashland Coal's activities were routinely monitored by designated executives of Protestor. There were certain voting requirements that required that all classes of stock be involved in certain significant business decisions. These were matters which Protestor could not individually approve but could individually "veto" and, thereby, control.

The situation is similar to that presented in M. Lowenstein Corp. v. S.C. Tax Com'n., 378 S.Ed2d 272, 278 (S.C. Ct. App. 1989), where the Court found that Lowenstein exercised virtual control over a subsidiary even though certain significant actions required approval of 96% of the stockholders, and Lowenstein owned only 93% of the stock.

Although potential control is not dispositive in determining whether a particular set of activities constitutes a unitary business for purposes of taxation, it is relevant both to whether or not the components of the purported unitary business share that degree of common ownership which is a prerequisite to a finding of unitariness, and also to whether there might exist a degree of implicit control sufficient to render the parent corporation and the subsidiary an integrated enterprise. Container, 463 U.S. at 159, n. 16. The evidence presented in this case clearly shows that high officials of Ashland Oil gave directions to Ashland Coal for compliance with the parent's standard of professionalism, profitability, and ethical practices.

FUNCTIONAL INTEGRATION

Container presented a case of a "functionally integrated enterprise". The Court looked at a combination of factors: Container's assistance to subsidiaries in obtaining equipment and filing personnel needs; loaning funds to subsidiaries and guaranteeing loans provided by others; considerable interplay between parent and subsidiaries in the area of corporate expansion; substantial technical assistance; provided by parent to subsidiaries. See also: Earth Resources Co. v. State Dept. of Revenue, 665 P.2d 960 (Alaska 1983).

In each of the foregoing respects, Protestor presents a case of "functionally integrated enterprise". There was a flow of capital resources from Protestor to Ashland Coal through loans and loan guarantees. Ashland Coal had an uncommitted line of credit with Ashland Oil provided for borrowing up to $30,000,000 with the interest rate based on money market rates; and Ashland Coal purchased petroleum products from Protestor totaling over $13,000,000 during the assessment period. From time to time, Ashland Coal did borrow money from Protestor; and Protestor was contingently liable under guarantees of certain debt and lease obligations of Ashland Coal. On Sept. 30, 1988, such obligations had a current value of about $21,600,000.

Protestor did centralized purchasing of office supplies for Protestor and Ashland Coal, resulting in the benefits of volume purchasing; and Protestor exchanged personnel with Ashland Coal. During the fiscal years 1985 - 1988, there was a total of 37 employees who transferred from Ashland Coal to Protestor, and a total of 8 employees who transferred from Protestor to Ashland Coal, while a total of 360 employees from eighteen different departments of Protestor were involved in providing services to Ashland Coal. Prior to the sale of Ashland Coal stock, Protestor's internal audit division audited the activities of Ashland Coal to prevent theft, fraud, waste or other abuses. Protestor made and/or approved major insurance policy decisions and maintained common insurance or insurance policies and plans, compensation plans, stock options, performance unit plans and salary review programs, retirement programs and other employee benefit plans, Ashland Oil provided on-the-job training programs for Ashland Coal employees. Increasing the coal operations of Ashland Coal was an important part of Ashland Oil's overall business strategy since 1981, it having been determined that diversification by investing in its non-refining business was essential to Ashland Oil's strong financial condition.

In M. Lowenstein Corp. v. S.C. Tax Com'n., 378 S.E.2d 272, 278 (S.C. Ct. App. 1989), an element of functional integration identifying a unitary relationship was "the corporations' holding themselves out to the public as being integrated." In this case, Protestor and Ashland Coal held themselves out to the public as being integrated in annual reports and Form 10-Ks - coal production and marketing appears as an "industry segment" in Protestor's annual reports and Form 10'Ks, and the 10-Ks indicate that Protestor is a substantial coal producer and marketer; and the annual reports indicate that Ashland Coal was a big factor in Protestor's success.

Another indicator of functional integration is "transactions not undertaken at arm's length." Allied-Signal, Inc. v. Director of Taxation, 60 U.S.L.W. 4554, 4559 (U.S. June 15, 1992) No. 91- 615. Protestor and Ashland Coal provided each other with many services and did not charge an "arm's length" fee which would have included a profit element. The respective party was billed at an hourly rate which equated to the employer's cost, including benefits, for the services of the employees involved, regardless of which company rendered the services and which company was the recipient of the services. Management/service fees equal to Protestor's costs were charged for some of the provided service in accordance with a May 1981 Service Agreement. The procedure for requesting and providing the services was intended "[t]o facilitate mutual cooperation and coordination of the affairs and activities of both Ashland Oil and Ashland Coal."

Ashland Coal's use of Protestor's offices and a secretary in New York and Washington, D.C. and use of Protestor's computers were not at "arm's length" either since the charge reflected on Protestor's cost. To the extent legal services were performed for Ashland Coal by Protestor, Ashland Coal was billed on a cost basis. The terms regarding fringe benefits, salary, etc. are different for transfers of personnel between Protestor and Ashland Coal than they would be if the two companies were unrelated corporations.

ECONOMIES OF SCALE

Economies of scale existed in many forms in addition to those already referred to. Protestor and Ashland Coal had uniform policies and procedures for hiring. Prior to 1986, Ashland Coal used a modified version of Protestor's Chart of Accounts. Protestor's internal audit division audited all activities of Ashland Coal and its affiliated companies to prevent theft, fraud, waste or other abuses. Protestor had guidelines and policies regarding insurance for Ashland Coal. Protestor made and/or approved major insurance policy decisions and engaged in insurance planning affecting Ashland Coal. Insurance for Protestor and Ashland Coal was maintained and administered through a captive insurance company, with Ashland Coal paying only its proportionate share of the cost of insurance. Protestor and Ashland Coal maintained common insurance or insurance policies. Protestor filed Ashland Coal's insurance claims. Ashland Coal participated in Protestor's executive compensation plans, incentive compensation plans, performance unit plans, stock options, and salary review progress. Protestor maintained the employee benefit plans or programs in which Ashland Coal employees participated. Protestor did centralized purchasing of office supplies with resulting savings from volume purchasing.

Ashland Coal had the right to use all ideas, concepts, know-how and techniques related to the documents and computer systems provided by the Services Agreement. It also had the right to copies of the computer programs used by Protestor in providing services to Ashland Coal. Protestor made its personnel available to Ashland Coal employees for on-the-job training in using the computer systems and know-how transferred to Ashland Coal, with Protestor only reimbursed for expenses.

Ashland Coal used Protestor's Government Relations staff, for which Protestor received a monthly charge. Ashland Coal had the right to use, at no charge, the name "Ashland" and related trademarks and tradenames until August 11, 1993.

II. DIVIDENDS FROM PAYORS OTHER THAN ASHLAND COAL WERE ALSO PROPERLY APPORTIONED UNDER IOWA LAW

Protestor has not satisfied its burden of establishing that either Ashland Coal or the other subsidiaries of Ashland Oil were not unitary with Protestor. Indeed, very little information was presented as regards subsidiaries other than Ashland Coal. Ashland Oil owned 50% or less of the stock in each of the other dividend paying companies, but that factor alone does not preclude a finding of unitariness. Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425, 63 L.Ed.2d 510, 100 S.Ct. 1223 (1980).

Protestor argues that Iowa requires a corporation to own 80% of the stock of another corporation before a unitary business relationship can exist between the two corporations.

The requirement of 80% ownership is not imposed by the portion of the consolidated return statute which refers to the unitary business, 422.37(2), but by the portion which requires that a consolidated return be filed for federal income tax purposes, 422.37(1). As Protestor points out, in order to be included in a consolidated federal return, at least 80% of a company's stock must be owned by the common parent of the affiliated group. The 80% ownership requirement has nothing to do with whether the affiliate satisfies the separate requirement of being subject to the Iowa tax or unitary with a member subject to the Iowa tax.

Protestor does not argue or contend that it was subjected to double taxation. Protestor's commercial domicile was, and is, Kentucky. On its Kentucky income tax return, Protestor did not allocate 100% of the capital gains at issue or dividend income to Kentucky, in that Kentucky does not tax dividends.

DECISION

The Department properly included the gains and dividends at issue in Protestor's apportionable income tax in that Protestor had a unitary relationship with Ashland Coal and the other dividend payors.

No affidavit has been filed by the Protestor under 701 IAC 7.9 seeking the deletion of identifying details in this case, if any.

Pursuant to Iowa Code 17A.15(3) (1991), this Proposed Order becomes the final order of the Iowa Department of Revenue and Finance without further proceedings unless there is an appeal to, or review on motion of, the Department within thirty (30) days of the issuance of this Proposed Order.

Issued this 11th day of December, 1992.

IOWA DEPARTMENT OF REVENUE AND FINANCE

Elizabeth W. Duncan Administrative Law Judge