In Agilent Technologies Inc.,¹ a Colorado District Court (court) held that the Colorado Department of Revenue (Department) erred in requiring a holding company with no property or payroll of its own to be included in an affiliate corporation's Colorado combined return because the holding company does not meet the definition of an "includable C corporation" under C.R.S. Section 39-22-303(12)(c). Notably, the court also held that the Department, for Colorado income tax purposes, is not required to treat the holding company and its foreign subsidiaries as a single C corporation merely because they elected to be treated as disregarded entities for federal income tax purposes.

Agilent Technologies and its consolidated group (Agilent) do business in Colorado and file a Colorado combined return. A related holding company, Agilent Technologies World Trade, Inc. and its foreign subsidiaries (collectively, World Trade) are part of Agilent's unitary business. At issue is whether the Department acted properly under C.R.S. Section 39-22-303 by requiring the inclusion of World Trade in Agilent's Colorado combined return.

Agilent argued that World Trade cannot be included in it Colorado combined return because: (1) World Trade did not meet the definition of an "includable C corporation" under C.R.S. Section 39-22-303(12)(c); (2) under the federal check-the-box regulations as followed by Colorado, the Department is precluded from including World Trade in the combined return; (3) World Trade cannot be included because it did not satisfy at least three of the six factors under C.R.S. Section 39-22-303(11)(a) (e.g., the statutory requirements for inclusion in a Colorado combined return); and (4) inclusion of World Trade results in the impermissible discrimination against corporations that own foreign subsidiaries. The Department argued that inclusion of World Trade in Agilent's combined return is warranted under Colorado's adjustment provision in C.R.S. Section 39-22-303(6) and the economic substance doctrine in order to clearly reflect the group's income.

In ruling in favor of Agilent, the court held that World Trade did not meet the statutory definition of includable C corporation and, therefore, should not be included in Agilent's Colorado combined return. Colorado's combined reporting statute defines an affiliated corporation or group as "one or more chains of includable C corporations connected through stock ownership with a common parent C corporation,"² and an includable C corporation as "any C corporation [that] has more than 20% of the C corporation's property and payroll as determined by factoring pursuant to section 24-60-1301, C.R.S. [the Multistate Tax Compact, which uses an equally weighted three-factor formula], assigned to locations inside the United States."³ The court found that "[t]here is some ambiguity as to how section 303(12)(c) should be applied to a company with no property or payroll of its own, such as World Trade," but determined that the Department directly addressed this ambiguity by its own regulation in 1 CCR 201-2, Reg. 39-22-303.(12)(c) (hereinafter, the regulation), which provides that corporations with no property or payroll of their own, by definition, cannot be included in a Colorado combined return because they cannot have 20% or more of their factors assigned to locations in the United States.

The Department argued that, despite the regulation, it is justified in including World Trade in Agilent's combined return under factoring conducted in accordance with C.R.S. 24-60-1301. Specifically, the Department argues that World Trade has value factors for purposes of C.R.S. 24-60-1301 — and consequently, C.R.S. Section 39-22-303(12)(c) — because it uses Agilent's property and personnel for all purposes, including documenting World Trade's loan transactions. This "required factoring," the Department argues, causes World Trade to be an includable C corporation. This argument, the court said, depends on it "disregarding ... the regulation in the face of statutory ambiguity." The court reviewed the history of the regulation and explained that the Office of Legislative Legal Services (OLLS) concluded that an earlier version of the regulation, which allowed a corporation with no property or payroll and functions through the use of personnel services and/or property of an includable corporation to also be an includable corporation, did not comply with the governing statute. The General Assembly agreed with OLLS's conclusion and voted to allow the former regulation to expire in June 1991. The current regulation was subsequently adopted in 1994.

Based on the history of the regulation, the court agreed with Agilent's argument that the General Assembly's rejection of the prior regulation "confirms to some degree that the Department's position is contrary to the intent of the General Assembly." Moreover, the court found the current regulation is directly on point and cannot be ignored while in effect. Accordingly, companies such as World Trade — a holding company with no property or payroll of its own — cannot be included in a Colorado combined report as an includable C corporation.

The court rejected all of the other arguments put forth by Agilent as well as the Department. Most notably, the court found that the Department is not required, for state income tax purposes, to treat World Trade as a single C corporation simply because it elected to have its subsidiaries treated as disregarded entities for federal income tax purposes. Under the federal check-the-box rules, certain entities elect how they will be classified for federal income tax purposes — e.g., for federal income tax purposes, the entity can elect to have its separate legal status disregarded and instead be treated as a division of its parent/owner/member. During the years at issue, World Trade and four of its foreign subsidiaries elected to be treated as disregarded entities for federal income tax purposes and were treated as a single C corporation as a result.

Agilent argued that the Department must respect World Trade's check-the-box election and treat World Trade and its foreign subsidiaries as a single C corporation for Colorado income tax purposes. In support of this argument, Agilent relied on C.R.S. Section 39-22-103(2.5) and (11) and 103(2.5), which defines a C corporation as any organization taxed as a corporation for federal income tax purposes, and 103(11), which provides, in relevant part, that terms used in the Colorado income tax code "shall have the same meaning as when used in a comparable context in the internal revenue code. ... " In further support of this assertion, Agilent relied on the legislative declaration in C.R.S. Section 39-22-102(b), which provides that one purpose of Colorado's Income Tax Act is aiding in the interpretation of state income tax law through increased use of federal judicial and administrative determinations and precedents.

In disagreeing with this argument, the court held that the plain language of C.R.S. Section 39-22-103(2.5) and (11) "does not support Agilent's interpretation because, taken together, these provisions "require the Department to look to federal law in determining whether an entity should be defined as a C corporation." Here, World Trade was incorporated in Delaware and is clearly defined as C corporation for federal income tax purposes. Moreover, the court found nothing in the statutory language requiring the Department to treat World Trade and its foreign subsidiaries' according to their check-the-box designation. The court also found a "contextual disconnect between the state and federal statutory schemes" that does not support Agilent's argument. Specifically, Colorado's combined reporting statute and the federal check-the-box rules serve different purposes,⁴ so "an entity's choice of federal designation is not binding for purpose of state application under [the state's combined reporting rules]." Lastly, the court found that "Agilent's interpretation would not 'give consistent, harmonious, and sensible effect' to the entirety of C.R.S. Section 39-22-303" in that it would create an opportunity for taxpayers to avoid application of C.R.S. Section 39-22-303(11), which sets forth the factors for inclusion of a subsidiary in its parents combined return, through "creative check-the-box elections."

In regard to the other arguments, the court held: (1) World Trade satisfied the requirements of C.R.S. Section 39-22-303(11)(a) for inclusion in a Colorado combined return (common directors, common officers, substantial use of trademarks); (2 ) inclusion of World Trade does not violate the Commerce Clause, as it does not result in the impermissible discrimination against corporations that own foreign subsidiaries; and (3) the Department's inclusion of World Trade in Agilent's combined return is not warranted under Colorado's adjustment provision in C.R.S. Section 39-22-303(6) and the economic substance doctrine.

Implications

In January 2016, the Department issued Notice Regarding Revenue Regulation 39-22-303.12(c), to advise taxpayers not to rely on the regulation except as it applies to a foreign sales corporations (FSC) until further notice. The Department explained that the regulation was intended to address the treatment of FSCs under C.R.S. Section 39-22-303(12)(c), and that it disagrees with some taxpayers' interpretations that the exclusion also applies to domestic holding companies with no foreign operations. The Department indicated that it will not take further action on the regulation until a final ruling is issued by the courts.

It is likely the Department will appeal this decision, and there is also said to be another similar case currently before the District Court. As it may take years for this issue to makes its way through the judicial process, taxpayers filing a Colorado combined report with holding company subsidiaries with no payroll or property of their own should considering their procedural options (e.g., filing amended returns to exclude such corporations).

The court's ruling that federal entity classifications do not apply when testing the status of an 80-20 company was surprising, and could have implications beyond the facts of this case. While the case specifically dealt with 80-20 company testing in the context of disregarded foreign entities, the court's rationale could extend to all determinations made with respect to Colorado's combined reporting rules. For example, when considering whether corporations meet the three of six unity tests, the court's rationale suggests that testing should be applied without consideration of federal entity classification rules (e.g. tests applied between and among corporations and DRES as single entities). As another example, the court's rationale could be read to suggest that, when a corporation forms or acquires a disregarded domestic single member LLC, that LLC would be separately removed from the Colorado combined return under the "two-year rule."

———————————————

———————————————
ENDNOTES

¹ Agilent Technologies, Inc. v. Colorado Department of Revenue, No. 2014CV393 (Colo. Dist. Ct., Denver Cnty., Jan. 20, 2016).

² C.R.S. Section 39-22-303(12)(a).

³ C.R.S. Section 39-22-303(12)(c).

⁴ Colorado's law provides rules for inclusion of a business in a unitary group; check-the-box allows affiliated companies to elect consolidation by choosing to be treated as a disregarded entity.