In two separate opinions — Agilent Technologies Inc.¹ and Oracle² — the Colorado Supreme Court (Court) affirmed lower court rulings and held that corporate taxpayers are not required by a state statute to include affiliated holding companies that do not have property or payroll in Colorado in their respective Colorado combined return because the holding companies did not fall within the definition of "includable C corporation" for purposes of Colorado's combined reporting rules. The Court also rejected the Department's alternative argument that it had the authority to allocate the holding companies' gross income to the affiliates to avoid abuse and to clearly reflect income, finding that the taxpayers followed the statutes as written. In response to these rulings, the Colorado Legislature approved and the Governor signed into law a legislative "fix" (SB 19-233), requiring domestic holding companies without property or payroll to be included in combined corporate income tax returns.

Background

By Colorado statute (Colo. Rev. Stat. (C.R.S.) Section 39-22-303(8)), corporate taxpayers are not required to include in a combined report the income of a C corporation that conducts business outside the US if 80% or more of its property and payroll is assigned (as determined by factoring formula for apportioning business income) outside the US. Another provision (C.R.S. Section 39-22-303(12)(c)) defines an "includable C corporation" as one that has more than 20% of its property and payroll (as determined by factoring formula for apportioning business income) assigned to locations inside the US. Further, the statutory provision (C.R.S. Section 39-22-303(11)(a)) for inclusion in a Colorado combined return requires a corporation to satisfy at least three of six factors (i.e., Colorado's unique "three-of-six test").

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) were stipulated to be part of Agilent's unitary business. World Trade did not conduct any activities in Colorado or own property or have payroll in the US. Rather, World Trade owned stock in foreign subsidiaries that operated outside the US. For the periods at issue, Agilent filed separate returns that did not include World Trade.

In the other case, similarly, Oracle is the parent corporation of a worldwide group of affiliated corporations. OJH is Oracle's wholly owned subsidiary. OJH did not conduct any activities in Colorado or own property or have payroll in US, but held stock in a foreign company. Oracle filed a Colorado combined return that did not include OJH.

At issue in both cases was whether the Colorado Department of Revenue (Department) acted properly under C.R.S. Section 39-22-303 by requiring the inclusion of each of these holding companies in their respective Colorado combined returns.

Lower courts held that the Department erred in requiring the inclusion of the holding companies in their affiliated corporations' respective Colorado combined returns because the holding companies did not have property or payroll of their own and, therefore, did not meet the definition of "includable C corporation" under C.R.S. Section 39-22-303(12)(c) and its associated Departmental regulation. These courts also found the Department's inclusion of the holding companies in the combined return was not warranted under Colorado's adjustment provision in C.R.S. Section 39-22-303(6) or the economic substance doctrine. The decisions were appealed.

In separate opinions, the Court ruled in favor of each of Agilent and Oracle, with the substance of the Court's analysis being set out in the Agilent decision and referenced in the Oracle ruling. Consequently, this Alert will focus on the Court's ruling in the Agilent decision.³

Holding companies are not includable C corporations

The Court first considered whether World Trade is an "includable C corporation" within the meaning of the statute such that the Department may include any such corporation that meets the three-of-six test in the taxpayer's combined return. The Court determined it "is not such a corporation." To be an includable C corporation under the statute, the corporation must have more than 20% of its property and payroll (as determined by the factoring rules set forth under C.R.S. 24-60-1301) assigned to locations in the US. Because World Trade does not have property or payroll in the US, it is does not meet that definition and therefore cannot be part of the chain of includable corporations, regardless of whether it meets the three-of-six text. Therefore, the Court concluded that the Department may not require including World Trade in Agilent's Colorado combined return under C.R.S. Section 39-22-303(11)(a).

The Court found "directly on point" in support of its conclusion the Department's own regulation (1 CCR 201-2, Reg. 39-22-303.12(c)), 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 US. The Court rejected the Department's argument that the regulation does not apply as it was intended to apply solely to foreign sales corporations as defined under the Internal Revenue Code at the time, finding that "[t]he regulation does not express any such limitation." Further, the Court "deem[s] as significant the fact that when the Department adopted a regulation that mirrored the argument that it is making before us, the legislature rejected the Department's position," with the Office of Legislative Legal Services determining that the regulation "conflict[ed] with the definition of "includible corporations" as set forth in C.R.S. Section 39-22-303(12)(c) … "

The Court also was unpersuaded by the Department's argument that World Trade should be included in the combined return because it had domestic property as it used Agilent's tangible property. The facts, the Court determined, failed to show how, if at all, World Trade used this property.

Allocation of the holding companies' gross income to affiliates not required to avoid abuse

The Court also rejected the Department's alternative argument that under C.R.S. Section 39-22-303(6) it could include the holding companies in the combined return to prevent abuse and to clearly reflect income. The Court was not persuaded by this argument, finding that the Department's "own regulation again undermine[d] its argument." The regulation, 1 CCR 201-2, Reg. 39-22-303.6, has been superseded by C.R.S. 39-22-303(11) as the provision that determines when combined reporting may be required. To find otherwise, the Court reasoned, would render C.R.S. 39-22-303(11) meaningless because the Department "could always override the result" as "necessary to avoid abuse and to clearly reflect income."

Further, the Court held that even if Reg. 39-22-303.6 could apply, it nevertheless is inapplicable to the facts at issue. The Court rejected the Department's view that "abuse" is a broad concept and can exist when a taxpayer reduces its tax liability by ordering its affairs to comply with statutory language while contradicting its intent that "a corporate structure may constitute abuse if that structure serves a legitimate business purpose." The Court reasoned that the Department's construction of the relevant statutes and regulations is "inconsistent with the clear and unambiguous language of those provisions … and [the Court] cannot adopt such a construction."

Lastly, the Court found that the evidence presented showed that Agilent formed World Trade for legitimate non-tax related purposes. Thus, the evidence precluded the Department from finding that an allocation is necessary to avoid abuse.

Legislative "fix"

As these cases were pending before the Court, the Legislature approved SB 19-233, in response to the earlier appellate court's ruling, to require domestic holding companies without property or payroll to be included in combined corporate income tax returns. Three days after the Court's ruling in these cases, Colorado Governor Jared Polis signed SB 19-233 into law.

Specifically, C.R.S. Section 39-22-303(12)(c) is repealed and new section C.R.S. Section 39-22-303(11)(f) is added to make clear that any domestically formed C corporation with de minimis or no property and payroll (as determined by factoring under C.R.S. 24-60-1301), will be deemed to satisfy the requirements under C.R.S. Section 39-22-303(11)(a) (i.e., the three-of-six test). The Department is tasked with promulgating rules prescribing the manner in which the de minimis standard will be uniformly applied.

Further, new section C.R.S. Section 39-22-303(11)(g) provides that for purposes of satisfying the conditions set forth in C.R.S. Section 39-22-303(11)(a)(I) to (11)(a)(IV), the activities of any domestically formed entity treated as a partnership will be treated as activities performed by the member of the affiliated group of C corporations that own a portion of the entity, if more than 50% of the entity's ownership interest is held in the aggregate by one or more members of the affiliated group. If there is more than one owner, the entity's activities will be treated as activities performed by each member that owns a portion of the entity.

The Department is required to convene a stakeholder working group on or before September 1, 2019, to discuss policies and issues arising from the state's combined reporting laws.

These changes will take effect on August 2, 2019, unless a referendum petition is filed against SB 19-233 before it takes effect. If such petition is filed, it will be voted on by residents of Colorado during the November 2020 general election.

Implications

Taxpayers filing a Colorado combined report with holding company subsidiaries that do not have any payroll or property of their own should consider their procedural options (e.g., filing amended returns to exclude such corporations for periods prior to the effective date of the legislative fix).

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ENDNOTES

¹ Colorado Dept. of Rev. v. Agilent Technologies, Inc., 2019 CO 41 (Colo. S.Ct. May 28, 2019).

² Colorado Dept. of Rev. v. Oracle, 2019 CO 42 (Colo. S.Ct. May 28, 2019).

³ For the reasons discussed below, the Court also held that the Department could not require Oracle to include OJH in its combined return because OJH was an includable C corporation. Further, the Department do not have the authority under Reg. 39-22-303.6 to allocate the holding company's gross income to the affiliates to avoid abuse and to clearly reflect income.