Tax And Auditing

Answer the questions described below. Please make sure to include citations to appropriate authorities.

A. Please defend Alixco’s non-unitary tax filing position.

B. How should the items of income for each company be characterized between business and non-business income? Please prepare your response assuming the auditor has prepared his audit report based on the MTC regulations.

C. Describe how sales of Alixco into California would be apportioned on the combined Missouri tax return and how sales of Alixco into California would be apportioned on the combined California corporate tax return (assuming California follows the “Finnigan” rule). Why?

Smith’s Home Hardware is a successful Arizona based retail operation, realizing significant profits from its retail hardware stores. Smith’s creates a subsidiary (“Alixco”) by contributing $70 million of capital. The contribution of capital includes: $15 million of inventory, $15 million of CD’s, a $10 million office building in Missouri, and patents on high-tech power tools worth $30 million. Alixco’s offices are entirely in Missouri. Alixco will manufacture and sell power tools to the construction industry. In 2001, Alixco realizes income as follows: tool sales $100 million, interest on commercial CD’s $50,000, rent from 9 floors of its 10-story office building $1.5 million, and royalty income of $3 million from overseas licensing of its tool patents. Total business deductions for the year are $85 million.

Alixco hires a president in Missouri. Officers of Smith’s Home Hardware make up the balance of the Board of Directors and Officers. Smith’s internal accounting staff in Arizona maintains the books. A CPA firm in Missouri prepares annual financial statements. The only assets held by Alixco are those mentioned above, plus a newly constructed manufacturing plant in New Mexico and another newly constructed plant across the border in Mexico.

The $15 million of CD’s and $10 million office building were acquired with funds available from retail hardware store operations. Smith’s Home Hardware and Alixco file a consolidated federal tax return. Smith’s Home Hardware files a separate California tax return from Alixco. During 2001, Smith’s Home Hardware received $2 million in dividends from Alixco, which was used to expand existing retail stores. Outside of the original contribution of inventory, there are no intercompany sales. However, approximately 20% of Alixco’s purchases are handled by Smith’s purchasing agents.

Smith’s Home Hardware realized net income in 2001 of $40 million, which was apportioned 75% to Arizona and 25% to California. Smith’s filed a separate return in California for 2001. The California Franchise Tax Board has audited Smith’s Home Hardware and concluded that Smith’s and Alixco should be members of a unitary group filing a combined California tax return. The auditor added the Alixco net business income into the combined return, resulting in a California tax increase of $300,000.