80-SBE- 103 - Board of Equalization - State of California

BEFORE THE STATE BOARD OF EQUALIZATION

OF THE STATE OF CALIFORNIA

In the Matter of the Appeals of )1

THE LEARNER COMPANY, ET AL. 1

Appearances:

For Appellants:

For Respondent:

Terrance L. StinnettAttorney at Law

Jay R. OliffCertified Public Accountant

Kendall E. KinyonCounsel

O P I N I O N-These appeals are made pursuant to section

25666 of the Revenue and Taxation Code from the actionof the Franchise Tax Board on the protests of TheLearner Company, Suan Shipping Company, Inc., andLearner Investment Company against proposed assessmentsof additional franchise tax in the following amounts forthe years indicated:

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Appeals of The Learner Company, et al.

A p p e l l a n t

The Learner Company

Suan Shipping Company, Inc.

Learner Investment Company

Income YearEnded

ProposedAssessment

Y/30/68 $ 12,295.04Y/30/69 18,797.65Y/30/70 36,250.56Y/30/72 29,544.15g/30/73 12,997.47g/30/74 186,785.19g/30/75 289,597.31

12/31/74 $ 17,044.65

2/28/70 $ 348.362/28/74 4,515.802/28/75 3,285.17

Subsequent to the filing of these appeals, appellantspaid the total proposed assessments of additional fran-chise tax issued against The Learner Company and SuanShipping Company, Inc. Accordingly, insofar as theappeals relate to those companies, they will be treatedas being from the denial of claims for refund, pursuantto section 26078 of the Revenue and Taxation Code. Theappeals of Learner Investment Company retain their orig-inal status.

The Learner Company is a California corpora-tion engaged in buyinq, processing and selling scrap.metals. Its headquarters and principal offices arelocated in Oakland, California, and it operates salvageyards in California and Utah. Mr. Paul W. Learner ispresident of the company and owns 99.6 percent of itsoutstanding stock. The Learner Company has one whollyowned subsidiary, Flynn-Learner,,a California corpora-tion engaged in the scrap metal business in Hawaii.

Mr. Learner owns 100 percent of the stock ofappellants Learner Investment Company and Suan ShippingCompany, Inc. Until its liquidation in 1969, Mr.Learner also was the controlling stockholder of TerrylinShipping Corporation. During the years under appeal,the operations of each of these companies were relatedin various ways to the scrap metal business of TheLearner Company.

Appellant Learner Investment Company, incorpo-rated under California law, owns land and improvementswhich generally are contiguous with The LearnerCompany's salvage yards. A major portion of the income

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of Learner Investment Company is derived from rentalsto affiliated companies.

Appellant Suan Shipping Company is aPanamanian corporation which owns and operates Liberianflag vessels. Prior to.1972 one such vessel, the M. V.Suan, was in operation: in 1972 the corporation acquiredand placed into service a second Liberian flag vessel,the M. V. Terrylin. Both ships apparently are availablefor charter but are used primarily for carrying scrapmetal on behalf of The Learner Company betweenCalifornia and foreign ports.

Prior to its liquidation in 1969, TerrylinShipping Corporation operated as a ship charteringagent. Its primary chartering activity was related toThe Learner Company's scrap metal shipments to Japan.It also acted as general agent for Suan ShippingCompany, Inc.

Most of The Learner Company's sales of scrapmetals are to customers outside California. During eachof the appeal years, at least 70 percent of those saleswere to customers located in Japan, and the propertysold was shipped from facilities located in California.Appellants did not file Japanese income tax returns, nordid they pay any income tax to Japan during the appealyears. The Learner Company and the other appellantsare represented in Japan by Hanyo Trading Company andPacific Suppliers, Ltd., through the president of thosetwo companies, Mr. Henry Tetsuo Osano, a Japanese citi-zen. The contractual relationship between appellantsand Mr. Osano apparently began on April 27, 1961, whenThe Learner Company and Pacific Suppliers, Ltd., asrepresented by Mr. Osano, entered into a two-year agree-ment. Pursuant to the terms of that agreement, TheLearner Company appointed Mr. Osano its representativeand agent in Japan and agreed to allow him and hiscompany to hold themselves forth as such. The agreementfurther provided that Mr. Osano was to perform thefollowing duties on behalf of The Learner Company:(1) negotiate and enter into agreements for the sale orpurchase of any and all commodities requested by TheLearner Company, consisting primarily of scrap metals;(2) in connection with any contracts with customersin Japan, attend to all shipments to see that properhandling takes place; and (3) work out settlements withall parties in Japan on behalf of The Learner Company.Mr. Osano was to be paid for his services.entirely bycommissions, and the agreement expressly provided that

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it was terminable by either party upon sixty dayswritten notice by registered mail.

The above contract has been extended by oral

;igevnt of the parties since its expiration date inPursuant to its terms, throughout the

appeir years Mr. Osano continued to negotiate and exe-cute on behalf of The Learner Company contracts for thepurchase and sale of scrap metals in Japan. In thisconnection, he kept The Learner Company's Oakland officeadvised periodically, via cable, of the progress of hisnegotiations, of prevailing market conditions, pricesbeing offered, and of sales by competitors. Ultimately,he established the sales prices, within ranges set byThe Learner Company, and worked out various other termsof sales contracts. As authorized under the agreement,he also oversaw The LearnerCompany's scrap metal ship-ments to Japan and negotiated or compromised disputeswhich developed with Japanese customers.

Pacific Suppliers, Ltd. and Hanyo TradingCompany have offices in Tokyo, Japan, and Honolulu,Hawaii. Mr. Osano hires his own employees to assist himin his duties as agent for The Learner Company and otherforeign principals trading in Japan. In correspondencewhich he issues on behalf of The Learner Company, Mr.Osano identi,fies himself as that company's representa-tive. It appears that the only Tokyo office expenseborne by The Learner Company is the cost of the cablestransmitted from Japan to The Learner Company by Mr.Osano and his assistants.

During the appeal years, Paul W. Learner,president of The Learner Company, and Ernest E.Bridgewater, its executive vice .president, made occa-sional trips to Japan. Their trips occurred once or

L/ The record does not indicate when Hanyo TradingCompany entered the factual picture. It appears, how-ever, that during the appeal years it was the operativeagent of The Learner Company in Japan, as represented byits president, Mr. Osano. For purposes of this opinion,Mr. Osano will at times be referred to as appellants'representative in Japan, although we are fully awarethat the contract in question was actually between TheLearner Company and Mr. Osano's wholly owned corpora-tion, Pacific Suppliers, Ltd.

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twice a year and were generally of one to three weeksin duration. During their stays in Japan, Messrs.Learner and Bridgewater visited a number of tradingcompanies and steel consumers, including both existingand potential customers of The Learner Company. Thestated purposes of those trips were to solicit sales ofscrap metal and to discuss various shipping problems.In the earlier appeal years, the visits also involvednegotiations for the construction in Japan of the M. V.Terrylin, appellant Suan Shipping Company, Inc.'s secondvessel, which was placed into service in 1972.

For each appeal year, appellants filedCalifornia franchise tax returns on a separate account-ing basis. In computing its income from Californiasources, The Learner Company treated all sales madeto customers located in foreign countries and statesother than California as sales without the state. Uponexamination of those separate returns, respondent deter-

\ mined that The Learner Company, Learner InvestmentCompany, Suan Shipping Company, Inc., Flynn-Learner

0and Terrylin Shipping Corporation were all engaged in asinqle unitary business. Accordingly, their income fromCalifornia sources was recomputed by use of a combinedreport and a three-factor (property, payroll and sales)apportionment formula. In computing the sales factorof the apportionment formula, respondent assigned toCalifornia those sales made by The Learner Company inJapan and other foreign countries. The assignment offoreign sales to California was based upon the provi-sions of sections 25122 and 25135 of the Revenue andTaxation Code and respondent's regulations issuedthereunder. In determining the factors of the variousaffiliated corporations, respondent included those ofSuan Shipping Company, Inc. on a "voyage day" basis.(Cal. Admin. Code, tit. 18, reg. 25101, subd. (b).) Forone of the appeal years, income year 1974, respondentissued a direct deficiency assessment against SuanShipping Company, Inc.

At the protest level, appellants objected torespondent's determination of their unitary status andto the factors used in the apportionment formula. Theynow appear to concede that the affiliated Learner com-panies constitute a unitary business. Accordingly,pursuant to the provisions of section 25101 of theRevenue and Taxation Code, their income from Californiasources is to be determined pursuant to the allocationand apportionment provisions of the Uniform Division ofIncome for Tax Purposes Act (UDITPA), which is contained

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in sections 25120-25139 of the Revenue and TaxationCode. Although appellants no longer question the pro-priety of applying an apportionment formula to determinethat portion of their net income which is subject to taxin California, they,contend that the formula used byrespondent fails to do this. The issues for decision,therefore, concern the composition of the three factorsused by respondent in computing appellants' income fromCalifornia sources, and the direct assessment of fran-chise tax against Suan Shipping Company, Inc. for theincome year 1974.

I. WHETHER, FOR PURPOSES OF COMPUTING THESALES FACTOR OF THE APPORTIONMENT FORMULA,RESPONDENT PROPERLY ASSIGNED TO CALIFORNIAALL SALES MADE BY OR ON BEHALF OF THELEARNER COMPANY TO CUSTOMERS IN JAPAN.

'Generally speaking, UDITPA requires that ataxpayer's business income be apportioned to this stateby multiplying the income by a fraction, the numerator,of which is the property factor plus the,payroll factorplus the sales factor, and the denominator of which isthree. (Rev. & Tax. Code, S 25128.) Section 25134 ofthe Revenue and Taxation Code definesthe sales factoras follows:

The sales factor is a fraction, thenumerator of which is the total sales of thetaxpayer in this state during the income year,and the denominator of which is the totalsales of the taxpayer everywhere during theincome year.

The rules for determining whether sales of tangiblepersonal property are in this state are set forth insection 25135 of the Revenue and Taxation Code asfollows:

Sales of tangible personal property arein this state if:

(a) The .property is delivered or shippedto a purchaser, other than the United Statesgovernment, within this state regardless ofthe f.o.b. point or other conditions of thesale; or

(b) The property is shipped from anoffice, store, warehouse, factory, or other

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Appeals of The Learner Company., et al.

place of storage in this state and (1) the,purchaser is the United States government or(2) the taxpayer is not taxable in the stateof the purchaser. (Emphasis added.)

As it is used in the apportionment provisions, the term"state" is defined to include any foreign country orpolitical subdivision thereof. (Rev. & Tax. Code,s .25120, subd. (f).) The purpose of subdivision (b)(2)of section 25135, commonly termed the '*throwback rule,"is to prevent the apportionment of sales under the usual"destination" rule to states or countries in which thetaxpayer is not doing business, thereby preventing theapportionment of income to a state or country which iswithout jurisdiction to tax such income. (Keesling andWarren, California's Uniform Division of Income for Tax

(Part II), 15 U.C.L.A. L. Rev. 655, 672

Under UDITPA, whether a California taxpayer istaxable outside of California is determined pursuant to

0the provisions of section 25122 of the Revenue andTaxation Code, which reads as follows:

For purposes of allocation and apportion-ment of income under this act, a taxpayer istaxable in another state if (a) in that stateit is subject to a net income tax, a franchisetax measured by net income, a franchise taxfor the privilege of doing business, or acorporate stock tax, or (b) that state hasjurisdiction to subject the taxpayer to a netincome tax regardless of whether, in fact,the state does or does not.

With respect to subdivision (b) of this section, respon-dent's regulations provide:

The second test, that of Section 25122(b), applies if the taxpayer's businessactivity is sufficient to give the statejurisdiction to impose a net income tax byreason of such business activity under theConstitution and statutes of the UnitedStates. Jurisdiction to tax is not presentwhere the state is prohibited from imposingthe tax by reason of the provisions of PublicLaw 86-272, 15 U.S.C.A. 6s 381-385. In thecase of any "state" as defined in Section25120(f), other than a state of the United

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States or political subdivision of such state,the determination of whether such "state" hasjurisdiction to subject the taxpayer to a netincome tax shall be made as though the juris-dictional standards applicable to a state ofthe United States applied in that "state.",If jurisdiction is otherwise present, such"state" is not considered as without juris-diction by reason of the provisions of atreaty between that state and the UnitedStates. (Cal. Admin. Code, t' . 18, reg.25122, subd. (c) (Art. 2.5).) ti

Applying the above rules in the instant case,respondent determined that The Learner Company‘s salesof scrap metal shipped from California to customers inJapan and other foreign countries should be treated asCalifornia sales and included in the numerator of thesales factor since, under the jurisdictional standardsapplicable in the case of another state of the UnitedStates, The Learner Company was not subject to a netincome tax in Japan or in the other foreign countriesin which.its customers were located.

Appellants apparently do not contest theassignment to California of The Learner Company's salesto purchasers in foreign countries other than Japan.Although they concededly paid no income tax to Japanduring the appeal years, they nevertheless contend thatthe business activities of The Learner Company and itsrepresentatives in Japan were sufficient to give thatcountry jurisdiction, hypothetically, to impose anincome tax under United States constitutional and statu-tory standards. Under those circumstances, appellantsurge, the sales to Japanese customers should not havebeen "thrown back" to California, the state from whichthe goods were shipped. Specifically, it is appellants'position that during the appeal years the statutoryimmunity from tax which is afforded by the provisions ofPublic Law 86-272 (15 U.S.C.A.S9: 381-384) to taxpayerscarrying on minimum business activities in sister states

2/ Respondent's regulation 25122, subd. (c) (Art. 2),applicable for income years beginning prior to December31, 1972, and ending after the effective date of theregulations in Article 2.5,as this provision.

reads substantially the same

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would not have been available to The Learner Company inJapan, if the same standards were applicable there.Since appellants herein have not challengeg

/either the

constitutionality of the "throwback rule,"- or theapplicability of Public Law 86-272 standards to foreigncommerce, we shall confine our discussion to their con-tention that the "throwback rule" was improperly appliedin this case.

By its enactment in 1959 of Public Law 86-272(73 Stat. 555, 15 U.S.C.A. § 381), Congress placed cer-tain limitations on the power of a state to impose a netincome tax on income derived by an out-of-state taxpayerfrom interstate commerce. Subdivision (a) of section381 of the codified law provides, in relevant part:

No State, . . . shall have power toimpose, . . . a net income tax on the incomederived within such State by any person frominterstate commerce if the only business *activities within such State by or on behalfof such person during such taxable year are. . . the following:

(1) the solicitation of orders by suchperson, or his representative, in such Statefor sales of tangible personal property, whichorders are sent outside the State for approvalor rejection, and, if approved, are filled byshipment or delivery from a point outside theState: . . .

In determining whether there is jurisdiction to tax, thecourts and this board have strictly limited the statu-tory immunity provided by Public Law 86-272 with respectto employee activity of the out-of-state seller tosolicitation of orders or activities incidental thereto.(See, e.g., Miles Laboratories, Inc. v. Oregon Depart-ment of Revenue, 274 Ore. 395 [546 P.2d 10811 (1976);Iron Fireman Mfg. Co. v. State Tax Commission, 251 Ore.

3/ It should be noted that the constitutionality of the"throwback rule" was recently upheld by the CaliforniaCourt of Appeal in Hoffman-La R&he, Inc. v. FranchiseTax Board, 101 Cal. App. 3d 691 (Jan. 31, 1980). OnApril 10, 1980, the taxpayer's petition for hearing inthe California Supreme Court was denied.

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227 [445 P.2d 126) (1968); Appeal of Riblet Tramway,Cal. St. Bd. of Equal., Dec. 12, 1967.) The maintenanceof a sales office-by the out-of-state seller in thetaxing state, staffed by the seller's employees, clearlyexceeds solicitation and is thus outside the statutoryprotection of Public Law 86-272. (Appeal of SchmidBrothers, Inc., Cal. St. Bd. of Equal., May 21, 1980;Appeals of CITC Industries, Inc. and Bob Wolf Associ-ates, Inc., Cal. St. Bd. of Equal., June 28, 1979.)

Where the out-of-state seller uses independentcontractors, rather than its own employees, to consum-mate sales in the taxing state, a greater degree ofactivity may be,enqaged in by such contractors withoutcausing the out-of-state'seller to lose its immunityunder Public Law 86-272. In this regard, subdivisions(c) and (d) of section 381 (15 U.S.C.A. 5 381) provide:

(c) For purposes of subsection (a) ofthis section, a person shall not be consideredto have engaged in business activities withina State during any taxable year merely byreason of sales in such State, or the solici-tation of orders for sales in such State, oftangible personal property on behalf of suchperson by one or more independent contractors,or by reason of the maintenance, of an officein such State by one or more independent con-tractors whose activities on behalf of suchperson in such State consist solely of makingsales, or soliciting orders for sales, oftangible personal property.

(d) For purposes.of this section-- ’

(1) the term "independent contractor"means a commission agent, broker, or otherindependent contractor who is engaged inselling, or soliciting orders for the sale of,tangible personal property for more than oneprincipal and who holds himself out as such inthe regular course of his business activities;and

(2) the term "representative" does notinclude an independent contractor.

As can be seen, under these'provisions an independentcontractor cannot 'only solicit sales but is also per-mitted to make sales and to maintain an office in the

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,


(I)

taxing state without destroying his out-of-state prin-cipal's jurisdictional immunity from tax on the incomederived from such sales.

Obviously, the taxing power of the country ofJapan is not restricted in any way by the provisions ofPublic Law 86-272. That law becomes pertinent, however,for purposes of determining whether sales in Japan by acompany engaged in a unitary business which is subjectto tax in California are to be included in theCalifornia numerator of the sales factor. Under respon-dent's regulations, the determination of whether aforeign country has jurisdiction to subject the taxpayerto a net income tax is made as though the jurisdictionalstandards applicable to a state of the United Statesapplied in that foreign country. (Cal. Admin. Code,tit. 18, reg. 25122, subd. (c).) Accordingly, in theinstant case it is necessary to determine whether TheLearner Company's activities in Japan during the appealyears were sufficient to give Japan jurisdiction toimpose a net income tax under the jurisdictional stan-dards of the United States Constitution and Public Law86-272, whether or not such a tax was in fact imposed.

Appellants first contend that the activitiesof Mr. Osano, as representative of The Learner Companyin Japan, met or exceeded the minimum standards setforth in Public Law 86-272, giving The Learner Companysufficient nexus with Japan to sustain that country'simposition of a net income tax on the income derived byThe Learner Company from its sales in Japan. There canbe little'doubt that if Mr. Osano were deemed to be anemployee of The Learner Company, his sales activity inJapan would exceed Public Law 86-272's "solicitation"standard, since he maintained an office in Japan andactually executed sales contracts on behalf of TheLearner Company. Conversely, if Mr. Osano were anindependent contractor, those same acts would not causeThe Learner Company to lose its immunity from tax inJapan under Public Law 86-272 standards.

Respondent contends that t!he contractualrelationship between Mr. Osano and The Learner Companywas that of independent contractor and principal.Anbellants disagree. They stated early in these appealproceedings that Mr. Osano was not an employee of TheLearner Company; they later characterized him as neitheran employee nor an independent contractor, but as some-thing somewhere between those two; finally, they urgethat if the choice is between Mr. Osano's being an

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Ameals of The LearnerCompany, et al.__ _____--* ,\

e;nployee ana an indepenoent contractor, he was anemployee during the years in question. In ascertainingwhether or not Public Law 86-272 standards have beenexceeded, it becomes essential to first determineexactly what the business relationship was between TheLearner Company and Mr. Osano.

As noted earlier, an "independent contractor"is defined, for purposes of Public Law 86-272, as "acommission agent, broker, or other independent contrac- stor who is engaged in selling, or soliciting orders’ forthe sale of, tangible personal property for more thanone principal and who holds himself out as such in theregular course of his business activities." (15U.S.C.A. 5 381, subd. (d)(l).) This definition has beencriticized on the ground that it uses the term to. bedefined as part of the definition (see Ueaman, PayingTaxes to Other States (1963) p. 6.23), and it is there-fore necessary to look to common law rules in orderto determine whether Mr. Osano was an independentcontractor.

Those rules were summarized by the CaliforniaSupreme Court in Empire Star Mines Co. v. CaliforniaEmployment Commission, 28 Cal. Zd 33 [16Y P.2d 6861(1946) as follows:

In determining whether one who performsservices for another is an employee or anindependent contractor, the most importantfactor is the riyht to control the manner andmeans of accomplishing the result desired.If the employer has the authority to exercisecomplete control, whether or not that rightis exercised with respect to all details, anemployer-employee relationship exists. Strongevidence in support of an employment relation-ship.is the right to discharge at will, with-out cause. [Citations.] Other factors to betaken into consideration are (a) whether ornot the one performing services is engaged ina distinct occupation or business: (b) thekind of occupation, with reference to whether,in the locality, the work is usually doneunder the direction of the principal or by aspecialist without supervision; (c) the skillrequired in the particular occupation: (d)whether the principal or the workman suppliesthe instrumentalities, tools, and the place ofwork for the person doing the work; (e) thelength of time for which the services are to

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be performed; (f) the method of payment,whether by the time or by the job; (g) whetheror not the work is a part of the regular busi-ness of the principal; and (h) whether or notthe parties believe they are creating therelationship of employer-employee. (Rest.,Agency, S 220; Cal. Ann. S 220.) (28 Cal. 2dat pp. 43-44.)

(See also Anglim v. Empire Star Mines Co., 129 F.2d 914(9th Cir. 19421.1 If it is otherwise determined that aperson performing services is an independent contractor,that status will not be lost by his principal's reten-tion of broad general powers of supervision and controlas to the results of the work, so as to insure satisfac-tory performance of the independent contract. (McDonaldv. Shell Oil Co., 44 Cal. 2d 785 (285 P.2d 9021 (1955);Appeal of Cagney Productions, Inc., Cal. St. Bd. ofEqual., April 21, 1959.)

Applying these principles here, we note thatunder the terms of the agreement between The LearnerCompany and Pacific Suppliers, Ltd., as represented byMr. Osano, The Learner Company was not authorized tocontrol, nor did it in fact exercise control, over themeans or methods by which Mr. Osano and his employeesconducted the operation of their offices in Tokyo andHonolulu. Although The Learner Company set certainlimits on prices and other terms of the contracts nego-tiated by Mr. Osano, it did not control the manner inwhich the negotiations were carried out. Mr. Osanomaintained his own company's office in Tokyo. He hiredthe company's employees, determined their work schedulesand what duties would be performed by them, and providedall office supplies. Clearly, Mr. Osano and'his cor-porations operated a business separate and apart fromThe Learner Company, one requiring special expertise,fluency in the Japanese language, and familiarity withJapanese cultural and .business traditions. The LearnerCompany paid Mr. Osano entirely on a commission basis,and the success and profitability of his independentbusiness depended upon his own efforts and the good willhe was able to establish and maintain among the Japanese

business people with whom he dealt. Although the origi-nal two-year contract between Pacific Suppliers, Ltd.and The Learner Company provided that it could be, ter-minate,d by either party upon sixty days written notice,it has in fact been orally renewed and the businessrelationship has continued for many years. We believeall of these facts establish that Mr. Osano was an

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Appeals of-The Learner Company, et al.

independent contractor performing services on behalf ofThe Learner Company, and the broad general powers ofsupervision exercised by The Learner Company were notinconsistent with that status. Furthermore, Mr. Osanoqualifies as an independent contractor under the defi-nition contained in Public Law 86-272, since he holdshimself out as being engaged in the business of sellingand soliciting orders for the sale of tangible personalproperty, and he performs such services for principalsother than The Learner Company.

Appellants next contend that even if it weredetermined that Mr. Osano was an independent contractor,the activities which he performed in Japan on behalf ofThe Learner Company exceeded those limited activities inwhich an independent contractor may engage under PublicLaw 86-272 standards without destroying the immunityfrom tax otherwise afforded his out-of-state principal.For the reasons stated hereafter, we cannot agree.

As noted earlier, Public Law 86-272 expresslyallows the independent contractor not only to solicitsales in the taxing state on behalf of his out-of-stateprincipal, but also to maintain an office in that stateand to make sales, without exposing his principal totax. Whether the independent contractor can conducteven more extensive activities than those mentioned andstill preserve his out-of-state principal’s Public Law86-272 immunity has been a subject of speculation bylegal writers (see, e.g., Beaman, supra, pp. 6.20-6.23and Lohr-Schmidt, Developing Jurisdictional Standardsfor State Taxation of Mul.tistate Corporate,Net Income,22 Hastings L.J. 1035 1088-93 (1971)); however, thereis no case law directly in point.

It has been settled law in California for manyyears that for tax jurisdictional purposes and for pur-poses of determining the source of income, the businessactivities of an independent contractor will not beeauated with the business activities of his principal.(See Irvine C&

v. McColgan, 26 Cal. 2d 160 1157 P;2d847) (19 5).)- In pre-UDITPA decisions, this

4/ The Irvine Co. case was decided under section 10 of‘fhe Bank and Corporation Franchise Tax Act,(an earlypredecessor of present section 25101 of the -Revenue- and(Continued on next page.)

:

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board has concluded that sales solicited outsideCalifornia by independent contractors acting on behalfof a California vendor cannot be treated as out-of-statesales in computing the sales factor of the apportionmentformula. (A eal of H.C. Smith Oil Tool Co., Cal. St.ppBd. of Equal., Sept. 20, 1962; Appeal of Cagney Pro-ductions, Inc., supra.) The tax policy behind thesedecisions is that a sale of goods by an independentcontractor constitutes a part of the independent con-tractor's own business, rather than the business of theindividual or corporation whose products he sells. Thestate in which the sale is made, has jurisdiction to taxthe independent contractor‘s profits from the sales, andthat state is therefore being paid for the protection itaffords the only activity occurring within its borders.The same reasoning serves as a basis for the policy setout in Public Law 86-272, which permits the out-of-stateseller to have the independent contractor do more thanit allows the seller's employees to do without incurringtax liability. (See Beaman, supra, p. 6.21.)

Public Law 86-272 was enacted in 1959 in aneffort to limit the power of the various states to taxincome derived from interstate commerce. AlthoughCongress,thereby carved out a specific area of immunityfrom state taxation, we find nothing in that law'slegislative history to indicate any congressional intentto change prior state law regarding the tax effect of acorporation's utilization of independent contractors toconsummate its sales in other states, provided suchindependent contractors otherwise come within the defi-nition contained in Public Law 86-272. (See generallyS. Hep. No. 658, 86th Cong. 1st Sess., reprinted in(1959) U.S. Code Cong. & Ad. News 2548-2561.) In fact,we believe it would be inconsistent with the wholerestrictive purpose of that federal law to construe itin a manner which would make the selling corporation

4/' (Continued)Taxation Code), when it was phrased in terms of "doingbusiness" rather than "source of income." We have held,however, that the same rule applies in determiningwhether a taxpa,yer derives income from sources withinand without California, making its income subject toformula apportionment; (Appeal of Great WesternCordage, Inc., Cal. St. Bd. of Equal., April 22,1948.)

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more vulnerable to state taxation after the enactment ofPublic Law 86-272 than it was, under pre-existing law.With these thoughts in mind, w,e conclude that all of thebusiness activities conducted by Mr. Osano as an inde-pendent contractor performing services on behalf of TheLearner Company and others in Japan were within thescope of activities allowable under the provisions ofPublic Law 86-272. According'ly, Mr. Osano's salesactivity on behalf of The Learner Company would not havecaused the income from such sales to be subject to taxin Japan, under Public Law 86-272 jurisdictional stan-dards, and respondent properly treated The.LearnerCompany's sales in Japan as sales attributable toCalifornia.

Alternatively, appellants argue 'that duringthe appeal years,the activities in Japan of Paul W.Learner and Ernest E. Bridgewater, president and exec-

utive vice president, respect,ively, of The LearnerCompany, exceeded the scope of "solicitation?, byemployees which is permissible under Public Law 86-272standards, thereby causing The Learner Company to loseits immunity from tax in Japan if those same federalstandards were applicable in .that country. They basethis contention on the fact that Messrs. Learner andBridgewater each typically made an annual trip to Japan.On those trips, of one to three weeks in duration, theyallegedly visited Japanese trading companies and steelconsumers, discussed all manner of shipping and collec-tion problems, and solicited sales of scrap metals.Respondent determined, and appellants do not deny, thatmost of the activities of the two chief executive offi-cers in Japan related to the business of Suan ShippingCompany, Inc., rather than to that of The LearnerCompany. Appellants nevertheless contend that thoseactivities which Messrs. Learner and Bridgewater didengage in on behalf of The Learner Company in Japanexceeded mere solicitation of sales under the.juris-dictional standards of Public Law 86-272.

Appellants have not alleged that any sales ofscrap metal were actually consummated by Messrs. Learnerand Bridgewater during their trips to Japan. In ouropinion, the infrequent visits of two of The LearnerCompany's top executives to Japan .can best be character-ized as good will or public relations missions, ratherthan sales trips. We have great difficulty equatingtheir brief annual visits to Japan with any type ofregular and substantial sales activity which would givethat country hypothetical jurisdiction to tax under

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.i


traditional due process standards. Certainly, we cannot.construe their activities during those visits as con-stituting employee business activity in excess of"solicitation," under the jurisdictional standardsof Public Law 86-272.

For the above reasons, we conclude that incomputinq the sales factor of the apportionment formula,respondent properly assigned to California all ofsales made by or on behalf of The Learner Companycustomers in Japan.

II. WHETHER, IN COMPUTING THE APPORTIONMENTFORMULA, RESPONDENT ERRED IN INCLUDINGFACTORS ATTRIBUTABLE TO SUAN SHIPPINGCOMPANY, INC.

theto

As noted earlier, Suan Shipping Company, Inc.(Suan) is a Panamanian corporation which is wholly ownedby Mr. Paul W. Learner, president and principal stock-holder of The Learner Company. Suan owns and operatesLiberian flag vessels which are available for charterbut are used primarily for carrying scrap metal ship-ments on behalf of The Learner Company. We do notbelieve that it can be seriously argued that, under wellestablished standards, Suan is not an integral part ofthe unitary business conducted by the other affiliatedLearner companies. For reasons hereafter stated, how-ever, appellants nevertheless object to any inclusionof factors attributable to Suan in the apportionmentformula used to determine the percentage of appellants'combined unitary income which was to be apportioned to _California for the years in question.

Initially, appellants contend that by includ-ing Suan factors in the apportionment formula, respon-dent has imposed a net,income tax on a foreign-basedcorporation engaged in foreign commerce, thereby placingan impermissible burden upon foreign commerce in viola-tion of the commerce clause of the United StatesConstitution. This argument disregards the operativeeffect of using the formula method in computing thetaxable income of a unitary business. Once it is deter-mined that a corporate taxpayer is engaged in a unitarybusiness which is deriving income from sources withinand without the taxing state, that state's applicationof a reasonable apportionment formula does not resultin the taxation of extraterritorial values, but ratherconstitutes an attempt to estimate that portion of thetotal apportionable income of the combined unitary

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weals of The Learner Company, et al.

operation which is reasonably attributable to localactivities carried out in the.taxing jurisdictiop.

Constitutional attacks against the inclusionof income derived from foreign sources in the preappor-tionment tax base have been notably unsuccessful. Asearly as 1924, the United States Supreme Court approvedNew York's imposition of an apportioned franchise tax ona British corporation which manufactured ale in GreatBritain and sold a portion of it in New York. (Bass,Ratcliff & Gretton, Ltd. v. State Tax Commission, 266U.S. 271 I69 L. Ed. 282) (1924).) The constitutionalvalidity of including foreign source income in theapportionable tax base was reaffirmed by the SupremeCourt as recently as March lg., 1980, in Mobil Oil .'Corporation v. Commissioner of Taxes of Vermont,-- U.S. -- (63 L. Ed. 2d 5101 (1980). Under the factsof that case, the Court determined that the State ofVermont's inclusion in the preapportionment tax baseof dividend income received by Mobil Oil, a New,Yorkcorporation, from its subsidiaries and affiliates doingbusiness abroad did not violate either the due processclause or the commerce clause of the United StatesConstitution. This conclusion appears to have turnedon Mobil Oil's failure to establish that the foreignoperations of its subsidiaries and affiliates wereunrelated to its integrated unitary petroleum enter-prise, a portion of which was conducted in Vermont.Applying the same princ'iples in the instant case, wemust conclude that appellants' initial commerce clauseargument is totally without merit.

Appellants next urge that respondent's inclu-sion of Suan's income in the apportionment formulaviolated the commerce clause of the federal Constitutionin another way. They argue that by its enactment ofsection 954 of the Internal Revenue Code of 1954,Congress exercised its exclusive constitutional powerto regulate foreign commerce, thereby demonstrating anintent that income of the type covered by that sectionshould be exempt from all tax. During the years inquestion, section 954(b)(2) provided that, for certainpurposes under the federal income tax law, a foreignbased company's income did not include income derivedfrom, or in connection with, the use (or hiring orleasing for use) of any aircraft or vessel in foreigncommerce, or the performance, of services directlyrelated to the use of any such aircraft or vessel. Wesee no need to go into a discussion of whether or notthis provision would have any relevance under the facts

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.


of this case since, unless specifically made applicableto the states, any congressional or treaty restrictionsplaced upon the imposition of a federal income tax donot limit the right of a state to impose an apportionedtax on net income. As the United States Supreme Courtobserved recently in the Mobil Oil case, cited above:

Concurrent federal and state taxation ofincome, of course, is a well-established norm.Absent some explicit directive from Congress,we cannot infer that treatment of foreignincome at the federal level mandates identicaltreatment by the States. (63 L. Ed. 2d atp. 528.)'

Furthermore, as has been pointed out earlier, the appor-tioned tax in question in the instant case is not a taxon foreign source income, but rather a tax on thatportion of the unitary business income of the Learnergroup which is reasonably attributable to its businessactivity in California.

We also summarily reject appellants' attemptsto show by means of separate accounting that inclusionof the Suan factors in the apportionment formula leadsto a disproportionate amount of Suan's income beingattributed to California. It is well settled thatseparate accounting figures cannot be used to impeachthe results of formula apportionment, once it is deter-mined that a unitary business exists, as is the casehere. (See Butler Bros. v. McColgan, 17 Cal. 2d 664Ill1 P.2d 3341 (1941), affd., 315 U.S. 501 I86 L. Ed.9911 (1942); John Deere Plow Co. v. Franchise Tax Board,38 Cal. 2d 21m-P.2d 5691 (1951), app. dism., 343U.S. 939 [96 L. Ed. 13451 (1952).)

Finally, appellants contend that the provi-sions of section 24320 of the California Revenue andTaxation Code prohibited respondent from including theincome of Suan Shipping Company, Inc. in the apportion-ment formula used to determine what portion of theLearner group's business income was to be attributedto California. That section, which was added to theRevenue and Taxation Code in 1969, reads as follows:

Income derived from the operation of

0aircraft or a ship or ships by a corporation ’organized under the laws of a foreign countryshall not be included in gross income, andshall be exempt from the taxes imposed by thispart if:

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(a) The aircraft are registered or theships are documented under the laws of the.foreign country;

(b) The income of the corporation isexempt from national income taxes by reason ofa treaty or agreement between such foreigncountry and the United States which providesfor an equivalent exemption to corporationsorganized in the United States; and

(c) Units of government (other thanat the national level) within such foreign

++ country do not impose a tax upon corporationsorganized in the United States with respect toincome derived from the operation of aircraftregistered or ships documented under the lawsof the United States. (Stats. 1969, ch. 1191,P'. 2321-2322.)

In a letter dated August 8, 1969, to then AssemblySpeaker Robert Monagan, Assemblyman Pete Wilson, whowas at that time a'member of the Assembly Committee onRevenue and Taxation, clarified the objectives of thislegislation and, the requirements for exemption unde.rsection 24320 [Senate Bill 1285 of the 1969 RegularSession] as follows:

Dear Mr. Speaker: The following explana-tion is offered to make clear the intent ofthe Legislature in enacting Senate Bill 1285.of the 1969 Regular Session by SenatorBurgener.

S.B. 1285 is a bill to secure forAmerican-based sea and air carriers operatingin foreign lands exemption from foreign pro-vincial (rather than national) taxation ofincome derived by such carriers from theiroperation in foreign lahds.

To secure this exemption for Americancarriers, the bill extends a reciprocal exemp-tion from the California Bank and CorporationTax to income earned by foreign carriers fromoperation within California, provided thatcertain specified conditions exist. One ofthe conditions is that the national governmentof the foreign carrier and the United Stateshave entered into a tax,treaty, granting

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reciprocal exemption from their respectivenational income tax to the carriers of theother nation.

Therefore the exemption from theCalifornia Bank and Corporation Tax proposedin this bill would not be available to car-riers of nations with whom the United Stateshas no such treaty. . . . (4 Assem. J. (1969Reg. Sess.) p. 8249.)

We agree with respondent that in order forincome to be exempt from tax under section 24320 of theRevenue and Taxation Code, all of the qualifying condi-tions specified in that section must be met. Insofar asis applicable here, the first such. requirement is thatthe income in question must be derived'fr6m the opera-tion of a ship or ships by a corporation organized underthe laws of a foreign country. It is undisputed thatthe income of Suan Shipping Company, Inc., a Panamaniancorporation, meets this initial statutory condition.

The second requirement for the exemption, setforth in subdivision (a) of section 24320, is that theship be documented "under the laws of the foreign coun-try." (Emphasis added.) Respondent argues that theuse of the definite article "the," as opposed to anindefinite "a," before the noun "foreign country'presents yet another qualifying condition, i.e., thatthe corporation and the ship must meet the dual test ofnationality and documentation before the section 24320exemption ,applies. Hespondent contends that supportfor its position is to be found in Revenue Ruling 75-459(1975-2 Cum. Bull. 289, revoking Rev. Rul. 73-350,1973-2 Cum. Bull. 251), an Internal Revenue Serviceinterpretation of section 883 of the Internal RevenueCode of 1954. That section provides a federal taxexemption to a foreign corporation deriving earningsfrom the operation of ships documented under the laws ofa foreign country which grants an equivalent exemption'sb United States citizens and corporations. Appellanturges that respondent's position, if adopted, woulddefeat the purposes for which section 24320 of theRevenue and Taxation Code was enacted.

We reserve decision on this issue for theproper case, in view of our belief that a third condi-tion for exemption under section 24320 has not been metin the instant appeals. That requirement, set forth insubdivision (b) of the section, is that the income of

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the foreign corporation'be exempt from national incometaxes by reason of a treaty or agreement between theforeign country and the United States which provides foran equivalent exemption to United States corporations.

We believe that the only reasonable construction ofsection 24320 is one which requires such a treaty oragreement between the United States and the foreigncountry of documentation, in this case, Liberia. Theincome in question is derived as a direct result of theoperation of ships flying the flag of that country, andthe "equivalent exemption" must exist between the UnitedStates and that country if the quid pro quo theme of thestatute is toe implemented.

No such qualifying treaty or agreement existsbetween the United States and Liberia. Although weunderstand that the shipping income of Liberian com-panies is unilaterally exempted from the United.Statestax base by reason of section 883 of the Internal Reve-nue Code, because Liberia unilaterally exempts from itsincome tax the income of all foreign owned ships engagedin foreign commerce, this is notsufficient to satisfythe requirements of section 24320 of the Revenue andTaxation Code. The latter section, unlike the federalincome tax provision, clearly conditions the availabil-ity of the exemption from tax in California on theexistence of a formal treaty or agreement between theUnited States and the foreign country in question.Unilateral accommodations will not suffice. Under thecircumstances, section 24320 is inapplicable in theinstant case, and it therefore presents no barrier toinclusion of the income of Suan Shipping Company, Inc.in the apportionment formula used .by respondent todetermine appellants' California franchise taxliability.

WHETHER THE DIRECT ASSESSMENT OF TAXISSUED AGAINST SUAN SHIPPING COMPANY,INC. FOR THE INCOME YEAR 1974 WAS PROPER.

III.

Generally speaking, the apportionment ofincome of a unitary business carried on by separate cor-porations consists of two steps. First, it is necessaryto determine by apportionment formula that amount of thetotal net income of the corporate group which is attrib-utable to California sources. If more than one of thecorporations is doing business in California, a secondstep is then undertaken in order to divide the aggregateCalifornia net income and the resulting Californiafranchise tax liability among those corporations doing

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business in California. (See Keesling and Warren, TheUnitary Concept in the Allocation of Income, 12 HastingsL.J. 42, 59 (1960).)

We-have already concluded that in all of theyears involved in these appeals, respondent properlyincluded the factors of Suan Shipping Company, Inc. incomputinq the combined unitary income of the relatedgroup of Learner corporations. In each year respondentthen completed the first step of the apportionmentprocess, as outlined in the preceding paragraph, bydetermining by formula apportionment what portion of thegroup’s unitary income was subject to tax in California.For all income years other than 1974, respondent thencarried out the second step mentioned above, furtherapportioning the aggregate California net income betweenThe Learner Company and Learner Investment Company andissuing direct assessments of franchise tax accordingly.For one income year only, 1974, respondent also issued adirect assessment against Suan Shipping Company, Inc.We confess to being puzzled by this distinct treatmentof Suan for that one year, in view of the fact that theLearner qroup's business operations were apparentlycarried on, in that year in the same manner as in everyother appeal year. Our only concern here, however, iswhether that direct assessment can be sustained.

The assessment against Suan Shipping Company,Inc. for the income year 1974 presumably was based uponrespondent's determination that Suan was not only apart of the Learner unitary group, but that it was alsodoing business in this state in that year. "Doing busi-ness" is defined in the Bank and Corporation Tax Law tomean "actively engaqinq in any transaction for the pur-pose of financial or pecuniary gain or profit," (Rev. &Tax. Code, S 23101.) In support of its determinationwith respect to 1974, which carries with it a presump-tion of correctness (Appeal of Halliburton Oil WellCementing Co., Cal. St. Bd. of Equal., April 20, 1955),respondent relies on the following undisputed facts:(1) Suan Shipping Company, Inc. was whollv owned by Xr.Paul W. Learner, a resident of California: (2) it ownedtwo Liberian flag vessels which were used primarily incarrying scrap metal shipments between California ports,principally the Port of Oakland, and foreign ports: (3)although Suan was 9 Panamanian corporation, its onlyrepresentative in Panama was a lifetime agent appointedon formation of the corporaiton; (4) Suan's corporateofficers, directors and shareholders were all residentsof California: (5) the meetings of Suan's board of

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directors and its shareholders were held. in California:(6) all records of that corporation, including books ofaccount, were maintained in this state; and (7) chartersfor the services of Suan's two Liberian flag vesselswere arranged by personnel of the affiliated Learnercompanies located in California.

The above facts do indicate that Suan ShippingCompany, Inc. had substantial contacts with the Stateof California in 1974. Furthermore, appellants have notargued that Suan was not doing business in California inthat year. They havexsed their contention that thedirect assessment was improper primarily on the applica-bility of Revenue and Taxation Code section 24320 toexempt Suan's income from taxation in California. Inview of our decision that section 24320 is not applica-ble in the. instant case, we must conclude that appel-lants have failed to establish error in respondent'sdirect assessment against Suan Shipping Company, Inc.for the income year 1974.

On the basis of the foregoing analysis, wehold that respondent's action in these matters must besustained in all respects. ,

O R D E R

Pursuant to the views expressed in the opinionof the board on file in this proceeding, and good causeappearing therefor,

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#Appeals of The Learner Company, et al.

IT IS HEREBY ORDERED, ADJUDGED AND DECREED,pursuant to section 26077 of the Revenue and TaxationCode, that the action of the Franchise Tax Board indenying the claims of The Learner Company and SuanShipping Company, Inc. for refund of franchise tax inthe following amounts for the years indicated:

Appellant,Income Year Refund

Ended Claimed

The Learner Company g/30/68 $ 12,295.049/30/6Q 18,7P7.65g/30./70 36,25?.56g/30/72 29,544.15g/30/73 12,997.47g/30/74 186,785.19g/30/75 289,597.31

Suan Shipping Company, Inc. 12/31/74 $ 17,044.65

be and the same is hereby sustained. It is furtherordered, pursuant to section 25667 of the Revenue and ITaxation Code, that the action of the Franchise TaxBoard on the protest of Learner Investment Companyagainst proposed assessments of additional franchise taxin the amounts of $348.36, $4,515.80 and $3,285.17 forthe income years ended February 28, 1970, February 28,1974, and February 25, 1975, respectively, be and thesame is hereby sustained.

Done at Sacramento, California, this 30th dayof September, 1980, by the State Board of Equalization.

&vMembe

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, Member

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80-SBE- 103 - Board of Equalization - State of California

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Transcript of 80-SBE- 103 - Board of Equalization - State of California