Chesapeake Industries, Inc. v. Comptroller of Treasury

ADKINS, Judge. In Art. 81, § 316(c), the Annotated Code of Maryland prescribes a formula method by which an appropriate share of the income, of a unitary multi-state operation doing business both within and without this state is allocated to Maryland. The case now before us requires us to decide the proper beginning point for application of that formula: is it (1) the combined or consolidated taxable income of a parent corporation and its wholly owned subsidiaries or (2) the taxable income of the parent, with respect to its return, and the taxable income of the Maryland subsidiary, with respect to its return? In the instant case, if method (1) is used, appellant Chesapeake Industries, Inc. (parent) is entitled to refunds for tax years 1973, 1974, and 1975 totalling $18,783.16 in principal amount.

Appellant Southern Door, Inc., (subsidiary) is entitled to refunds for 1972, 1973, and 1974 totalling $36,295.00. If method (2) is applied, Chesapeake is entitled to refunds for 1974 and 1975 totalling $1,454.16, but Southern Door owes additional taxes for 1974 and 1975 aggregating $43,524.00. The Issue Although the case sub judice is somewhat beclouded by semantic disputes as to the differences between what the Comptroller terms “consolidated returns”, what appellants prefer to call “unitary returns” and what others designate “combined reporting”, it is hard to quarrel with the statement that “[i]n the area of state taxation, the most controversial issue today is the validity and propriety of combined reporting.” J. Buresh and M. Weinstein, Combined Reporting: The Approach and Its Problems, 1 Jnl. of State Taxation 5 (1982). The precise scope of this issue in Mary ³⁷³ land has been stated succinctly by E. Derby in his chapter on “Maryland Corporate Income Tax”, Maryland Taxes 41-1 to 4-36 (MICPEL 1981).

At page 4-14, Mr. Derby observes: In Maryland the issue of whether a parent corporation and its subsidiaries are permitted, or can be required, to file together a consolidated return as a unitary business has not been finally determined. By statute each corporation, even if affiliated with another corporation, must file a separate income tax return. Separate returns are required even by members of an affiliated group filing consolidated federal returns. The unresolved issue is whether the statutory requirement that each corporation must file a separate return precludes a unitary business operated through separate corporate entities from calculating the tax due from each corporate entity by a unitary apportionment method using as a base the consolidated income of the unitary corporate group [footnotes omitted].

It is that “unresolved issue” that we must decide in this case. Facts During the tax years 1972 through 1975, Chesapeake was a parent corporation with a number of subsidiaries operating in a number of states. The subsidiaries were engaged chiefly in the manufacture of doors and related products. Chesapeake’s business was the management of its manufacturing subsidiaries.

One of these subsidiaries, Southern Door, was, like the parent Chesapeake, located in Maryland. All parties agree that the operation was a unitary business. See Xerox Corporation v. Comptroller, 290 Md. 126 , 428 A.2d 1208, 1209 (1981). For the tax years in question, Chesapeake and Southern Door each initially filed Maryland income tax returns showing the separate taxable income of each corporate entity.

Later, each corporation filed amended returns. On all of ³⁷⁴ the latter returns, the taxable income was stated as “Taxable Income [of] Chesapeake Industries, Inc., and Subsidiaries Consolidated.” The effect of this approach was to state the combined or consolidated income of Chesapeake and all its subsidiaries — all but two of which corporations did no business in Maryland and were not taxed by Maryland — as the taxable income for both Chesapeake and Southern Door. The result was that both Chesapeake and Southern Door reported on line 1 of their respective Maryland returns identical losses for each year. As a consequence, after application of the § 316(c) formula, the refunds we have noted (under method (1) above) were generated.

The Comptroller took the position that the amended returns were consolidated returns and as such not allowed by Maryland law. Chesapeake and Southern Door appealed to the Tax Court, which agreed with the Comptroller, as did the Circuit Court for Baltimore City when the matter reached it. We, too, sustain the Comptroller’s view and affirm. Discussion Article 81, § 295 must be the starting point of our discussion.

In pertinent part it provides: Every corporation ... (domestic and foreign) having any income allocable to this State under the provisions of § 316 hereof ... shall file a return stating specifically the items of gross income and items claimed as deductions allowed by this subtitle. Corporations ... which are affiliated shall each file separate returns. It is this language that precludes a corporation from filing a consolidated return in Maryland. “In the case of a consolidated return the separate entities of the various member corporations are, in a sense, disregarded; the consolidated income of the entire group is reported on a single return; and a single tax is paid on the total income shown on such return.” E. Rudolph, State Taxation of Interstate ³⁷⁵ Business: The Unitary Business Concept and Affiliated Corporate Groups, 25 Tax L.Rev. 171, 197 (1969-70).

See also D. Kahn, Basic Corporate Taxation, § 12.11 (3d ed. 1981). Section 295 does not permit this approach because it requires “[corporations and associations which are affiliated [to] ... file separate returns.” This construction of the statute was noted by the Court of Appeals in Comptroller v. Atlantic Supply Co., 294 Md. 213, 219-20 , 448 A.2d 955 (1982). It also has been recognized by the General Assembly. Joint Resolution 19 (HJR No. 34) of 1980 requested “the Legislative Policy Committee ... to ask the appropriate committee to study and decide whether a system of consolidated corporate income tax returns should be adopted for use by Maryland taxpayers and, if so, to determine which method of consolidation should be used.... ” The Legislative Policy Committee referred the matter to the Senate Budget and Taxation Committee and the House Ways and Means Committee.

They reported that “[presently, Maryland Corporate Income Tax Law ... does not permit State consolidated corporate income tax returns....” Reports of Legislative Committees to 1981 General Assembly, 1980 Interim, Fiscal Committees at 43 (Budget and Taxation) and 463 (Ways and Means). They recommended against the adoption of the consolidated return approach. Id. at 45 and 467. Despite these adverse recommendations a bill to permit consolidated returns was introduced at the 1984 session of the General Assembly.

This bill, HB 1384, died in the Ways and Means Committee. In light of this judicial and legislative history, the parties do not disagree that consolidated corporate income tax returns are prohibited in Maryland. Their dispute involves whether the amended returns filed by Chesapeake Industries and Southern Door fall within the scope of that prohibition. Appellants argue that those returns gratified the provisions of § 295 in that each corporation filed a separate ³⁷⁶ return for each year in question.

That line 1 of each of these returns was identical is permitted, they say, because this method does not produce consolidated returns but rather is a “unitary apportionment method” required to apportion taxable income to Maryland pursuant to § 316(c). The “unitary apportionment method”, more commonly referred to as “combined reporting”, is not identical to the consolidated return approach, although the Court of Appeals seems to have treated them as equivalent in Atlantic Supply Co., supra, 294 Md. at 220, n. 2 , 448 A.2d 955 . As Buresh and Weinstein observe: In a combined report ... the combined income of the affiliated group is not computed for the purpose of taxing such income, but rather as a basis for determining the portion of income from the entire unitary business attributable to sources within the state which is derived by members of the group subject to the state’s jurisdiction. It is viewed as something closer to an information return than a combined tax return. 1 Jnl. of State Taxation, supra, at 7.

According to appellants, this combined or unitary method of apportionment is a fair and reasonable method by which to calculate the amount of the taxable income of each Appellant allocable to Maryland. It has the important advantage of recognizing substance over form where an integrated business, such as Appellants, is operated as a number of separate corporations rather than as a single multistate corporation. They cite a number of cases from foreign jurisdictions in support of this argument. The fountainhead of this line of cases is Edison California Stores, Inc. v. McColgan, 30 Cal.2d 472 , 183 P.2d 16 (1947).

The California law considered in Edison, like Maryland law (Art. 81, § 316(c)) provided that for a multistate business, California taxable income should be determined by a three-factor formula. Unlike Maryland law (§ 295), Califor ³⁷⁷ nia could require consolidated returns. But the ability of the California taxing authorities to do this was not decisive: Power to apply the formula allocation in this or in the Butler Brothers case is not derived from the authority to require the filing of consolidated returns, since the latter indicates that the income of the groups will be taxed as a unit. The power flows from the authorized method of ascertaining the income attributable to a taxpayer’s activities within the state; and by a parity of reasoning the authority to pursue the method is present whenever activities are partially within and partially without the state ... as in the case of a unitary system, whether the integral parts of the system are or are not separately incorporated; or ... the accounting system of the taxpayer does not clearly reflect the income, which may be the case when it is part of a unitary system.

The legislature by enacting the foregoing sections, and the courts in the Butler Brothers decisions, Butler Brothers v. McColgan, 17 Cal.2d 664 , 111 P.2d 334 (1941), aff'd., 315 U.S. 501 , 62 S.Ct. 701 , 86 L.Ed. 991 (1942) ] recognized that the separate accounting method is appropriate to determine the true income of a separate business; but that when the business is not separate, and is an integral part of a larger and unitary system, the separate accounting is inadequate and unsatisfactory in ascertaining the true result of the activities and values attributable to that business. If the operation of the portion of the business done within the state is dependent upon or contributes to the operation of the business without the state, the operations are