1 CA-TX 97-007



(Not for Publication; Rule 28,

Arizona Rules of Civil

Appellate Procedure)

Appeal from the Arizona Tax Court
Cause No. TX 94-00082
The Honorable William J. Schafer, III, Judge


Michael Bray, Esq. New York
and Snell & Wilmer L.L.P.
by Janet E. Barton, Esq.

Attorneys for Plaintiffs-Appellants Phoenix
Grant Woods, The Attorney Genera
by Kimberly J. Cygan, Assistant Attorney General
Attorneys for Defendant-Appellee Phoenix

M c G R E G O R, Judge

This appeal invokes the principles we adopted in State ex rel. Arizona Department of Revenue v. Talley Industries, Inc., 182 Ariz. 17, 893 P.2d 17 (App. 1994), for determining whether an affiliated group of multistate companies may file a single Arizona income tax return that combines all net incomes and net losses of each company "into a single, group-wide net income or loss figure for apportionment to Arizona." See id. at 18, 893 P.2d at 18.

The affiliated companies in this case are F.W. Woolworth Co.

(FWW) and its wholly-owned subsidiaries, Kinney Shoe Corporation and Kinney Service Corporation (collectively Kinney). For tax years 1982 through 1985, FWW sustained substantial net losses, while Kinney had substantial net income. FWW and Kinney originally filed separate Arizona income tax returns for those years. Later, they sought unsuccessfully to substitute combined returns, on the theory that the nature of their commercial activities constituted them a "unitary business" whose true Arizona source income could not otherwise be accurately determined. See 182 Ariz. at 22, 893 P.2d at 22. They appeal from summary judgment for the Arizona Department of Revenue (DOR) on their claims for refunds of Arizona income taxes paid in excess of the amounts they would have paid under combined returns for those years.

The appeal requires us to decide whether the tax court erred in ruling that FWW and Kinney failed to qualify under Arizona Revised Statutes Annotated (A.R.S.) sections 43-942 and 43-947.A as a "unitary business" entitled to file combined Arizona income tax returns for tax years 1982 through 1985.

The audit period in this case encompassed FWW and Kinney's fiscal years ending January 31, 1983, through January 31, 1986, also referred to as their 1982 through 1985 fiscal years. During the audit period, the Woolworth's organization, consisting of FWW, Kinney, and their subsidiaries, engaged in the business of selling general merchandise and apparel at retail through chain store "formats" or "concepts" approved and directed by the "corporate office" division of FWW. FWW's corporate office included senior management, planning and development, human resources, treasury, audit, real estate, management information services, controller, legal, personnel benefits and tax. FWW also included a merchandising division that directly operated five to eight store formats over the 1982 through 1985 fiscal years.

FWW's annual reports for the 1983, 1984, and 1985 fiscal years all featured this introductory statement:

The mission of F. W. Woolworth Co. is to provide value to consumers in North America, Germany and Australia through its distinctly individual but complementary retailing businesses. Under the general guidance of corporate management, these businesses will generate levels of profit that not only satisfy investors and sustain long-term growth, but also provide full, competitive financial rewards for employees and benefit the communities in which they live and work.

FWW's corporate policy manual of December 22, 1981, states in its "Background and Purpose" section:

F.W. Woolworth Co., including its subsidiaries, is and plans to remain a diversified and decentralized retailing company operating internationally. The Board of Directors and senior management of the Company are cognizant of the need for and committed to maintaining a corporate structure that allows each operating division or subsidiary of the company to conduct its business with as great a degree of autonomy, flexibility and independent judgment as possible consonant with the need to preserve the common interests of the Company and to provide for the uniformity and coordination of action necessary for a large and complex organization.

During the audit period, management personnel in the FWW corporate office regularly interacted with all the organization's eighteen store formats, including the formats operated by FWW's wholly-owned subsidiaries Richman Brothers Co., Holtzman's Little Folk Shop, Inc., and Kinney, as well as those operated by FWW's own merchandising division. The store formats directly under FWW's merchandising division were general merchandise and specialty stores in the United States. The store formats directly under Kinney bought and sold shoes and apparel under the Kinney name and through other specialty stores. Kinney also engaged in the business of shoe manufacturing. Kinney conducted its own buying, marketing and real estate functions. Kinney also had its own data processing facilities. FWW had no intention of centralizing these functions.

FWW's corporate office established criteria for each of the FWW and Kinney store formats. These criteria defined and regulated each format's operating choices or targets with a view toward achieving their maximum potential profitability. The issues that any given store format's criteria addressed included location or site selection; store size; merchandise mix; profile of targeted customers; price points (e.g., mid-price or low market); gross margins; inventory levels and markdown policy; allocated capital (for new stores, refurbished stores, fixtures, inventory, etc.); and return on investment (compared to competitors). According to former Price Waterhouse accountant William U. Westerfield, who was that firm's engagement partner for FWW during the years 1977 through 1983, the making of decisions substantially affecting the foregoing, factors constitutes "basic operations" in the chain retailing business.

FWW's corporate office in New York daily controlled and actively evaluated all decisions affecting the store formats. It did so in several ways. It published a manual that established requirements and procedures for making operating decisions, including those concerning working capital and store investments in fixtures and inventory. To help guide strategic planning, the corporate office established a calendar, under which regular meetings, deadlines, daily phone calls, and weekly field visits were set for discussions among corporate office management and personnel with Kinney and FWW's merchandising operations. The resulting discussions covered marketing trends, store formats, and operating strategies on pricing, margins, fashion, store size, demographics, product mix, site selection, markdowns, customer service and advertising.

The daily activities of FWW's chief operating officer (COO) during the audit period exemplified the corporate office's senior management function. During the audit period the COO would visit several malls each weekend and on the following Monday would call the senior executive vice president at Kinney to institute changes. His responsibilities were divided between close supervision of specific store units and overall planning for all units to ensure a constant flow of merchandising expertise among units and the most efficient use of total corporate resources. Similarly, FWW's vice president for corporate planning and development evaluated all new and existing ventures and their future potential. FWW required him to "manage certain basic operational decisions" of Woolworth's store formats. According to the deposition of FWW's chief executive officer, the vice president, acting directly and through others.

Recommended and implemented store cut downs to replace inefficient variety store units with Kinney or Footlocker units. This provided access to malls that otherwise lacked available space or choice space.

Evaluated and disseminated to middle management new retail space availability, rental expense trends, forecasts, most efficient square footage use, merchandise formats, and best rental market locations.

Recommended and implemented the phase out of Kinney free standing stores that were not operating as profitably as those in shopping centers.

Recommended and implemented the sale of the United Kingdom subsidiary and shut down of Woolco department stores in the U.S.

Evaluated and disseminated to middle management consumer demographic, psychographic and buying trends to guide changing of merchandise, locations, and type of retail businesses.

FWW's corporate office affected the operations of the FWW and Kinney store formats in other ways. The corporate office's market analyses substantially influenced choices concerning which store formats would be allowed to expand and which kinds of locations would be preferred for expansion.

The corporate office also had considerable bargaining power with mall landlords. This helped FWW and Kinney store formats obtain choice locations within malls, lower base rents, larger landlord contributions or allowances to fund store improvements or pre-opening expenses, and lower common area maintenance charges; prevail over landlord opposition to leasing available space to particular types of stores; and gain a competitive advantage over Thom McAn, the Kinney Family Shoe format's principal competitor.

Additionally, the FWW corporate office could borrow larger sums on better terms than any of the FWW or Kinney operating units because of the substantial cash flow from FWW's general merchandising departments. This allowed the Woolworth organization's operating units to expand and take advantage of market trends more rapidly than they or their competitors could do on their own. Similarly, the corporate office provided efficient cash management services, maximizing the availability of cash generated by daily store receipts to satisfy the operating units' cash needs. It also developed a successful commercial paper program that allowed operating units to borrow funds at favorable interest rates.

Through Woolworth overseas Corporation (WOC) a Kinney Shoe Corporation subsidiary, the corporate office also assisted in providing the FWW and Kinney operating units with purchasing services for goods from Asia at greater efficiency and lower cost than any individual operating unit could have achieved. WOC brokered overseas purchases on behalf of FWW and Kinney's store formats for a commission of eleven percent. In addition, during the audit period the corporate office negotiated volume discounts and attractive lease financing terms on behalf of all the FWW and Kinney operating units for the acquisition of new point-of-sale equipment for each store. The use of this equipment was intended to provide item-by-item sales tracking information for management.

Through the audit period, Kinney sold shoes to FWW for sale through FWW's merchandising division. In the period 1983 through 1985, Kinney's wholesale sales of shoes to FWW constituted an average of 0.267 percent of Kinney's total merchandise sales, and an average of 0.137 percent of FWW's total merchandise sales. Over the same period, FWW's retail sales of shoes purchased from Kinney at wholesale were an average of 7.79 percent of its total shoe sales, and an average of 1.7 percent of its total merchandise sales.

Kinney's sales of its own manufactured shoes formed a steadily declining percentage of its total sales, from 10.51 percent in 1983 to 7.17 percent in 1986. The balance of the shoes that Kinney sold were obtained from manufacturing sources outside the Woolworth organization. Among these sources were those located and enlisted by WOC in Asia. The retail value of goods that Kinney purchased from these sources in fiscal 1982 was 11.8 percent of its total sales for that year. The corresponding percentages for fiscal 1983 through 1985 were 12.6 percent, 20.5 percent, and 22.6 percent.

At all times material to this litigation, both FWW and Kinney Shoe Corporation did business in Arizona. Kinney and FWW filed combined income tax returns in ten states other than Arizona over the fiscal 1982 through 1985 audit period. In the forty remaining states they filed separate returns during that time.

FWW's separate Arizona returns calculated its Arizona "taxable income" for fiscal year's 1982 through 1985 as net losses of $4,412,960, $5,543,873, $5,589,584, and $5,634,646, respectively. FWW obviously reported no Arizona income taxes due on any of these figures. For the same years, Kinney Shoe's separate Arizona income tax returns calculated its Arizona taxable income as $770,272, $1,153,005, $1,731,418, and $2,155,937, respectively. Kinney Shoe reported pre-credit Arizona income taxes of $80,599, $120,786, $181,519, and $226,074, respectively, totalling $608,978, on these four taxable income figures.

In September 1987 DOR conducted a field audit of Kinney Shoe Corp. The audit determined that Kinney Shoe Corp. and Kinney Service Corp., a warehousing company operated in, Pennsylvania solely for Kinney Shoe's benefit, should have filed combined Arizona income tax returns and calculated their Arizona deductions for federal income taxes on that basis for, fiscal years 1982 through 1985. The effect of DOR's audit determination was to reduce Kinney service and Kinney Shoe's combined Arizona income tax liability by a total of $35,279 for the four year period.

Kinney protested the concomitant calculation of its deduction for federal income taxes. It did not protest DOR's determination that combined returns were required for Kinney Shoe and Kinney Service. Kinney filed amended returns that incorporated DOR's ruling on its contentions concerning the deduction for federal income taxes. In addition, for the first time, FWW joined in Kinney's combined filings.

Kinney and FWW later withdrew Kinney's protest concerning the deduction for federal income taxes. They instead requested refunds based on the apportioning of their net combined incomes/losses for the four fiscal years. DOR's Corporate Income Tax Audit Section declined the combined filings and denied FWW and Kinney's refund requests.

Kinney and FWW resorted to and exhausted their administrative

remedies. FWW and Kinney brought this tax court appeal pursuant to A.R.S. sections 12-165 and 42-124 on February 22, 1994. On cross-motions for summary judgment, the tax court ruled for DOR. The tax court reasoned in part:

The treasury, personnel and benefits, internal audit and accounting, and legal functions for all divisions, including Kinney, is centrally managed by Woolworth.

Woolworth assigns store criteria" to each division. The criteria listed targets affecting profitability, such as site selection, store size, merchandise mix pricing, gross margins Inventory level, markdown policy, fashions, and advertising. Woolworth also set up Woolworth Overseas Corporation, which both Kinney and Woolworth, use to purchase goods from overseas;

Aside from these internal services, Kinney and Woolworth do not share resources. Woolworth does not assist Kinney or its chain shore divisions with manufacturing, hauling, or warehousing of merchandise. Except for thirty-three employees Kinney transferred to Woolworth to consolidate the benefits and insurance program, the two do not share operational employees.

Fortunately (for the Court agrees), both sides agree that the holding in State v. Talley Industries, 182 Ariz. 17, 893 P.2d 17 (App. 1994), dictates the result in this case. . . .

. . . .

Although Talley was certainly an integrated business, because there was no "substantial interrelationship or interdependence of basic operations . . . among the various subsidiaries . . .," it could not combine the income or losses of its subsidiaries into a single figure for apportionment to Arizona - in other words, for Arizona income tax purposes, it was not a "unitary" business - combined reporting was not necessary to determine the amount of income attributable to subsidiaries in the different states.

The taxpayer notes that the Talley opinion held as it did because that Court found that the relationships between the subsidiaries were not substantial - here, the taxpayer argues, the relationships are substantial and that makes all the difference.

Based upon the record developed in this Court, I do not agree with the taxpayer. I do not see a substantial relationship that warrants a combined return.

From formal judgment in accordance with the tax court's ruling, Kinney and FWW appeal. We have jurisdiction under A.R.S. section 12-2101.B.

As we observed above, the principles we adopted in State ex rel. Arizona Department of Revenue v. Talley Industries, Inc. 182 Ariz. 17, 893 P.2d 17 (App. 1994), control this case. In Talley we were faced with the question whether Talley Industries, Inc. and its twenty-five subsidiaries constituted a "unitary" or integrated" business and were thus "entitled to apportion to Arizona a share of the Talley group's overall income from sources within and outside Arizona." 182 Ariz. at 17, 893 P.2d at 17. We found that A.R.S. sections 43-942 (Supp. 1993) and 43-947.A (1980) required us to focus our analysis on the question "whether the combined reporting of overall net income by all twenty-six members of the Talley group was necessary in order 'to clearly reflect the taxable income earned by such corporation or corporations from business done in this state.'" Id. at 21, 893 P.2d at 21 (quoting A.R.S. 43-947.A)

In support of its claim of entitlement to combined filing, the Talley group relied on facts demonstrating Talley industries, centralized management of the group, sharing of technical and management expertise among the parent and the group members, and economies of scale created by the parent's activities on the subsidiaries' behalf.182 Ariz. at 19, 893 P.2d at 19. We concluded:

Notwithstanding the above, the record establishes no substantial interrelationship between the subsidiaries. There were no transfers of materials, products, goods technological data relating to products, processes machinery, or equipment by subsidiaries operating wholly outside Arizona to subsidiaries with operations in Arizona. Also, virtually no flow of product and no vertical or horizontal integration of business operations exists between the subsidiaries with, and those without, income-producing factors and business operations in Arizona. No basic operational ties, existed between the two Arizona real estate subsidiaries and any other Talley subsidiary.

182 Ariz. at 19, 893 19.

In the Talley analysis, we observed that the question of how a court is to determine whether a given multistate group of affiliated companies constituted a unitary business was a matter first impression in Arizona. We rejected as too narrow the approach to that question exemplified in Texas Co. v. Cooper, 107 So. 2d 676 (La. 1958), in which a vertically integrated producer, refiner and seller of oil products across a number of states was required to report its in-state production income on a separate accounting basis. 182 Ariz. at 23, 893. P.2d at 23.

We also rejected as over broad and imprecise the "three-unities" test, under which a multistate group of affiliated companies is deemed to be a unitary business if three elements exist: unity of ownership; unity of operation as evidenced by central purchasing, advertising, accounting and management; and unity of use of the group's centralized executive force and general system of operation.Id. 8.14[8] - 8.15, at 8-156 - 8-157. Id. We determined that the three-unities test had little relation to the fundamental question in an Arizona unitary business case -- whether combined reporting of overall net income or loss was necessary to clearly reflect the taxable income earned by members of a multistate group of companies with Arizona income factors. Id. at 25, 893 P.2d at 25.

In Talley we adopted from 1 Jerome R. Hellerstein and Walter Hellerstein, State Taxation (2d ed. 1993) (Hellerstein) an intermediate test for the existence of a unitary business: "[a]n enterprise is not unitary unless . . . there is a substantial interdependence of basic operations among the various affiliates or branches of the business . . . ." 182 Ariz. at 24, 893 P.2d at 24 (quoting Hellerstein 8.11[5], at 8-92). Following Hellerstein, we found this test quantifiable and objective, and better suited to the goal of clearly reflecting Arizona source income. We explained:

[T]he problem with separate accounting in a unitary business is the "inability to establish fair arm's-length prices for goods transferred, or basic operational services rendered, between controlled branches or subsidiaries of an enterprise." [Hellerstein] 8.10[1][a].

The unitary business rule, then, essentially rests on the difficulty of determining the amount of income attributable to various stages of producing, refining, manufacturing, transporting, buying, selling, and the like, conducted in different states. This consideration does not exist, at least to the same extent, to centralized management or control, financing, research, legal, accounting, or other internal services rendered by one branch or affiliate to another. Id. 8.11[4][b]. Such services are not contained in the product or its delivery to the customer and may be considered as an accessory to the operations of the business. Id. Furthermore, "unlike the elusive efforts to determine the proper cost to be attributed to articles produced or manufactured by one branch or affiliate and sold to another," management costs and other services can be charged to the various operations by using generally accepted accounting methods. Id. The result is that the same state tax avoidance opportunities afforded by intercompany transfer pricing, which are inherent in transfers of materials, products, or goods between branches or affiliates, are not present in attributing to various states management costs and the costs of other types of internal services and facilities. Id.

[T]he costs of these services can be charged to the various subsidiaries . . . under established accounting methods. See [id] 8.11[4][b].

What might well give rise to the problem of practical inability to apportion income to individual states would be the existence of substantial transactions, interrelations or interdependence of basic operations among the various income-earning subsidiaries.

Id. at 25, 893 P.2d at 25. Cf. Louis Dreyfus Corp. v. Huddleston, 933 S.W.2d. 460, 467 (Tenn. Ct. App. 1996) ("A unitary business is a business whose components are too closely connected and necessary to each other to justify division or separate consideration as independent units . . . . It is operated as a whole, and its components are substantially interdependent.") Because Talley did not dispute the proposition that no operational ties existed among its subsidiaries, we found no basis for unitary apportionment of the Talley group's combined income. Talley, 182 Ariz. at 25, 893 P.2d at 25.

FWW and Kinney now contend the tax court erred in holding that as in Talley, there were no substantial transactions, interrelations, or interdependence of basic operations between FWW and Kinney. They contend that the undisputed facts in the record, including the unchallenged expert opinion testimony of William Westerfield, demonstrated the existence of substantial basic operational ties that took the form of sharing, among the corporate office and FWW and Kinney's store formats, the following "corporate resources": merchandising expertise (gross profit management, budgeting analysis, markdowns); bargaining power over regional mall landlords common to two or more FWW or Kinney store formats; buying services (WOC); sales revenue; borrowed capital; information systems; strategic plan (store concepts to be grown, cut back - when and how); customers in malls with two or more FWW or Kinney store formats; and market research (targeted customers, competition, economic trends).

On their face these corporate resources appear to correspond closely to "centralized management or control, financing, research, legal, accounting, or other internal services rendered by one branch or affiliate to another, or to business conditions that arise from the performance of such services. As we held in Talley, the costs of such services "can be charged to the various operations by using generally accepted accounting methods," and accordingly do not render the corporate group a "unitary business." 182 Ariz. at 25, 893 P.2d, at 25.

FWW and Kinney nevertheless seek cover under the Talley umbrella on the theory that all these corporate resources constitute basic operational services" that are transferred among FWW and Kinney and their operational units and that are not subject to reliable valuation or separate accounting. Central to this theory is expert William Westerfield's averment that in the chain retailing business, "basic operations" is to be defined as the making of decisions substantially affecting store format criteria such as location, store size, merchandise mix, targeted customer profiles, and other factors of store format profitability.

We cannot agree. FWW and Kinney's analysis departs from Talley rather than following it, and moreover is fallacious as applied to the facts of this case.

We have no doubt that the making of managerial decisions in designing and adjusting the operational parameters of store formats to maximize profits is an essential function in the chain retailing business. Contrary to the implicit assumption underlying FWW and Kinney's analysis, however, the question whether this function constitutes the "basic operations" of that business within Talley is not a pure question of fact. It is at most a mixed question of law and fact, which we may review and determine de novo. In re Steven 0., 188 Ariz. 28, 29-30, 932 P.2d 293, 294-95 (App. 1997). We are not bound by witness Westerfield's opinion about the nature of "basic operations" in chain-store retailing.

We refer instead to the Talley opinion and Hellerstein. Talley made clear that by "basic operations," it meant "producing, refining, manufacturing, transporting, buying, selling, and the like. Talley, 182 Ariz. at 25, 893 P.2d at 25. Cf. Hellerstein 8.11[5], at 8-94 ("basic operations" of container manufacturer and seller in Container Corp. of America v. Franchise Tax Bd. of California, 463 U.S. 159 (1983), consisted of "the acquisition of raw materials, manufacturing, transportation, and marketing . . . .").

We distill from Talley that "basic operations" in the context of unitary business analysis are those concrete business activities whose performance directly yields revenue to the enterprise. They are to be distinguished from "accessories" to the operations of the business, 1ike "centralized management or control, financing, research, legal, accounting, or other internal services rendered by one branch or affiliate to another. . . ." Talley, 182 Ariz. at 25, 893 P.2d at 25. FWW and Kinney found their claim of "basic operational interdependence" within Talley on the permeation of the Woolworth enterprise by corporate office services such as gross profit management, budgeting analysis, strategic planning, and market research, and on the business conditions their performance produces, such as enhanced bargaining power, shared customers, and economies of scale. These plainly fall within the "accessories" classification.

FWW and Kinney nevertheless argue that the interorganizational presence of managerial services and their resultant business conditions require unitary business treatment on the ground that such services cannot be reliably valued and therefore preclude separate accounting. Managerial services and the favorable conditions they produce undoubtedly are difficult to value. However, FWW expends the cost of those services -- not their arm's-length value -- in managing its own and Kinney's operating units. As Hellerstein states:

[U]nlike the elusive efforts to determine the proper cost to be attributed to articles produced or manufactured by one branch or affiliate and sold to another, the costs of executive management, legal, accounting, merchandising and other services, patents, research, interest on intercompamy loans, and the like are comparatively easy to spread among the various components of a business, under established accounting methods that are widely used for nontax purposes. The result is that the State tax avoidance opportunities afforded by intercompany transfer pricing, which are inherent in transfers of materials, products, or goods between branches or affiliates, are not likely to present overly formidable problems in attributing to various States the costs of the types of internal services and facilities under discussion.

Hellerstein 8.11[4][b], at 8-90 (emphasis added).

FWW and Kinney also place considerable reliance on the function of WOC as the source of goods from Asia for all eighteen of the Woolworth organization's store formats. Contrary to their implicit contention, however, WOC's business relations with the store formats do not give rise to the problems inherent in intercompany transfer pricing. WOC did not buy goods from outside the organization and resell them to Kinney or FWW's operating units. WOC acted strictly as a commissioned purchasing agent. The economies of scale its operations produced benefitted each operating unit in a quantifiable way. WOC produced no distortions of income as between Kinney and FWW.

Finally, we re-emphasize the central point of our decision in Talley. The focus in Arizona is not whether combined filing is permissible because a group of multistate affiliated corporations meets one or another Platonic form for "unitary business." it is whether combined filing is necessary to clearly reflect the Arizona source income of those group members with income factors in Arizona. The relief that FWW and Kinney seek in this litigation does not show up well against that background. Even assuming that the services and conditions created by FWW's corporate office enhanced Kinney's overall income in unquantifiable sums, FWW and Kinney do not seek to offset those income enhancement against any corresponding corporate office "losses" or expenditures. They seek instead to cancel out the independent business losses FWW sustained through its merchandising division, which, somewhat at odds with FWW and Kinney's analysis, had the benefit of the same corporate office expertise as did Kinney. The prospects for greater accuracy in determining Arizona source income through combined filing under this scenario appear greatly overstated.

For the foregoing reasons, we hold that the tax court did not err in granting summary judgment for DOR. Accordingly, we deny appellant's request for an award of attorney's fees.



1996 Michael G. Galloway

Everything contained in this website is resource material only and not intended as legal advice. Case summaries are basic overviews for guidance and should not be used as a substitute for reading and analyzing the case.  If you have a legal issue regarding state or local taxation, please consult with an attorney who is experienced in the field. Sending an e-mail to does not establish an attorney-client relationship and the communication is not subject to attorney-client privilege.