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STATE OF MINNESOTA TAX COURT COUNTY OF RAMSEY REGULAR DIVISION Express Scripts, Inc., Appellant,
FINDINGS OF FACT CONCLUSIONS OF LAW AND ORDER FOR JUDGMENT
vs. Docket
No. 8272 R
Commissioner of Revenue, Dated: August 20, 2012 Appellee. This matter was heard before the Honorable Sheryl A. Ramstad, Judge of
the Minnesota Tax Court, on May 25 and 29, 2012, at the Minnesota Tax Court,
Minnesota Judicial Center, St. Paul, Minnesota.
Walter A. Pickhardt, Attorney at Law, represented the Appellant.
Mark Levinger, Assistant Attorney General, represented the Appellee.
The parties submitted a Stipulation of Facts. Both parties submitted post
trial briefs. The matter was submitted to the Court for decision on June 22, 2012.
The Court, having heard and considered the evidence adduced at the
hearing, and upon all of the files, records and proceedings herein, now makes
the following:
FINDINGS OF FACT
1. Express Scripts, Inc. (“Appellant”) is a publicly traded corporation,
organized under the laws of Delaware. Appellant provides pharmacy
benefit management (“PBM”) services and also operates a mail-order
pharmacy.
1
2. PBM services began during the late 1980s to coordinate the
distribution of outpatient pharmaceuticals through a combination of
benefit management services, including retail drug card programs,
mail pharmacy services, and formulary management programs.
3. As was customary for PBM services, Appellant worked with clients,
manufacturers, pharmacists, and physicians to increase efficiency in
the drug distribution chain, to manage costs in the pharmacy benefit,
and to improve member health outcomes and satisfaction.
4. Appellant saved its clients, and their members, money and in turn
made money by developing clinically sound formularies, by
aggressively promoting the use of less expensive generic drugs, and
by supporting the use of clinically appropriate lower-cost brand name
drugs.
5. During the tax years 2001–2004 (“years at issue”), more than 95% of
Appellant’s revenues were generated from its PBM activities. For the
years at issue, Appellant’s revenues ranged from $8.6 billion to $15.1
billion, and its net income ranged from $125 million to $278 million.
6. On or about February 20, 2001, Appellant and the other two leading
PBM services, AdvancedPCS and Merck-Medoc, (“Founders”) formed
RxHub (“RxHub”), LLC to create an electronic prescription and
information routing service to facilitate prescription benefit
communications. The Founders expected that use of the RxHub
would enable the prescription fulfillment process to be conducted
2
more quickly, with greater reliability and at lower cost. This would
occur by each service acting by itself in creating multiple electronic
networks. At the time RxHub was formed, there were more than 50
electronic prescription-writing platforms, and no single standard link
with health plans, pharmacies, and benefit managers. Prior to
founding RxHub, each of the Founders had tried pilot projects with E-
prescribing, but none of them had a sufficiently large enough market
presence to develop industry standards. By forming RxHub, the
Founders believed that physician adoption of E-prescribing would
occur.
7. Each Founder owned a one-third membership interest in RxHub
during the years at issue, had a one-third voting interest, and had all
of the voting power allotted to the Members under the RxHub Limited
Liability Company Agreement (“LLCA”). Although a simple two-thirds
majority vote of the Founders was required for approval of most
RxHub matters, each Founder had veto power over the choice of chief
executive officer and outside manager for RxHub.
8. RxHub had a Board of Managers, with each member initially naming
one manager. The members were required to elect two “Outside
Managers,” by unanimous vote, who were to be unrelated to any of
the members. Appellant named Agnes Rey-Giraud as its manager to
the RxHub Board who, during the years at issue, was either a vice
president or senior vice president. She was also a member of
3
RxHub’s initial Steering Committee and was in charge of the Steering
Committee’s technical team. Other Appellant employees were also
members of the RxHub technical team. RxHub did not pay Appellant
employees for time spent on RxHub board matters or reimburse
Appellant for any expenses incurred or time spent by its employees
on RxHub matters.
9. Certain RxHub actions required a unanimous vote of the three
Founders including: the selection of outside managers; RxHub’s
entering a new line of business; any amendment of the LLCA or other
operating documents; a change of the equity structure; a change of
the Board structure; entering into mergers, consolidations, or
alliances; accelerating or deferring capital calls; amending operating
principals; and selection of the chief executive officer. Most other
matters needed to be approved by a two-thirds majority vote of the
members.
10. RxHub developed three products during the years at issue:
Physicians Reducing Negative Events (“PRN”), Script Information
Gateway (“SIG”); and Medication and Eligibility Delivery Solution
(“MEDS”).
11. Beginning in the fourth quarter of 2002, PRN, the only product
generating revenue for RxHub during the years at issue, provided
non-hospital physicians with patient-specific medication histories and
pharmacy benefits information at the point of care. Specifically, PRN
4
provided Appellant with the ability to provide to prescribing physicians
at an early point information regarding lower-cost alternatives to retail
pharmacies in drug prescriptions, including mail order pharmacies,
generic drugs, and formulary compliance. The fee RxHub charged for
PRN services was $0.15 per transaction-record-found payable by
PBMs and other
participating payers.
12. RxHub tried to recruit other customers for the PRN, but only the
Founders participated in the PRN services during the years at issue.
13. Appellant paid RxHub for PRN services during the years at issue:
$51,024 for 2002; $109,226 for 2003; and $177,972 for 2004.
14. SIG provided direct electronic delivery of new prescriptions from
prescribers to the patient’s selected pharmacy. Pharmacies could
send renewal requests or change requests to prescribers and receive
an immediate electronic response. Appellant had a mail order
pharmacy that was a potential user of the SIG service, but it did not
use it until after the years at issue.
15. MEDS provided physicians in an inpatient setting with patient-specific
medication histories at the point of care. Although RxHub first offered
MEDS in 2004, it did not earn revenues from it during the years at
issue. Appellant was not a potential customer of MEDS because it did
not operate a hospital. Appellant agreed to provide patient-specific
medication histories through RxHub to users of the MEDS services,
5
for which Appellant was to be compensated $0.05 per transaction.
Nothing was paid to Appellant during the years at issue.
16. Pursuant to the LLCA, the members contributed $52,504,767 to the
capital of RxHub during 2001 through 2003, with Appellant
contributing one-third of that amount.
17. One of RxHub’s operating principles was that it would be operationally
independent of its members, which it was during the years at issue.
18. There was a separation of personnel between RxHub and Appellant
during the years at issue, with Appellant employing no RxHub
employee and RxHub employing no Appellant employee.
19. RxHub and Appellant maintained separate human resources
personnel, separate employee benefit plans, separate legal and
accounting departments, separate purchasing offices, separate bank
accounts, and separate data processing during the years at issue.
20. RxHub and Appellant had no common ownership of and did not
license to each other their respective intellectual property.
21. RxHub reduced administrative costs for Appellant because
pharmacists and physicians had no need to call Appellant to verify
eligibility and drug plan benefits.
22. RxHub increased the volume at Appellant’s mail order pharmacy.
23. The direct value to Appellant of RxHub-provided governmental
relations services is unclear from the record. Similarly, when RxHub
ended its own governmental relations functions in late 2003, and the
6
Founders began to represent RxHub in Washington, D.C., the value
of the services rendered is not established in the record.
24. Appellant provided some legal support for RxHub in 2003 and 2004,
but the value of services rendered is not established in the record.
25. By Order dated June 8, 2010, the Commissioner of Revenue
(“Commissioner”) assessed Appellant $532,296.34 in additional
corporate franchise tax and interest relating to the years at issue. The
Order was predicated on the determination that Appellant was a
unitary business with RxHub, LLC, a company headquartered in
Minnesota.
CONCLUSIONS OF LAW
The Order of the Commissioner of Revenue, dated June 8, 2010, is
hereby reversed.
LET JUDGMENT BE ENTERED ACCORDINGLY. A STAY OF FIFTEEN
DAYS IS HEREBY ORDERED. THIS IS A FINAL ORDER.
BY THE COURT, Sheryl A. Ramstad, Judge MINNESOTA TAX COURT
DATED: August 20, 2012
7
Memorandum Introduction
Express Scripts, Inc. (“Appellant”) challenges the Notice of Determination
on Appeal dated June 8, 2010, (“Order”) issued by the Commissioner of
Revenue (“Commissioner”) assessing $532,296.34 in additional corporate
franchise tax and interest relating to the tax years 2001 – 2004 (“years at issue”).
There are two issues in this case. On May 25 and 29, 2012, the trial was held,
which dealt exclusively with the first issue: during the years at issue was
Appellant engaged in a unitary business with RxHub LLC (“RxHub”). The second
issue is presented through a full Stipulation of Facts: was Diversified
Pharmaceutical Services, Inc. (“DPS”), a subsidiary of Appellant, required to
apportion its federal net operating loss limitation? In the Order the Commissioner
computed the allowable net operating loss deductions claimed by DPS.
Facts
Background of Appellant
Appellant is a publicly traded corporation organized under the laws of
Delaware.1 Appellant provides pharmacy benefit management (“PBM”) services
and also operates a mail-order pharmacy. During the years at issue, it was one
of the largest PBMs in North America.2 PBMs coordinate the distribution of
outpatient pharmaceuticals through a combination of benefit management
services, including retail drug card programs, mail pharmacy services, and
formulary management programs. Since the emergence of PBMs during the late
1 Stipulation of Facts, Paragraph 1 (“Stip.¶__”). 2 Stip. ¶ 6.
8
1980s, PBMs have combined retail pharmacy claims processing and PBM-
operated mail pharmacy services to create an integrated product offering to
manage the prescription drug benefit for payers.3
During the years at issue, more than 95% of Appellant’s revenues were
generated from its PBM activities.4 For those years, Appellant’s revenues ranged
from $8.6 billion to $15.1 billion, and its net income ranged from $125 million to
$278 million.5
Formation and Operation of RxHub
As of February 20, 2001, Appellant and two of its PBM competitors,
Advance PCS (“Advance”) and Merck-Medco Managed Care, LLC (“Medco”),
formed a new limited liability company known as RxHub, LLC (“RxHub”). During
the years at issue, Appellant, Advance, and Medco were the Founders, the
Members, and the Designating Members under the LLC Agreement.6 The
Founders were the three largest providers of PBM services in the United States,
providing coverage for 70% of Americans who had prescription benefits. At the
time RxHub was formed, there were more than 50 electronic prescription-writing
platforms.7 Because it was critical for the electronic prescription industry to
succeed that a single standard be developed, Rx Hub was formed to create an
electronic prescription and information routing service to facilitate prescription
benefit communications.8 By providing a single standardized platform, Appellant
3 Stip. ¶ 5. 4 Stip. ¶ 8. 5 Jt. Exs. 85-88. 6 Jt. Ex. 3; Tr. at 149. 7 Jt. Ex. 2; T. at 235. 8 Stip. ¶ 19; Jt. Ex. 2; Tr. at 200.
9
and the other Founders of RxHub9 believed they could “jumpstart broad adoption
by enabling physicians to identify patient benefit coverage and eligibility.”10 By
doing so, their goal was that physician adoption of E-prescribing would occur.11
RxHub was designed to be a utility, with its services available to all
participants in the industry.12 It was intended that RxHub would “address the
information gap…among physicians, pharmacies, health plans and PBMs.”13 In
other words, RxHub was not designed to make money from the
commercialization of data, but only to act as a utility or switch.14 According to its
Operating Principles, RxHub would “serve all POC Vendors, PBMs, pharmacies,
health plans and other entities that [became] Participants.”15 Its services were
available on a non-discriminatory basis.16 RxHub neither favored the Founders
nor gave them a discount.17 Although the Founders were its first customers,
RxHub diligently marketed its services to other PBMs.18
Each Founder owned a one-third membership interest in RxHub during
the years at issue.19 Each Founder had a one-third voting interest. RxHub was
managed by its Board of Managers, with each of its members initially naming one
9 Prior to founding RxHub, the three Founders had each tried pilot projects with E-prescribing, but one of them worked. Tr. at 160. Even though each of the three PBMs was a large corporation prominent in the PBM industry, none of them had sufficient market presence to develop industry standards on its own. Jt. Ex. 2. 10 Jt. Ex. 2. 11 Jt. Ex. 58. 12 Jt. Ex. 2; Tr. at 173-74. 13 Jt. Ex. 53. 14 Tr. at 325. 15 Jt. Ex. 3. 16 Tr. at 43, 46. 17 Tr. at 43, 46. 18 Tr. at 159, 177. 19 Stip. ¶ 21.
10
manager.20 Certain RxHub actions required unanimous approval of the
members,21 including the selection of outside managers; RxHub’s entering a new
line of business; any amendment of the operating documents; a change of the
equity structure, a change of the Board structure; entering into mergers,
consolidations, or alliances; accelerating or deferring capital calls; amending
operating principles; and selection of the chief executive office.22 Most matters,
however, needed to be approved by a two-thirds majority vote of the Members.
RxHub’s Products
RxHub developed three products during the years at issue: Physicians
Reducting Negative Events (PRN); Script Information Gateway (SIG), and
Medication and Eligibility Delivery Solution (MEDS).23 However, PRN was the
only product generating revenue for RxHub during the years at issue.24
PRN provided Appellant with the ability to give information to prescribing
physicians at an early point regarding lower-cost alternatives to retail pharmacies
for drug prescription, including mail order pharmacies, generic drugs, and
formulary compliance.25 Appellant purchased the PRN service from RxHub,
paying $0.15 per transaction-record found. This was the same fee charged to
any other customer purchasing the PRN service. Appellant’s payments to RxHub
for PRN during the years at issue were: $51,024 for 2002; $109,226 for 2003;
and $177,972 for 2004.
20 Stip. ¶¶ 28-29, 34. 21 Stip. ¶ 35. 22 Stip. ¶¶ 35-36. 23 Stip. ¶ 45. 24 Tr. at 162-67. 25 Stip. ¶ 42.
11
MEDS was a service whereby physicians in an inpatient setting were
provided with patient-specific medication histories at the point of care.26 RxHub
charged a fee for use of MEDS services. That fee varied according to the specific
hospitals participating in the program. Although RxHub began to offer the MEDS
service in 2004, it earned nothing from it during the years at issue. Appellant and
other PBMs agreed to provide patient specific medication histories through
RxHub to users of the MEDS service, for which RxHub agreed to compensate
the PBMs for their costs in providing the information. However, RxHub did not
pay any PBM for providing patient-specific medication histories during the years
at issue.
SIG provided direct electronic delivery of new prescriptions from
prescribers to the patient’s selected pharmacy. Pharmacies could send renewal
requests or change requests to prescribers and receive an immediate electronic
response.27 RxHub charged a fee to the pharmacy receiving the new prescription
or initiating a renewed prescription. Although RxHub first offered the SIG service
in 2005, it did not produce any revenue for RxHub during the years at issue.
Appellant did not use the SIG service until after the years at issue.
Burden of Proof
Orders of the Commissioner are presumed correct and valid.28 A tax
assessed by the Commissioner is presumed valid; the burden is on “the taxpayer
to show its incorrectness or invalidity.”29 Thus, Appellant bears the burden of
26 Stip. ¶ 47. 27 Tr. at 44-45; Stip. ¶ 50. 28 Minn. Stat. § 271.06, subd. 6. 29 Minn. Stat. § 270.68, subd. 3 (2002) (recodified at Minn. Stat. § 270C.61, subd. 5 (2006));
12
proving that Appellant and RxHub were not a unitary business during the years at
issue.
Statutes
Minnesota Statute Section 290.17, subdivision 4(a) (2000) provides in
pertinent part that:
If a trade or business conducted wholly within this state or partly within and partly without this state is part of a unitary business, the entire income of the unitary business is subject to apportionment pursuant to section 290.191. The statutory definition of unitary business, found in Minn. Stat. § 290.17,
subd. 4(b) (2000) provides as follows:
The term “unitary business” means business activities or operations which result in a flow of value within them. The term may be applied within a single legal entity or between multiple entities and without regard to whether each entity is a sole proprietorship, a corporation, a partnership or a trust.
The statute next defines a presumption that a unitary business exists in
certain circumstances:
Unity is presumed whenever there is unity of ownership, operation, and use, evidenced by centralized management or executive force, centralized purchasing, advertising, accounting, or other controlled interaction, but the absence of these centralized activities will not necessarily evidence a nonunitary business. Unity is also presumed when business activities or operations are of mutual benefit, dependent upon or contributory to one another, either individually
or as a group. Where a business operation conducted in Minnesota is owned by a business entity that carries on business activity outside the state different in kind from that conducted entirely outside the state, it is presumed that the two business operations are unitary in nature, interrelated, connected, and independent unless it can be shown to the contrary.30
Minn. Stat. § 271.06, subd. 6 (2002). 30 Minn. Stat. § 290.17, subd. 4(c) and (d).
13
Finally, the presumption based upon unity of ownership (when coupled
with unity of operation and use) is modified by the following:
Unity of ownership is not deemed to exist when a corporation is involved unless that corporation is a member of a group of two or more business entities and more than 50 percent of the voting stock of each member of the group is directly or indirectly owned by a common owner or by common owners, either corporate or noncorporate, or by one or more of the member corporations of the group. For this purpose, the term “voting stock” shall include membership interests of mutual insurance holding companies formed under section 66A.40.31
Analysis
Unitary Business
RxHub was an LLC. Since tax law has rules for taxing corporations and
partnerships but not LLC’s, an LLC taxpayer is allowed to choose whether to be
taxed as a corporation or partnership. RxHub elected to be taxed as a
partnership. Here, Appellant reported that it was not unitary with RxHub. The
Commissioner disagreed. The first question before us is whether, on the facts
presented, Appellant and RxHub were a “unitary business” and, therefore,
required to combine their incomes for purposes of apportioning incomes subject
to tax by Minnesota.
Revenue Notice 08-03 addresses how a corporate partner’s share of LLC
income is to be apportioned, with the rules differentiating between the
corporation and the partnership having a unitary or a nonunitary relationship. If
the corporation and the partnership are unitary, then the corporate taxpayer
includes its share of partnership income on the corporation’s return, and it
31 Minn. Stat. § 290.17, subd. (e).
14
combines its factors with the partnership’s factors for apportionment purposes. If
the corporation and the partnership are not unitary, then the corporate taxpayer
also includes its share of partnership income on the corporation’s return, but the
corporation apportions the partnership income using the partnership’s own
factors.32 In both cases, the income is taxed, but there is a difference in how the
apportionment is done.
Appellant argues that control by one business entity over another is
fundamental to considering the two entities as unitary. Appellant contends that it
did not have potential or actual control of RxHub so that it should not be
considered unitary with RxHub. Appellant claims that its lack of control over
RxHub is dispositive as to whether the two entities should be considered as
unitary. In other words, Appellant’s position is that because Appellant did not
control RxHub, the two companies did not have a unitary relationship.
The Commissioner claims that unitary business must be considered in
terms of a flow of value between the entities claimed to be unitary. Much of the
testimony and other evidence presented addresses this issue. The
Commissioner argues that Appellant benefited significantly from the formation of
32 “When a corporation and a partnership are engaged in a unitary business, the corporation must include its partnership income in its apportionable business income. The corporation must also include its pr-rata share of the partnership’s property, payroll, and sales/receipts located within and outside Minnesota in the corporation’s property, payroll, and sales/receipts numerator and denominator. …If the corporation and partnership are not engaged in a unitary business, the corporation must report its partnership income or loss as separately stated income or loss. If the partnership’s business is conducted wholly within Minnesota, the corporate partner’s share of partnership income or loss must be assigned entirely to Minnesota by the corporate partner. … If the partnership conducts its business both within and without Minnesota, the corporate partner’s share of partnership income or loss is assigned to Minnesota based on the partnership’s property, payroll, and sales/receipts apportionment factors.” Minnesota Commissioner of Revenue Notice No. 08-03.
15
RxHub and that RxHub’s services brought value to Appellant. Specifically, the
Commissioner claims that RxHub: provided a significant reduction in
administrative costs to Appellant; increased the volume at Appellant’s mail order
pharmacy; and helped lobby Congress for legislation that benefited Appellant.
Moreover, the Commissioner claims that Appellant and RxHub mutually
supported one another, adding value to both of them. This support included
Appellant’s personnel performing RxHub’s work, as well as collaborative efforts
between Appellant personnel and RxHub personnel.
Business Relationship between Appellant and RxHub
The first question before us is whether, on the facts presented, Appellant
and RxHub were a “unitary business” and, therefore, required to combine their
incomes for purposes of apportioning incomes subject to tax by Minnesota. For
the reasons set forth below, we find there was no unitary business relationship
between Appellant and RxHub.
A. Flow of Value
Minnesota law states that the “term ‘unitary business’ means business
activities or operations which result in a flow of value between them.”33 The “flow
of value” language comes from the U. S. Supreme Court case Container
Corporation v. Franchise Tax Board,34 which held that foreign subsidiaries could
be included in a unitary business on a combined report. That case involved a
vertically integrated manufacturer of custom ordered paper packaging board and
33 Minn. Stat. § 290.17, subd. 4(b) (2000). 34 463 U.S. 159 (1983).
16
had over 50% ownership of 24 subsidiaries.35 Sales of materials from the parent
to its subsidiaries accounted for about 1% of the subsidiaries’ total purchases.
The Court upheld the unitary business finding based upon the facts that the
parent held half of the subsidiaries’ long-term debt, the parent provided active
consultation with the subsidiaries, and the parent assisted the subsidiaries in
procuring equipment.36 In Container Corporation, the Court used the phrase “flow
of value” for the first time in addressing federal constitutional limitations on a
state’s power to tax the income of a multistate business by stating that a
“prerequisite to a constitutionally acceptable finding of unitary business is a flow
of value.”It then said:
[A] relevant question in the unitary business inquiry is whether “‘contributions to income [of the subsidiaries] result[ed] from functional integration, centralization of management, and economies of scale.’” [citations omitted] “[S]ubstantial mutual interdependence” can
arise in any number of ways; a substantial flow of goods is clearly one but just as clearly not the only one.37 The Supreme Court addressed the constitutional limitations on a state’s
power to tax the income of a multistate business in Mobil Oil Corporation. v. Commissioner of Taxes38 indicating that “the linchpin of apportionability in the field of state income taxation is the unitary business principle.” Following the Mobil holding, the Supreme Court determined that wholly-owned divisions of a vertically integrated oil company were engaged in a unitary business in Exxon Corporation. v. Department of Revenue of Wisconsin,39 stating that Exxon was a
35 Id. at 171. 36 Id. at 173. 37 Id. at 178-79 (citations omitted). 38 445 U.S. 425, 439 (1980). 39 447 U.S. 207, 224 (1980).
17
“highly integrated business which benefits from an umbrella of centralized management and controlled interaction.” In ASARCO, Inc. v. Idaho State Tax Commission40 and F.W. Woolworth Company v. Taxation and Department of Revenue,41 two cases decided by the U.S. Supreme Court on the same day, the unitary business concept was further clarified. The state of Idaho was trying to tax intangible income from foreign subsidiary investments in ASARCO. Rejecting Idaho’s argument that corporate purpose should define unitary business, the Supreme Court said:
This definition of unitary business would destroy the concept. The business of a corporation requires that it earn money to continue operations and to provide a return on its invested capital. Consequently all of its operations, including any investment made, in some sense can be said to be “for purposes related to or contributing to the [corporation’s] business.” When pressed to its logical limit, this conception of the “unitary business″ limitation becomes no limitation at all. When less ambitious interpretations are employed, the result
is simply arbitrary.42 In Woolworth, the Supreme Court found that a subsidiary was not unitary with its parent where the parent company owned 100% of the stock of three subsidiaries and 52% of a fourth. Although there were some managerial links, the Court found that because Woolworth’s operations were not functionally integrated with its subsidiaries and there was decentralized management, the companies were not unitary.43 Here, the Commissioner argues there was a flow of value because Appellant purchased services from RxHub, and presumably benefited from those
40 458 U.S. 307 (1982). 41 458 U.S. 354, 354-65 (1982). 42 458 U.S. 307 at 326. 43 458 U.S. 354 at 365-66.
18
services. The Commissioner claims that Appellant benefitted by purchasing the PRN service, which was the only service that Appellant purchased from RxHub during the years at issue.44
Appellant’s purchases of the PRN service began in October 2002 and
continued through December 2004, averaging $13,010 per month over that 26-
month period. Appellant agrees that it received some benefit from purchasing the
PRN service from RxHub, maintaining that in the absence of any benefit
Appellant would not have purchased the service. Appellant contends that
substantial intercompany transactions do not result in a flow of value if they are
at fair price. Appellant points out that it paid RxHub’s standard price for the PRN
service, which was the same price that other PBMs paid, and received neither a
discount nor preferential treatment from RxHub.
This case is similar to both a U.S. Supreme Court case and a Minnesota
Supreme Court case, in which the Courts determined that there was no unitary
purpose because the price was fair and the nature of the transactions was at
arm’s length. In ASARCO, the U.S. Supreme Court concluded that Idaho could
not tax intangible income from foreign subsidiary investments because there was
no unitary business. Similarly, in Hercules, Inc. v. Commissioner of Revenue,45
the Minnesota Supreme Court determined that the taxpayer was not unitary with
its subsidiary even though the taxpayer contracted to buy all of its polypropylene
requirements at a 2.5% volume discount from its subsidiary. Because the price
was fair (even with the discount), and the transactions were arm’s length, the
44 Stip. ¶ 188; Tr. at 42-49; 169-70. 45 575 N.W.2d 111 (Minn. 1998).
19
Court held that they did not reflect the requisite flow of value to create a unitary
business relationship. Here, as in ASARCO46and in Hercules,47 Appellant
received no favorable treatment in the PRN transactions; they were at arm’s
length, with pricing at fair market value. Thus, it cannot be said that the PRN
transactions resulted in a flow of value to Appellant.
Further, the Commissioner argues that substantial value implicitly flowed
from RxHub to Appellant because otherwise Appellant and RxHub’s other two
Founders would not have committed to providing $20 million in capital
contributions to an entity set up as a not-for-profit entity. In other words, the
Commissioner contends that these capital contributions would not have been
made had there been no flow of value to the Founders. We find the
Commissioner’s argument to be unpersuasive; it would mean that any member of
an LLC or a partnership which, by definition, contributes either capital or services
would be unitary. In Hercules, each owner of a 50%-owned subsidiary made
capital contributions to the subsidiary.48 Despite these contributions, the
Minnesota Supreme Court held that there was not a unitary relationship.49
Additionally, the Commissioner maintains that there was a flow of value
between RxHub and Appellant because RxHub served Appellant’s corporate
46 The Court held that ASARCO and its Southern Peru subsidiary were “insufficiently connected to permit the two companies to be classified as a unitary business” even though ASARCO bought 35% of Southern Peru’s copper production at “average representative trade prices,” and even though ASARCO provided purchasing, traffic, and tax services to Southern Peru at “fair” rates. 458 U.S. at 320-22. 47 In Hercules, the Court determined that the taxpayer was not unitary with its subsidiary even though the taxpayer contracted to buy all of its polypropylene requirements from the subsidiary at a volume discount price. Further, although the taxpayers provided many administrative services to its subsidiary, “[t]he arm’s length nature of these transactions [meant] that they did not embody the requisite flow of value to create a unitary business relationship.” 575 N.W.2d at 114. 48 575 N.W.2d at 116. 49 575 N.W.2d at 113.
20
business purpose. The Commissioner reasons that because all of RxHub’s
functions and services were evaluated in terms of their benefit or potential benefit
to the Founders, Appellant benefited from RxHub’s operations.
Appellant responds by pointing out that since everything a corporation
does is in furtherance of its business purpose, the Commissioner’s argument
would destroy the concept of unitary business. We agree. The Supreme Court
also agreed in ASARCO, holding that despite the fact that the subsidiaries sold
ore to the parent company, serving the parent’s business purpose, this did not
make the companies unitary. Thus, because RxHub was expected to serve
Appellant’s business purpose did not make it unitary because simply serving a
corporate business purpose does not establish a unitary relationship.50
The Commissioner further argues that RxHub’s functions and services
were all evaluated in terms of the potential benefit to the Founders. Specifically,
the Commissioner contends that the “SIG and MEDS products were intended to
provide value to [Appellant].” Appellant disputes this, contending that none of
RxHub’s products was developed to favor the Founders. Appellant maintains that
RxHub’s products were designed and operated so as to be completely neutral
because if RxHub favored its Founders, other pharmacies would not sign up for
its services, resulting in the failure of these products. Moreover, Appellant claims
50 In ASARCO, the Supreme Court said:
The business of a corporation requires that it earn money to continue operations and to provide a return on its invested capital. Consequently all of its operations, including any investment made, in some sense can be said to be “for purposes related to or contributing to the [corporation’s] business.” When pressed to its logical limit, this conception of the “unitary business” limitation becomes no limitation at all. When less ambitious interpretations are employed, the result is simply arbitrary. 458 U.S. at 326.
21
that the Founders were not even customers of the SIG or MEDS products during
the years at issue and that neither SIG nor MEDS produced any revenue for
RxHub until after 2004. Thus, Appellant challenges the Commissioner’s claim
that RxHub’s services and functions were evaluated in terms of the potential
benefit to Appellant, calling it “absolutely not true.” 51
Again, we are not persuaded by the Commissioner’s contention that SIG
and MEDS provided value to Appellant inasmuch as Appellant participated in
neither program during the years at issue. Further, these programs produced no
revenue for RxHub until after 2004. Moreover, RxHub paid no fees to Appellant
during the years at issue.
In addition, the Commissioner claims that RxHub provided Appellant with
valuable legal research. Appellant responds by asserting that this claim is
unsupported by the record. We agree. The research at issue was performed by
RxHub’s legal counsel at a time when it had no employees. Thus, the law firm
doing the work discussed it with in-house counsel for the three Founders, but
there is no evidence in the record that the report went to Appellant or that
Appellant ever benefitted from the research.
The Commissioner further observes that Appellant contributed the time of
Agnes Rey-Giraud as Board Manager for RxHub. In addition to being one of only
three or four board members, the Commissioner contends that Ms. Rey Gerard
was in charge of the RxHub Technical Steering Committee, acted as chairperson
of the Compensation Committee of the RxHub Board of Managers and as
chairperson of the Board’s Business Development Committee.
51 Appellant’s Reply Brief, p. 11.
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Appellant asserts that Ms. Rey-Giraud was selected for her positions at
RxHub to help Appellant manage its investment in RxHub. Appellant cites
Woolworth in support of its position that oversight activities by an investor, which
any parent company gives to any subsidiary, does not create unity. We agree.
There is no requirement that a company which has initially invested in another
company cannot participate on the board to protect its investment. In fact, it is
prudent for an investor to keep a watchful eye over the activities of the company
in which it has invested. The fact that Ms. Rey-Giraud was not paid is irrelevant
inasmuch as none of the managers representing the Founders were paid by
RxHub. For the Founders to pay their own employees appointed to manage
RxHub is consistent with and supports Appellant’s argument that these
employees were responsible for safeguarding the Founders’ investments. Since
they were representing the Founders’ interests when participating in RxHub’s
board and committee functions, it was appropriate for the Founders to pay their
own employees for that work.52 Here, Ms. Rey-Giraud’s participation on the
board and on committees of the board did not create a unitary relationship.
Moreover, the Technical Steering Committee’s technical assistance was advisory
only, with none of the Committee members actually performing technical
functions. RxHub’s technical employees operated independently of Appellant and
the other Founders.53 The testimony at trial established the RxHub had its “own
52 As the U.S. Supreme Court found in Woolworth, 458 U.S. at 369, an investor’s oversight activities, which any parent company gives to a subsidiary, does not create a unitary relationship. Similarly, in the Hercules, 575 N.W.2d at 113, case, the Minnesota Supreme Court held that Hercules and Himont were not unitary despite the fact that Hercules appointed three out of Himont’s six directors. 53 Tr. at 195-97.
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technical infrastructure both from a production perspective as well as an
administrative perspective” and that “everything that [RxHub] did was for RxHub
with… [its] own personnel.54
The Commissioner also points to the activities of Barrett Toan, Appellant’s
CEO, alleging that his substantial support of RxHub supports concluding that
there was a unitary relationship between Appellant and RxHub. The evidence,
however, does not support this allegation. The record shows that Mr. Toan
visited RxHub only once.55 While a memorandum showed that he wanted
RxHub to succeed,56 that hardly demonstrates a flow of value. Further, Mr.
Toan’s suggestion that Appellant talk to the other Founders to “get more support
for RxHub” was consistent with his role in acting on Appellant’s behalf to oversee
its investment in RxHub.
In view of the foregoing, we find that there was insufficient flow of value
between Appellant and RxHub to establish a unitary business relationship
between the two entities. While the Commissioner introduced a great deal of
evidence and testimony attempting to show interaction and overlap between
Appellant and its subsidiary, the evidence is uncontroverted that RxHub had its
own departments responsible for making its own operational and strategic
decisions. During the years at issue, Appellant employed no RxHub employee,
and none of Appellant’s employees was employed by RxHub. The two
businesses maintained separate human resources personnel who functioned
54 Tr. at 181. 55 Tr. at 346-47. 56 Ex. 51.
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independently of each other.57 They had separate legal and accounting
departments, with each company maintaining its own books and records.58 In
addition, they had separate data processing systems, intellectual property
ownership, purchasing and office facilities, and bank accounts. The extent to
which Appellant’s personnel interacted with RxHub’s committees, activities, and
Board is consistent with any parent corporation’s senior management and board
of directors oversight of and involvement in its subsidiaries. Appellant’s payment
of its own personnel while they were involved with RxHub is consistent with the
personnel acting on Appellant’s behalf. The evidence is that Appellant and
RxHub had arm’s length transactions; we find this fails to establish a unitary
business relationship between Appellant and RxHub.
B. Control
Next, we address the issue of control. Case law provides that before one
entity can be treated as unitary with another, there must be at a minimum
potential control.59 If potential control exists, the question then becomes whether
the potential control was actually exercised.60 The Commissioner argues that
Appellant exerted significant control over RxHub in a variety of ways. First, the
Commissioner asserts that RxHub received substantial support from Appellant
57 Tr. at 187; Stip. ¶ 82. 58 Tr. at 185-87; Stip. ¶¶ 93, 94. 59 ASARCO at 320-24. In ASARCO, the U.S. Supreme Court held “that a unitary business finding was impermissible because the partial subsidiaries were not realistically subject to even minimal control by ASARCO, and were therefore passive investments in the most basic sense of the term.” 60 In Woolworth, 458 U.S. at 362-64, the Court found that the companies were not unitary where the parent owned 100% of three subsidiaries and 52% of a fourth because although there was the potential for control, the parent did not exercise it. Similarly, the Minnesota Supreme Court stated in Wallow Winona, Inc. v. Commissioner of Revenue, 495 N.W.2d 427, 432 (Minn. 1993) that “[t]he Supreme Court has made it clear that the potential to operate a company as part of a unitary business is not dispositive on unitary taxation questions. The potential to do so must actually be exercised.”
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and the other Founders, and without that financial and technical support, RxHub
could not have existed. Additionally, the Commissioner maintains that Appellant
had veto power over all of RxHub’s major decisions.
Appellant claims that it is not unitary with RxHub because Appellant did
not have the potential to control RxHub. Even if it had the potential, Appellant
argues that it did not actually control RxHub. In addition, Appellant points out that
any member of an LLC or partnership, by definition, makes contributions of either
capital or services. While Appellant agrees that it had veto power for a limited
number of RxHub’s actions, Appellant relies upon ASARCO to support its
position that veto power is not control.
The parties agree that RxHub was formed as a utility whose products
would be available to any PBM, not just the Founders.61 Further, neither party
claims that the Founders received special treatment or were charged different
fees than all other PBMs.62 While the Commissioner maintains that RxHub’s
functions and services were evaluated in terms of potential benefit to the
Founders,63 we find no evidence to support this assertion. Although the MEDS
program had the potential to eventually encourage physicians who worked in the
hospital setting to expand its use of the MEDS program to the ambulatory setting,
there was no assurance that this would occur.64 The Founders were not even
customers of the MEDS product. MEDS was built to serve doctors in clinic, not
61 Tr. at 173. 62 Tr. at 204. 63 Commissioner’s Brief, p. 22. 64 Tr. at 315-16.
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hospital, settings.65 PBMs, including Appellant, did not process prescriptions in
hospital settings, thus, the MEDS product was not developed solely for the
Founders’ potential benefit. Rather, MEDS was developed because RxHub had
access to the pharmacy history data and believed there was a market in hospital
settings for such information.66 RxHub developed MEDS because it made
business sense to do so, and any potential benefit to the Founders was purely
speculative.
The Commissioner also asserts that Appellant controlled RxHub through
the ability of the Managers to set RxHub’s fees. This does not establish
Appellant’s control inasmuch as it only had one vote out of three. Appellant did
not have more than one manager who could have been part of the group of three
that set the fees.
Further, the Commissioner claims that Appellant controlled which entities
RxHub sought as its customers, relying upon evidence showing that if RxHub
wanted to talk to one of Appellant’s clients then Appellant wanted to know about
the contact. While this evidence showed that Appellant wanted to be informed,
there is no evidence that Appellant restricted RxHub’s solicitation of customers
so as to maintain control over RxHub. To the contrary, the evidence is that
Appellant favored RxHub increasing its customers because it was essential for
RxHub’s success.67 RxHub actively marketed its services to PBMs generally so
65 Tr. at 47-48, 165-66. 66 Tr. at 165-66. 67 Tr. at 173, 235.
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that by January 12, 2003, RxHub had contacted 31 companies that were in the
PBM business to attempt to build its customer base.68
Next, the Commissioner maintains that Appellant controlled RxHub
by financially supporting it. Appellant’s contributions of capital to RxHub were no
different than either of the other two Founders of the LLC. By definition, a
member or an LLC or a partnership makes contributions of either capital or
services. That contribution cannot be equated to control without recognizing that
all the Founders, who each contributed one-third of the capital, would then have
had control of RxHub. Yet the Minnesota Supreme Court held that Hercules did
not have “sole control over [its subsidiary] because it had to share [that]
control…” 69
In summary, we find that Appellant neither had the potential to control nor
did it actually exercise control of RxHub; nor was there a flow of value between
the two entities. The facts presented show that despite the presumption of
validity of the Commissioner’s finding of a unitary business and despite the
statutory presumption of unity, there was insufficient flow of value between the
businesses and inadequate control by one over the other to satisfy the test of
unity during the audit period. Thus, there was no unitary business relationship
between RxHub and Appellant during the years at issue. The income of RxHub
cannot, therefore, be combined with that of Appellant for apportionment
purposes.
We turn next to the net operating loss issue.
68 Stip. ¶ 45. 69 575 N.W.2d at 116.
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Net Operating Loss
The net operating loss (“NOL”) issue is whether DPS, Appellant’s
subsidiary, is required to apportion its section 382 limitation. The issue requires
an interpretation of Minn. Stat. § 290.095, subd. 3(d).
The NOL deduction allows a taxpayer with losses in one or more years to
carry those losses to a subsequent income year. Minnesota law allows NOLs to
be carried forward for 15 years.70 They must be deducted in the earliest year to
which they can be carried. If they are not used up in 15 years, NOLs expire.
The Minnesota NOL deduction is based upon the amount of federal NOLs
that the taxpayer can deduct under I.R.C. §172.71 However, for Minnesota
purposes, the federal NOLs have to be apportioned using the Minnesota three-
factor formula set forth in Minn. Stat. § 290.191.
This case involves a dispute over the apportionment of a limitation on the
NOL deduction—the so-called “section 382 limitation,” which is a cap on the
amount of the deduction that can be claimed in a given year. Here, Appellant
acquired all of DPS’ stock for $715,000,000 on April 1, 1999. Because
Appellant’s subsidiary, DPS, had an ownership change in April 1999, a section
382 limitation needed to be computed. As of that date, DPS had accumulated
$370,588,828 of federal NOLs that were generated during the 1995, 1996, and
1997 tax years. The issue here concerns the amount of the Minnesota section
382 limitation.
When a corporation apportions its income, Minn. Stat. § 290.095, subd.
70 Minn. Stat. § 290.095, subd. 3. 71 Minn. Stat. § 290.095, subd. 1(a).
29
3(c) sets forth how the NOL deduction is to be apportioned, while §290.095,
subd. 3(d) addresses the section 382 limitation. Although paragraph (c) specifies
that the apportionment ratio to be used in apportioning an NOL is the ratio for the
loss year or the year in which the NOL was incurred, paragraph (d) does not.
Rather, paragraph (d) simply uses the phrase “before apportionment” without
specifying whether the apportionment ratio should be the ratio for the income
year or the ratio for the loss year. Thus, paragraph (d) provides: “[t]he limitation
amount determined under [Code] section 382 shall be applied to net income,
before apportionment, in each post change year to which a loss is carried.”72
Appellant argues that paragraph (d) stating “before apportionment” should
be construed to mean that no apportionment ratio applies to the section 382 limit.
In support of this argument, Appellant contends that the legislature did not
specify which apportionment ratio (income year or loss year) should be used
because they intended that none be used. Thus, Appellant’s position is that the
Commissioner exceeded his statutory authority in apportioning the section 382
limitation.
The Commissioner claims that the section 382 limitation must be
apportioned and uses the apportionment ratio of the income years to reduce the
section 382 limitation from $30 million to $120,000. In other words, the
Commissioner reduces the section 382 limitation by applying the post-change
year’s apportionment percentage to determine the limited amount of apportioned
taxable net income eligible for a NOL for losses being carried forward from pre-
change years.
72 Minn. Stat. § 290.095, subd. 3(d).
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We turn next to the question as to whether paragraph (d) requires that
Appellant apportion its section 382 limitation. In interpreting the statutory
provision, we cannot add statutory language that the legislature failed to
include.73
The Commissioner ‘s decision relies upon Revenue Notice 99-07 in
stating that “the amount of Minnesota net income used to determine the net
operating loss deduction, with regard to pre-change losses, is limited to the IRC §
382 limitation determined for that year.” Appellant agrees with that part of the
Commissioner’s notice, but disagrees with the requirement added that by the
Commissioner that the section 382 limitation must be reduced by applying the
taxpayer’s “post-change year’s apportionment percentage to determine the
limited amount of (apportioned) taxable net income that is eligible for a net
operating loss deduction for those losses being carried forward from pre-change
years.” Appellant argues that this latter provision does not follow the statutory
directive, contending that no apportionment is appropriate when Minn. Stat. §
290.095, subd. 3(d) says the section 382 limitation is to be determined “before
apportionment.” We agree.
While the Commissioner’s Revenue Notice is a statement of department
policy, it does not have the force of law and has no precedential effect.74 We,
therefore, must rely upon the statutory language in determining whether or not
apportionment of the section 382 limitation is appropriate. Clearly, when the
73 See Hutchinson Tech., Inc. v. Commissioner of Revenue, 698 N.W.2d 1, 8 (Minn. 2005) (“we will not add requirements to the statute beyond those specified by the legislature”); Green Giant Co. v. Commissioner of Revenue, 534 N.W.2d 710, 712 (Minn. 1995) (“we will not supply that which the legislature purposefully omits or inadvertently overlooks”). 74 Minn. Stat. § 270C.07, subd. 1-2.
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legislature intended apportionment, it not only said so but also said which income
ratio applied in Minn. Stat. § 290.095, subd. 3(c). However, Minn. Stat. §
290.095, subd. 3(d) does not refer to apportionment. Thus, we interpret Minn.
Stat. § 290.095, subd. 3(d) as requiring no apportionment.
Furthermore, “[w]here the state government, acting independently in its
own sphere, copies a federal statute, the state act will be construed to have the
same meaning as the federal act.”75 Here, the calculations of both the NOL
carryover itself and the section 382 limitation for Minnesota tax purposes begin
with their federal counterparts. With respect to the amount of the deduction for
Minnesota tax purposes, Minn. Stat. § 290.095, subd. 3 (c) starts with a
taxpayer’s federal NOL amount. With respect to the Minnesota section 382
limitation, paragraph 3(d) cross references the taxpayer’s federal section 382
limitation. It is noteworthy that I.R.C. § 382 provides a fixed, unchanging NOL
limit that is determinable at the time of the corporate change of control. This
aligns sellers’ and buyers’ valuations of target corporations’ NOLs by providing a
fixed limit on the annual utilization of those NOLs after a corporate change in
control. However, the Commissioner’s methodology of basing a taxpayer’s
section 382 limitation amount on post-change actions by the new corporation
results in a section 382 limitation that changes each year and would be,
therefore, indeterminable at the time of the change of control. Under the
Commissioner’s methodology, buyers and sellers would be unable to value NOLs
because they would not know the apportionment percentages for future years.
75 Christmas v. Woodlawn Cemetery Assoc., 393 N.W. 619, 625 (Minn. 1940).
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Conclusion
In summary, the Commissioner’s methodology for applying a section 382
limitation for Minnesota tax purposes is unsupported by the plain language of the
statute and would create an unnecessary disconnect between Minnesota and
federal law. Minnesota Statute Section 290.095 requires a taxpayer to apply its
section 382 limitation to its net income before apportionment. We, therefore,
agree with Appellant’s calculation of its taxable income in the years at issue and
reverse the Order.
S. A. R.
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