Perspective: A Primer on Building a Paper Trail That Will Win Tomorrow's Audits

The Bloomberg BNA Tax Management Weekly State Tax Report filters through current state developments and analyzes those critical to multistate tax planning.

By Geoffrey J. Christian, James S. Helms, and Melanie C. Hill

Geoffrey Christian is a managing member and James Helms and Melanie Hill are tax specialists with Dow Lohnes Price Tax Consulting Group LLC, a non-legal affiliate of Dow Lohnes PLLC. Mr. Christian and Mr. Helms have significant experience in making unitary determinations and documenting the facts needed to win the position in numerous states. This article is adapted from a presentation made by Mr. Christian at the Council On State Taxation (COST) Spring Income Tax Conference.

INTRODUCTION

Like archaeologists who mine data from the past to interpret prior events, state and local tax professionals often resort to data digs to develop and defend tax positions taken years earlier. As in archaelogy, disputes arise when critical pieces to the puzzle are missing, such as when incomplete documentation allows opposing interpretations of a prior event between taxpayers and auditors.

State and local tax (SALT) professionals have one advantage, though, that archaeologists do not; archaeologists can only look backwards, but SALT professionals can look ahead, and with a little advanced planning, accumulate a wealth of data that may be mined later to help support tax positions.

Taxpayers often fail to realize that the documentation required to support a broad range of tax issues at the time of an accrual or filing can be very different from what is needed to win a dispute over a filing method under audit. Failing to preserve the proper documentation means that many tax opportunities may be left on the table, or severely compromised. But if the taxpayer had the foresight to create a time capsule for future use, there's no need to search for a Rosetta Stone.

In this article, the authors explain how to create a time capsule to be used by the SALT professional in unitary determinations. This article provides a template for accumulating public and internal documents and explains how these documents can be used to create the paper trail needed to defend a unitary filing method position on audit (or to defend against a forced combination).

A word of caution: while the following discussion centers on winning a corporate unitary filing position, unitary principles are not limited to unitary relationships between corporations. A unitary analysis can, and should, be applied to partnership investments to argue that partnership factors should not be flowed through to the owner when a unitary relationship does not exist.

An experienced SALT professional can find other ways to employ unitary principles in winning tax disputes not centered around filing methods.

ORGANIZING THE TIME CAPSULE

There is no standard format for a SALT time capsule; it could consist of documents accumulated in boxes or filed in electronic folders where the content is organized by both time periods and types of records. But regardless of whether the system used to create the time capsule is paper-based, electronic, or a combination, each document should have at least four tags in the file name or index: date, source, type, and description. While a tax professional will need to design the system, it should be easily implemented and maintained by administrative staff. The tags are important because they allow the tax professional to browse the accumulated data to find documents indexed, saved, and filed by support staff or predecessors.

Best Practices for Document Tags

• Start with the date using the “big endian form” of yyyy-mm-dd. This format is standard in Asian countries and is the only format which allows documents to automatically be stored and sorted in date order; it is also consistent with western decimal numbering systems.
• Assign codes to designate the source, at least differentiating between public, internal and privileged documents.
• Consider using codes for each document type such as Web sites, telephone lists, press releases, minutes, officer lists, etc.
• Using the above tagging conventions will allow more space in the file name or index to be attributed to the description. Periodic updates can be simply identified as such while documents pertaining to specific transactions or events can be described in the tag with keys words and names.

Upon audit, the taxpayer should have the benefit of inside knowledge over the state, but the benefit only comes into play if the tax professional has access to the knowledge five to 10 years later, when the position is challenged by the state.

Public Documents

Public documents should be included in the time capsule and can easily be accumulated by support staff with very little oversight. Press releases and annual reports are important elements for the time capsule because they may or may not portray a public image of unity. For example, in its annual reports, Container Corp. identified itself as “the world's largest producer of paperboard packaging” in referring to overseas and domestic operations. 1 This self-promotional phrase painted a unitary enterprise and was significant enough to be cited by the U.S. Supreme Court.

1 Container Corp. of America v. California Franch. Tax Bd., 463 U.S. 159 (1983).

Although corporate Web sites were unknown in 1983 when Container was decided, Web sites have become important in supporting unitary filing positions at the administrative hearings level. For this reason, we recommend periodic documentation ( i.e., downloading and saving or printing and filing) of the taxpayer's public Web site(s). State auditors commonly refer to a company's Web site in planning or conducting an audit but are generally limited to the current Web site. By having access to the archived Web site within the tax department, the SALT professional can review the archived Web site for evidence of a shift to a unitary business and develop a historical context for a position or transaction, evidence which is not available to the auditor.

Last year, the U.S. Supreme Court remanded the Mead case back to Illinois for a factual determination of whether the corporation met the unitary standards outlined in Container. 2 Both the Illinois Appellate Court and the U.S. Supreme Court highlighted Mead's public self-description as engaged in electronic publishing and information retrieval and its claims of success in developing the small legal databases into a premier online legal information service.

While these statements were included in annual reports and designed to promote investment in Mead, it would be interesting to note how well these statements correlated to the Web sites for Mead and its Lexis division. If the correlation is not high, the Web sites may provide a truer picture of the company's self-description since these are the portals used by customers and suppliers and more directly related to day-to-day operations.

2 MeadWestvaco Corp. v. Illinois Dept. of Rev., 128 S. Ct. 1498 (2008), vacating and remanding 371 Ill. App. 3d 108.

Press releases and annual reports are important elements for the time capsule because they may or may not portray a public image of unity.

While Web sites, annual reports, and press releases lie entirely within the dominion of the taxpayer and are therefore significant indicators of how companies view themselves, public documents generated by unrelated entities and news organizations are also important precisely because they are not within the taxpayer's control. To the extent that these documents corroborate the taxpayer's position in asserting its evolution to a unitary business, they add weight to the taxpayer's position.

Our own support staff, armed with lists of clients and potential clients, search several business news and industry-specific news sources on a daily basis for data which we accumulate and maintain in the course of our consulting practice. While a tax department may not have the resources to perform this function, it is likely being performed in the company's legal or public relations departments, and forwarding this information to the tax department would be an efficient sharing of information among departments.

Internal Documents

Most of the documents in the time capsule will be internally generated for employee use and can be characterized as routine, nonroutine, or privileged. The tax professional should consider the many routine information resources available in the company and list them as elements of the time capsule to be accumulated and maintained by the support staff. While tax professionals likely request information from other departments on an annual basis to be used in preparing tax returns, the requests may not go so far as to include data which should be accumulated to potentially claim or defend a unitary filing position; the additional information could easily be piggy-backed onto existing information requests.

The time capsule for each entity should include officer and board of directors lists as part of a routine information request from the legal department.

Office directories and employee telephone directories should be added to the time capsule on an annual basis. These documents are helpful in placing other documents and transactions in context; they also provide support for factual narratives.

To illustrate: while a routine memo on a change in capital budgeting procedures has the potential to be valuable, the value is solidified only if the author's location and position is known. If this information is not identified on the memo itself, the phone directory and officer list may be used by a tax consultant assisting the corporate successor to identify the author. With additional information to put the memo in context, the document could be used to demonstrate centralization of management. Institutional knowledge is often lost after acquisitions, and while former officers may be available to provide consultations and depositions, unlimited access to an organized time capsule to determine fundamental facts will allow the more limited access to former officers to focus on the more important, and less tangible, aspects of developing a narrative for the unitary position. Once a narrative is developed to illustrate one aspect of the unitary position, the tax professional can locate documents in the time capsule to create a paper trail of evidence.

Documents such as employment figures by division and department, statistics for employee transfers across divisions, summaries of promotions from within, phone records, travel logs, and expense reports can be mined for evidence supporting unitary characteristics. It is impractical for the time capsule to include all the details, but the SALT professional can be included in distribution lists for quarterly or annual summary reports and simply add those reports to the time capsule as received. The data can be mined later when the position paper or brief is prepared.

Three Prongs of Unitary Test


Functional integration, economies of scale, and centralized management are the three prongs in the unitary test. 3 The Illinois Hercules decision provides a laundry list of centralized functions to be evaluated in a unitary determination including “advertising, public relations, accounting, engineering, medical, legal, tax, audit, billing, purchasing and information technology.” 4 While the centralized provision of these types of services is relatively easy to document, a deeper look is required to determine if the arrangement represents a unitary business relationship. 5 Therefore, the time capsule should include management service agreements and supporting documentation on how the fees were computed and why the computation method used was selected among alternatives. Employee intranet Web sites, internal newsletters, and corporate policies regarding record retention, travel, entertainment, holidays, vacation, automobiles, charitable contributions, budgets, capital expenditure, purchasing, lobbying, promotions from within, and job postings are routine internal documents which should be included in the time capsule.

3 See Container, above, and F.W. Woolworth Co. v. New Mexico Dept. of Tax. and Rev., 458 U.S. 354 (1982).

4 Hercules Inc. v. Illinois Dept. of Rev., 324 Ill. App. 3d 329 (June 29, 2001).

5 In Hercules, these services were provided at arm's-length pricing, a factor indicating that the arrangement did not create value for the enterprise and, thus, were indicators that a unitary relationship did not exist. Furthermore, no evidence was found that Hercules exerted management control through provision of these services.

While individual corporate policies should be included in the time capsule, changes in corporate policy should also be added to the time capsule. In making a unitary determination, it is important to document whether each policy is dictated from a central location or parent company, and from what level, or adopted at the division or entity level. Thus, policies for each operating division and entity should also be included in the data base and could easily be included in the annual tax department information request.

Once a narrative is developed to illustrate one aspect of the unitary position, the tax professional can locate documents in the time capsule to create a paper trail of evidence.

The time capsule also should include nonroutine documents because they may signal a shift to a unitary business. Changes in top management or organizational structure, or relocation of entities or divisions are all potentially significant events in a unitary analysis, and internal documents announcing such changes should be retained. For example, Arizona case law requires a higher level of functional integration among lines of business than is required by California or Illinois. Therefore, notices announcing appointments and promotions between lines of business or divisions may be particularly helpful in Arizona to provide additional evidence of functional integration between lines of business.

Other examples of nonroutine internal documents include documentation of new logos, evidence demonstrating cross-use of logos between companies and divisions, marketing campaigns, and cross-marketing efforts between companies and divisions, special events, special projects, and intercompany transactions.

Intercompany debt and use of corporate funds for acquisitions and investments are often related, and documentation gathered for a unitary determination is useful in resolving other tax disputes. In addition to obtaining the debt instrument, documentation should be accumulated to explain and justify the interest rate charged.

While back office and professional services may be provided in such a way as to contribute to a unitary relationship, at least one court regarded such services as “accessories” and not nearly so important to a unitary analysis as the intergroup provision of “basic” operations, such as “producing, refining, manufacturing, transporting, buying, or selling merchandise.” 6 The time capsule, therefore, should include the contracts or agreements governing intercompany purchases of goods or services, including supporting documentation to explain why an affiliated supplier was chosen over alternative suppliers and how the purchase price was computed. Since affiliated supply contracts will always be examined in a unitary determination, the search for documentation should not stop until the tax professional is confident whether or not the arrangement represents a flow of value between the entities as an enterprise.

6 F.W. Woolworth Co., Kinney Shoe Corp., and Kinney Service Corp. v. Arizona Department of Revenue, Div. 1, Dept. T, No. 1 CA-TX 97-0007, Dec. 11, 1997.

The tax professional will likely need access to certain confidential or privileged documents in order to complete a unitary analysis. It may not be possible to wrestle recent privileged documents from the legal department or executive management, but such documents are often key to identifying unitary factors.

One approach may be to work with general counsel to obtain copies of the documents on a time-lapsed basis. The concerns of counsel with regard to confidentiality may be eased after a couple of years and yet the documents are still timely for tax purposes in evaluating refund opportunities and planning audit defense. Another option is to request an annual listing or index of confidential documents from executive officers in lieu of requesting copies of the documents as a first step in determining which documents are most relevant to the position. Alternatively, the tax professional may schedule periodic visits to the legal department for “in camera” access to confidential or privileged documents. While the privileged documents themselves may not be released for use in the paper trail, the tax professional can search afterwards for non-privileged documents to corroborate the unitary characteristic contained in the privileged document. Actual use of privileged documents should be undertaken with care and in coordination with counsel since the privilege may be broken. 7

7 The work product doctrine is stronger and not generally waived unless the disclosure substantially increases the chances of an adversary obtaining the information. Regions Fin. Corp. v. United States, 101 AFTR 2d 2008-2179 (N.D. Ala. May 8, 2008).

Instant Unity

The data listed by the SALT professional for creating a time capsule should also be requested from predecessor owners at the time of the acquisition. In acquisitions, it is important to identify whether it is beneficial to file on a unitary basis and to consider establishing a unitary filing position in the first return filed subsequent to the acquisition. At the time of acquisition, SALT professionals should be especially alert in identifying internal documents that address policy with regard to the acquired company. If the taxpayer can document that the acquired and acquiring corporations were unitary on the date of acquisition, the taxpayer may be able to achieve instant unity for state tax purposes.

Although it is uncommon for instant unity to be addressed in statutes, some states have addressed the issue through regulations or administrative policy. An instant unity filing position is not automatic merely because the acquiring corporation has previously filed returns on a unitary basis; an instant unity claim is achievable but subject to a separate determination and factual review. For example, California adopts a presumption against instant unity on the premise that unity is a function of time, which must develop through integration. Although Illinois law does not address instant unity, the position can be won by applying California case law on instant unity to the taxpayer's facts. Instant unitary determinations can have ramifications for business-nonbusiness issues in addition to filing methods. For example, we have been successful in claiming instant unity in an acquisition for multiple lines of business while also winning the position that one of the lines of business was not instantly unitary. This interim step strategically allowed a subsequent gain on the sale of that line of business to be classified as nonbusiness income.

CREATING A PAPER TRAIL TO BUILD A UNITARY CASE

Once it has been determined that a change to a unitary filing position is a desired result, a tax planning process is implemented to document the extent of unity and to develop a strategy for ultimately winning a unitary filing position. The audit process itself can be important to creating the paper trail. We have successfully asserted a change in unitary filing method during the audit itself in an affirmative action, in part relying on the information document request (IDR) process to include with every document requested by the auditor a direct or indirect statement as to how the document aligned with the proposed change in method. Because the IDRs created during the audit documented that functional integration existed between the taxpayer's lines of business, the multimillion-dollar tax refund was incorporated by the auditor into the audit workpapers. Thus, proactive action during the audit averted the need for a refund claim followed by a protracted dispute resolution process.

As an example, the following process would be used to evaluate corporate policies in making a unitary determination. After reviewing the initial policy data which has been accumulated, a follow-up questionnaire is developed for the operating divisions for the purpose of determining the extent and depth of unity. While this level of analysis into individual corporate policies at each division may be time-consuming, and the inclusion of supporting documents for the analysis may be voluminous, such an analysis is essential to building a case. 8

8 This process should at least begin when the audit notice is received, because most unitary determinations can be won at the audit or informal hearing level. In order to win a large-dollar unitary tax dispute at this level, the position must be fully developed with supporting evidence. In our experience, it can take two to four years to resolve a multi-million-dollar unitary assessment without litigation. The ability to identify and accumulate documentary evidence decreases over time, so putting the maximum effort into resolving the issue within the administrative realm results in the strongest case, should the matter ultimately be litigated, or the lowest cost, since litigation was not necessary and the matter was resolved more quickly. Compare this to the Mead case, which involves tax on a 1994 transaction and 15 years later is still unresolved, or the Container case, which was decided 18 years after the end of the tax period.

In Container, the U.S. Supreme Court considered the issuance of policy decisions from the highest levels of the organization to be a factor of great importance. 9 In this case, the taxpayer argued that the state equated the potential to control the subsidiaries with actual control and that, in fact, its subsidiaries were largely autonomous. In dismissing this position, the U.S. Supreme Court noted that high-level employees of the parent company provided corporate policy on ethics, professionalism, and profitability to executives of the subsidiaries. These are policy areas where one might expect even nonunitary corporations to have common ground, and the weight assigned by the court to these factors may be surprising given the other policy areas controlled at the subsidiary level. For this reason, it is essential to assess the depth of unity of use in all policy areas.

9 See Container, above.

In Container, the senior vice president over subsidiary operations also dealt with long-term decisions and major problems of the subsidiaries. The facts cited by the court noted that capital expenditures were subject to review and problems with the capital expenditures budget were consensually resolved, as opposed to being dictated. Given that the U.S. Supreme Court did not require overwhelming control by the parent company in order to find the taxpayer unitary, it is clear that the nuances in how policy is controlled by the parent company must be understood and evaluated.

To reach this depth of understanding, follow-up questionnaires used to explore unity in capital budgeting may include the following questions:

• What is the parent company's involvement in the capital budgeting process in terms of preparing a budget, requesting details, reviewing and approving the budget and follow-up?
• Which persons at the holding company participate in the process, what are their titles, and to what degree do they participate?
• What is your experience in having capital expenditure requests denied by the holding company, who communicated the decision, and what was their title?
• Has an acquisition been approved in the budgeting process and then denied in the capital expenditure approval process? Please provide examples.
• How does prior experience in the past two to four years compare to more recent experience?

Similar questions would be posed to holding company personnel in an effort to gain an accurate understanding of the unity of use in the capital budgeting process in addition to added questions to determine the budgeting control exercised by the holding company on capital budgeting across divisions or entities. If similar questions are developed for each policy item and the results for each division are reviewed, the support for line of business and unitary filing methods can be assessed and used to draft a narrative in support of the desired position. There is no substitute for thoroughly documenting the existence of functional integration in matters of corporate policy.

In our experience, a narrative, by itself, will not win a switch to a unitary filing position. While some audit supervisors, hearing officers, and administrative law judges respond well to written narratives and briefs, others respond to tabular formats and graphic displays. For this reason, we typically add to a narrative an assimilation of the paper trail into a table, which strips the relevant facts from the most pertinent court case in the jurisdiction and compares and contrasts these facts to the taxpayer's facts. This process is repeated to include other significant cases, in various jurisdictions, so that multiple tables are presented, each of which examines in depth the relevant factors demonstrating unity of use, all supported by documents in the data base.

BEYOND THE UNITARY AUDITS

Combined reporting legislation has been introduced in numerous states, and taxpayers in these states should, at a minimum, begin to evaluate whether they will be required to implement a change in filing method. 10 In addition, combined filing may be an option under relief provisions in separate return states, but only to the taxpayer who has made a unitary determination and found that the relief provision may be applicable.

10 Mandatory combined reporting legislation has been introduced in 2009 in Alabama, Florida, Iowa, Maryland, Missouri, Rhode Island, and Tennessee; although Connecticut and New Mexico allow combined reporting, legislation has been introduced in 2009 to make it mandatory. West Virginia and Wisconsin enacted mandatory combined reporting effective in 2009 while Massachusetts, Michigan, and Texas previously enacted mandatory combined reporting effective for 2008.

A well-planned and maintained SALT time capsule is valuable for opportunities that may not be identified while the data is accumulated. Sometimes value is realized after an acquisition and the person mining the data base is able to create valuable positions that were inapplicable to the predecessor; as consultants, we are often called in to act as an archaeologist in building a successful unitary position for successor taxpayers. Or value may be realized when precedential litigation is decided on facts which are relevant to the taxpayer and supported by documents previously accumulated. Now is the time to implement routine procedures to build the cache of information needed to win future audits and affirmative refund claims.

Points to Remember

• Public documents retained for unitary determinations include archives of the corporate website and published articles.
• Archived officer and director lists and office and telephone directories allow other documents to be placed in context.
• Corporate policy documents are a first step in accumulating data; a deeper look will be needed to make a unitary determination.
• Unitary determinations apply to all entity types and not just C corps.
• Don't overlook an instant unity determination.
• Build your best case at the lowest level: it forces you to hunt for documents now that will not be easier to find later and it increases your ability to win the position at administrative levels.