Lies, Damn Lies and Taxes
Oregon Taxes a Non-Resident Insurer’s Income
The Oregon Tax Court was asked to resolve issues concerning earnings and taxes imposed on the Costco Wholesale Corporation (the “Taxpayer”) who is engaged in the operation of membership warehouses offering branded and private label products in a range of merchandise categories in no-frills, self-service warehouse facilities throughout the United States, including warehouses in Oregon. The Taxpayer is the parent corporation of a federal affiliated group comprised of Costco, NW Re Ltd. (the insurance company) and other domestic corporations. Taxpayer filed federal consolidated income tax returns on behalf of the affiliated group for each of the tax years at issue. Taxpayer filed Oregon consolidated corporation excise tax returns on behalf of itself and its subsidiaries for each of the tax years at issue. The Tax Court resolved disputes over what was taxable income in Costco Wholesale Corp. and Subsidiaries v. Department of Revenue, State of Oregon, No. TC 4956 (Or.Tax Ct. 07/16/2012).
Calculating the Oregon taxable income for each of the years at issue for Taxpayer and its subsidiaries, Taxpayer subtracted the insurance company’s income from Taxpayer’s affiliated group’s federal taxable income. The department conducted an Oregon corporation excise tax audit of Taxpayer and its subsidiaries covering the tax years at issue. As a result of the audit, the department proposed certain adjustments to the Oregon returns as originally filed by Taxpayer and its subsidiaries.
The department issued notices of deficiency assessment (Notices of Assessment) where the department asserted that Taxpayer was liable for additional tax, plus interest and penalties for each of the tax years at issue. In the Notices of Assessment, among other adjustments, the department determined that the insurance company was unitary with Taxpayer and that the insurance company’s income should be included with the Oregon taxable income of Taxpayer and its subsidiaries.
The insurance company is a wholly owned subsidiary of Taxpayer. During the tax years at issue, the insurance company was a Bermuda entity that elected to be treated as a domestic corporation for federal income tax purposes pursuant to Internal Revenue Code (IRC) section 953(d). The insurance company insures general liability, workers compensation, and automobile liability risks of Taxpayer’s affiliated group, including Taxpayer.
The insurance company receives insurance premiums from Taxpayer’s affiliated group including Taxpayer. Through the Green Island Reinsurance Pool, the insurance company also receives reinsurance premiums from unrelated third parties. During the tax years at issue, the insurance company did not own or rent any property located in Oregon. Nor did the insurance company have any employees located in Oregon. The insurance company was not registered to do business in Oregon during the tax years at issue. The insurance company did not file Oregon corporation excise tax returns for any of the tax years at issue.
The issue presented at this stage of the case is whether the income of the insurance company is to be included in the calculation of the Oregon taxable income of Taxpayer.
Of the foregoing facts stipulated for purposes of these motions, two are of particular importance. The first of those is that Taxpayer and the insurance company are, under Oregon tax law, in a unitary relationship with each other. The second of those is that the insurance company is not subject to taxation in Oregon and is not required to file a return pursuant to Oregon statutes.
The resolution of this case then depends on whether the return of Taxpayer must include the income of the insurance company in the computation of the Oregon taxable income of Taxpayer.
Even though the effects of combination of income of all unitary affiliates often increased the tax base significantly, this was offset by including, in the apportionment factor denominators, the factor values for all of the unitary affiliates as well. Nonetheless, foreign governments and their domestic corporations objected to the worldwide combination approach as it exposed foreign companies to burdensome and costly audit procedures.
In 1984 Oregon responded to these objections by adopting a “waters-edge” system. The “waters-edge” approach was one in which the income of foreign parent or subsidiary companies was not included in the calculation of Oregon tax base for a related company doing business in Oregon. This result was technically accomplished by using, as a starting point for the calculation of companies filing in Oregon, only the federal consolidated income of groups that included companies doing business in Oregon. Because federal consolidated returns may only include the income of companies incorporated in one of the states of the United States, the choice of that starting point for determination of tax base meant that the starting number for calculation of the tax base would not include the income of parent or subsidiary companies incorporated in foreign countries.
That said, Oregon did not otherwise abandon its historical commitment to the determination of the income tax base of Oregon Taxpayers by use of the apportionment of the combined income of all companies that were, within the United States, in a unitary relationship. As in the past, determinations of income were to occur for each unitary group – that is each group of companies engaged in a single trade or business. For purposes of these motions both parties have accepted the assumption that Taxpayer and all of its subsidiaries – including the insurance company – comprise one unitary group.
Because the federal consolidated return statutes and regulations do not take into account the concept of a unitary group, the Oregon statutes provide a set of rules for the separate determination of the income of each unitary group in cases where more than one unitary group exists within one federal group of affiliated companies filing a consolidated return. Although the income of each unitary group is separately determined, there is in the statute no provision or indication that would permit the total income of all unitary groups found within one federal consolidated return to be less than the consolidated federal taxable income found on the federal tax return.
As to the one unitary group of companies assumed to exist in this case and found within the federal consolidated return, it is important to determine which company has (or which companies have) by reason of sufficient contact with Oregon, an obligation to file a return in Oregon. For these motions, it is assumed there is only one unitary group existing within the federal affiliated group of corporations. That unitary group includes Taxpayer, the insurance company and all of their federal affiliates. Accordingly, the starting point for the determination of the Oregon taxable income of Taxpayer is the entire consolidated federal taxable income for the year in question. This amount includes the income of the insurance company – it was, after all, included in the federal consolidated return.
The starting point is simple: if a corporation files a separate federal return, it will file a separate Oregon return. If the corporation is included in a federal consolidated return, it will file an Oregon consolidated return.
The fact that the insurance company has insufficient contacts with Oregon to support jurisdiction once again concludes the analysis. If Oregon does not have jurisdiction to require the insurance company to file a return the taxing statutes cannot and do not apply to the insurance company. The tax court concluded that the income of the insurance company, being in the federal consolidated income of the unitary group to which Taxpayer belongs, must be, after any adjustments otherwise required by Oregon law, included in the Oregon tax base of Taxpayer subject to apportionment.
The Oregon consolidated return provisions were designed to exclude from Oregon unitary returns the tax items of corporations incorporated in foreign countries. That was a legislative choice and not required of Oregon. The legislature did not go further. Inclusion of the income of the insurance company in the return calculations for Taxpayer does not therefore, conflict with the purposes of the Oregon unitary tax rules.
Further, nothing in any of the statutory provisions indicates that the legislature intended to exempt the income of some insurance companies. It bears observing that Oregon is, in no way, requiring the insurance company to file a consolidated return or asserting jurisdiction over it. Nor is Oregon directly imposing a tax on the income of the insurance company. Oregon is only taking into account the income of a unitary affiliate in computing, on an apportioned basis, the tax liability of corporations over which Oregon has jurisdiction to tax.
Old Ben Franklin was right – the only certainty in life is death and taxes. In this case, Costco created an insurance company based in the Bahamas that has no connection to the state of Oregon and yet the income of the insurer was included – for tax purposes – for the benefit of the state of Oregon. If each of the 50 states where Costco does business applies the same rule Costco’s tax obligation will increase logarithmically and may make it less expensive for Costco to buy insurance – whose premiums would be deducted as a business expense – than to operate its own insurer that might even make a profit if run well.
© 2012 – Barry Zalma
Barry Zalma, Esq., CFE, has practiced law in California for more than 40 years as an insurance coverage and claims handling lawyer. He also serves as an insurance consultant and expert witness specializing in insurance coverage, insurance claims handling, insurance bad faith and insurance fraud. Mr. Zalma serves as a consultant and expert, almost equally, for insurers and policyholders.
He founded Zalma Insurance Consultants in 2001 and serves as its senior consultant.
Mr. Zalma recently published the e-books, “Zalma on Insurance Fraud – 2012″; “Zalma on Diminution in Value Damages – 2012,”“Zalma on Insurance,” “Heads I Win, Tails You Lose — 2011,” “Zalma on Rescission in California,” “Arson for Profit” and others that are available at www.zalma.com/zalmabooks.htm.