In 1960, the US Supreme Court ruled that when Mr. Berman gave his friend, Mr. Duberstein, a Cadillac to thank him for some business referrals, Mr. Duberstein (who thought he had received a gift and did not report it as income) had to include the car in income as taxable compensation. The Supreme Court said that a gift proceeds from a “detached and disinterested generosity) and is given out of affection, respect, admiration, charity or like impulses,” (a donative intent in the Court’s famous words). But where the value given proceeds from an “involved and intensely interested” act then the value is compensatory in nature and taxable. Because of the pre-existing relationship between Mr. Berman and Mr. Duberstein, the Supreme Court said that Mr. Berman’s transfer of the car to Mr. Duberstein was not made out of a “detached and disinterested generosity,” but rather to compensate him for past services or to induce him to provide future services. To make matters worse for Mr. Duberstein, he testified at a lower court hearing that he already had a Cadillac and an Oldsmobile and didn’t really need another car!
Two recent cases, one involving the City of Seattle and the other the State of Washington taxing authorities, show that the question of defining “what is income” remains as alive as ever, regardless of whether the tax is an income tax (Duberstein) or a gross receipts tax (Seattle and Washington State).
Getty Images v. Seattle is a very different matter from Duberstein, to be sure, because it involved not a gift from one person to another, but an attempt at tax planning among several different entities in a large corporate family. But Getty is yet another instance of the constant see-saw battle between taxpayers and taxing agencies like the City of Seattle as to when money received is taxable income and when it is not.
Getty, a company located in Seattle, was the parent corporation of 60 affiliated companies worldwide. Getty had at one time provided a wide range of administrative services for its affiliates, presumably without charging them. In 2001, as a result of a foreign audit, Getty began charging the affiliates for the services because the charges improved the affiliates’ own tax position. In an apparent attempt to avoid City of Seattle and Washington State B & O tax on the revenues derived from providing the services, Getty created a new subsidiary (Management) in California. Management was a shell company with no assets, no employees and it did not perform any services. Management contracted with all of the affiliates for services totaling anywhere from $25M to almost $100M a year, and then subbed the work out to Getty in Seattle. Getty then entered into a contract with Management whereby Management paid Getty $1M a year for all services Getty performed. Getty reported the $1M contract payments from Management as income to the City of Seattle.
Because Getty employed some 450 people in Seattle to perform services for the affiliates, and had other costs as well, Getty also withdrew substantial funds from a corporate cash management account (an account into which all the corporate family funds were deposited), booking the amounts it withdrew as loans from its affiliates. These funds were used to cover the costs which Getty had incurred to provide the services. Because loans are not taxable, the only income Getty reported was the $1M from Management, not the many millions more it withdrew from the management account.
The City of Seattle didn’t see things Getty’s way, and assessed it for city B&O tax on the full amount of its costs for performing these services, plus the $1M. In other words the City of Seattle imposed its tax on both the $1,000,000 per year actual contract payments from Management and all of the additional withdrawals that were recorded as money borrowed from its affiliates ($25-100M a year). When Getty appealed the assessment to the Seattle City Hearing Examiner, the hearing examiner upheld the tax assessment. The King County Superior Court upheld the Examiner’s decision and the Washington State Court of Appeals upheld the Superior Court decision. The Washington State Supreme Court denied review so that the Court of Appeals decision stands.
The Court of Appeals, 163 Wash. App. 590 (2011), rev. denied, 173 Wash. 2d 1014 (2012), rejected the argument that Getty’s compensation was limited to the contract amount of $1M. Discussing the Seattle Code’s definition of “gross income” the Court of Appeals said that “broader language could hardly be devised to convey the idea implicit in the foregoing definitions that the tax applies to everything that is earned, received, paid over to or acquired by the seller from the purchaser or the latter’s alter ego.” Noting that the amount of money which Getty withdrew from the cash management account was needed to cover the expenses of providing the services to its affiliates, the Appeals Court agreed that the funds transferred from the cash management system to the Getty Seattle bank account to pay the costs of providing administrative services was “compensation for the rendition of services” subject to the B & O tax under SMC 5.30.035(D).
Klein Honda v. Department of Revenue issued by the Board of Tax Appeals on June 6, 2012, (Docket No. 10-270), held that so-called “dealer cash” paid by Honda Motors to a Honda dealer in connection with the sale of particular vehicles was subject to Washington State B & O tax, rather than being treatable as a reduction in wholesale cost. The case turned in large part on whether the dealer had income under Washington law, the dealer arguing that it did not perform extra services in exchange for the cash back but was already obligated to do exactly what it was doing under the terms of its franchise agreement with Honda Motors. Citing to the section in the law which defined “gross income,” the Board found the definition so broad as to cover the cash back even if it was not paid as compensation for services. The definition was so broad that, in the Board’s words “Under this section, the taxpayer can have taxable income from business activity without providing any specific services.”
This is a very important issue for car dealers, because it has been the trend for years for auto manufacturers to increase their wholesale cost, effectively reducing the dealer’s profit margin, and to “give back” the full profit margin only in the form of “bonuses” – if and when dealers comply with numerous “customer satisfaction” and other requirements. Dealers have to do more work and effectively pay tax twice, once on the gross selling price of the car and again when they receive bonus monies from the manufacturer (which just gets them back to their originally expected profit margin). Our office recently appealed such a situation and we were surprised when the Appeals Division not only denied the appeal, but basically ignored the arguments we raised on behalf of our client, and also ignored a favorable decision we have obtained in a very similar case about 10 years ago.
These three cases, Duberstein, Getty Images and Honda are vastly different, but share one thing in common: except for the easy cases (like when you borrow money against your house, which is obviously a nontaxable loan, or sell something at a retail location, which is obviously part of gross proceeds of sale) there are always new ways, new situations and new reasons why a business is receiving funds, not all of which are easily thought of as “income.” The Getty and Honda cases show that Seattle and Washington State aggressively respond to these new situations and, predictably, see additional taxable income. We continue to appeal these cases for clients and raise all available arguments our clients may have to avoid additional tax.
Learn more about Attorney Martin Silver, PS.