In ComCon Prod. Servs. I, Inc. v. Cal. Franchise Tax Bd., Cal. Ct. App., No. B259619 (December 14, 2016), the California Court of Appeals, Second Appellate District, affirmed the lower court’s judgment, holding that Comcast Corporation and its then majority-owned subsidiary, QVC, Inc., were not unitary, but that a $1.5 billion termination fee that Comcast received in its failed merger with MediaOne Group, Inc. was apportionable business income. The Appellate Court also addressed two issues not discussed by the lower court concluding that (1) the taxation of the termination fee was proper under the Due Process Clause, finding a “definite link” between the termination payment and California (as the MediaOne merger failure impacted the value of every aspect of Comcast’s business); and (2) Comcast forfeited its right to argue, as it failed to raise the issue in its refund claim, that the termination fee should have been included in its sales factor denominator.

Unitary Business Analysis

In analyzing the unitary business issue, the Appellate Court considered the California Franchise Tax Board’s argument that the lower court had failed to analyze Comcast’s facts under the dependency and contribution test for a unitary business. The Board claimed that the trial court erred by “applying a more limited three-factor (or ‘three hallmarks’ test).” The Appellate Court rejected the Board’s argument, recognizing three unitary business tests as valid: (1) the three hallmarks test (centralization of management, functional integration, and economies of scale), (2) the three unities test (unity of use, operation, and ownership), and (3) the dependency and contribution test. The Appellate Court noted the three unitary business tests were logically consistent variations of the same theme — searching for evidence of unquantifiable flows of value.

After reviewing the evidence presented to the lower court, the Appellate Court concluded that “substantial evidence supports the conclusion” that QVC did not engage in a unitary business with Comcast. Specifically, the Appellate Court opined that despite being commonly owned, the entities were not integrated in a way that transferred value between them (i.e., there was insufficient centralized management, functional integration, and economies of scale). For example, while QVC paid a five percent commission to Comcast to operate on its network, the commission was the industry standard for unrelated parties, and thus constituted an arm’s-length payment. Additionally, while Comcast was the majority owner of QVC and, thus, could have exercised control over its day-to-day operations, extensive evidence existed that Comcast did not exercise such control over QVC (a finding that was consistent with established U.S. Supreme Court Precedent).

Business Income Analysis

In considering the termination payment, the Appellate Court noted that California classifies income as business income subject to apportionment if the income satisfies either a transactional test or a functional test. The Appellate Court concluded that the termination payment satisfied the transactional test and, thus, did not consider the functional test.

Under the transactional test, the transaction or activity that gives rise to the income must occur in the regular course of a taxpayer’s trade or business to be business income. Using this test, the Appellate Court rejected Comcast’s argument that the lower court incorrectly focused on the asset that gave rise to the termination payment — a cable company acquisition agreement — rather than the transaction that directly generated the income — the termination of a merger agreement. According to the Appellate Court, the relevant question was not whether the termination fee itself was income in the regular course of business, but rather, whether the activities giving rise to the termination fee (i.e., the merger agreement) were conducted in the regular course of business. Because Comcast conceded that mergers and acquisitions were performed in the regular course of its business, the resulting termination fee, although a once-in-a-lifetime event, was apportionable business income. Additionally, according to the Appellate Court, Comcast’s use of the termination fee income to pay general business obligations was a “significant consideration” in identifying business income under the transactional test. However, this future “use of proceeds” concept has been rejected by other courts in cases involving the application of the unitary business test (e.g., ASARCO, Inc. v. Idaho State Tax Comm’n, 458 US 307, 326 (1982). The mere possibility that cash might be used in the business in the future, and was in fact used, does not necessarily justify treating the cash as used in the business at the time it was received.

Failure to Raise the Claim

After concluding that the termination fee was business income, the Appellate Court considered an argument raised by Comcast that the termination fee should thus be included in the sales factor denominator.

In calculating its assessment of additional tax for Comcast, the Board included the $1.5 billion termination fee in apportionable business income but failed to include the termination fee in the denominator of the sales factor. Comcast argued that inclusion of the termination fee in the sales factor denominator was required by statute absent “exceptional circumstances” (which did not exist in this case) and asserted that the factor should have been 6.6239% while the Board had used a factor of 9.22355%. Nevertheless, the Appellate Court found that Comcast was precluded from asserting its apportionment argument because it failed to raise the argument in its original tax refund claim.

This conclusion underscores the importance of carefully analyzing and raising all potential issues in the proper forum (generally, early and often), because a second bite at the apple is often forbidden.