Wisconsin Tax Appeals Commission Docket No. 97-I-265 and 97-I-266

STATE OF WISCONSIN

TAX APPEALS COMMISSION

MILWAUKEE SAFEGUARD INSURANCE CO. and,

MILWAUKEE GUARDIAN INSURANCE, INC

c/o Unitrin, Inc.

One East Wacker Drive

Chicago, IL 60601

Petitioners,

vs.

WISCONSIN DEPARTMENT OF REVENUE

P.O. Box 8933

Madison, WI 53708

Respondent.

Docket Nos. 97-I-265 and 97-I-266

DECISION AND ORDER

DON M. MILLIS, COMMISSIONER:

These matters come before the Commission for a decision on stipulated facts. Both parties have submitted briefs in support of their respective positions. Petitioners are represented by Foley and Lardner, by Attorney Timothy C. Frautschi. Respondent is represented by Attorney John R. Evans, Chief Counsel.

FINDINGS OF FACT

The Commission adopts as its Findings of Fact the facts stipulated by the parties. The Commission has made non-substantive revisions to the stipulated facts, for purposes of form, consistency, and paragraph order. The Commission has also omitted references to exhibits.

1. On April 5, 1996, respondent issued assessments of additional Wisconsin franchise tax and interest for years ending December 31, 1990, through December 31, 1993, (the "years at issue") against Milwaukee Safeguard Insurance Company ("Safeguard") and Milwaukee Guardian Insurance, Inc. ("Guardian").

2. On June 3, 1996, Safeguard and Guardian ("petitioners") filed timely petitions for redetermination with respondent.

3. Each petitioner timely deposited with respondent the amount of franchise tax assessed, plus interest through June 4, 1996.

4. On May 20, 1997, respondent issued notices of action granting in part and denying in part petitioners' petitions for redetermination.

5. On July 14, 1997, petitioners filed timely petitions for review with the Commission, and under date of January 22, 1998, petitioners filed amended petitions for review.

6. Each petitioner is a property and casualty insurance company domiciled in the state of Wisconsin.

7. Each petitioner is a domestic insurer, not engaged in the sale of life insurance, which, during the years at issue, collected premiums written where the subjects of insurance were resident, located or to be performed outside Wisconsin, within the meaning of section 71.45(3)(intro.) of the Statutes.

8. One hundred percent of petitioners' stock was owned by Milwaukee Insurance Group, Inc. ("MIG"), throughout the years at issue. MIG is a publicly traded holding company, domiciled in Wisconsin. Milwaukee Mutual Insurance Company ("Mutual") is a shareholder of MIG. During the period under review, Mutual owned the following approximate percentages of MIG stock (the remaining shares were held by the public in general):

Approx. Percent of MIG

Period Stock Owned by Mutual

1/1/90 to 6/10/93 65.0%

6/11/93 to 12/31/93 48.5%

9. Mutual's percentage ownership of MIG stock dropped below 50% on June 11, 1993, due to a second public stock offering of MIG stock, and remained below 50% from that date through the end of the period under review.

10. At no time after June 10, 1993 were petitioners and Mutual part of the same controlled group as defined in section of 267(f)(1) of the Internal Revenue Code. After June 10, 1993, Mutual owned less than 50% of MIG, and MIG owned 100% of the stock of each petitioner as well as of each of the following companies: Alpha Property & Casualty Insurance Company, USA Insurance Services, and Milwaukee Life Insurance Company.

11. Petitioners had no employees and paid no payroll during the years at issue.

12. All services performed for petitioners during the years at issue were performed by employees of Mutual, for which petitioners paid Mutual a fee. The management fees petitioners paid to Mutual during the years at issue were:

Year Safeguard Guardian

1990 $3,968,873 $3,968,873

1991 3,903,075 3,903,075

1992 3,884,825 3,884,825

1993 4,673,602 4,676,565

13. The services performed by Mutual's employees for which petitioners paid a management fee were performed outside Wisconsin in the following percentages:

Percent Outside Wisconsin

Year Safeguard Guardian

1990 15.406% 15.406%

1991 16.258% 16.258%

1992 16.799% 16.799%

1993 17.102% 17.102%

14. For purposes of section 71.45(3)(b), petitioners' payroll paid outside this state and petitioners' total payroll paid everywhere are both zero for the year 1993. The parties disagree as to the numerator and denominator of the payroll percentage under section 71.45(3)(b) for years 1990-1992.

15. Petitioners' premiums written percentage under section 71.45(3)(a) for each year are as follows:

Percent Outside Wisconsin

Year Safeguard Guardian

1990 61.388539% 53.401118%

1991 70.449778% 54.588200%

1992 76.213766% 55.620004%

1993 78.532441% 55.268982%

16. Mutual, Milwaukee Guardian Insurance Company, Inc., and petitioners were members of a pooling agreement during the years at issue. In respondent's audit and during its review of the petitions for redetermination, respondent accepted petitioners' use of the pooling agreement for determining the payroll apportionment factor as reported on their returns.

17. Petitioners timely filed Wisconsin insurance franchise tax returns for each of the years at issue. Amended returns for the year ending December 31, 1990 were filed to take into consideration federal IRS audit changes, and no other amended returns were filed for the years under review.

18. Petitioners have not filed refund claims for any of the years at issue.

19. The parties have stipulated that these matters present certain issues. The parties have also agreed to certain outcomes, depending on how the Commission resolves these issues:

Apportionment Issue:

If it is determined that the payroll factor as described in section 71.45(3)(b) is 100% and that this factor is to be included with the premiums written factor described in section 71.45(3)(a) in calculating the arithmetic average under sections 71.45(3)(intro) and 71.45(3m), and if the apportionable net incomes prior to apportionment are the amounts set forth in respondent's notices of action, then the decrease in taxable incomes after apportionment from that set forth in the notices of action are as follows:

Year Safeguard Guardian

1990 $ 64,449 $ 81,213

1991 333,796 362,221

1992 1,353,340 1,333,340

1993 1,493,716 1,519,036

Total $3,245,301 $3,295,810

If it is determined that no payroll factor as described in section 71.45(3)(b) can be calculated, and that the payroll factor must therefore be eliminated and the premiums written factor be taken as the sole factor, and if the apportionable net incomes prior to apportionment are the amounts set forth in respondent's notices of action, then the decrease in taxable incomes after apportionment are as follows:

Year Safeguard Guardian

1990 $ 35,032 $ 36,477

1991 216,009 165,795

1992 966,433 622,124

1993 1,173,051 839,555

Total $2,390,525 $1,663,951

If it is determined that the payroll factor described in section 71.45(3)(b) is zero percent and that this factor is to be included with the premiums written factor described in section 71.45(3)(a) in calculating the arithmetic average under section 71.45(3)(intro.), and if the apportionable net incomes prior to apportionment are the same amounts set forth in respondent's notices of action, then the adjustments as shown on the amended reports, dated May 14, 1997, will be affirmed.

U. S. Government Interest Issue Amounts:

If it is determined that U.S. Government interest income should be excluded from the measure of net income before apportionment, then the resulting decrease in net incomes before apportionment are as follows:

Year Safeguard Guardian

1990 $ 349,573 $ 363,443

1991 646,367 680,445

1992 904,334 935,894

1993 791,948 849,016

Total $2,692,222 $2,828,798

APPLICABLE WISCONSIN STATUTES

71.25 Situs of income; allocation and apportion-ment. For purposes of determining the situs of income under this section:

* * *

(8) PAYROLL FACTOR. For purposes of sub. (5):

* * *

(d) In this subsection, compensation includes deductible management or service fees paid to a related corporation as consideration for the performance of personal services, and the situs of those fees is in this state if the services fulfill one of the requirements under par. (b). ... Except for management or service fees, payments made to a related corporation, an independent contractor or any person not properly classifiable as an employe are excluded. In this paragraph, "related corporation" means a corporation which is part of a controlled group as defined in section 267(f)(1) of the internal revenue code."

(e) If the company has no employes and pays no management or service fees or the department determines that employes are not a substantial income-producing factor and that the management or service fees paid are insubstantial, the department may order or permit the elimination of the payroll factor.

71.43 Imposition of tax.

* * *

(2) FRANCHISE TAX ON CORPORATIONS. All provisions of this chapter and ch. 73 relating to income taxation of corporations shall apply to franchise taxes imposed under this subsection, unless the context requires otherwise. The tax imposed by this subsection on insurance companies subject to taxation under this chapter shall be based on Wisconsin net income computed under s. 71.45, and no other provision of this chapter relating to computation of taxable income for other corporations shall apply to such insurance companies. All other provisions of this chapter shall apply to insurance

companies subject to taxation under this chapter unless the context clearly requires otherwise.

71.45 Income computation.

* * *

(3) APPORTIONMENT. With respect to domestic insurers not engaged in the sale of life insurance but which, in the taxable year, have collected premiums written on subjects of insurance resident, located or to be performed outside this state, there shall be subtracted from the net income figure derived by application of sub. (2)(a) to arrive at Wisconsin income constituting the measure of the franchise tax an amount calculated by multiplying such adjusted federal taxable income by the arithmetic average of the following 2 percentages:

(a) The percentage of total premiums written on all property and risks other than life insurance, wherever located during the taxable year, as reflects premiums written on insurance, other than life insurance, where the subject of insurance was resident, located or to be performed outside this state.

(b) The percentage of total payroll, exclusive of life insurance payroll, paid everywhere in the taxable year as reflects such compensation paid outside this state. Compensation is paid outside this state if the individual's service is performed entirely outside this state; or the individual's service is performed both within and without this state, but the service performed within is incidental to the individual's service without this state; or some service is performed without this state and the base of operations, or if there is no base of operations, the place from which the service is directed or controlled is without this state, or the base of operations or the place from which the service is directed or controlled is not in any state in which some part of the service is performed, but the individual's residence is outside this state.

CONCLUSIONS OF LAW

1. The payroll percentage under section 71.45(3)(b) of the Statutes is excluded from the average of percentages under section 71.45(3) with respect to an insurer who has no payroll.

2. Interest on U.S. Government obligations was properly included in petitioners' respective apportionable incomes. American Family Mut. Ins. Co. v. Dep't of Revenue, 222 Wis. 2d 650, 671 (1998).

OPINION

The parties agree that these dockets present two issues: What is the proper method to apportion petitioners' income under sections 71.43 and 71.45 of the Statutes for the years at issue? Was petitioners' interest income from U.S. Government securities properly includible in their Wisconsin apportionable incomes for the years at issue?⁽¹⁾

Apportionment of Petitioners' Income

The parties agree that the apportionment of petitioners' income is governed by the provisions of section 71.45(3) of the Statutes. This complicated apportionment scheme can be described in the following step-by-step process:

Step 1. Determine the net income under section 71.45(2)(a) of the statutes;

Step 2. Subtract from the amount determined in Step 1, the product of adjusted federal taxable income multiplied by the percentage derived in Step 3;

Step 3. Determine the average of the following two percentages:

A. Percentage of insurance premiums written on property or persons located outside of Wisconsin compared to total insurance premiums;

A. Percentage of payroll paid outside Wisconsin compared to total payroll.

The apportionment issue in this case hinges on the application of Step 3.B. Both petitioners had no payroll. Petitioners contracted with Mutual for management services. Petitioners argue that the percentage to be derived in Step 3.B. should be 100%. Arguing that any number divided by itself equals 1, petitioners claim the following fraction equals 1:

Payroll Outside Wis: 0

Total Payroll: 0

Hence, the argument that the resulting percentage should be 100%.

As an alternative, petitioners argue that the payroll factor should be dropped altogether. Thus, for each year at issue, petitioners' net income determined under section 71.45(2)(a) should be reduced by the product of petitioners' Wisconsin federal taxable income multiplied by the percentage derived by Step 3.A alone.

Respondent argues that the number to be derived by Step 3.B. is zero. Respondent argues that fractions and mathematics are not germane to this discussion. The factor must be zero simply because there is no payroll.

Alternatively, respondent argues that the payroll percentage in Step 3.B. should be determined by using the management fees petitioners paid to Mutual. In fact, for 1990 through 1992, petitioners used the management fees when calculating the percentage in Step 3.B. Respondent did not object.

Unfortunately, the plain language of section 71.45(3)(b) does not dictate any solution under the facts of this case, including the four solutions offered by the parties. Therefore, we conclude that as applied to the facts of this case, this statute is ambiguous, and we must resort to the rules of statutory construction for guidance. NBZ, Inc. v. Pilarski, 185 Wis. 2d 827, 836 (Ct. App. 1994).

Respondent's Zero Option

Respondent argues that since petitioners have no payroll, the "payroll factor" determined by section 71.45(3)(b) must be zero. We cannot agree with this analysis for three reasons.

First, respondent's construction has no support in the language of section 71.45(3). The statute requires petitioners to determine a percentage based upon payroll outside of Wisconsin compared to all payroll. Nowhere does the statute provide that the lack of payroll requires the resulting percentage to be zero.

Second, the language of another statute makes it clear that had the legislature intended respondent's construction it would have explicitly provided for this in the statute. Section 71.45(2) is the first step in computing income for insurers. Section 71.45(2)(b) deals with insurance companies that are engaged in life insurance and other types of insurance. This section provides that the net income derived by section 71.45(2)(a) is to be multiplied by a fraction where the numerator is the net gain on insurance other than life insurance and the denominator is the net gain on all operations. This section explicitly provides that if the numerator is zero or a negative number the multiplier is 0. Conversely, if the denominator is zero or a negative number, the multiplier is 1. In crafting section 71.45(2)(b), the legislature contemplated situations in which the numerator or denominator of the subject fraction was zero and created special rules for these situations. Had the legislature wanted to create a special rule for similar fractions in section 71.45(3)(b), it would have done so. The fact that it did not discredits respondent's construction.

Finally, when construing a tax imposition statute, the statute must be narrowly construed, with all ambiguity and doubt resolved against the one seeking to impose the tax. Kearney & Trecker Corp. v. Dep't of Revenue, 91 Wis. 2d 746, 753 (1979). Respondent's construction will always result in the greatest possible tax liability, actually resolving the ambiguity and doubt in its favor and against the taxpayer. Such a construction is at odds with the rules for construing an imposition statute. For these reasons, we reject respondent's zero option.

Respondent's Management Fee Approach

As an alternative, respondent argues that the Commission could conclude that the amounts petitioners paid in management fees to Mutual could be substituted for payroll in the calculation under section 71.45(3)(b). In certain circumstances, such fees are included in the payroll factor for the apportionment formula applicable to most corporations. Wis. Stat. § 71.25(8)(d). However, section 71.43(2) of the Statutes does not allow the Commission to adopt respondent's approach. This statute provides, in part:

The tax imposed by this subsection on insurance companies subject to taxation under this chapter shall be based on Wisconsin net income computed under s. 71.45, and no other provision of this chapter relating to computation of taxable income for other corporations shall apply to such insurance companies. All other provisions of this chapter shall apply to insurance companies subject to taxation under this chapter unless the context clearly requires otherwise. [Emphasis supplied.]

Respondent argues that this passage does not apply to the apportionment provisions of section 71.45. Respondent argues that income computation is distinct and separate from apportionment. Thus, respondent argues that the Commission, consistent with the last sentence of the above-quoted passage, may import the provisions from section 71.25(8)(d) counting management fees in the calculation of payroll.

Respondent's contention is at odds with the plain language of the statute. While in common parlance computation of income might be distinct from apportionment, the language of the statutes involved in this case does not support such a difference. As an initial matter, we note that section 71.43(2) refers to all of section 71.45 and not only certain subsections. Specifically, section 71.43(2) does not omit reference to section 71.45(3), the apportionment provision at issue.

More importantly, section 71.43(2) requires "Wisconsin net income" to be computed under section 71.45. "Wisconsin net income" must include the application of the apportionment provisions of section 71.45(3) because it is upon the "Wisconsin net income" that the franchise tax is imposed. Wis. Stat. § 71.46(2). The rates are applied after the apportionment provisions of section 71.45(3) are employed. Thus, apportionment in section 71.45(3) must be part of the computation of Wisconsin net income and, therefore, must be determined in accordance with section 71.45 only.

Section 71.43(2) also forbids the application to insurance companies of provisions relating "to computation of taxable income" found elsewhere in chapter 71. The language of section 71.45(3) makes it clear that apportionment is one step in the determination of "taxable income." Section 71.45(3)(intro.) provides that the object of subsection (3)--the subsection that provides for the manner of apportionment--is to "arrive at Wisconsin income constituting the measure of the franchise tax." The phrase "Wisconsin income constituting the measure of the franchise tax" is synonymous with "taxable income." It is clear that section 71.45(3)(intro.) contemplates that apportionment is part of income computation. Therefore, section 71.43(2) prohibits the use of any other apportionment provision in chapter 71 with respect to apportionment of insurance company income. This includes the use of management fees as a proxy for payroll.⁽²⁾

Petitioners' 100 Percent Solution

Petitioners argue that the appropriate percentage determined under section 71.45(3)(b)--or Step 3.B. described above--is 100%. Petitioners rely on the mathematical maxim that any number divided by itself equals 1. Thus, petitioners claim, a fraction with a numerator of zero (payroll outside of Wisconsin) and a denominator of zero (total payroll) equals 1.

There are exceptions to every rule, including the rule relied upon by petitioners. A fraction with zero in both the numerator and the denominator is an undefined number with an indeterminate value. B.H. West, et al., The Prentice-Hall Encyclopedia of Mathematics 186-87. This can be illustrated by the following syllogism:

If, 0/0 = A, then 0 = 0 x A.

Since any number multiplied by zero equals zero, then any number can be substituted for A in the above equation. Hence, the value of 0/0 is indeterminate. Id. Therefore, petitioners' assertion that 0/0 equals 1 is incorrect.

Dropping the Payroll Factor

Petitioners argue that if the Commission does not accept their 100% solution, then the Commission should drop the payroll factor altogether and simply multiply petitioners' adjusted federal taxable income by the premiums percentage set forth in section 71.45(3)(a). Petitioners argue that this result is mandated for two reasons.

First, petitioners argue that under section 71.25(8)(e), respondent has the duty to eliminate the payroll factor from the apportionment formula for those companies that have no employees and pay no management fees. While this provision states that respondent may permit or order the elimination of the payroll factor under these circumstances, petitioners argue that respondent's failure to exercise its discretion under the facts of this case is unreasonable.

We reject this rationale for eliminating the payroll percentage, because the apportionment provisions of section 71.25(8)(e) are not found in section 71.45. As indicated above, only apportionment provisions found in section 71.45 may apply to insurance companies.

Petitioners' second rationale supporting the elimination of the payroll percentage is petitioners' contention that respondent's construction of section 71.45 is unconstitutional. While we agree that statutes should be construed so as to avoid a constitutional infirmity, we do not believe it is necessary to reach a constitutional issue to determine that elimination of the payroll factor is necessitated by the facts of this case.

We conclude that the payroll percentage must be eliminated because there is no other way for the apportionment provisions of section 71.45(3) to be reasonably applied to these facts. Section 71.45(3) seeks to average two percentages. This task is impossible in this case because one of the percentages is an indeterminate number. It is not possible to determine an average between two numbers when one number is 0/0. Because the statutory scheme does not work under these facts, it only makes sense to omit the factor that prevents the scheme from working. Therefore, the most reasonable construction of section 71.45(3) under these circumstances is to multiply adjusted federal taxable income only by the percentage derived in section 71.45(3)(a), which is the only percentage determinable under section 71.45(3).

We disagree with respondent that this solution is tantamount to amending the statute. We are obligated to avoid an unreasonable application of this statute. Department of Trans. v. Office of Comm'r of Trans., 159 Wis. 2d 271, 275 (Ct. App. 1990). Moreover, we are not to construe this statute "in derogation of common sense." Town of DePere v. City of DePere, 184 Wis. 2d 278, 283 (Ct. App. 1994). Our conclusion does nothing more than avoid an unreasonable application with a common sense construction of the statute under these facts.

Interest on U.S. Government Obligations

In their amended petitions for review, petitioners argue that respondent erroneously failed to remove interest earned on U.S. Government obligations from their respective apportionable incomes. Petitioners were relying on the Court of Appeals decision in American Family Mut. Ins. Co. v. Dep't of Revenue, 214 Wis. 2d 577 (Ct. App. 1997). In this case, the Court of Appeals held that section 71.43(2) impermissibly imposed the franchise tax on income from U.S. Government obligations, in violation of federal law. Id. at 588.

As these dockets were being briefed, the Wisconsin Supreme Court reversed the decision of the Court of Appeals, holding that section 71.43(2) did not violate the federal law and that the calculation of income under section 71.43(2) may include interest on U.S. Government obligations. American Family Mut. Ins. Co. v. Dep't of Revenue, 222 Wis. 2d 650, 671 (1998). The parties did not brief this issue, apparently leaving resolution of this issue to the result of the Supreme Court's decision in American Family.

Based on the Supreme Court's decision in American Family, we must conclude that interest on U.S. Government obligations were properly included in apportionable income under section 71.45(2).

ORDER

Respondent's actions on petitioners' petitions for redetermination are modified as indicated in Conclusion of Law 1 and Finding 19 and, as modified, are affirmed.

Dated at Madison, Wisconsin, this 12th day of November, 1999.

WISCONSIN TAX APPEALS COMMISSION

___________________________________________

Mark E. Musolf, Chairperson

___________________________________________

Don M. Millis, Commissioner

___________________________________________

Thomas M. Boykoff, Commissioner

ATTACHMENT: "NOTICE OF APPEAL INFORMATION"

December 8, 1999 Department of Revenue non-acquiesced under § 73.01(4)(e)2

¹ Respondent submitted three additional issues for consideration in the event that the Commission agreed with petitioners' contentions (1) that the payroll percentage under section 71.45(3)(b) was 100%, or (2) that interest on U.S. Government obligations was not properly included in petitioners' respective apportionable incomes. Since the Commission did not agree with either contention, there is no need to address these issues.

² It should be noted that, with respect to 1993, payroll in section 71.45(3)(b) may not include management fees as described in section 71.25(8)(d). Section 71.25(8)(d) only applies to fees paid to a related corporation, which is defined as a corporation that is part of a controlled group defined in section 267(f)(1) of the Internal Revenue Code. Beginning on June 11, 1993, neither petitioner was in the same controlled group as Mutual, the recipient of the management fees. In fact, respondent apparently conceded this point when it stipulated that petitioners had zero payroll in 1993.