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Rent-A-Center West Inc. v. South Carolina Department of Revenue

Court of Appeals of South Carolina

October 26, 2016

Rent-A-Center West Inc., Appellant,
South Carolina Department of Revenue, Respondent. Appellate Case No. 2012-208608

          Heard March 16, 2016

         Appeal From The Administrative Law Court Ralph King Anderson, III, Administrative Law Judge


          John C. Von Lehe, Jr. and Bryson Moore Geer, both of Nelson Mullins Riley & Scarborough, LLP, of Charleston, for Appellant.

          William J. Condon, Jr. and Sean Gordon Ryan, both of the South Carolina Department of Revenue, of Columbia, for Respondent.

          KONDUROS, J.

         Rent-A-Center West Inc. (RAC West) appeals the administrative law court's (ALC) finding the standard statutory apportionment formula did not fairly represent its business activities in South Carolina and the Department of Revenue's (the DOR) alternative apportionment method for calculating its income tax was reasonable. It also maintains the ALC erred in finding it was not a unitary business. It further asserts the ALC erred by concluding the DOR did not violate its constitutional rights. We reverse.


         This case involves the assessment of corporate income tax on RAC West, a subsidiary of the Rent-A-Center Inc. business. Rent-A-Center is a rent-to-own business, providing consumer goods to customers for rent. Rent-A-Center East Inc. (RAC East) owns and operates retail stores in eastern states including South Carolina and is a wholly-owned subsidiary of Rent-A-Center. RAC East has two wholly-owned subsidiaries: RAC West, which owns and operates retail stores in western states, and Rent-A-Center Texas LP, which owns and operates retail stores in Texas and provides management services. RAC West does not operate any retail stores in South Carolina, but it owns and licenses the Rent-A-Center intellectual property, including the trademarks and trade names to all other Rent-A-Center companies. These royalty payments for the use of the intellectual property by the South Carolina stores are RAC West's only activity in the state. This arrangement was formalized in a licensing agreement between RAC West and RAC East. The licensing agreement sets the amount of a royalty fee equal to 3% of the gross revenues of the RAC East stores, an amount based upon a transfer pricing study.[1]

         RAC West filed their corporate income tax returns for 2003, 2004, and 2005 using the three-factor apportionment formula, consisting of property, payroll, and sales.

         The DOR audited RAC West's 2003-2005 initial tax returns and found RAC West owed an additional $144, 971 in corporate income tax; $35, 086 in interest; and $36, 243 in penalties for the period of 2003-2005. According to the DOR, RAC West's only income in South Carolina was the royalty income it obtained from RAC East. The DOR applied an alternative apportionment method pursuant to section 12-6-2320(A) of the South Carolina Code, which it stated "more fairly represent[ed] the taxpayer's activity in South Carolina." The DOR based this alternative apportionment method on RAC West's 3% royalty agreement with RAC East.

         RAC West filed an appeal and requested a hearing before the ALC. One month prior to the hearing, RAC West filed amended South Carolina income tax returns, changing the method from the three-factor apportionment formula for dealers of tangible personal property to the gross-receipts method under section 12-6-2290 of the South Carolina Code.[2] This single-factor apportionment formula required RAC West to pay an additional $1, 326 in taxes to what it had previously paid.

         The ALC held a hearing on August 10 and 11, 2011. The DOR argued RAC West diluted the sales/gross receipts ratio by including the retail sales of RAC West in the denominator because no retail sales are in the numerator, as RAC West's only activity in South Carolina is the licensing of the intellectual property. According to testimony from Dr. Glenn Harrison, the DOR's expert witness on law and economics, the gross receipts ratio did not provide an accurate reflection of the economic connection of RAC West to South Carolina. Dr. Harrison indicated including royalty receipts in the numerator of the ratio while including both total royalty and total retail receipts in the denominator was like putting apples in the numerator and apples and oranges in the denominator. He further testified the DOR's alternative method was economically reasonable and excluding the retail operations from the calculations was essential in order to "come up with a tax burden that fairly represented the economic nexus of the entity with South Carolina." Additionally, Dr. Harrison indicated even if RAC West was a unitary business, it should still be able to separate its accounts.

         RAC West argued there is a unitary relationship between the business activities of the retail stores in the western states and the licensing of intellectual property in other states because the same management is over both businesses and the stores contribute to the profitability of the intellectual property and vice versa. Further, it argued it does not separately track the costs of the intellectual property alone and this South Carolina audit was the first time it had been asked to do so.

         According to RAC West's expert economist, Dr. Ronald P. Wilder, and tax policy expert, Professor Richard Pomp, RAC West was a single unitary business based upon the mutual interdependence of the trademark and retail business. Dr. Wilder was asked his opinion of whether or not the standard apportionment formula fairly represented the extent of RAC West's activities in the state, and he responded that it did. Dr. Wilder based this "conclusion on the fact that RAC West uses its total corporation income as what is to be apportioned [and t]hat the use of corporation net income corresponds to the economic concept of profit on which taxable income should be based." When asked what would result if the retail sales from RAC West were not included in the denominator of the apportionment formula, Dr. Wilder explained that because RAC West is a unitary business, the "separate accounting cannot accurately measure the activities of RAC West." Professor Pomp explained the standard apportionment worked the way it was supposed to in this case. He stated, "That's not a defect. That's not anything unusual, out of the ordinary." Further, he found an "inextricable link" and "synergy" between the value of the intellectual property and the profitability of the retail store business.

         Joseph P. Southard, a former employee of the DOR who worked specifically on the RAC West audit, testified the audit began as a routine audit of Rent-A-Center as a whole. When asked why the DOR did not make an assessment based on the standard apportionment formula, Southard responded the gross receipts formula "didn't fit into the definition, " so the DOR "had to come up with kind of a hybrid."

         The ALC found for the DOR on all issues except the penalty, which it dismissed. Specifically, the ALC found (1) the DOR demonstrated RAC West's apportionment formula failed to fairly represent its business in South Carolina; (2) the DOR's proposed alternative apportionment method was reasonable in light of RAC West's business activities in South Carolina; (3) the imposition of an alternative method in this case did not violate the Constitution; (4) RAC West did not substantiate any expenses, therefore it was not entitled to deduct any expenses; and (5) RAC West was not liable for substantial understatement penalties.

         RAC West filed a motion for reconsideration, which the ALC denied. RAC West filed a Notice of Appeal and shortly thereafter requested, with the DOR's consent, a stay of the matter until a final decision was made in Carmax Auto Superstores West Coast, Inc. v. South Carolina Department of Revenue (Carmax I), 397 S.C. 604, 725 S.E.2d 711 (Ct. App. 2012), aff'd as modified, 411 S.C. 79, 767 S.E.2d 195 (2014). The parties asserted some or all of the issues could be decided or affected by the final decision in that case. This court granted the stay on April 16, 2012. Following a decision by the supreme court, [3] this appeal proceeded.


         The review of the [ALC]'s order must be confined to the record. The court may not substitute its judgment for the judgment of the [ALC] as to the weight of the evidence on questions of fact. The court of appeals may affirm the decision or remand the case for further proceedings; or, it may reverse or modify the decision if the substantive rights of the petitioner have been prejudiced because the finding, conclusion, or decision is:

(a) in violation of constitutional or statutory provisions;
(b) in excess of the statutory authority of the agency;
(c) made upon unlawful procedure;
(d) affected by other error of law;
(e) clearly erroneous in view of the reliable, probative, and substantial evidence on ...

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