Although Colorado adopted its unique combination statute in 1985, there were, to date, no court decisions discussing any of the six tests. (The statute provides six independent tests, three or more of which must be satisfied for the current tax year and the previous two years before combination can be allowed or forced.) The Denver District Court recently addressed one of the six tests and ruled that The Kroger Co. ("Kroger") and certain combined affiliates were not unitary with other subsidiaries (the "Subsidiaries") that had no nexus with Colorado. Kroger Co. v. Fisher, No. 02 CV 6564 (District Court, City and County of Denver, June 10, 2004). Therefore, the Subsidiaries could not be included in the combined Colorado income tax reports.
Kroger and its combined subsidiaries challenged the Colorado Department of Revenue's forced combination of the Subsidiaries. The Subsidiaries were engaged primarily in the supermarket business in Arizona and had no operations or physical presence in Colorado. Kroger and its combined affiliates operated grocery stores, convenience stores, manufacturing operations and other businesses.
Under 39-22-303(11)(a), C.R.S., three or more of six tests must be satisfied to establish a unitary relationship. The parties agreed that two tests had been satisfied (regarding shared directors and officers) and that three tests had not been satisfied (regarding intercompany sales, services and debt) with respect to the Subsidiaries. The parties disagreed regarding whether the remaining test had been met. The test at issue, which we refer to as the "intellectual property test," looks to whether one entity "substantially uses" the patents, trademarks, service marks, logotypes, trade secrets, copyrights or other proprietary materials ("Intellectual Property") of the other entity.
The Department took the position that the Subsidiaries substantially used Kroger's Intellectual Property because the Subsidiaries sold products that bore trademarks owned by Kroger. While the marks are owned by Kroger, many of the products do not indicate that Kroger is the owner of the marks, as Kroger also sells the products to third parties. These products amounted to less than 1% of the Subsidiaries' total store-keeping units (each distinct configuration of a product has a unique store-keeping unit), and sales of these products produced less than 1% of their total sales.
The court held that the Subsidiaries' sale of products bearing trademarks owned by Kroger does not constitute the use of Kroger's Intellectual Property because in the intellectual property context, "use generally refers to displaying the trademark or logo of another entity pursuant to a licensing or royalty agreement." The Subsidiaries did not license the use of the trademarks, rather they purchased the products and sold the products in their stores. The court correctly observed that a retailer's sale of Coca Cola products would not normally be deemed to be the use of the Coca Cola proprietary brand -- it is merely the sale of Coca Cola product.
The court also noted that while intercompany sales are a factor in determining whether or not there is a unitary business, this factor is addressed in another subsection of the unitary statute. Therefore, viewing intercompany sales of product as the use of intellectual property would dilute the intellectual property test.
The court held that even if the sales of the products bearing Kroger's trademarks could be considered a use, the use was not substantial. The court disagreed with the Department's assertion that the mere sale of a single branded product would be a substantial use of intellectual property. As the court concluded, the Department's interpretation would replace the word "substantial" with "any" and this was not the word used by the Legislature.
As the intellectual property test was not satisfied, only two of six criteria of unity were satisfied, and the Department did not have the discretion to force Kroger and its combined affiliates to include the Subsidiaries in their Colorado income tax reports. This decision clarifies an uncharted area of Colorado tax law and holds that the mere purchase of products from a related company will not be double-counted as unitary factors for purposes of the Colorado unitary statute. An appeal is pending with the Colorado Court of Appeals.