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Romantix Holdings, Inc. v. Iowa Department of Revenue

Court of Appeals of Iowa

May 3, 2017


         Appeal from the Iowa District Court for Polk County, Richard G. Blane II and Karen A. Romano, Judges.

         A parent corporation and its subsidiaries appeal the district court's ruling on judicial review affirming the Iowa Department of Revenue's conclusions that the parent corporation was ineligible to join its subsidiaries' consolidated Iowa income tax returns because it had no taxable income in Iowa and that its subsidiaries could not claim certain expenses incurred and paid by the parent corporation.

          Ronald L. Mountsier of Dickinson, Mackaman, Tyler & Hagen, P.C., Des Moines, for appellants.

          Thomas J. Miller, Attorney General, and Paxon J. Williams, Assistant Attorney General, for appellee.

          Heard by Vogel, P.J., and Doyle and McDonald, JJ. Blane, S.J., takes no part.

          DOYLE, Judge.

         The Director (Director) of the Iowa Department of Revenue (Department) issued a final order concluding a parent corporation, Romantix Holdings, Inc. (Holdings), was ineligible to join its subsidiaries' (Iowa Subsidiaries) consolidated Iowa income tax returns because Holdings was not doing business in Iowa for purposes of inclusion on a consolidated tax return. It also concluded the Iowa Subsidiaries were ineligible to deduct certain expenses incurred and paid by Holdings. Holdings and the Iowa Subsidiaries (collectively Petitioners) petitioned for judicial review. Following judicial review, the district court affirmed the agency's final order. On appeal, Petitioners contend Holdings derived taxable income from the Iowa Subsidiaries entitling it to join the Iowa Subsidiaries' Iowa consolidated income tax returns. Additionally, it is argued that the Iowa Subsidiaries properly claimed the expenses of Holdings because the Iowa Subsidiaries were jointly and severally liable for payment of the expenses and "paid" the expenses by allocation. Upon our review, we affirm the district court's ruling denying and dismissing Petitioners' petition for judicial review and affirming the Director's order on remand.

         I. Standard of Review.

         Our review of final decisions of the Department is governed by the Iowa Administrative Procedure Act, codified at Iowa Code chapter 17A (2015). See Iowa Code § 422.29; KFC Corp. v. Iowa Dep't of Revenue, 792 N.W.2d 308, 312 (Iowa 2010). Under section 17A.19, we must determine "[t]he validity of agency action . . . in accordance with the standards of review" set forth in that provision. Iowa Code § 17A.19(8)(b). We "give appropriate deference to the view of the agency with respect to particular matters that have been vested by a provision of law in the discretion of the agency." Id. § 17A.19(11)(c). Section 422.68(1) gives the Director "the power and authority to prescribe all rules not inconsistent with the provisions of this chapter, necessary and advisable for its detailed administration and to effectuate its purposes." Consequently, we will uphold the Department's decision unless its interpretation is irrational, illogical, or wholly unjustifiable. See id. § 17A.19(10)(l); Myria Holdings Inc. v. Iowa Dep't of Revenue, ___ N.W.2d___, ___, 2017 WL 1103175, at *3 (Iowa 2017). A decision is "irrational" if it is "not governed by or according to reason, " illogical if it is "contrary to or devoid of logic, " and "unjustifiable" if "it has no foundation in fact or reason." The Sherwin-Williams Co. v. Iowa Dep't of Revenue, 789 N.W.2d 417, 432 (Iowa 2010).

         II. Background Facts and Proceedings.

         Holdings is a holding company that owns and operates numerous subsidiaries as well as the Romantix trademark. Each individual subsidiary performs a function in the overall business. Some subsidiaries own Romantix' adult book stores, nine of which are located in Iowa, which sell apparel, novelties, lubricants, lotions, books, magazines, and DVDs. Another subsidiary, Romantix Inc. (Inc.), acts as a management company. All the revenue from the stores is transferred to Inc. daily, and Inc. then uses this money to pay the stores' expenses. Another subsidiary, RMI Aviation (RMI), owns an airplane and an airplane hangar. The airplane is used by the Midwest stores for business travel. Inc. uses the funds received from the stores that utilized their services to pay RMI's expenses. Holdings does not, by itself, sell products or provide services in Iowa.

         The current owner of Petitioners, Steven Brown, acquired ownership in a transaction dated September 26, 2007. As part of the acquisition transaction, a number of documents and agreements were executed, including a stock redemption agreement, a loan agreement, a redemption note, a subsidiary guaranty, and a security agreement. The transaction involved two steps: Brown personally bought 100 shares of stock in Holdings from Edward Wedelstedt, and Holdings redeemed from Wedelstedt the remaining shares Wedelstedt owned in Holdings. The redemption was financed by debt incurred by Holdings; the debt was payable in monthly installments over a course of 15 years and had an interest rate of 8.5%. None of the subsidiaries owned by Holdings bought any of the shares from Wedelstedt, but all the Iowa Subsidiaries agreed to guaranty the debt. Also, included in the stock redemption agreement was a covenant not to compete. The covenant prohibited Wedelstedt from opening a competitive store within 25 miles of any of the stores that were part of the purchase agreement, including the nine Iowa stores. In exchange for the covenant not to compete, Holdings agreed to pay $100, 000 per year for 15 years. The Iowa Subsidiaries guaranteed this debt as well.

         At issue here are the 2009 and 2010 consolidated Iowa income tax returns of the Iowa Subsidiaries. The 2009 Iowa consolidated return included Holdings and all of its subsidiaries (including non-Iowa subsidiaries), but did not include the interest and amortization as an expenses for the subsidiaries because the entirety of the expense was allocated to Holdings. The 2010 consolidated Iowa return included Holdings' Iowa subsidiaries, but not Holdings, and the interest and amortization expenses were allocated to the Iowa Subsidiaries based on a percentage of revenue approach. The Department apparently disallowed the expenses, and Petitioners filed a protest. A hearing was held before an administrative law judge (ALJ). The ALJ reversed the Department's income tax assessments pertaining to the expenses. The Department appealed the ALJ's proposed decision to the Director. The Director issued a final order ruling that Holdings should not be included on the Iowa Subsidiaries' consolidated Iowa income tax returns and that the Iowa Subsidiaries were not allowed to deduct Holdings' acquisition debt and covenant not to sue expenses because the subsidiaries did not owe and did not pay the expenses.

         Petitioners filed a petition for judicial review. The district court found that "the Director's finding that Iowa Subsidiaries did not owe the [acquisition and covenant not to compete] debt is not supported by substantial evidence." The court remanded the matter to the Director "to give more specific reasoning for why the individual statutes and rules cited by Petitioners when applied to the facts of this matter do not allow Petitioners to make the desired deduction." The court affirmed the Director's finding that Holdings is not subject to Iowa income tax and is therefore prohibited from being included in the Iowa Subsidiaries' consolidated tax return.

         On remand, the Director concluded in her final order that "[b]ecause the Iowa subsidiaries are not the primary obligors under the Loan Agreement, [Petitioners] fail the first test for deductibility of the acquisition interest." The Director also concluded "[Petitioners] have failed to meet their burden to establish that the covenant not to compete was acquired, directly or indirectly, by the Iowa [S]ubsidiaries." The Director ordered that the Iowa Subsidiaries were not entitled to deduct interest and amortization expenses related to redemption of Holdings stock.

         Taking issue with a number of the Director's conclusions, Petitioners again filed a petition for judicial review. The district court concluded:

While the Director erred in failing to recognize the Iowa Subsidiaries as primary obligors of the acquisition debt, the Director, in noting the Iowa Subsidiaries' failure to pay the expenses originally allocated to Holdings, provided a proper basis for the Iowa Subsidiaries to nevertheless be unable to deduct the expenses.

         The court denied and dismissed Petitioner's petition and affirmed the ...

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