Smith’s Home Hardware is a successful Arizona – based retail operation, realizing significant profits from its retail hardware stores. Smith’s creates a subsidiary (“Alixco”) by contributing $70 million of capital. The contribution of capital includes: $15 million of inventory, $15 million of CD’s, a $10 million office building in Missouri, and patents on high-tech power tools worth $30 Million. Alixco’s offices are entirely in Missouri. Alixco will manufacture and sell power tools to the construction industry. In 2001, Alixco realizes income as follows: tool sales $100 Million, interest on commercial CD’s $50,000, rent from 9 floors of its 10-story office building $1.5 Million, and royalty income of $3 Million from overseas licensing of its tool patents. Total business deductions for the year are $85 Million.

Alixco hires a president in Missouri. Officers of Smith’s Home Hardware make up the balance of the Board of Directors and Officers. Smith’s internal accounting staff in Arizona maintains the books. A CPA firm in Missouri prepares annual financial statements. The only assets held by Alixco are those mentioned above, plus a newly constructed manufacturing plant in New Mexico and another newly constructed plant across the border in Mexico.

The $15 Million of CD’s and $10 Million office building were acquired with funds available from retail hardware store operations. Smith’s Home Hardware and Alixco file a consolidated federal tax return. Smith’s Home Hardware files a separate California tax return from Alixco. During 2001, Smith’s Home Hardware received $2 million in dividends from Alixco, which was used to expand existing retail stores. Outside of the original contribution of inventory, there are no intercompany sales. However, approximately 20% of Alixco’s purchases are handled by Smith’s purchasing agents.

Smith’s Home Hardware realized net income in 2001 of $40 Million, which was apportioned 75% to Arizona and 25% to California. Smith’s filed a separate return in California for 2001. The California Franchise Tax Board has audited Smith’s Home Hardware and concluded that Smith’s and Alixco should be members of a unitary group filing a combined California tax return. The auditor added the Alixco net business income into the combined return, resulting in a California tax increase of $300,000. Please defend Alixco’s non-unitary tax filing position.

Please defend Alixco’s non-unitary tax filing position.