Originally Published on forbes.com on November 20th, 2011
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The Massachusetts State Appelate Tax Board decision Sysco Corporation v Department of Revenue makes me nostalgic for the days long gone by when money used to earn interest. In the early eighties my friend, William Donoghue wrote The Complete Money Market Guide. With that book, Bill energized the 99% to Occupy Corporate Cash Managementand cut the banks out of the huge profits they were making by paying their depositors a mere 4%. At any rate, the case gives an excellent description of one of the types of corporate cash concentration system that inspired the creation of money market funds.
Sysco ran a pretty decentralized organization when it came to operations:
All of Sysco’s revenue was generated from the activities of the operating companies. Each operating company that was a corporation had a board of directors and each company that was a limited liability company had a board of managers. Each operating company had its own officers, and the presidents of the operating companies had responsibility for hiring and dismissing employees. While the management of Sysco made suggestions regarding operating company personnel, the operating companies were not obligated to follow Sysco’s suggestions. Sysco’s chief operating officer was responsible for hiring and dismissing the operating companies’ presidents.
The treasury operation was a different story, though:
The cash-management system, which was managed by Sysco’s treasury department, had several components. Each operating company maintained bank accounts with commercial third-party banks, including a main depository account and a disbursement account. The companies deposited all revenue generated from operations into their respective depository accounts. At the daily close of business, Sysco initiated a transfer of funds from the depository accounts to what Sysco referred to as its “concentration accounts.” While cash receipts were transferred on a daily basis, the depository accounts were not left with a zero balance because sums reflected in accounts as a result of check deposits were not transferred to the concentration accounts until the checks had cleared.
The disbursement accounts, through which the operating companies paid their expenses, were “zero balance accounts.” Operating company checks presented for payment on a given day were funded by Sysco, which initiated a transfer of funds from the concentration accounts to the disbursement accounts sufficient to cover the checks. Thus, the disbursement accounts were left with a zero balance at the end of each day. An operating company that desired capital expansion requiring approval from Sysco submitted a capital investment proposal (“CIP”), which Sysco in its sole discretion could approve or reject. If approved, an operating company might receive a fixedinterest rate and term for the amount approved. Purported payments relating to the capital funding were made through the accounts comprising the cash-management system.
Presumably the treasury minions at corporate were investing the cash, earning as much overnight on treasury repurchase agreements as you earn in a month nowadays.
Regardless, the way this was accounted for between the subsidiaries and the parent was as loans. Profitable operating companies would be in a net lending position to the parent and would get a daily credit of prime minus one. Unprofitable companies or those that “borrowed” from the parent to make capital expenditures would be in a net borrowing position and would get a daily charge of prime. The Massachusetts Department of Revenue did not believe that these arrangements were really loans. DOR viewed the money going up to the parent as dividends and the money coming down as capital contributions. The accounting entries for interest expense and income were not meaningful in the eyes of DOR.
Sysco filed a combined return with Massachusetts so it is not instantly clear why this made a difference. It did, of course, make a difference, since there would not otherwise be litigation. The difference was 7.2 million for the years 1996, 1997 and 1998. The case does not explain the computations so I have to speculate just a bit. In a consolidated report the interest income and interest expense would be eliminated leaving the same total profit (I am ignoring the possibility that some of the interest might have been capitalized.) In figuring corporate state income tax, though, some income is “apportioned” and some is “allocated”. Apportionment means you take the net profit and apply a percentage factor derived from sales, property owned and payroll. Allocate means that you look at an individual item and decide whether it should be taxed by that state. Allocated items are not included in the profit that is apportioned. The interest expense would be reducing the apportioned income.
The interest income, on the other hand, would not be included in apportioned income, but rather would be allocated based on commercial domicile. That could be the reason that even though the adjustment would be a wash on the federal return it might make a big difference to a particular state. A SALT expert would be able to greatly expand this discussion, but I fear I have already lost some people, so I will leave it at that.
The decision is fairly lengthy, although well worth reading. Sysco ended up losing for several reasons. One was that it was clear that there was never any intention to repay subsidiaries that were net lenders in the system. The whole system was more one of corporate discipline than real borrowing and lending. Two things that hurt Sysco are worth mentioning though. Thedocumentation for the system was a comprehensive manual. There were, however, no notes and loan agreements. The other was that the interest income and expense was handled by journal entries. As I have mentioned elsewhere, I have come to believe that nobody believes in journal entries except accountants. Judges certainly have little respect for them. After listing several reasons why the arrangement did not work the Board concludes:
The decision is fairly lengthy, although well worth reading. Sysco ended up losing for several reasons. One was that it was clear that there was never any intention to repay subsidiaries that were net lenders in the system. The whole system was more one of corporate discipline than real borrowing and lending. Two things that hurt Sysco are worth mentioning though. Thedocumentation for the system was a comprehensive manual. There were, however, no notes and loan agreements. The other was that the interest income and expense was handled by journal entries. As I have mentioned elsewhere, I have come to believe that nobody believes in journal entries except accountants. Judges certainly have little respect for them. After listing several reasons why the arrangement did not work the Board concludes:
More importantly though, interest accounting entries were just that,and amounts credited to operating companies as interest were immediately swept up to Sysco forming part of a rapidly growing net liability from Sysco to the companies during the tax years at issue.