Smiths Home Hardware is a successful Arizona – based retail operation, realizing significant profits from its retail hardware stores. Smiths creates a subsidiary (Alixco) by contributing $70 million of capital. The contribution of capital includes: $15 million of inventory, $15 million of CDs, a $10 million office building in Missouri, and patents on high-tech power tools worth $30 Million. Alixcos 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 CDs $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 Smiths Home Hardware make up the balance of the Board of Directors and Officers. Smiths 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 CDs and $10 Million office building were acquired with funds available from retail hardware store operations. Smiths Home Hardware and Alixco file a consolidated federal tax return. Smiths Home Hardware files a separate California tax return from Alixco. During 2001, Smiths 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 Alixcos purchases are handled by Smiths purchasing agents.
Smiths Home Hardware realized net income in 2001 of $40 Million, which was apportioned 75% to Arizona and 25% to California. Smiths filed a separate return in California for 2001. The California Franchise Tax Board has audited Smiths Home Hardware and concluded that Smiths 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 Alixcos non-unitary tax filing position.
Please defend Alixcos non-unitary tax filing position.  
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