CarMax Auto Superstores, Inc. v. S.C. Dep't of Revenue

ORDER OF REMAND

Ralph King Anderson, III Chief Administrative Law Judge

This matter is before the South Carolina Administrative Law Court (Court) pursuant to a request for contested case filed by CarMax Auto Superstores, Inc., (Petitioner or CarMax East) on June 8, 2019. Petitioner contests the final agency decision of the South Carolina Department of Revenue (Department), in which the Department, following an audit, imposed an alternative apportionment method to assess additional corporate income taxes and interest for fiscal years 2016-2018 (the audit period).^[1] As of June 14, 2021, the assessment totaled $2,224,389.00 for the audit years.^[2]

The Court held a hearing on the merits at its offices in Columbia, South Carolina, from May 23, 2023, through May 26, 2023. Based upon my review of the testimony, the evidence presented, and the parties' arguments, I conclude the matter must be remanded to the Department.

MOTION IN LIMINE AND SUBSEQUENT RULING

On April 21, 2023, Petitioner filed a Motion in Limine to Exclude Expert Testimony Challenging the 2004 Valuation Study (Motion).^[3] Petitioner sought to exclude certain testimony

of Dr. David DeRamus, Respondent's expert witness, that would challenge the Valuation Study. Petitioner argued four grounds in its Motion: (1) the Valuation Study is nearly twenty years old; (2) the Department did not challenge the Valuation Study; (3) the Department did not disclose the Valuation Study as a subject of potential expert testimony; and (4) the Valuation Study is not relevant to any issue in the case.

On May 2, 2023, the Court held a conference call on the Motion. During the conference call, the Department admitted it did not directly cite to or challenge the Valuation Study in its determination; however, it argued (1) the transfer prices at issue in this case are intimately tied to the Valuation Study, (2) its expert disclosure was sufficient to put Petitioner on notice that the Valuation Study could be reviewed, and (3) it could challenge the Valuation Study because CarMax East presented the study as support for its position in the case.

In the Court's view, both parties made valid points. On the one hand, the Department failed to give clear notice that it intended to specifically challenge the Valuation Study through its expert or otherwise. Indeed, the Valuation Study was not a proposed exhibit for Dr. DeRamus's deposition. On the other hand, Petitioner's argument that it could not have reasonably anticipated the Department's challenge to the Valuation Study and was wholly unprepared (and therefore prejudiced) to discuss a document it provided in support of its case seemed disingenuous. Accordingly, the Court orally ruled the Department could not introduce the Valuation Study in its case in chief but could attack it if Petitioner "opened the door."^[4]

At the hearing, Petitioner renewed its Motion.^[5] The Court initially upheld its previous oral ruling, but also held the ruling could change based upon the evidence presented. Ultimately, after several continuing objections and discussions, the parties made the Court aware that the Valuation

Study had already been admitted as Joint Exhibit 55.^[6] After this revelation, the Court ruled that Petitioner had opened the door to Respondent attacking the 2004 Valuation Study by agreeing, without objection, to admit it as an exhibit.

FINDINGS OF FACT

Having observed the witnesses and exhibits presented at the hearing and taking into consideration the burden of proof and the credibility of the witnesses, I make the following findings of fact by a preponderance of the evidence.

History of The CarMax Group

CarMax, Inc., (CarMax) began its operations in 1993 under the ownership of Circuit City stores, Inc (Circuit City). At that time, CarMax Auto Superstores, Inc. (CarMax East) and CarMax Auto Superstores West Coast, Inc. (CarMax West) were subsidiaries of CarMax. CarMax East owned the majority of the company's retail operations, which were located in eastern states. It also performed back-office support functions and finance functions for the company. CarMax West owned the company's western retail stores and owned the company's tradenames and trademarks (intellectual property or "IP").^[7]

In 2002, CarMax separated from Circuit City and emerged as a separate publicly traded company. After the separation, CarMax became the parent holding company for three subsidiaries: CarMax East, CarMax West, and Glen Allen Insurance, Ltd. (GAIL). CarMax East continued to hold the majority of the company's retail operations, back-office support functions, and finance functions.^[8] CarMax East also owned its own subsidiaries, including CarMax Properties, LLC (performed real estate functions for the group) and CarMax Auto Funding, LLC (provided

financing). CarMax West continued to own the California and Nevada retail operations and also owned the CarMax IP. GAIL was a captive insurance company that provided workers' compensation and garage liability insurance plans.

In early 2004, CarMax began the process of restructuring its business and employed the firm of Ernst and Young (E&Y) to advise it. In an presentation given on April 6, 2004, CarMax's Board of Directors (Board) considered consolidating the shared services functions within the group into a new LLC (CarMax Business Services or "CBS") that would house the headquarters operations, the administrative and decision-making functions, and the company's financing activities.^[9] They also considered the benefits of reorganizing the company to provide better legal protections (isolating its California liability) and to facilitate compliance with new legislation like the Gramm-Leach-Bliley Act.^[10] Overall, according to the Board minutes, the Board determined the proposed restructuring would allow CarMax "to realize greater operational, legal and tax advantages than were being realized under the current structure." The Board approved the restructuring plan; however, it was changed and tweaked over the next several months.

Although most of the restructuring was implemented on December 1, 2004, some parts of the process were implemented before then. On April 23, 2004, CarMax West formed CarMax Business Services, LLC (CBS), a single-member Delaware limited liability company. Thereafter on April 28, 2004, CBS formed CarMax Superstores Services, Inc. (CASS), a Virginia corporation and wholly owned subsidiary of CBS. CASS would later become the holding company for CarMax's employees. Finally, on May 3, 2004, CarMax West formed CarMax Auto Superstores California, LLC, a single-member limited liability company.

Then, on December 1, 2004, CarMax took the following steps to effectuate the restructuring:

1. CarMax West contributed its California stores to CarMax Auto Superstores California, LLC.

2. CarMax (the parent holding company) contributed 100% of its stock in CarMax West to CarMax East.

3. CarMax East contributed its Business Process Intangibles^[11] and West Creek land to CarMax West.

4. CBS became a partnership and received the following contributions:

a. CarMax West contributed the Business Process Intangibles, the West Creek land, and the CarMax IP. In exchange for these contributions, CarMax West received a 93.5% ownership interest in CBS.

b. CarMax East contributed the Business Functions (headquarters functions), certain contractual obligations, and some cash. In exchange, CarMax East received a 6.5% ownership interest in CBS.

5. CBS contributed the employee workforce to CASS and entered into an employee servicing agreement with CASS.

6. CBS entered into the Master Management Service Agreement (MMSA) with CarMax East, CarMax West, and CarMax California.

Thus, after the restructure, CarMax (the CarMax Group) was structured as depicted below:

(Image Omitted)

Master Management Service Agreement

As part of the restructuring, CarMax East, CarMax West, and CarMax California entered into a Master Management Services Agreement (MMSA) with CBS.^[12] Under the MMSA, CBS agreed to provide the other members of the agreement with back-office services (legal services, finance and accounting, human resources, information technology, sales operations, and training), real estate services, marketing and advertising services, and quantitative analytics services. In exchange for these services and for managing the IP, CBS charged a Management Fee, which was a flat fee charged per vehicle sold.

Effect of the 2004 Restructuring

From the customer's perspective, the restructuring had no effect on their experience shopping at CarMax. However, internally, the restructuring changed the assigned functions of the different CarMax entities. For example, prior to the restructuring, CarMax East performed the back-office functions. Afterwards, CBS took over those functions.

From a tax perspective, the restructuring had a significant effect because the MMSA and the partnership affected the flow of income between the companies. Specifically, because CBS is structured as a partnership, it is not directly taxed. Rather, the income it generates flows back to its partners-CarMax East and CarMax West. Therefore, whatever income CBS earns, through the MMSA and otherwise, is distributed back to CarMax East and CarMax West for tax purposes. Based upon the assigned ownership percentages of CBS, CarMax West receives 93.5% of CBS's income and CarMax East receives 6.5% of CBS's income.

The effect of this structure during the audit period is stark. During this period, CBS generated about half of its income from the Management Fees it charged CarMax East and CarMax West. Since CarMax East was the owner...