## Facts

- Southern Railway Company (Southern) and its wholly owned subsidiary, Cincinnati, New Orleans and Texas Pacific Railway Company (Pacific), operated railroads in Kentucky and other states.
- Southern and Pacific, along with other Southern-related railroad companies, ran their rail operations as a pooled, integrated system with common management.
- Employees were often used across affiliated companies; an individual formally employed by one company could perform work for another affiliated company.
- When an employee of one company performed services for another, the employee’s actual employer paid the wages and then billed the benefiting affiliate for reimbursement.
- Kentucky determined each company’s Kentucky income tax liability using a three-factor apportionment formula (property, payroll, and sales) based on Kentucky amounts compared to total amounts, consistent with Kentucky’s adoption of UDITPA.
- In computing Pacific’s payroll factor, the Kentucky Department of Revenue included compensation paid by Southern to Southern employees when those employees performed work for Pacific, even though Pacific did not employ or directly pay them.
- The Department’s approach assigned compensation to the company “for which the work was performed,” rather than to the company that employed and paid the workers.
- The circuit court rejected the Department’s method and ruled that compensation belongs in the payroll factor of the corporation that employed and paid the employee, notwithstanding intercompany reimbursement.
- The Department appealed the circuit court’s ruling.

## Issues

1. Under Kentucky’s UDITPA-based apportionment statute and regulations, may the Department include in a corporation’s payroll factor compensation paid by an affiliated corporation’s employees who performed reimbursed services for the taxpayer?

## Decision

- The Kentucky Court of Appeals affirmed the circuit court’s judgment in favor of the railway companies.
- The court held that, for payroll-factor purposes, compensation is attributed to the corporation that employs and pays the employee.
- The Department could not shift Southern-paid wages into Pacific’s payroll factor merely because the services were performed for Pacific and Pacific reimbursed Southern.

## Legal Principles

- The payroll factor in a UDITPA-based apportionment formula turns on “compensation paid” by the taxpayer, which ties the factor to the taxpayer’s role as employer and payor.
- Intercompany reimbursements for shared employee services do not convert the workers into employees of the reimbursing affiliate for payroll-factor computation.
- Separate corporate identity controls apportionment-factor accounting unless the legislature authorizes combined reporting or another method that reallocates items among related entities.
- A revenue agency may not replace the statute’s payroll-factor definition with a “work performed for” rule when the enacted text measures payroll by compensation paid by the taxpayer.

## Conclusion

The court required Kentucky’s payroll factor to be computed based on wages paid by each corporation to its own employees, rejecting the Department’s effort to attribute affiliate-paid compensation to the company that benefited from the services under reimbursement arrangements.


Cincinnati, New Orleans and Texas Pacific Railway Company v. Kentucky Department of Revenue, 684 S.W.2d 303 (1985)