                    IN THE COURT OF APPEALS OF IOWA

                                  No. 16-0416
                               Filed May 3, 2017


ROMANTIX HOLDINGS, INC., ROMANTIX, INC., ABV MANAGEMENT, INC.,
BOOKS, INC., PPI, INC., PPA, INC., and SWAN BOOKS, INC.,
    Petitioners-Appellants,

vs.

IOWA DEPARTMENT OF REVENUE,
     Respondent-Appellee.
________________________________________________________________


      Appeal from the Iowa District Court for Polk County, Richard G. Blane II

and Karen A. Romano, Judges.




      A parent corporation and its subsidiaries appeal the district court’s ruling

on judicial review affirming the Iowa Department of Revenue’s conclusions that

the parent corporation was ineligible to join its subsidiaries’ consolidated Iowa

income tax returns because it had no taxable income in Iowa and that its

subsidiaries could not claim certain expenses incurred and paid by the parent

corporation. AFFIRMED.




      Ronald L. Mountsier of Dickinson, Mackaman, Tyler & Hagen, P.C., Des

Moines, for appellants.
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        Thomas J. Miller, Attorney General, and Paxon J. Williams, Assistant

Attorney General, for appellee.


        Heard by Vogel, P.J., and Doyle and McDonald, JJ. Blane, S.J., takes no

part.
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DOYLE, Judge.

       The Director (Director) of the Iowa Department of Revenue (Department)

issued a final order concluding a parent corporation, Romantix Holdings, Inc.

(Holdings), was ineligible to join its subsidiaries’ (Iowa Subsidiaries) consolidated

Iowa income tax returns because Holdings was not doing business in Iowa for

purposes of inclusion on a consolidated tax return. It also concluded the Iowa

Subsidiaries were ineligible to deduct certain expenses incurred and paid by

Holdings. Holdings and the Iowa Subsidiaries (collectively Petitioners) petitioned

for judicial review.   Following judicial review, the district court affirmed the

agency’s final order. On appeal, Petitioners contend Holdings derived taxable

income from the Iowa Subsidiaries entitling it to join the Iowa Subsidiaries’ Iowa

consolidated income tax returns.        Additionally, it is argued that the Iowa

Subsidiaries properly claimed the expenses of Holdings because the Iowa

Subsidiaries were jointly and severally liable for payment of the expenses and

“paid” the expenses by allocation. Upon our review, we affirm the district court’s

ruling denying and dismissing Petitioners’ petition for judicial review and affirming

the Director’s order on remand.

       I. Standard of Review.

       Our review of final decisions of the Department is governed by the Iowa

Administrative Procedure Act, codified at Iowa Code chapter 17A (2015). See

Iowa Code § 422.29; KFC Corp. v. Iowa Dep’t of Revenue, 792 N.W.2d 308, 312

(Iowa 2010). Under section 17A.19, we must determine “[t]he validity of agency

action . . . in accordance with the standards of review” set forth in that provision.

Iowa Code § 17A.19(8)(b). We “give appropriate deference to the view of the
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agency with respect to particular matters that have been vested by a provision of

law in the discretion of the agency.” Id. § 17A.19(11)(c). Section 422.68(1) gives

the Director “the power and authority to prescribe all rules not inconsistent with

the provisions of this chapter, necessary and advisable for its detailed

administration and to effectuate its purposes.” Consequently, we will uphold the

Department’s decision unless its interpretation is irrational, illogical, or wholly

unjustifiable.   See id. § 17A.19(10)(l); Myria Holdings Inc. v. Iowa Dep’t of

Revenue, ___ N.W.2d ___, ___, 2017 WL 1103175, at *3 (Iowa 2017).                        A

decision is “irrational” if it is “not governed by or according to reason,” illogical if it

is “contrary to or devoid of logic,” and “unjustifiable” if “it has no foundation in fact

or reason.” The Sherwin-Williams Co. v. Iowa Dep’t of Revenue, 789 N.W.2d

417, 432 (Iowa 2010).

       II. Background Facts and Proceedings.

       Holdings is a holding company that owns and operates numerous

subsidiaries as well as the Romantix trademark.             Each individual subsidiary

performs a function in the overall business. Some subsidiaries own Romantix™

adult book stores, nine of which are located in Iowa, which sell apparel, novelties,

lubricants, lotions, books, magazines, and DVDs. Another subsidiary, Romantix

Inc. (Inc.), acts as a management company. All the revenue from the stores is

transferred to Inc. daily, and Inc. then uses this money to pay the stores’

expenses. Another subsidiary, RMI Aviation (RMI), owns an airplane and an

airplane hangar. The airplane is used by the Midwest stores for business travel.

Inc. uses the funds received from the stores that utilized their services to pay
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RMI’s expenses. Holdings does not, by itself, sell products or provide services in

Iowa.

        The current owner of Petitioners, Steven Brown, acquired ownership in a

transaction dated September 26, 2007. As part of the acquisition transaction, a

number of documents and agreements were executed, including a stock

redemption agreement, a loan agreement, a redemption note, a subsidiary

guaranty, and a security agreement. The transaction involved two steps: Brown

personally bought 100 shares of stock in Holdings from Edward Wedelstedt, and

Holdings redeemed from Wedelstedt the remaining shares Wedelstedt owned in

Holdings. The redemption was financed by debt incurred by Holdings; the debt

was payable in monthly installments over a course of 15 years and had an

interest rate of 8.5%. None of the subsidiaries owned by Holdings bought any of

the shares from Wedelstedt, but all the Iowa Subsidiaries agreed to guaranty the

debt. Also, included in the stock redemption agreement was a covenant not to

compete. The covenant prohibited Wedelstedt from opening a competitive store

within 25 miles of any of the stores that were part of the purchase agreement,

including the nine Iowa stores. In exchange for the covenant not to compete,

Holdings agreed to pay $100,000 per year for 15 years. The Iowa Subsidiaries

guaranteed this debt as well.

        At issue here are the 2009 and 2010 consolidated Iowa income tax returns

of the Iowa Subsidiaries. The 2009 Iowa consolidated return included Holdings

and all of its subsidiaries (including non-Iowa subsidiaries), but did not include

the interest and amortization as an expenses for the subsidiaries because the

entirety of the expense was allocated to Holdings. The 2010 consolidated Iowa
                                          6


return included Holdings’ Iowa subsidiaries, but not Holdings, and the interest

and amortization expenses were allocated to the Iowa Subsidiaries based on a

percentage of revenue approach. The Department apparently disallowed the

expenses, and Petitioners filed a protest.        A hearing was held before an

administrative law judge (ALJ). The ALJ reversed the Department’s income tax

assessments pertaining to the expenses. The Department appealed the ALJ’s

proposed decision to the Director. The Director issued a final order ruling that

Holdings should not be included on the Iowa Subsidiaries’ consolidated Iowa

income tax returns and that the Iowa Subsidiaries were not allowed to deduct

Holdings’ acquisition debt and covenant not to sue expenses because the

subsidiaries did not owe and did not pay the expenses.

       Petitioners filed a petition for judicial review. The district court found that

“the Director’s finding that Iowa Subsidiaries did not owe the [acquisition and

covenant not to compete] debt is not supported by substantial evidence.” The

court remanded the matter to the Director “to give more specific reasoning for

why the individual statutes and rules cited by Petitioners when applied to the

facts of this matter do not allow Petitioners to make the desired deduction.” The

court affirmed the Director’s finding that Holdings is not subject to Iowa income

tax and is therefore prohibited from being included in the Iowa Subsidiaries’

consolidated tax return.

       On remand, the Director concluded in her final order that “[b]ecause the

Iowa subsidiaries are not the primary obligors under the Loan Agreement,

[Petitioners] fail the first test for deductibility of the acquisition interest.” The

Director also concluded “[Petitioners] have failed to meet their burden to
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establish that the covenant not to compete was acquired, directly or indirectly, by

the Iowa [S]ubsidiaries.” The Director ordered that the Iowa Subsidiaries were

not entitled to deduct interest and amortization expenses related to redemption of

Holdings stock.

       Taking issue with a number of the Director’s conclusions, Petitioners again

filed a petition for judicial review. The district court concluded:

       While the Director erred in failing to recognize the Iowa
       Subsidiaries as primary obligors of the acquisition debt, the
       Director, in noting the Iowa Subsidiaries’ failure to pay the
       expenses originally allocated to Holdings, provided a proper basis
       for the Iowa Subsidiaries to nevertheless be unable to deduct the
       expenses.

The court denied and dismissed Petitioner’s petition and affirmed the Director’s

order on remand.

       Petitioners appeal.

       III. Discussion.

       On appeal, Petitioners argue that because the Iowa Subsidiaries do

business within Iowa, Holdings, in effect, does business within Iowa and should

therefore be included for taxation purposes in the consolidated Iowa tax returns.

Additionally, Petitioners argue that even if Holdings is not included, the Iowa

Subsidiaries are responsible for and paid the disputed expenses. We address

their arguments in turn.

       A. Including Holdings in Consolidated Return.

       Petitioners contend Holdings is not exempt from taxation under Iowa Code

section 422.34A(5) because it “directly owned intangible property that was

utilized by its subsidiaries in the subsidiaries’ Iowa business activity,” which they
                                         8


argue “has the functional equivalent of physical presence in the state that relates

to the ownership or control of the subsidiary.” A similar argument was raised and

recently rejected by the Iowa Supreme Court in Myria Holdings Inc., ___ N.W.2d

at ___, 2017 WL 1103175, at *6.

       In Myria Holdings Inc., Myria and its subsidiaries argued Myria had a

taxable nexus with Iowa because its subsidiaries did business in Iowa and

because it owned “two types of intangible property with a situs in Iowa: shares of

stock and money.” Id. at *7. First, the court concluded that the activities Myria

performed for its Iowa subsidiaries “were all activities of owning and controlling a

subsidiary corporation,” removing Myria from the safe harbor of section

422.34A(5), since the “legislature has exempted from income taxation the

activities of owning and controlling a subsidiary corporation under Iowa Code

section 422.34A(5).”     Id. at *7-8.     Second, the court concluded section

422.34A(5)

       clearly contemplates that an entity engaging in activities of owning
       a subsidiary corporation necessarily holds some evidence of its
       ownership interest. If the statute is to have any meaning or effect
       as a safe harbor, the certificates evidencing Myria’s ownership
       interest in [its subsidiaries] cannot themselves create a taxable
       nexus with the state sufficient to remove Myria from the safe
       harbor.

Id. at *7. Similarly, the court determined Myria did not establish a taxable nexus

with the state by permitting its subsidiaries to use its “money” under the tax

allocation agreement, explaining “the quarterly payments by the subsidiaries of

amounts equal to their respective shares of [Myria’s and its subsidiaries’] income

tax obligation did not constitute Myria’s money with a situs in Iowa under rule

701-52.1(1)(d) promulgated by the Department.” Id. at *8. The court therefore
                                         9


concluded “all of Myria’s activities with its subsidiaries doing business in Iowa

were activities of owning and controlling [its subsidiaries] within the meaning of

section 422.34A(5) and Myria did not acquire a taxable nexus by virtue of owning

‘shares of stock’ or ‘money’ in Iowa.” Id.

        Based upon the court’s ruling in Myria Holdings Inc., it is clear the Iowa

Subsidiaries and their intangible property are not enough to establish a taxable

nexus with Iowa sufficient to remove Holdings from the safe harbor. See id. at

*7-8.    Like Myria, by electing to have the Iowa Subsidiaries taxed as

corporations, Holdings chose to receive not only the tax advantages of corporate

taxation but any disadvantages as well.       All of Holdings’s activities with its

subsidiaries doing business in Iowa in the relevant tax years were activities of

owning and controlling a subsidiary corporation within the meaning of Iowa Code

section 422.34A(5). Holdings has not otherwise established a taxable nexus with

the state. Thus, because Holdings lacked a taxable nexus with the State of Iowa

in relevant tax years, the Department correctly concluded Holdings could not join

the consolidated return. We therefore affirm on this issue.

        B. Payment of Expenses by the Iowa Subsidiaries.

        Petitioners also argue that regardless of whether Holdings could join the

consolidated return, the Iowa Subsidiaries should be able to claim the disputed

expenses for several reasons. First, Petitioners assert Holdings allocated the

disputed expenses to the Iowa Subsidiaries for tax purposes. However, mere

allocation is not enough under Iowa’s taxation structure, as detailed by the

Director:
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       The allocation of expenses by Holdings is not binding on Iowa for
       tax purposes. See Iowa Admin. Code r. 701-53.15(6)(c) (stating
       that no agreement entered into among members of the affiliated
       group shall have the effect of reducing the Iowa tax liability of the
       members subject to Iowa’s income tax). The way [Holdings] may
       choose to treat [Holdings’s] expenses on internal reports or reports
       to creditors is not binding on Iowa for tax purposes. See [id.]

       Additionally, Petitioners contend the Iowa Subsidiaries could claim the

disputed expenses because the expenses were paid by the Iowa Subsidiaries.

Petitioners first assert they were not on notice that the Department’s decision

was based upon the Iowa Subsidiaries’ failure to pay the expenses; rather, they

argue the Department only provided notice that its decision was based upon the

fact the Iowa Subsidiaries did not owe the expenses.              Petitioners claim their

alleged lack of notice meant the Department, and then the district court on

review, could not reject the expenses because the Iowa Subsidiaries did not pay

the expenses.

       Upon our review of the record, it is clear the Department’s position was

that expenses not owed1 and paid by the subsidiaries could not be claimed as

expenses of the subsidiaries. In fact, there is nothing in the record that indicates

Petitioners ever claimed, until the hearing, that the Iowa Subsidiaries paid the

1
  The district court found that “the Director’s findings that the Iowa Subsidiaries did not
owe the debt is not supported by substantial evidence, as the security agreement shows
that all of the individual subsidiaries which make up the Iowa Subsidiaries agreed to the
terms and conditions set out in the loan agreement.” The Director’s order on remand
ignored this ruling. In its ruling on judicial review from the Director’s order on remand,
the district court reversed the Director’s ruling that the Iowa Subsidiaries are not primary
obligors and did not owe the acquisition debt. No doubt the Department did not appeal
from this adverse ruling because the district court denied and dismissed Petitioners’
petition for judicial review. On appeal, the Department continues to assert that “[b]eing
guarantors for the loan from Wedelstedt to Holdings does not entitle the [Iowa
Subsidiaries] to deduct the loan expenses as their own.” Having concluded the Iowa
Subsidiaries did not pay the disputed expenses, we need not decide the issue of
whether the Iowa Subsidiaries, as guarantors, were entitled to take a deduction for the
interest on the loan obligation.
                                        11


disputed expenses. The Department could not formally reject an assertion that

was never made by Petitioners. Moreover, Petitioners had the burden of proving

the Iowa Subsidiaries actually paid the disputed expenses.        See Iowa Code

§ 421.60(6)(c).

      At the hearing before the ALJ, counsel for the Department, in her opening

statement, explained the Department’s position was that because the Iowa

Subsidiaries did not pay the claimed expenses—rather Holdings paid the

expenses—the Iowa Subsidiaries were not permitted to deduct the expenses.

The president of Holdings, Steven Brown, testified at the hearing that Holdings

itself did not conduct business directly as an entity, explaining, “Well, there’s no

sales and no checks being written other than for the notes. The line of credit is

held by [Holdings] because that’s the ultimate company. The bank wants it that

way.” The Department tried to clarify whether Holdings or one of its subsidiaries

paid the claimed expenses, and the following exchange with Brown occurred:

              Q. And you stated [Holdings] has no sales, writes no checks,
      except for it has a line of credit, and then also it, I think you
      testified—and I just want to clarify—that they did write checks, then,
      on the acquisition, and for that you’re referring to these various
      agreements that are exhibits, the stock redemption agreement and
      the loan agreement and the loan that was taken—the note that was
      taken? A. The loan payments—well—
              Q. Were made by [Holdings]? A. Again, let me clarify. They
      don’t write the checks. Romantix, Inc., writes the checks, but it’s
      charged to them because the notes are set up in the Holdings.
              Q. Right. It’s Romantix— A. We have an intercompany
      transaction.
              Q. [Holdings] gets paid? A. [Holdings], that’s paid from
      Romantix.
              Q. Correct. A. Yeah.
              Q. Okay. I think we’re— A. Yeah.
              Q. So in the [Holdings]’s exhibits, when it allocates interest—
      the interest that’s at issue here, then it’s based on something other
      than the amounts that those subsidiaries actually wrote checks for
                                               12


       and paid. A. I’m going to tell you how I think it is, and then maybe
       [the CPA that completed the tax returns] can make sure that I’m
       right.

The CPA was not specifically asked if Holdings or its subsidiaries paid the

disputed expenses.

       The ALJ found “Holdings makes payments on the principal and interest

through funds generated by its subsidiaries.” However, he concluded ultimately

Petitioners “cannot be barred from claiming expenses paid by subsidiaries or the

parent company that are part of the greater corporate structure doing business in

Iowa,” reversing the Department’s tax assessments pertaining to the claimed

expenses.

       After the Department appealed the ruling to the Director, the Director

factually found, in part of its ruling, that

       [a]ll revenue from sales by the stores comes into the subsidiaries
       that own them and then is transferred to [Inc.] on a daily basis.
       [Inc.] uses those funds to pay expenses and allocates a paper
       expense to each subsidiary. Some of the expenses are directly
       related to the subsidiary, e.g., salaries for employees who work at a
       store. Other expenses are more general, such as accounting and
       management, and are apportioned to subsidiaries based on a
       proportion of the revenue produced by the subsidiary.

(Emphasis added.) The Director went on to find, like the ALJ, that “Holdings

makes payments on the principal and interest through funds generated by its

subsidiaries.” The Director concluded:

             The amounts at dispute include expenses for amortization of
       a non-compete agreement for the previous owner, [Wedelstedt],
       and expenses for interest on the debt from the acquisition of the
       business. The legitimate expenses incurred and paid by Holdings,
       pursuant to the redemption loan and agreement, cannot be
       deducted by other corporations. Neither the ALJ nor [Petitioners]
       have cited any federal or Iowa statute or rule that allows the
                                        13


      subsidiaries subject to Iowa income tax to deduct expenses that
      they never paid and that were not legally owed by them.

The Director explained the Department appropriately allowed the Iowa

Subsidiaries to claim expenses they paid to another of Holdings’s subsidiaries

that did not do business in Iowa because they were the Iowa Subsidiaries’

expenses, which they themselves paid.

      Although the Department allowed expenses related to Inc. and
      [RMI] as deductions for Holdings’ subsidiaries subject to Iowa’s
      income tax, they are easily distinguished from Holdings’ interest
      and amortization expenses. The expenses allowed were for
      expenses of the subsidiaries and were paid by the Iowa
      [S]ubsidiaries for services received by the subsidiaries that were
      necessary for and benefitted the affiliates’ business activities. As
      part of the management services, Inc.’s employees came into the
      state and oversaw activities of stores in Iowa. In the case of [RMI,
      RMI] owns an airplane that was used primarily for the . . . stores
      located in the Midwest. The Iowa [S]ubsidiaries pay [RMI] for its
      services and the Department allowed the subsidiaries to deduct
      their own expenses paid to [RMI] for services it provided to the
      subsidiaries, not Holdings’ expenses.

We surmise from the above quoted paragraph that the Director was

distinguishing Inc.’s payment of the subsidiaries’ expenses from the expenses

related to Holdings.    Although Inc. may have actually cut the checks for

Holdings’s interest and amortization expenses, the Director did not find that Inc.

paid Holdings’s expenses.

      The district court agreed with this distinction, finding “that these cases are

different, as Iowa Subsidiaries pay the RMI related expense while Iowa

Subsidiaries do not pay Holdings’s expenses,” and the court concluded

substantial evidence showed “the checks written to pay the debt were charged to

Holdings and Inc. only supplied the money to pay the debt.” The court reasoned

that because
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       deductibility requires that a taxpayer both owe the expense and pay
       it . . . , a taxpayer cannot claim a right to a deduction for expenses
       they owe but have not paid. Payment by the Iowa Subsidiaries was
       something Petitioners had to prove in order to clearly establish that
       the Iowa Subsidiaries were entitled to a deduction and that the
       Department acted erroneously. Petitioners did not do this.

The court concluded the Director’s finding that the Iowa Subsidiaries failed to pay

the expenses originally allocated to Holdings “provided a proper basis for the

Iowa Subsidiaries to nevertheless be unable to deduct the expenses.” Further,

even if the internal allocation of the amortization expense amongst the Iowa

Subsidiaries constituted “payment” of the expenses, the agency was correct in

disallowing the deductions because the amortization expenses were not a

“necessary and reasonable expense” of the subsidiaries in generating taxable

income.     See I.R.C. § 162 (allowing for deductions against income the

“necessary and reasonable expenses” incurred in generating the income); see

also In re US Bancorp Piper Jaffray, Inc. v. Dep’t of Revenue & Fin., No.

2002DORFC005, 2002 WL 32931969, at *3 (Iowa Dep’t Inspections & App. May

14, 2002) (stating the general rule). Based on the record before us and the

reasons stated by the district court, we agree. We therefore affirm on this issue.

       IV. Conclusion.

       Because Holdings lacked a taxable nexus with the State of Iowa in

relevant tax years, the Department correctly concluded Holdings could not join

the consolidated return. Additionally, Petitioners did not establish the disputed

expenses were paid by the Iowa Subsidiaries. Accordingly, we affirm the ruling

of the district court denying and dismissing Petitioners’ petition for judicial review

and affirming the Director’s order on remand.

       AFFIRMED.
