Editor: Harlan J. Kwiatek, CPA, J.D., LL.M.
In MeadWestvaco Corp. v. Illinois Dep’t of Revenue (Mead), 1 the U.S. Supreme Court held that the operational function test was not intended to modify the unitary business principle by adding a new ground for apportionment. In so doing, the Court modified our understanding of Allied-Signal Inc. v. Director, Div. of Tax’n, 2 which some consider to have created a separate operational function test for apportionment absent a unitary relationship. Now that Mead has become part of the canon of U.S. Supreme Court state tax cases, state tax courts and revenue departments have started to apply the decision in determining whether an item of income is apportionable or allocable.
Unitary Business Purpose vs. Operational Function Test
Since the Supreme Court issued its ruling in Allied-Signal, corporate taxpayers have struggled with the relationship between the unitary business principle and the operational function test. Under the unitary business principle, if at least one member of a corporate group is subject to a state’s taxing jurisdiction, the entire income of the corporate group can become part of the group’s apportionable tax base in that state if the group and the member are deemed unitary. The operational function test is used to determine whether an asset is part of the unitary corporate group, thus making income from a capital transaction involving the asset includible in the group’s apportionable tax base. Under the operational function test, even if the payer and payee of a capital transaction do not have a unitary relationship with each other, the asset is part of a taxpayer’s unitary business if it serves an operational function as opposed to an investment function.
On April 15, 2008, the Court clarified in Mead that the operational function test is not a separate test for finding apportionable income, stating that the test was “not intended to modify the unitary business principle by adding a new ground for apportionment,” 3 but simply recognizes that an asset can be part of a taxpayer’s unitary group even if there is not a unitary relationship between the payer and the payee in a capital transaction.
State tax courts and revenue departments can thus now look to the Mead opinion to determine whether an item of income is apportionable or allocable. Interestingly, two recent decisions that have considered Mead in their analysis did so in situations that did not mimic the Mead fact pattern and that involved the sale of a division doing business in the taxing state: One case involved a stock redemption, the other a Sec. 338(h)(10) transaction.
Blue Bell Creameries
With Mead as its guide, the Tennessee Court of Appeals recently concluded that capital gain income earned by a limited partnership in a stock redemption transaction with its majority shareholder, a holding company, was not apportionable because the entities were not unitary and the redemption did not serve an operational function. 4 A multistep reorganization occurred where the stated purpose was for the company to remain a private company for an indefinite time in order to make an S corporation election, reduce the number of shareholders to comply with the 75-shareholder limit under the S corporation rules then in effect, 5 and retire ineligible shareholders.
The predecessor of the taxpayer, Blue Bell Creameries, L.P., was a limited partnership with a Delaware holding company, Blue Bell Creameries, USA (BBC USA), as a general partner with a 1% interest and BBC Limited Partner, Inc., as a limited partner with a 99% interest. The limited partnership was engaged in the business of production, distribution, and sale of ice cream products.
The limited partnership transferred its ice cream business to newly formed Blue Bell Creameries, L.P. (BBCLP), a Texas limited partnership, for a 99% limited partnership interest; another subsidiary was formed to become a 1% general partner of BBCLP. The limited partnership transferor was then liquidated into its limited partner. As part of the reorganization, BBC USA became an S corporation. The majority of BBC USA’s shareholders transferred their stock to BBCLP in exchange for approximately 30% of BBCLP, and the ineligible shareholders of BBC USA were redeemed. The stock so transferred to BBCLP was redeemed by BBC USA for cash, resulting in a reported long-term capital gain, directly allocable to the limited partners, former shareholders of BBC USA under subchapter K rules.
BBCLP treated the gain as nonbusiness earnings for Tennessee excise tax purposes. The Tennessee Department of Revenue determined that the capital gain was apportionable business earnings and issued an assessment. BBCLP paid the amount due and applied for a refund. Both parties’ arguments before the trial court relied on the unitary business principle, which required an analysis of the connection between the stock redemption and BBCLP’s ice cream business conducted in Tennessee. The trial court determined that the assessment was unconstitutional and that there were insufficient facts to determine whether the capital gain was business earnings. The Department of Revenue appealed.
Because there was no dispute that BBCLP had done some business in the taxing state, the issue shifted to what income the state could tax. The court noted that in answering that question, the unitary business principle governs. Citing the Supreme Court’s decision in Mead, the court ruled that the principle allows a state to tax an apportioned sum of the corporation’s multistate business if the business is unitary. To exclude such income from the apportionment formula, a taxpayer must prove that the income was earned in the course of activities unrelated to those carried out in the taxing state. Again citing Mead, the court noted that “the pivotal question in cases such as this one is whether the business income sought to be included in the apportionable tax base derives from an unrelated business activity constituting a discrete business enterprise that is not part of the taxpayer’s unitary business.”
The Department of Revenue argued that the taxation of capital gains was “constitutionally permissible under the standard of unitariness required by the Due Process and Commerce Clauses of the United States Constitution” because BBCLP’s acquisition, and BBC USA’s subsequent redemption, of the BBC USA stock were both “undertaken as a part of the unitary Business of which both [BBCLP] and [BBC USA] were a part.” BBCLP countered that the one-time stock redemption transaction, carried out in Texas, “simply lacks sufficient nexus with [BBCLP’s] production, sale, and distribution of ice cream in the state of Tennessee to justify imposition of a tax.”
In determining whether a unitary relationship existed, the court examined whether the “hallmarks of a unitary relationship”—centralization of management, functional integration, and economies of scale—existed. The court examined in detail various aspects of the structure between BBCLP and BBC USA. After much analysis, the court determined that:
- The record did not reflect sufficient control on the part of BBC USA over BBCLP’s activities in Tennessee to support a finding of centralized management;
- Functional integration was not present because the reorganization was engineered for the purpose of converting BBC USA into an S corporation so BBC USA and its shareholders could obtain favorable tax treatment, not for the benefit of the entire business; and
- There is no evidence that BBC USA provided any central services to BBCLP to support economies of scale between the businesses, which could have undermined BBCLP’s operational independence.
After it provided a unitary analysis, the court considered the operational function test. The court explained that, as the Supreme Court had indicated in Mead, the test did not add a new ground for apportionment. The court found that BBCLP distributed the capital gains realized from the redemption and did not use them as operational funds. Thus, it concluded that the earnings were nonoperational.
McKesson Water Products
The fact that Mead seemed to downgrade the importance of the operational function test was at issue in McKesson Water Products Co. v. Division of Tax’n, 6 where the New Jersey Superior Court, Appellate Division, affirmed a New Jersey Tax Court ruling that the gain from a Sec. 338(h)(10) deemed asset sale was not allocable to New Jersey and was subject to the corporation business tax (CBT) because the gain was properly classified as nonoperational income.
The taxpayer, McKesson Water Products (Water Products), was incorporated in Delaware, had its principal place of business in California, and was a wholly owned subsidiary of McKesson Corporation (McKesson). McKesson entered into an agreement to sell all its stock in Water Products to an unrelated third party in a Sec. 338(h)(10) transaction. As a result of the Sec. 338(h)(10) election, McKesson’s sale of Water Products was treated as if Water Products (the target corporation) had sold its assets to a new company for an amount equal to the purchase price paid for its stock (plus any assumed liabilities), and Water Products was deemed to have liquidated and distributed the proceeds to McKesson. New Jersey follows the Sec. 338(h)(10) regime and, under NJ Admin. Code Section 18:7-5.8, a target must report and pay tax on the recognized gain from a Sec. 338(h)(10) election.
Following the transaction, Water Products filed a short-period New Jersey CBT return for the period beginning with the first day of its tax year through the date of the stock sale (deemed asset sale). Water Products did not allocate (apportion) any of the Sec. 338(h)(10) gain to New Jersey. Subsequently, the New Jersey Division of Taxation audited Water Products and issued a determination letter based on the assertion that the gain from the deemed asset sale constituted operational income and was required to be allocated to New Jersey. Under NJ Stat. Ann. Section 54:10A-6.1, as amended in 2002,
“Operational income” subject to allocation to New Jersey means income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations and includes investment income serving an operational function. Income that a taxpayer demonstrates with clear and convincing evidence is not operational income is classified as nonoperational income, and the nonoperational income of taxpayers is not subject to allocation but shall be specifically assigned.
McKesson appealed to the New Jersey Tax Court, which ruled that the gain from the deemed asset sale did not constitute operational income and must therefore be assigned to California, the state where Water Product’s principal place of business was located. Shortly after the Tax Court rendered its decision in favor of the taxpayer, the U.S. Supreme Court handed down its decision in Mead. Subsequently, the Division of Taxation appealed to the New Jersey Superior Court, Appellate Division, arguing that the Tax Court erred in classifying the gain as nonoperational income and seeking a remand to consider the applicability of the unitary business principle under Mead. However, the Superior Court disagreed and concluded that remand was unnecessary.
The Superior Court explained that the unitary business principle is “rooted in the constitutional limitations imposed by the Commerce Clause and the protections afforded under the Due Process Clause of the Constitution,” both of which ultimately limit a state’s power to tax out-of-state activities. However, because the issue at hand—whether or not the gain could be taxed by New Jersey—could be decided on statutory grounds, there was no reason to address the unitary business principle. Thus, the Superior Court agreed with McKesson’s argument that the unitary business principle was merely a fallback argument and denied the Division of Taxation’s request for remand. The Superior Court went on to affirm the Tax Court’s decision and ruled that because the gain from the Sec. 338(h)(10) election did not constitute operational income as defined in NJ Stat. Ann. Section 54:10A-6.1, the gain was not subject to the CBT. However, although it did not undertake a unitary analysis, what is notable is that the Division of Taxation’s appeal called for such an analysis to be made. This action indicates that the unitary business principle clearly remains paramount in deciding, on constitutional grounds at least, whether income is apportionable or allocable.
State courts and revenue departments are just now beginning to consider how Mead will be applied in determining whether income is apportionable. However, there seems to be little doubt that courts will continue to use the unitary business principle as the primary standard for determining whether apportionment is proper. Thus, tax practitioners should revisit Butler Bros. v. McColgan, 7 where the U.S. Supreme Court held that the existence of a unitary business can be established using the “three unities test”; Edison California Stores v. McColgan, 8 where the California Supreme Court held that a unitary business exists “[i]f the operation of the portion of the business done within the state is dependent upon or contributes to the operation of the business done without the state”; and Mobil Oil Corp. v. Commissioner of Taxes of Vermont, 9 where the U.S. Supreme Court referred to a unitary business as one that exhibits contributions to income that result from functional integration, centralized management, or economies of scale between related corporations.
What is less clear is the role of the operational function test in this post-Mead world. In Mead, the Court concluded that references to operational function in Allied-Signal and Container Corp. of America v. Franchise Tax Board 10 were not intended to modify the unitary business principle by adding a new ground for apportionment. The concept of operational function “simply recognizes that an asset can be a part of a taxpayer’s unitary business even if what we may term a ‘unitary relationship’ does not exist between the ‘payor and payee.’” 11 Thus, while a unitary analysis is necessary, when dealing with certain assets the operational function test is still relevant.
© 2010 PricewaterhouseCoopers. All rights reserved. PricewaterhouseCoopers refers to the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity. This document is for general information purposes only and should not be used as a substitute for consultation with professional advisers.
1 MeadWestvaco Corp. v. Illinois Dep’t of Rev., 553 U.S. 16 (2008).
2 Allied-Signal Inc. v. Director, Div. of Tax’n, 504 U.S. 768 (1992).
3 Mead, slip op. at 11.
4 Blue Bell Creameries, L.P. v. Chumley, No. M2009-00255-COA-R3-CV (Tenn. Ct. App. 9/29/09).
5 The shareholder limit was later increased to 100 and was accompanied by favorable changes to treat members of a family as one shareholder (Sec. 1361(b)(1)(A), amended by the American Jobs Creation Act, P.L. 108-357, §§231, 232).
6 McKesson Water Prods. Co. v. Division of Tax’n, 974 A.2d 443 (N.J. Super. Ct. App. Div. 2009), aff’g 23 N.J. Tax 449 (2007).
7 Butler Bros. v. McColgan, 315 U.S. 501 (1942), aff’g 111 P.2d 334 (Cal. 1941).
8 Edison California Stores v. McColgan, 183 P.2d 16 (Cal. 1947).
9 Mobil Oil Corp. v. Commissioner of Taxes of Vt., 445 U.S. 425 (1980).
10 Container Corp. of Am. v. Franchise Tax Bd., 463 U.S. 159 (1983).
11 Mead, slip op. at 11–12.
Harlan Kwiatek is with Rubin Brown LLP in St. Louis, MO, and is chair of the AICPA Tax Division’s State & Local Tax Technical Resource Panel. Adam Weinreb is a director in the tax knowledge management group with PricewaterhouseCoopers in New York, NY. For more information about this column, please contact Mr. Weinreb at email@example.com.