The distinction between business and nonbusiness income.
Business vs. Nonbusiness Income
A multistate corporation generally will allocate and apportion its net income among the states in which it is doing business or subject to the income/franchise tax. The majority of states distinguish business income from nonbusiness income when determining whether income should be apportioned or allocated. Some states do not distinguish between business and non-business income and are considered "full apportionment" states.
Business income is generally apportioned (applying a formula apportionment) among the states in which the corporation is doing business; nonbusiness income is allocated to a single taxing state. States have often adopted their own definitions of business and nonbusiness income; this classification varies. Different approaches in deciding whether an item of income is allocable (nonbusiness) or apportionable (business) include:
* Uniform Division of Income for Tax Purposes Act (UDITPA);
* Type of income; and
* Unitary business.
Many states have adopted the definition under UDITPA, which defines business income as income arising from transactions and activity in the regular course of the taxpayer's trade or business and includes 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.
This definition contains two independent tests. The transaction test addresses whether the transaction or activity that gave rise to the income in question occurred in the regular course of a taxpayer's trade or business. The functional test is based on the functional integration of the income-producing property and the taxpayer's unitary business operations. If either test is met, the income is apportionable business income.
Although each state can follow either a functional or income-type approach, the unitary business approach (which focuses on the relationship between the taxpayer and the entity) may be applied as an additional or alternative test.
Presumption That Income Is Apportionable
Multistate Tax Commission regulations state that, in essence, all income arising from the conduct of trade or business operations of a taxpayer is business income. The regulations presume that income is business income unless it is clearly classified as nonbusiness income. The burden of overcoming the presumption rests with the taxpayer.
The landmark cases of Allied Signal, 112 S.Ct. 2251 (1992) and ASARCO, 458 US 307 (1982), established positions for an alternative unitary approach and exceptions to business income for taxpayers, even if the business income tests are met in states adopting UDITPA.
Because business income can often be determined to be income arising in a taxpayer's regular course of business, or from transactions constituting an integral part of a taxpayer's business, state courts have developed numerous ways and approaches to define a taxpayer's regular course of business.
State Case Developments
In Union Carbide Corp. v. Offerman, N.C. Ct. Apps., No. 97-956 (9/15/98), the North Carolina Court of Appeals held that income from the return of funds from a company's overfunded pension plan was nonbusiness income. Union Carbide is a New York corporation domiciled in Connecticut and qualified to do business in North Carolina. The North Carolina Court of Appeals held that the income received from a reversion of pension plan assets was nonbusiness income, and thus not apportionable to North Carolina for corporate income tax purposes. Instead, it was allocable to the state of domicile, because it arose from an extraordinary event not in the regular course of the company's trade or business. The income did not arise from the management of the pension plan, but from the reversion of excess funds as part of an attempt to avoid a hostile takeover. Therefore, the company was entitled to a full refund of tax paid to North Carolina.
An Illinois Circuit Court determined that interest income from arbitrage activities was business income subject to apportionment (Mitsubishi International, Inc. v. Dep't of Rev., Ill. Cir. Ct, No. 96 L 50393 (2/4/98)). The court concluded that arbitrage interest income received by a NewYork corporation constituted business income subject to apportionment in Illinois, because it arose from transactions in the regular course of the taxpayer's business and the acquisition, management and disposition of the taxpayer's arbitrage property constituted integral parts of its business operations. The interest income met both the transaction test and the functional test to determine business income, and so was subject to apportionment.
The arbitrage group was subject to the unitary business principle because the taxpayer's activities were highly integrated. The arbitrage activities were linked to the corporation's resources, including use of the taxpayer's company name to make deals. Mitsubishi is a NewYork corporation headquartered and commercially domiciled in New York. It engages in an international general trading business composed of seven trading groups, with offices in 20 U.S. cities. The taxpayer maintained offices in Illinois for four of its seven trading groups.
In Tennessee, investment earnings from a bond trading group were deemed to be business income, but the corporation was not subject to the Tennessee corporate excise tax, because the activities were not "unitary" (Louis Dreyfus Corp. v. Comm. of Rev., Tenn. Ct. Apps., No. 01-A-01-9505-CH-000218 (5/31/96)). In Louis Dreyfus, a corporation domiciled in Connecticut was not subject to Tennessee corporate excise tax on investment earnings generated by its bond trading group, because the activities of the bond trading group were not unitary with the corporation's other commodities groups. Utilizing the "three unities test" to determine whether the business was a unitary business, the Tennessee Court of Appeals examined the unity of ownership, the unity of operation and the unity of a centralized executive force.
Pennsylvania decided that the gain from the sale of stock by a foreign corporation was apportionable business income, because "the taxpayer failed to prove a factual background indicating that the stock did not contribute to the corporation's business in the state" (Cadbury Schweppes, Inc. v. Commonwealth Ct. of Pa., No. 353 ER. 1992 (6/5/98)).
Dividend and interest income from excess cash on hand was characterized as nonbusiness income for the California corporation income and franchise tax (Legal Ruling 98-5, California Franchise Tax Board (11/30/98)).
Review and identify. Nonbusiness income is often categorized to include dividends, interest, rents, royalties and certain capital gains. This is not always the case, however. It must first be determined if (1) the asset generating the income was used in the taxpayer's regular trade or business and (2) whether the acquisition, management and disposition of property constitute an integral part of a taxpayer's trade or business.
In addition, when reviewing for nonbusiness income, focus on the following factors:
* The purpose for acquiring or holding the investment;
* The source of funds used to acquire the investment; and
* The use of the income generated from the investment.
States vary as to their definitions of business vs. nonbusiness; some follow UDITPA, while others do not; some are "full apportionment" (and do not distinguish), while others may apply a transaction or functional test. Double taxation, is a possibility. Each state's rules must be reviewed.
Watch for large and unusual transactions. Review transactions of a large and significant nature, including the renting and leasing of buildings, sales of stock, sales of assets and extraordinary, infrequent and irregular items of other income. States will often identify and challenge the character and classification of such items as business or nonbusiness income, depending on whether there is a tax benefit attached. Consider obtaining a ruling in advance from a state regarding its classification of business vs. nonbusiness income.
Use case law to advantage. For example, for out-of-state businesses, losses should be apportioned to North Carolina and other states adopting the functional test for infrequent or irregular activities.
(For a discussion of other business/nonbusiness income cases, see Boucher, "Current Corporate Income Tax Developments," TTA, March 1999, at pp. 180-182.)
FROM DAVID L. HUIZENGA, CPA, MST, CHARLOTTE, NC
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|Title Annotation:||state taxation|
|Author:||Huizenga, David L.|
|Publication:||The Tax Adviser|
|Date:||May 1, 1999|
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