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Sourcing income from stock and corporate debt: a current perspective.

I. INTRODUCTION

The circumstances under which a state or locality may constitutionally apportion a nondomiciliary corporation's income from stocks and corporate debt continues to be addressed by state courts.(1)(*) Most recently, the New Jersey Supreme Court, in Bendix Corp. v. Director, Division of Taxation,(2) held that capital gains from stock sales may constitutionally be apportioned where the stated purpose for the stock acquisitions and divestitures was to expand existing operations and enter new businesses. In reaching this conclusion, the New Jersey Court interpreted U.S. Supreme Court precedent as not limiting apportionment to the situation where the selling corporation and the corporation generating the gain are engaged in a unitary business.(3)

The propriety of the New Jersey court's interpretation will be determined by the Supreme Court of the United States, which recently agreed to review the Bendix case (renamed Allied Signal, Inc. v. Director, Division of Taxation). This article briefly analyzes key U.S. Supreme Court decisions in this area and discusses the merits and ramifications of the New Jersey court's decision in Bendix as well as recent contrary holdings of the Arkansas and Virginia Supreme Courts. Also discussed is the Maine Supreme Court's decision in Tambrands, Inc. v. State Tax Assessor,(4) Which required apportionment, factor representation in a unitary context.

II. U.S. SUPREME COURT DECISIONS

A. Mobil

In 1980, the Supreme Court of the United States issued its landmark decision in Mobil Oil Corp. v. Commissioner of Taxes of Vermont, which solidified the constitutional requirements for apportioning dividends (and arguably other forms of income) from nontaxpayer subsidiaries.(5) In that case, Mobil Oil Corp. (a commercial domiciliary of New York) sold petroleum products from locations in Vermont (representing one aspect of its overall petroleum business) and received dividends from subsidiaries engaged in a broader spectrum of petroleum business activities.

The Court first confirmed the Due Process and Commerce Clause limitation that a state may only tax income generated in interstate commerce if (1) there is a minimal connection between the interstate activities ties and the taxing state, and (2) a rational relationship exists between the income attributed to the state and the intrastate values of the enterprise. Because the first requirement was not at issue owing to Mobil's sales from Vermont locations, the decision focused on the rational relationship requirement, which was found to be satisfied because the dividend income was earned in the course of activities related to the sale of petroleum products in Vermont. Consequently, the Supreme Court ruled that Vermont was within its constitutional authority in apportioning the dividend income. In so holding, the Court found that there should be no difference (for this purpose) between income derived from a functionally integrated division and income derived from a subsidiary. It reasoned that "[o]ne must look principally at the underlying activity, not at the form of investment, to determine the propriety of apportionability".(6) The Court noted, however, that:

Where the business activities of the dividend a payor have nothing to do with the activities of the recipient in the taxing state, due process considerations might well preclude apportionability, because there would be no underlying unitary business.(7)

A dissenting opinion by Justice Stevens in Mobil argued that the Court's majority had improperly accepted a largely unsupported proposition that all of the subsidiaries were engaged in activities that were unitary with Mobil's business in Vermont. Justice Stevens also stated that "of greatest importance, the record contains no information about the payrolls, sales or property values of any of those corporations [the subsidiaries], and Vermont has made no attempt to incorporate them into the apportionment formula computations." The majority explicitly did not address the issue of factor representation for the dividend income because it found that Mobil had disclaimed any dispute with respect to the accuracy or fairness of Vermont's apportionment formula.

B. ASARCO and Woolworth

In 1982, the Supreme Court utilized the constitutional standards developed in Mobil in deciding the cases of ASARCO Inc. v. Idaho State Tax Commission(8) and F.W. Woolworth Co. v. Taxation and Revenue Department of New Mexico.(9) ASARCO (a New York-based corporation) was engaged in silver mining in Idaho and received dividends, interest, and capital gains from nontaxpayer subsidiaries engaged in the same general line of business. The Court applied the unitary business principle of Mobil by focusing on whether the activities of the subsidiaries were unitary with ASARCO's silver mining business in Idaho and found that no such unitary relationship existed. It was, therefore, held that these income items could not constitutionally be apportioned.

In F.W. Woolworth, the Court applied Mobil's underlying unitary standard in the same manner as in ASARCO by focusing on whether there was functional integration between the taxpayer-parent and the nontaxpayer subsidiaries. Even though the parent owned all or a majority of the stock in each subsidiary and the subsidiaries were engaged in the same line of business as the parent, the Court held that the potential to operate these subsidiaries did not establish a unitary business because the subsidiaries operated discrete business enterprises. The Court concluded that the dividends paid by these subsidiaries could not constitutionally be apportioned by New Mexico.

Although the factual finding that no unitary relationship was present in either Woolworth of ASARCO has been criticized, the Court clearly delineated the constitutional requirement in those cases (as well as in Mobil) that an underlying unitary business must be conducted by the generating and recipient corporations in the state seeking apportionment.

III. APPLICATION TO OTHER FORMS OF PASSIVE INCOME

Question: Does the underlying unitary standard apply equally to dividends, interest income, and capital gains?

Conclusion: Existing case law strongly supports the equal application of the underlying unitary standard to dividends, interest income, and capital gains.

The underlying unitary standard utilized by the Supreme Court is based on the proposition that dividends, interest income, and capital gains derived from subsidiaries constitute income earned through the activities of the subsidiaries rather than the parent-recipient. This proposition can most easily be accepted in the case of dividends because such income can be directly traced to the earnings of the subsidiary and, unlike interest, the parent is not required to furnish consideration in addition to its capital contribution. With respect to capital gains, there is arguably a more indirect relationship between the gain and the earnings of the subsidiary (as compared to dividends or interest) because the amount realized from the sale of the stock may reflect anticipated future earnings or other non-quantifiable factors. In ASARCO, however, the Supreme Court agreed with the parties' stipulation that "the same standard applies to the question of whether gains from the sale of stock are business income as applies to the question whether dividends from ;he stock are [apportionable] business income"(10) and applied the same unitary standard to dividends, interest and capital gains. As support for its position, the Court in ASARCO cited it8 statement in Mobil that "[o]ne must look principally at the underlying activity, not the form of investment, to determine the propriety of apportionability."

Recent cases in Arkansas and Virginia have relied on ASARCO and Mobil in applying the underlying unitary standard to capital gains and interest income. In Pledger v. Illinois Tool Works, Inc.,(11) the nondomiciliary corporation recognized capital gains from the sale of minority stock interests in corporations that conducted discrete and separate businesses outside of Arkansas. In holding that the capital gains could not constitutionally be apportioned by Arkansas, the Arkansas Supreme Court invalidated regulations applying the unitary standard to dividends only and overruled its 1979 decision that interest income from subsidiaries could be apportioned if it were subsequently commingled with business funds.(12) The Virginia Supreme similarly applied the underlying unitary standard to capital gains and interest income in Corning Glass Works, Inc. v. Virginia Department of Taxation(13) and held that the state was prevented from apportioning the income.

IV. APPORTIONMENT IN THE ABSENCE OF A UNITARY BUSINESS

Question: Can a state constitutionally apportion income derived from a subsidiary not engaged in a unitary business with the parent if the purpose for acquiring or disposing of the stock was to expand existing operations or enter new businesses?

Conclusion: U.S. Supreme Court precedent that might be interpreted as supporting the right to apportion under these circumstances is tenuous compared with the decisions utilizing the underlying unitary standard.

In Bendix Corp. v. Director, Division of Taxation, the New Jersey Supreme Court held that capital gains from the sale of non-unitary subsidiaries can constitutionally be apportioned where the stock is purchased and sold for the purpose of expanding and diversifying the taxpayer's existing business.(14) Bendix was engaged in the business of producing aerospace systems and manufacturing electric power-generating equipment in New Jersey and manufacturing automobile and aviation parts outside of New Jersey. One of Bendix's acquisitions and divestitures was 20.6 percent of the stock of ASARCO that was engaged in the natural resource business. The ASARCO stock was purchased because Bendix was "bullish on basic resources" and believed that ASARCO would help it reduce dependence on the aerospace and automotive market, broaden its industrial/energy group, generate good cash flow, and expand its holding in basic commodities.(15) During the period that Bendix held the ASARCO stock, the corporations operated as distinct and separate enterprises with little interaction between them. Bendix then sold its stock to ASARCO for the stated purpose of moving into the high technology field which would make the entire company less dependent on the automobile business as well as benefit and complement its New Jersey operations. Bendix did, in fact, use a portion of the ASARCO proceeds in its failed attempt to purchase 70 percent of the stock of Martin Marietta whose business would have complemented Bendix's aerospace industry in New Jersey.

In holding that New Jersey was within constitutional limitations in taxing a proportionate share of the $211.5 million capital gain from the sale of the ASARCO stock, the New Jersey Supreme Court stated that:

The tests for determining a unitary business are not

controlled ... by the relationship between the taxpayer

recipient and the affiliate generator of the income

that becomes the subject of State tax. . . . What

controls is the underlying activities that reflect the

economic realities of the corporate business.... When

capital investment activities are long-term integral

operational corporate functions rather than passive

investment functions, they can serve as the basis for

concluding a unitary business exists.(16)]

As support for this proposition, the New Jersey Supreme Court in Bendix cited the U.S. Supreme Court's post-ASARCO opinion in Container Corp. of America v. Franchise Tax Board,(17) which, in turn, cited the 1955 federal income tax case of Corn Products Refining Co. v. Commissioner.(18) Container addressed the factual issue whether a U.S. corporation was engaged in a unitary business with its non-U.S. subsidiaries (which was held in the affirmative) and focused on why the Foreign Commerce Clause of the United States Constitution did not prohibit the state from requiring a combined report. Corn Products dealt with the proper characterization (ordinary versus capital) of a gain from the sale of corn futures contracts which were purchased for the business purpose of hedging against a decline in the value of inventory. The Court in Corn Products held that the gain was ordinary rather than capital because these futures contracts were excluded from the Internal Revenue Code's definition of a capital asset.

At the time Container was decided in 1983, the prevailing interpretation of Corn Products was that the business purpose for the acquisition of the futures contracts caused the resulting gain to be ordinary.(19) Container used the concept of Corn Products that "capital transactions can serve either an investment function or an operational function" to support its finding of a unitary business while stating that investments in subsidiaries that are engaged in the same rather than a distinct) line of business are much more likely to serve an operational function. In 1988, however, the U.S. Supreme Court, in Arkansas Best Corp. v. Commissioner,(20) narrowly construed Corn Products as having excluded the futures contracts from capital asset status because they were the equivalent of inventory rather than because of the associated business purpose. Therefore, for purposes of the Internal Revenue Code, Arkansas Best substantially narrowed what is considered an operational, as opposed to an investment, function.

Although it can be argued that a concept of "operational function" that is broader than that used in Container or Corn Products may constitutionally be used for apportionment purposes, such a conclusion does not resolve the underlying difference between Bendix and the U.S. Supreme Court cases. Bendix attributed the capital gain income to the earnings activity of the parent rather than the subsidiaries and found that the business purpose for those activities supplied the rational relationship between the pin and the New Jersey business. The U.S. Supreme Court, on the other hand, requires that the activities of the subsidiary that generates the income be part of the parent's unitary business conducted in the state and has not differentiated between dividends, interest and capital gains.

Even assuming that the capital gains should properly be attributed to the earnings activities of the parent, it is not entirely clear how the "business purpose" for acquiring or disposing of the investment assets created the rational relationship between these activities and the New Jersey business. First, it was not alleged that Bendix was engaged in a separate trade or business of securities trading or dealing that is required by federal income tax law (outside of the limited context of Corn Products) in order for gain or loss to be ordinary. Rather, the New Jersey Court attributed these investment activities to the New Jersey business because their purpose allegedly went beyond securing a return on its capital. Yet, investments are often selected for their capacity to serve a variety of purposes in addition to securing an acceptable return, and virtually every investment can, in some sense, be said to complement the existing business through, for example, diversification. In most situations, therefore, the New Jersey Supreme Court's interpretation would appear not to provide a limitation on apportionment that is any greater than the standard rejected in ASARCO. In addition, even if the standard used in Bendix is constitutionally permitted, it could increase the level of administrative uncertainty as compared with the more objective underlying unitary standard.

There is some authority, however, (not cited by the New Jersey court in Bendix) supporting the position that it is possible to satisfy the U.S. Supreme Court's unitary standard in the absence of a unitary relationship between the corporations. Footnote 21 in ASARCO cites the trial court's findings that ASARCO "has never been required to utilize its stock as security for borrowing of working capital, acquiring stock or securities in other companies or to support any bond issues." This language could be interpreted to mean that using the investment vehicles as business collateral (which does not require an intercorporate relationship) would satisfy the unitary standard. The Ohio Supreme Court, in American Home Products Corp. v. Limbach,(21) applied this collateral test to a non-unitary subsidiary but held that the facts did not support its application. Therefore, it could be argued that other ways of satisfying the unitary standard are also available.

V. FACTOR REPRESENTATION

Question: Where income from subsidiaries is properly apportioned, is the state constitutionally required to include a proportionate share of the generating corporation's property, payroll, and sales in the recipient corporation's apportionment denominators and, if so, under what circumstances is such factor representation required?

Conclusion: Recent state court decisions portend progress toward increased factor representation, at least where the tax without the additional factors is "grossly disparate" by comparison.

If the proposition is accepted that there should be no difference between income derived from a functionally integrated division as opposed to a subsidiary, then consistency demands factor representation in the subsidiary context. Recent progress may have been made to this end at the state court level. First, the South Carolina Supreme Court remanded the case of NCR Corp. v. South Carolina Tax Commission(22) to determine whether the tax calculated without such factor representation is unconstitutionally "grossly disparate" when compared to the tax calculated with the increased denominators.

Following the lead of NCR Corp., the Supreme Court of Maine (in Tambrands, Inc. v. State Tax Assessor) held that internal consistency or, alternatively, basic due process requires the state to include additional factors that will "fairly represent" the taxpayer's business activity in Maine. There is no mention of the "grossly disparate" requirement in Tambrands. Although it would be premature to conclude that these cases represent a trend toward factor representation, they may articulate what the U.S. Supreme Court did not have the opportunity to address in Mobil.

VI. CONCLUSION

Existing U.S. Supreme Court decisions do not appear to support the right to apportion any type of a nondomiciliary's income from stocks or corporate debt where no underlying unitary business is being conducted in the state. Alternative standards developed by states may, therefore, fall short of what is constitutionally required. By granting review to Bendix, the U.S. Supreme Court will have the opportunity to restore some degree of certainty to this important area of state tax law.

Notes

(1) Although this article is limited in scope to income from stock and corporate debt, the principles discussed in the text may also apply to income from other intangible property forms. (2) 125 N.J. 20 (1991), aff'g 237 N.J. Super. 328 (1989), aff'g 10 N.J. Tax 46 (1988), petition for cert. granted sub nom. Allied Signal, Inc. v. Director, Division of Taxation, U.S. Sup. Ct. Dkt. No. 91-615 (Nov. 27, 1991). Oral argument in Allied Signal is scheduled for March 4, 1992. (3) A few other state courts have made basically the same interpretation. See e.g., NCR Corp v. Comptroller, 313 Md. 118 (1988); Comptroller v. Armco Inc., 70 Md. App. 403 (1987); Silent Hoist & Crane Co. v. Director, 100 N.J. 1, cert. denied, 474 U.S. 995 (1985); M. Lowenstein Corp. v. South Carolina Tax Comm'n, 298 S.C. 93 (Ct. App. 1989). The majority of state cases, however, have applied the underlying unitary standard. See, e.g., Pledger v. Illinois Tool Works, Inc., 306 Ark 134 (1991), cert. denied, U.S. Sup, Ct. Dkt. No. 91-530 (Nov. 12, 1991); Corning Glass Works, Inc. v. Virginia Dep't of Taxation, 241 Va. 134 (1991), cert. denied, U.S. Sup. Ct. Dkt. 90-1852 (Oct. 7. 1991); Jewel Companies v. Montana Dep't of Revenue, No. BDV-89-29X (remanded by First District Ct.); American Home Products Corp. v, Limbach, 49 Ohio St. 3d 158 (1990), Brunner Enterprises, Inc. v. Department of Revenue, 452 So. 2d 550 (Fla. 1984); James v. International Telephone & Telegraph Corp., 654 S.W. 2d 865 (Mo. 1983). (4) Tambrands, Inc. v. State Tax Assessor, Dec. No. 5909 (Me. Aug. 7, 1991). (5) 445 U.S. 425 (1980). For purposes of this article, the term "subsidiary" is not limited to corporations in which there is any particular threshold of stock ownership, though the control that may be represented by a certain percentage of stock may indicate the presence of an underlying unitary business. (6) Id. at 439. (7) Id. at 44 1. (8) 458 U.S. 301 (1982). (9) 458 U.S. 354 (1982). (10) 458 U.S. at 329.u 306 Ark. 134 (1991), cert. denied, U.S. Sup. Ct. Dkt. No. 91-530 (Nov. 12, 1991). (12) Regulation 1984-2 and Qualls v. Montgomery Ward & Co., 266 Ark. 207 (1979). (13) 241 Va. 353 (1991), cert. denied, U.S. Sup. Ct. Dkt. No. 90-1852 (Oct. 7, 1991). (14) One of the subsidiaries that Bendix sold -- UGC -- was found to have been engaged in a unitary business with Bendix. The New Jersey court, however, apparently did not rely on this unitary relationship in holding the capital gain from the sale of the UGC stock to be apportionable. Instead, the court reasoned:

What controls is the underlying activities that reflect the economic

realities of the corporate business.... From that perspective,

we are satisfied the capital gains from the sale of stock in

both UGC and ASARCO are apportionable under the unitary

business principle. In using the phrase "unitary business principle," the New Jersey Supreme Court was not referring to an underlying unitary business being conducted by the parent and subsidiary. (15) Bendix Corp, 237 N.J. Super. at 338. (16) Bendix Corp., 125 N.J. at 30. (17) 463 U.S. 159 (1983). (18) 350 U.S. 46 (1955), cited in Container, 463 U.S. at 179 n.19. (19) See, e.g., Bittker, Federal Taxation of Income, Estates and Gifts [paragraph] 51.10.3, at 61-62 (1981). Consequently, taxpayers been asserting a business purpose for transactions that resulted in losses in order to receive ordinary lose treatment. (20) 486 U.S. 212 (1988). (21) 49 Ohio St. 3d 158 (1990). (22) 402 S.E.2d 666 (1991).
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Author:Peters, Jeffrey S.
Publication:Tax Executive
Date:Jan 1, 1992
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