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When does the sale of corporate assets produce business income for state corporate franchise tax purposes?

I. Introduction

When the assets of a corporate business are sold, the resulting gain or loss is either apportioned among the various States in which the corporation does business or it is allocated entirely to one or more States. The typical pattern is that income that is classified as "business" income is apportioned pursuant to a formula (typically based on property, payroll, and sales), whereas income that is treated as "nonbusiness" income is allocated (typically to the State of the taxpayer's commercial domicile or to the State in which tangible property producing the gain is located). This is the pattern of the Uniform Division of Income for Tax Purposes Act (UDITPA), which is followed by many of the States.

When a corporation sells a business, the classification of any resulting gain or loss as business or nonbusiness income can have significant consequences. If the State of the corporation's commercial domicile has high tax rates, classifying the income as nonbusiness income and allocating it entirely to that State can be less desirable than classifying the income as business income and apportioning it among all of the States in which the corporation does business. On the other hand, if the State of commercial domicile has low tax rates, the taxpayer may prefer to have the gain on the sale of its assets treated as nonbusiness income and allocated all to that State. Although the pattern in several recent cases has been for the taxpayer to argue for nonbusiness income treatment (and the state tax department to argue for business income treatment), taxpayers and tax administrators have sometimes found themselves on different sides of the fence.

UDITPA defines "business income" in deceptively simple terms, as follows:

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.(1)

Nonbusiness income is defined as "all income other than business income."(2)

These provisions are certainly among the simpler tax statutes around, but their meaning is by no means clear and their interpretation has given rise to extensive litigation. This article reviews the state of the law.

II. Interpretation of the Statute

A. Introduction

The courts have developed two approaches in determining whether the sale of business assets produces business or nonbusiness income under UDITPA. Under the "transactional" test, income is business income if the transaction that generates it occurs in the ordinary course of the taxpayer's trade or business. Under the "functional" test, income is business income if it results from the sale of assets that were used in the taxpayer's business, even if the transaction producing the income did not occur in the ordinary course of business.(3) The transactional test is clearly part of the statute. One issue with which the courts have had to deal is whether the functional test is an additional and independent test that can produce business income even if the transactional test is not met, or whether the second part of the UDITPA definition--referring to the acquisition, management, and disposition of the property--is merely an elaboration of the transactional test.

The difference between the transactional and the functional tests is particularly important in connection with the sale of a business because often the sale of the business will not be a regular incident of the taxpayer's operations. If a corporation sells all of its businesses and then liquidates, this clearly will not be a common transaction and, under the transactional test, it will be hard to conclude that it produces business income. On the other hand, the functional test could produce business income in such a transaction.

B. The Transactional Test

The source of the transactional test is the first clause of the UDITPA definition, which provides that business income includes "income arising from transactions and activity in the regular course of the taxpayer's trade or business."(4)

The prototypical example of a sale that produces business income under the transactional test is the sale of inventory to customers in the ordinary course of business. An automobile dealership clearly realizes business income when it sells cars to customers from its regular inventory. A trickier case is presented when the dealer uses a particular automobile as a demonstrator for six months and then sells it. Even though the demonstrator has been used in the business and not merely held for sale to customers, its sale is a regular part of the dealer's business and was undoubtedly contemplated when it was bought from the manufacturer. A reasonable argument can be made that the resulting income should be business income under the transactional test. The issues get murkier where the dealer sells a lot and building on which it does business. If the lot and building represent the dealer's only facility and it then liquidates and goes out of business, courts applying the transactional test will generally find that the resulting income is nonbusiness income. If, instead, the dealer sells one of several facilities and remains in business at other locations, the answer is not so clear. It may depend on whether the sales proceeds are reinvested in the business or distributed to the shareholders.

C. The Functional Test

Under the functional test, income from the sale of property is business income if the property is used in the taxpayer's business, even if its sale is not a regular incident of the business. Courts applying the functional test find its source in the second clause of the UDITPA definition of business income, which includes income from property "if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations."(5) Under the functional test, the transaction giving rise to the income can be an extraordinary transaction. If the property that is sold produced business income while used by the taxpayer, its sale also produces business income even if the sale is not a regular incident of the taxpayer's business. Under the functional test, the "extraordinary nature or the infrequency of the transactions is irrelevant."(6) The courts that apply the functional test have not claimed that it is the only test but merely that it is applied in addition to the transactional test. Under this approach, income will be business income if it satisfies either test.

III. The Multistate Tax Commission Regulations

The Multistate Tax Commission (MTC) has adopted regulations under the UDITPA business income definition that incorporate a strong presumption in favor of business income. The general definition of business and nonbusiness income provides:

[A]ll income which arises from the conduct of trade or business operations of a taxpayer is business income. For purposes of administration of Article IV, the income of the taxpayer is business income unless clearly classifiable as nonbusiness income. ... In general all transactions and activities of the taxpayer which are dependent upon or contribute to the operations of the taxpayer's economic enterprise as a whole constitute the taxpayer's trade or business and will be transactions and activity arising in the regular course of, and will constitute integral parts of, a trade or a business.(7)

The regulation specifically dealing with gain from the sale of property clearly adopts the functional test:

Gain or loss from the sale, exchange or other disposition of real or tangible personal property constitutes business income if the property while owned by the taxpayer was used in the taxpayer's trade or business.(8)

It is hard to imagine a sale of property that will not be treated as business income within the meaning of the MTC regulations.

The courts, however, have been more restrictive. The Missouri Supreme Court in James v. International Telephone & Telegraph Corp. held that gains from the sale of four subsidiaries pursuant to an antitrust consent decree were not business income. In doing so, the court criticized the sweeping nature of the regulations, holding that they purported to expand a "broad" statute "even further."(9) The Supreme Court of Kansas was even less kind, holding in Appeal of Chief Industries, Inc. that the taxpayer's gain from the sale of stock was nonbusiness income under the transactional test.(10) In that case, the taxpayer manufactured and sold recreational vehicles and other types of products. It had an automotive division that produced and sold automobile frame straighteners. In order to raise money for its other operations, it decided to sell the automotive division, which it did by transferring the assets of that division to a new corporation and making a public offering of that corporation's stock.

In an earlier case, the court had held that the transactional test was the sole test determining whether income was business income; the functional test did not apply.(11) After the earlier case was decided, the Kansas Department of Revenue adopted the MTC regulations.(12) The Department then argued in Chief Industries that the earlier case was distinguishable because the regulations had not been in effect and that the regulations were controlling in the case before the court. The court was unimpressed. It brusquely observed that its holding in the earlier case had not been modified in the intervening 25 years and that the legislature had not seen fit to reverse it by changing the statute.(13) It reminded the Department of Revenue that, while the legislature had the power to overturn a decision of the State's highest court, the Department did not.

The dissent in Chief Industries argued that the history of the Multistate Tax Compact and its adoption by Kansas and other States suggested that uniformity among the States was paramount and that the MTC regulations interpreting a statute under these circumstances should be given great weight. The dissent argued that the majority had ignored the legislative history of the development of UDITPA.(14)

IV. Cases Applying The Transactional Test

A. The Transactional Test As The Sole Test

A number of courts have held that the transactional test is the sole test and that the functional test does not exist. In Western Natural Gas Co. v. McDonald, the taxpayer was an integrated oil company that was in the business of exploring for, producing, refining, and selling petroleum products.(15) It acquired oil and gas leases between 1941 and 1947, which it held for exploration and production and not for resale. Between that time and 1963, it never sold a lease. In 1963, the company decided to liquidate. It sold its properties, including the leases, in that year and went out of business. The taxpayer successfully argued that its income on the sale was nonbusiness income. In rejecting the Department of Revenue's argument that the functional test (though it did not then have a name) required that the taxpayer's gain be treated as business income, the court said:

It is not the use of the property in the business which is the determining factor under the statute. The controlling factor by which the statute identifies business income is the nature of the particular transaction giving rise to the income. To be business income the transaction and activity must have been in the regular course of the taxpayer's business operations.(16)

The court read the words "and activity" following the word "transactions" as being part of the same concept and not a separate concept. It refused to infer from them that gain from the sale of property that was used in an income-producing activity would produce business income unless the actual sale transaction was a typical incident of the business.

In another early case, McVean & Barlow, Inc. v. New Mexico Bureau of Revenue, the Court of Appeals of New Mexico rejected the functional test although it did not speak in terms of the transactional and functional tests.(17) The court held that the taxpayer's gain from the sale of pipeline equipment resulted in nonbusiness income because it was an unusual transaction that occurred in connection with a partial liquidation of the company. Although the court did not refer to the transactional and functional tests as such, its logic in effect adopted the transactional test and rejected the functional test.

A series of cases in Tennessee clearly adopted the transactional test as the sole test over the strenuous objections of the Department of Revenue. The Department laughed last, however, because it was ultimately able, after losing in court, to persuade the legislature to change the statute to incorporate the functional test.

In General Care Corp. v. Olsen, the Supreme Court of Tennessee held that capital gains realized when a corporation liquidated four subsidiary corporations were nonbusiness income.(18) The taxpayer owned and operated nursing homes and hospitals, some outright and some through subsidiary corporations. Neither the taxpayer nor any of its subsidiaries had ever sold a hospital outright to an unrelated party, although minority interests had occasionally been sold to physicians. In connection with an acquisition of the taxpayer by the Hospital Corporation of America (HCA), it liquidated its four hospital management subsidiaries, receiving their assets, and then merged into an HCA subsidiary in a transaction that was treated for income tax purposes as a taxable sale and liquidation. The court held, at the taxpayer's request, that the resulting income was nonbusiness income. It said that the functional test had no basis in the statutory language. Looking at the second clause of the UDITPA definition, which the Department of Revenue insisted adopted the functional test, the court noted that the word "disposition" was preceded by the word "and," not by the word "or." From this, the court concluded:

The disposition, as well as the acquisition and management of property must be an integral part of the taxpayer's regular trade or business operations in order to produce business earnings.(19)

Citing general principles of statutory construction to the effect that statutes should be read to give every word meaning and not to make any word superfluous, the court held that gain from the sale of property that was used in the taxpayer's business was not business income unless the property's disposition as well as its use was a regular incident of the taxpayer's business.(20) The court cited Western Natural Gas and McVean & Barlow in support of its analysis.

Several years later, the Department of Revenue tried again, but fared no better. In Federated Stores Realty, Inc. v. Huddleston, the Tennessee Supreme Court held that gains from the sales of shopping centers pursuant to a decision by a retailer to discontinue its real estate operations were nonbusiness income.(21) The court quoted extensively from its earlier opinion in General Care and held that it saw no reason to change its mind. It reaffirmed that view in Union Carbide Corp. v. Huddleston.(22)

The Department of Revenue concluded that it would get no relief from the courts, and it turned to the legislature. It succeeded in having the statute amended to incorporate the functional test expressly. This was done by separating the two parts of the UDITPA definition into independent parts and by changing the word "and" before the word "disposition" to "or." The revised statute reads, as follows:

"Business earnings" means (1) earnings arising from transactions and activity in the regular course of the taxpayer's trade or business or (2) earnings from tangible and intangible property if the acquisition, use, management or disposition of the property constitutes an integral part of the taxpayer's regular trade or business operations.(23)

The Supreme Court of Iowa has recently criticized the functional test. In Phillips Petroleum Co. v. Iowa Department of Revenue and Finance, the court held that the taxpayer's gain on the sale of oil and gas-producing properties in order to finance a buy-back of its stock to defend against a hostile takeover was nonbusiness income. The court expressed its disapproval of the functional test, but it did not reject it outright:

Cases from other jurisdictions, while occasionally according lip service to a second (functional) test, quite uniformly reject it as a vehicle for allowing taxation under circumstances similar to those here.(24)

Having said this, the court observed that the test for determining business income was "basically transactional, existing largely though not exclusively in those situations described by the first sixteen words" of the statute.(25) The court then said that the income on the sale was business income under neither the functional test nor the transactional test. In the sentence immediately proceeding this conclusion, however, the court noted that the assets that were sold were held "for purposes of petroleum production, not for trading purposes," thus suggesting that it was thinking in terms of the transactional test even as it was saying that the functional test would not produce a different result.(26)

B. Sales as Principal Business Activity

The clear and easy case for the application of the transactional test is the sale of inventory to customers in the ordinary course of the corporation's business. When the property sold is not inventory, the courts applying the transactional test have often differed on its scope.

In McVean & Barlow, Inc. v. New Mexico Bureau of Revenue, the court appeared to take a narrow view of the statutory language.(27) The court held at the taxpayer's request that gain from the sale of pipeline equipment was nonbusiness income. The taxpayer's business involved two types of pipelines, one with small diameters and one with large diameters. In 1973, in connection with a restructuring of the corporation, it sold the equipment that was used in the large diameter pipelines. The taxpayer regularly bought and sold equipment of the type that was sold in the normal course of replacing used or scrap equipment to buy new equipment. The court nevertheless held that the taxpayer "was not in the business of buying and selling pipeline equipment and, in fact, the transaction in question was a partial liquidation of taxpayer's business and a total liquidation of taxpayer's big inch business."(28) The court appeared to view the transactional test as requiring that the property sold be the property that the taxpayer was in business to sell. It was not enough that the taxpayer regularly sold such property in its business. This narrow approach, if generally followed, could limit the application of the transactional test to inventory and similar property.

Similarly, in Federated Stores Realty, Inc. v. Huddleston, the Supreme Court of Tennessee, in holding that gains from the sale of shopping centers were nonbusiness income, said that the taxpayer was not in the business of selling real estate, noting that its principal business activity was to own and lease shopping centers to retailers, including its corporate parent.(29) The court said that sales were not in the regular course of a corporation's business unless they were "steady or uniform in course, practice, or occurrence, not subject to unexplained or irrational variations; steadily pursued, ... returning, recurring, or received at stated, fixed or uniform intervals."(30)

In Phillips Petroleum Co. v. Iowa Department of Revenue and Finance, the court suggested that a primary purpose test might apply.(31) The parties stipulated that the taxpayer occasionally sold assets of the type in question, but the court pointed out that its purpose in holding the assets was to produce petroleum and not to sell the property. It is possible to infer the existence of a primary purpose component to the transactional test from this analysis, though the court purportedly applied the functional test in this part of the opinion.

It is not clear that a primary purpose test would be proper. Recall the automobile dealer who sells demonstrator models. Cars that are used as demonstrators for six months and then sold are arguably acquired for the primary purpose of being used as demonstrators, but the fact that the taxpayer intends to sell them eventually and always does so suggests that their sale is a normal and recurring aspect of the business and that the dealer's income on their sale should be business income under the transactional test.

A narrow application of the transactional test was also suggested by the Supreme Court of New Mexico in Champion International Corp. v. New Mexico Bureau of Revenue, which held that the statutory language referred to:

business deals and the performance of a specific function in the normal, typical, customary accustomed policy or procedure of the taxpayer's trade or business.(32)

Other cases applying the transactional test have adopted a broader reading of the statutory language. For example, in Atlantic Richfield Co. v. The State of Colorado, the court held that the sale of assets acquired in a merger with another corporation in order to avoid antitrust problems produced business income.(33) The taxpayer was a large integrated oil company that was engaged in the business of exploring for, producing, refining, and marketing crude oil and other petroleum products. It merged with another company that was engaged in the same business and, in order to forestall an expected antitrust challenge from the federal government, it agreed to sell all of its properties in the Northeastern United States to an unrelated competitor. Nevertheless, the Justice Department brought an action to prevent the merger. The taxpayer then amended the original sale agreement to sell to the buyer properties in the Southeastern United States and to sell substantially all of its assets in other regions within three years. As a result, the Justice Department withdrew its objections and the merger closed. The sale of the properties occurred on the same day as the merger.

Even though the company was not in the business of buying and selling the assets in question, the court said that sales of large blocks of assets were common in the business and for the taxpayer in question. It pointed out that during the 12-year period preceding the tax litigation the company was involved in 15 major purchases or mergers and 11 sales of corporations or large blocks of assets. The court noted that sales of assets to meet antitrust requirements were common in the business. Even though the company was not in business to sell the assets in question, their sale was such a normal incident of the business that it was deemed to produce business income.

In Welded Tube Co. of America v. Commonwealth of Pennsylvania, the court held at the taxpayer's request that gains from the sale of a manufacturing facility and machinery and equipment were business income.(34) Even though the taxpayer had disposed of real property only twice over its 30-year history, the court said that it was not necessary that the transactions occur in the regular course of the taxpayer's "principal business."(35) The taxpayer's "regular practice" was to acquire property as its business expanded and the sale was viewed as a normal incident of the taxpayer's business. The court noted that the business was not liquidated and that the sale proceeds were reinvested in the business. The opinion suggests that the functional tax was being applied, but the court said that it was applying both tests and that the income was business income under each of them.

The transactional test can result in business income even if the particular transaction is uncommon, as long as it is of a type that is not unusual. In Tipperary Corp. v. New Mexico Bureau of Revenue, the sale of a coal lease to an oil company was held to produce business income to a corporation that was in the business of developing oil and gas properties where the taxpayer had not previously sold a coal lease but had often disposed of other types of leases and other kinds of property.(36)

One common type of transaction that, surprisingly, has never been addressed by the courts is the bulk sale of inventory. Inventory is defined as property that is held for sale to customers in the ordinary course of business and its sale in the ordinary course of business produces business income under the transactional test. If a corporation's income is sold in bulk to a buyer of the business and not to customers in the ordinary course of business, how should the income be treated? If the theory of the transactional test is that the nature of the transaction controls the characterization of income and not the nature of the property that is sold, gain from a bulk sale of inventory should be nonbusiness income.

There is precedent in the federal tax area for treating a bulk sale of inventory as other than income in the ordinary course of business. Under prior law, a corporation's gain on the sale of property was exempted from tax if the corporation adopted a plan of liquidation, sold property, and liquidated within a year after the plan's adoption.(37) Although gains on the sale of inventory during this period were not exempted from tax if the inventory was sold in the ordinary course of business, the exemption did apply to the sale of all of the corporation's inventory in bulk to a single buyer. The concept continues in section 453(h) of the Internal Revenue Code, which permits the use of the installment method of reporting gain when a corporation sells property and liquidates.

One can argue that gain from the sale of inventory, which was held to produce business income by its sale in the ordinary course of business, should not be converted to nonbusiness income because the inventory is sold in a bulk sale and not in the ordinary course of business. On the other hand, the buyer who buys inventory in bulk will not pay the full retail price because it will want to resell the inventory to its customers at a profit. That profit will be business income. Nevertheless, the fact remains that a bulk sale of inventory from the initial holder to a new holder results, under a literal application of the transactional test, in a conversion of part of the spread between the initial holder's cost and the retail price from business income to nonbusiness income.

C. Factors Used in Applying the Transactional Test An important factor in applying the transactional test is the frequency of sales of similar property. When sales occur often and on a regular recurring basis, there is a strong inference that the transaction in question is "in the regular course of the taxpayer's trade or business" within the meaning of UDITPA. Courts applying the transactional test have often held that the infrequency of transactions suggests that the resulting income is nonbusiness income.

In Ross-Araco Corp. v. Commonwealth of Pennsylvania, the taxpayer's gain on the sale of a tract of land was held to be nonbusiness income.(38) The taxpayer was in the construction business. It bought a 24.5-acre parcel of land and used a building on a fenced 3-acre portion of the parcel to store equipment and materials used in the construction business. The remaining 21.5 acres were wooded and undeveloped. The taxpayer sold the 21.5 acre tract and invested the proceeds in U.S. Treasury notes.

In concluding under the transactional test that the sale of the real estate produced nonbusiness income, the court noted that the corporation had sold only 2 parcels of real estate in its 31-year history. Similarly, in Associated Partnership I, Inc. v. Huddleston, the court held that the lack of frequent and regular recurring sales (i.e., the taxpayer had never sold similar assets before) evidenced, under the transactional test, that income on the sale of property was nonbusiness income.(39) On the other hand, if sales of similar property have not been uncommon in the taxpayer's business, the sale may produce business income even if the property sold is not of the type that the taxpayer is primarily in business to sell.(40)

In assessing the frequency and regularity of sales, it is necessary to examine the nature of the property sold. In Welded Tube Co. of America v. Commonwealth of Pennsylvania, the Department of Revenue argued that gain from the sale of the taxpayer's manufacturing plant was not business income because the taxpayer had disposed of real property only twice in the course of its 30 years in business. The court rejected this argument but its rationale is unclear. The court explicitly stated that the gain was business income under both the transactional and the functional tests, yet its rejection of the revenue department's argument that the infrequency of sales prevented the transactional test from being met was framed in terms of the functional test. The court observed that the corporation frequently acquired property in the expansion of its business and "that such property constituted an integral part of its business operations and that its disposition generated business income."(41)

Courts applying the transactional test have generally held that a sale in connection with the liquidation of a business produces nonbusiness income because the liquidation represents the winding up of the business and can hardly be said to be a normal incident of the business. Although most (perhaps all) businesses are liquidated at some time or another and do not last forever, a liquidation is not what companies are in business to do, either primarily or secondarily. Hence, a sale pursuant to the liquidation of a business can in no sense be said to be a normal incident of the business. As the court in Western Natural Gas Co. v. McDonald said, a sale in connection with a liquidation of a business "contemplated cessation rather than operation of the business."(42)

The court reached a similar conclusion in McVean & Barlow, Inc. v. New Mexico Bureau of Revenue,(43) even though the corporation liquidated only one of its two businesses and continued to conduct the other business, which was similar in nature to the one that was liquidated. The dissenting opinion in McVean argued that the case involved only a partial liquidation and that it was therefore distinguishable from Western Natural Gas.

The courts sometimes refer to the use of the sale proceeds, holding that a failure to use the sale proceeds in the business indicates that the sale did not produce business income. In some cases, the failure to use the proceeds in the business is viewed as evidence that the business was liquidated.(44) On the other hand, the reinvestment of sale proceeds in the business has been held to support treatment of the gain on the sale as business income.(45)

Some courts seemingly regard the use of the sale proceeds as an independent factor and not merely evidence of whether a liquidation had occurred. In General Care Corp. v. Olsen, the court said that "[u]nder the transactional test, earnings held for use in the regular course of on-going business operations or expended to acquire assets to be used in the regular course of future business activities, have been held to be properly apportionable as business income."(46) In Union Carbide Corp. v. Huddleston, the court held that a factor pointing to nonbusiness income treatment was whether the sales proceeds were distributed to the corporation's shareholders rather than being reinvested in the business.(47) The court in Ross-Araco Corp. v. Commonwealth of Pennsylvania reached a similar conclusion, although it is not clear whether it was right on the facts.(48) The corporation was a general and mechanical contractor and reinvested the proceeds from the sale of land in U.S. Treasury notes. The court did not seem to have considered the possibility that the proceeds might have been needed to be held in that form to meet bonding requirements.

On the other hand, the Supreme Court of Arkansas in Pledger v. Illinois Tool Works, Inc. said that the fact that money from the sale of land might have been used in the corporation's business did not require that the sale be treated as producing business income.(49)

One factor pointing toward nonbusiness income treatment under the transactional test is whether the sale in question is an extraordinary or unusual transaction. The transactional test in general is based on the assumption that business income should be limited to income arising in the ordinary course of the corporation's business. If a sale is prompted by an extraordinary need for funds that has nothing to do with the company's normal business operations, it is reasonable to conclude that under the transactional test the resulting income should be nonbusiness income.

In Union Carbide Corp. v. Huddleston, the court held that the taxpayer's income from selling seven profitable lines of business and its corporate headquarters was nonbusiness income.(50) The sales were pursuant to a restructuring program that was required by financial difficulties resulting from the highly-publicized accident in Bhopal, India, in which gas escaping from a Union Carbide storage tank caused many deaths and much damage. As a result of the accident, class action lawsuits were brought against the company and the lawsuits were eventually settled by a payment by Union Carbide of $470 million. The company also needed money to make a tender offer to repurchase its own shares from the public in order to resist a hostile tender offer from G.A.F. Corporation. Although Union Carbide had bought and sold many businesses, the court held that the transactions in question were highly unusual. They involved a complete discontinuance of seven lines of business, all of which had been profitable. In the past, the company had sold only unprofitable operations. Moreover, the sales proceeds were not used in business operations but were used to make payments to the Union Carbide shareholders and to the plaintiffs in the lawsuits. Interestingly, although the court referred to the unusual nature of the sales in the course of its factual discussion, it did not refer to it in discussing the application of the transactional test. It might well have done so. It is hard to imagine a more unusual set of circumstances, and it would seem eminently reasonable to regard that as a factor pointing to nonbusiness income.

Phillips Petroleum Co. v. Iowa Department of Revenue and Finance also involved a sale of property under unusual circumstances.(51) The taxpayer was threatened with a hostile takeover attempt. It responded by buying back a substantial amount of its common stock from its public shareholders. It borrowed the money to finance the repurchase and, in order to retire the debt, it sold oil and gas-producing properties, producing revenues of about $2 billion. Even though the property was of a type that the taxpayer occasionally sold in the ordinary course of its business, the court was influenced by the extraordinary nature of the particular sale, describing it as "clearly a once-in-a-corporate-lifetime occurrence."(52)

The analysis of the Iowa court in Phillips Petroleum (and, arguably, that of the Tennessee court in Union Carbide) suggests that it might have found the sale to produce nonbusiness income even if it had been of inventory or other property that was routinely sold in the ordinary course of the corporation's business.

Courts applying the transactional test have been influenced by the size of the transaction, holding that a sale's being unusually large suggests that the transaction is not in the normal course of the taxpayer's business. The court in Union Carbide was clearly influenced by this consideration.(53) It stated that the proceeds of the sale were 12 times greater than any other divestiture in a single year and more than four times greater than the aggregate value all other divestitures in the 13 preceding years. Even though the company had regularly bought and sold businesses and large blocks of assets, the sales in question were so unusual and of such a magnitude that they could not be held to be in the regular course of business.

Similarly, in Phillips Petroleum the court noted that, although the company had previously sold assets of the type sold during the taxable year at issue, no prior sales "approached the magnitude" of the sales in question.(54) For the three years before the disposition program, Phillips had sold no oil reserves and only small amounts of natural gas reserves. The sales in question resulted in decreasing its developed oil and gas acreage by 16 percent and its undeveloped acreage by 39 percent. It resulted in a 25-percent reduction in the number of its employees.

In none of these cases has the courts suggested that sales must be large, extraordinary, or nonrecurring to result in nonbusiness income. They have, however, held that sales that are so described will result in nonbusiness income.

D. Planning Under The Transactional Test

The foregoing cases suggest some planning opportunities with respect to the transactional test, although obviously they must yield to business considerations. For example, if the taxpayer wishes to avoid business income characterization, it is helpful to aggregate sales. If a series of sales are made at the same time and, arguably pursuant to the same transaction, they are more likely to result in nonbusiness income than if they are spread over time and each sale by itself is relatively small in size.

Nonbusiness income characterization under the transactional test is facilitated by a business structure in which the taxpayer's operations are conducted by different corporations rather than by unincorporated divisions of a single corporation. If combined reports are not required of separate subsidiaries, the activities of one corporation will likely not be imputed to another and any corporation in the group will be able to sell assets and have the sale treated as resulting in nonbusiness income even though other related corporations sell similar assets in the ordinary course of their business. The Tennessee Department of Revenue in Associated Partnership I, Inc. v. Huddleston argued that, in applying the transactional test, the court should properly look at the activities of all of the related corporations and not just of the taxpayer.(55) The court rejected this argument, concluding that the statute required each corporation to compute its separate tax liability and that the Department had the power to combine both reports if that was appropriate.(56)

V. Cases Applying The Functional Test

Several courts have applied the functional test in determining whether income was business income. Although none of them holds that the functional test is the sole test, they all conclude that it is an additional test that may result in income being treated as business income even if it is not so classified under the transactional test. The courts that have applied the functional test have not challenged the statutory analysis of the courts that have held that the conjunctive nature of UDITPA (the word "and" preceding the word "disposition") requires that the disposition of property must be a regular part of the corporation's business for the sale to result in business income. Rather, they have simply assumed that the second clause in UDITPA incorporates a second independent test. The statement of the court in National Realty and Investment Co. v. Illinois Department of Revenue is typical:

The second clause of the statutory definition sets out an alternative, functional test, under which all gain from the disposition of property is considered business income if the property disposed of was used by the taxpayer in its regular trade or business operations.(57)

In District of Columbia v. Pierce Associates, Inc., the court held that insurance proceeds received by the taxpayer for flood damage to its manufacturing plant was business income.(58) The court described the first clause of the UDITPA definition as reflecting the transactional test and the second clause as reflecting the functional test. The court initially held that UDITPA encompassed only the transactional test and that the insurance payments were not business income because the taxpayer was not in the business of selling real estate.(59) When the case came back to the court a second time, however, it reconsidered its earlier view and reached a contrary conclusion, holding that the second clause of the definition was an alternative to the transactional test and not a supplement to it:

If the property had an integral function in the taxpayer's unitary business, its income properly can be apportioned and taxed as business income, even though the transaction itself does not reflect the taxpayer's normal trade or business.(60)

The Pennsylvania courts have also adopted the functional test. In Welded Tube Co. of America v. Commonwealth of Pennsylvania, the court held that gains from the sale of a manufacturing facility and equipment were business income.(61) The taxpayer decided to close down a manufacturing facility that had been incurring losses and it sold the building and the machinery and equipment at a gain. The court had little difficulty in concluding that under the functional test the income was business income.(62) In Ross-Araco Corp. v. Commonwealth of Pennsylvania, the court applied both the transactional and functional tests, holding that the sale of undeveloped land did not produce business income because the land was held as a passive investment and was not used in the company's business. The Department argued that the land had been used in the business because it was carried on the taxpayer's balance sheet and was pledged to obtain performance bonds from insurance companies. The court rejected this argument, emphasizing that the land was listed on the balance sheet at its original cost of $11,099, an insignificant amount in the context of the taxpayer's total assets, which ranged from about $4 million to about $15 million during the years preceding the sale. Therefore, this did not rise to the level of a "use" of property in the taxpayer's business.(63)

Laurel Pipe Line Co. v. Commonwealth of Pennsylvania presented an interesting application of the functional test.(64) The court held that the taxpayer's gain on the sale of an interstate pipeline that had been idle for three years was nonbusiness income that had to be allocated entirely to Pennsylvania and could not be apportioned, as requested by the taxpayer. Laurel was engaged in the business of transporting refined petroleum products through a pipeline that it owned and operated. As a result of changing distribution patterns and insufficient volume, the company discontinued operation of one of its pipelines and later sold the pipeline along with related assets. The proceeds were distributed to its stockholders as a dividend and were not used to acquire other assets for use in the business. The parties agreed that the sale would not produce business income under the transactional test, and the only issue in the case was whether the income from the sale was business income under the functional test. The pipeline had been idle for more than three years, and the court concluded that it was not an integral part of Laurel's regular business but was merely sold pursuant to a liquidation of part of its assets. Curiously, although the court said that it was applying the functional test, its analysis is consistent with the application of the transactional test. The court even recognized that the placement of the word "and" before the word "disposition" in the statute meant that the disposition of property had to be an integral part of the taxpayer's business.

It is hard to disagree with the court's conclusion in Laurel, but a variation in the facts presents an interesting situation. The pipeline in question had produced revenue for the taxpayer in the past, but it had not done so for three years. If it had been sold while it was producing revenue, clearly a functional test analysis would conclude that the resulting gain was business income. The same result would probably be reached if it had been sold immediately after its business use was discontinued. On the other hand, if it had not been used in the business for 100 years before the sale, no one could reasonably argue that a functional test analysis would conclude that the sale produced business income. The MTC regulations include a less-extreme example, which provides that a taxpayer that sells a plant 18 months after closing it and putting it up for sale realizes business income. They do not address what period of dormancy, if any, would change the result.(65)

Several cases have held that gain from the sale of the entire assets of an operating business was business income under the functional test, even though the proceeds were invested in passive investments and even though the transaction would not have resulted in business income under the transactional test.(66) The Arizona Department of Revenue has adopted the functional test, holding that gain from the sale of real estate that is used in the taxpayer's business is business income even if the taxpayer is not a dealer in real estate.(67)

On the other hand, property that is held as a passive investment and not used in the corporation's business produces nonbusiness income even under the functional test. In Pledger v. Illinois Tool Works, Inc., the Arkansas court held, at the taxpayer's request, that the sale of stock in two corporations, undeveloped real property, U.S. Treasury notes, and foreign currency produced nonbusiness income.(68) The court said that the real estate was a passive investment that was not used in the taxpayer's business, explaining that the property was located in Chicago and was not an integral part of the taxpayer's manufacturing and leasing businesses, which were carried on in Arkansas. In Pledger v. Getty Oil Exploration Co., another Arkansas case, the court held that managing a promissory note was not part of the corporation's business and that its sale produced nonbusiness income, even though the note was received in payment for assets that, if sold directly, would have produced business income under the functional test.(69)

In National Realty and Investment Co. v. Illinois Department of Revenue, the taxpayer unsuccessfully argued that gain from the sale of real estate was nonbusiness income.(70) Although the court accepted the functional test, it held that the taxpayer failed to meet its burden of proof because the only evidence that it introduced were financial statements and corporate documents relating to the sale of the property. Nothing in the record addressed the use to which the property had been put before its sale.

There have been hints in some cases that the functional test is limited to fixed assets that are used in the taxpayer's business. In In the Matter of Ashland Oil, Inc., the Iowa State Board of Tax Review held that the taxpayer's gain from the sale of stock in a coal company was nonbusiness income.(71) Although citing the Phillips Petroleum case, which appeared to hold that the controlling standard was the transactional test, the Board examined the transaction under both the transactional test and the functional test and held that under neither test was the income business income. The Board applied a curious version of the functional test, describing it as "involving disposal of fixed assets by taxpayers who emphasize the trading of assets as an integral part of regular business."(72) It said that the assets sold (stock in a coal company) were not an integral part of Ashland's business and, hence, that the functional test was not met.

In fact, nothing in the statutory language limits the functional test to the sale of fixed assets. The sale of any asset used in the taxpayer's business can and should be subject to the test.

An issue can arise under the functional test about the treatment of the sale of marketable securities that are held as working capital. Although marketable securities are classic investment assets, amounts held in a working capital reserve are held for use, or to produce funds for use, in the business at an early time. They typically are not long-term investments. Their sale should produce business income under the functional test.

The sale of marketable securities inevitably leads into the seemingly impenetrable thicket of the constitutionality of taxing sales of corporate stock. The treatment of the sale of stock of affiliated corporations has been extensively litigated. The Supreme Court of the United States has held, and recently reaffirmed, that gain or loss from the sale of such stock can be apportionable business income only if the corporation is engaged in a unitary business with the seller.(73) The Supreme Court in ASARCO, Inc. v. Idaho State Tax Commission said that there was no significant distinction in constitutional terms between dividend and interest income on the one hand and gains from the sale of stock on the other. It concluded that gains from the sale of stock of affiliated corporations were subject to the unitary business principle.(74) In Allied-Signal, Inc. v. Director, Division of Taxation, the Supreme Court reaffirmed the significance of the unitary business principle but carved out an exception for the sale of stock if holding the stock served an "operational" rather than an investment function.(75)

The treatment of working capital under the operational test is uncluear. Working capital is obviously held for business purposes. On the other hand, a corporation's decision to invest its working capital in marketable securities is an investment decision and not a business decision. The decision to buy a particular security is similarly an investment decision. Still, securities held in a working capital reserve serve an operational function (and not an investment function) and gain from their sale should not be precluded from business income treatment just because the issuers of the securities are not engaged in a unitary business with the taxpayer. The Constitution should not pose an impediment to the treatment of such gain as business income, and the gain's characterization as such should be determined under the functional test or the transactional test. The MTC regulations provide that income of any kind is business income "if it arises from transactions and activity occurring in the regular course of a trade or business" and it seems clear that under the MTC approach gain from the sale of securities that are held as part of a working capital reserve would be business income.(76)

None of the post-Allied-Signal cases has addressed the application of the operational exception to working capital reserves.(77)

VI. Analysis

As a matter of pure statutory interpretation, the proponents of the view that the transactional test is the exclusive test under UDITPA have the better of the argument. The functional test may seem reasonable as a matter of tax policy, but it is hard to extract it from the language of the statute, inasmuch as the disposition of property under either the first or the second clause of the UDITPA definition of business income must be a normal incident of the business. The literal language of the second clause of the definition provides that gain from the sale of property will be business income only if the property's "disposition" is an integral part of the taxpayer's business. The word preceding the word "disposition" is "and"--not "or"--and it seems clear as a matter of statutory interpretation that the mere use of the property in the business is not enough to convert gain from its sale into business income. Property that is not regularly disposed of, but rather is held indefinitely, does not fit within the definition. The careful reading of the statute by the Tennessee court in General Care is persuasive.

Arguably, the word "disposition" could be interpreted to include the discarding of property when its useful life has ended or its sale as scrap, but such a construction seems to be stretching the point. The thrust of the statute is that disposing of the property must have something to do with the taxpayer's business and a reasonable inference is that the disposition must be viewed by the taxpayer as an income-producing activity, even if it is not part of the taxpayer's principal income-producing activity. While it would not be unreasonable to argue that selling used property and equipment for something, however little, contributes to the taxpayer's revenue and can be viewed as part of the taxpayer's business, it is hard to say that such transactions are an "integral" part of the business.

Nevertheless, taxpayers clearly should assume that both tests will have to be addressed, particularly in States that have adopted the MTC regulations. Although the regulations do not have the force of law, regulations are generally presumed to be correct. The presumption can, of course, be overcome, and taxpayers seeking to do so can point to the decision of the Kansas Supreme Court in Chief Industries, which addressed the validity of the regulations and held that they improperly interpreted the statute.(78)

From a policy standpoint, the functional test has some appeal. The distinction between business and non-business income is really a distinction between business and investment income. If assets are held to produce business income, they are on the business side of the corporation's leger; their sale should arguably produce business income, even if it is unusual and not part of normal business operations. However attractive the argument, the drafters of UDITPA did not reflect it in their statute, and proponents of the functional test may have to take their battle to the legislatures rather than to the courts.

Notes

(1)UDITPA [sections] 1(a).

(2)UDITPA [sections] 1(e).

(3)Laurel Pipe Line Co. v. Commonwealth of Pennsylvania, 527 Pa. 205, 642 A.2d 472 (1994).

(4)UDITPA [sections] 1(a).

(5)UDITPA [sections] 1(a).

(6)Atlantic Richfield Co. v. State of Colorado, 198 Col. 413, 417, 601 P.2d 628, 631 (1979).

(7)MTC Reg. [sections] IV.I.(a).

(8)MTC Reg. [sections] IV.1(c).(2).

(9)654 S.W.2d 865, 867 (Mo. 1983). The court held that the subsidiaries the stock of which was sold were not engaged in a unitary business with the taxpayer and, hence, that the Due Process Clause of the United States Constitution prohibited the gain from being apportionable business income.

(10)255 Kan. 640, 875 P.2d 278 (1994).

(11)Western Natural Gas Co. v. McDonald, 202 Kan. 98, 446 P.2d 781 (1968).

(12)Kan. Admin. Regs. [sections] 92-12-73.

(13)The court pointed out that the legislature in Tennessee had reversed similar holdings by the Tennessee courts interpreting an identical statute by changing the Tennessee statute but that the Kansas legislature had not seen fit to take similar action. See note 23 infra and accompanying text.

(14)The dissent's argument is not persuasive. It may well be that the drafters of UDITPA had the functional test in mind, but the question before the court was whether they reflected it in the statute and whether the MTC regulations correctly interpreted the statute. If a court concludes that the regulations as adopted by a particular State do not properly interpret the language of the statute as adopted by that State, its proper response, while giving due deference to the presumptive correctness of regulations, is to overturn them. The MTC is not a legislative body and the interest in uniformity among the different States does not extend to sanctioning uniformly incorrect interpretations of the statute.

(15)202 Kan. 98, 446 P.2d 781 (1968).

(16)202 Kan. at 101, 446 P.2d at 783.

(17)88 N.M. 521, 543 P.2d 489 (N.M. Ct. App.), cert. denied, 89 N.M. 6, 546 P.2d 71 (1975).

(18)705 S.W.2d 642 (Tenn. 1986).

(19)705 S.W.2d at 646.

(20)The court had little difficulty in concluding that the income was nonbusiness income under the transactional test because neither the taxpayer nor any of its subsidiaries had ever sold similar assets before.

(21)852 S.W.2d 206 (Tenn 1992).

(22)854 S.W.2d 87 (Tenn. 1993).

(23)Tenn. Code Ann. [sections] 67-4-804(a)(1)(A). The provision applies to taxable years ending after July 14, 1993. The Department continued to contest earlier years and in Associated Partnership I, Inc. v. Huddleston, the Tennessee Supreme Court reaffirmed its earlier position under the prior statute and rejected the Department's contention that the functional test should control. __S.W.2d__, 1994 Tenn. LEXIS 306 (1994).

(24)511 N.W.2d 608, 610 (Ia. 1993).

(25)Id.

(26)Id.

(27)88 N.M. 521, 543 P.2d 489 (1975).

(28)88 N.M. at 524, 543 P.2d at 492.

(29)852 S.W.2d 206 (Tenn. 1992).

(30)852 S.W.2d at 211.

(31)511 N.W.2d 608 (Ia. 1993).

(32)88 N.M. 411, 414, 540 P.2d 1300, 1303 (1975).

(33)198 Colo. 413, 601 P.2d 628 (1979).

(34)101 Pa. Commw. 32, 515 A.2d 988 (Pa. Commw. Ct. 1986).

(35)101 Pa. Commw. at 45, 515 A.2d at 994.

(36)93 N.M. 22, 595 P.2d 1212 (N.M. App. 1979).

(37)Prior I.R.C. [sections] 337, before repeal by the Tax Reform Act of 1986.

(38)644 A.2d 235 (Pa. Commw. Ct. 1994).

(39)__S.W.2d__, 1994 Tenn. Lexis 306 (Tenn. 1994).

(40)Atlantic Richfield Co. v. The State of Colorado, 198 Col. 413, 601 P.2d 628 (1979).

(41)101 Pa. Commw. Ct. 32, 45, 515 A.2d 988, 994 (Pa. Commw. Ct. 1986).

(42)202 Kan. 98, 101, 446 P.2d 781, 784 (1968). See also Associated Partnership I, Inc. v. Huddleston, __S.W.2d__, 1994 Tenn. Lexis 306 (Tenn. 1994).

(43)88 N.M. 521, 543 P.2d 489 (1975).

(44)See, e.g., Federated Stores Realty, Inc. v. Huddleston, 852 S.W.2d 206 (Tenn. 1992).

(45)See, e.g., Welded Tube Co. of America v. Commonwealth of Pennsylvania, 101 Pa. Commw. 32, 515 A.2d 988 (Pa. Commw. Ct. 1986).

(46)705 S.W.2d 642, 644 (Tenn. 1986).

(47)854 S.W.2d 87 (Tenn. 1993).

(48)644 A.2d 235 (Pa. Commw. Ct. 1994).

(49)306 Ark. 134, 812 S.W.2d 101, cert. denied, 502 U.S. 958 (1991).

(50)854 S.W.2d 87 (Tenn. 1993).

(51)511 N.W.2d 608 (Ia. 1993).

(52)511 N.W.2d at 611.

(53)854 S.W.2d 87 (Tenn. 1993).

(54)511 N.W.2d 608, 609 (Ia. 1993).

(55)__S.W.2d__, 1994 Tenn. Lexis 306 (Tenn. 1994).

(56)Nevertheless, the court discussed the activities of the related corporations and held that the transactional test would not be met even if they were included.

(57)144 Ill. App.3d 541, 554, 494 N.E.2d 924, 932 (Ill. App. Ct. 1986).

(58)462 A.2d 1129 (D.C. 1983).

(59)440 A.2d 325 (D.C. 1981).

(60)462 A.2d at 1131.

(61)101 Pa. Commw. 32, 515 A.2d 988 (Pa. Commw. Ct. 1986).

(62)The court's analysis that a similar result was reached under the transactional test is less persuasive. See text accompanying notes 34-35 and 41, supra.

(63)The court did not state whether the record showed that the insurance companies looked only at the property's cost nor indicated its actual fair market value.

(64)537 Pa. 205, 642 A.2d 472 (1994).

(65)MTC Reg. [sections] IV.1.(c)(1).

(66)Appeal of Triangle Publications, Inc., California State Board of Equalization, CCH California State Tax Reporter, 1981-84 Transfer Binder [paragraph] 400-905 (1984); L.A.F. Delaware Co. v. Director of Revenue, State of Missouri, Missouri Administrative Hearing Commission No. RI-82-0451, CCH Missouri State Tax Reporter, 1983-89 Transfer Binder [paragraph] 201-077 (1987).

(67)Corporate Tax Ruling CTR 94-9, CCH Arizona State Tax Reporter [paragraph] 300-151 (1994).

(68)306 Ark. 134, 812 S.W.2d 101, cert. denied, 502 U.S. 958 (1991).

(69)309 Ark. 257, 831 S.W.2d 121 (1992).

(70)144 Ill. App.3d 541, 494 N.E.2d 924 (Ill. App. Ct. 1986).

(71)Docket No. 693, CCH Iowa State Tax Reporter [paragraph] 200-854 (1994).

(72)CCH Iowa State Tax Reporter at 11,732.

(73)See, e.g., ASARCO, Inc. v. Idaho State Tax Commission, 458 U.S. 307 (1982); F.W. Woolworth Co. v. Taxation and Revenue Department, 458 U.S. 354 (1982); Allied Signal, Inc. v. Director, Division of Taxation, 112 S. Ct. 2251 (1992). A discussion of the circumstances in which a unitary business will be found is beyond the scope of this article.

(74)458 U.S. at 330.

(75)112 S. Ct. 2251 (1992).

(76)MTC Reg. [sections] IV.1.(a). The MTC regulations would treat gain from the sale of stock of an affiliated corporation as business income regardless of whether the two corporations were engaged in a unitary business. In some circumstances, this approach may run afoul of the unitary business principle as prescribed by the Supreme Court.

(77)The California State Board of Equalization has held that stock of a 20-percent-owned corporation was held for operational purposes and that gain from its sale was business income where the seller acquired and later sold the stock of a corporation that did contract manufacturing for it in a new marketing area. CTS Keene, Inc., CCH California State Tax Reporter [paragraph] 402-589 (1993).

(78)255 Kan. 640, 875 P.2d 278 (1994).
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Date:May 1, 1995
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