United States: Oregon Tax Court Rules On Business Income And Sales Factor Issues Arising From Sale Of Subsidiary Stock

The Oregon Tax Court has held that gains from the taxpayer's sales of its subsidiaries' stock must be included in the taxpayer's Oregon sales factor denominator and excluded from the numerator for purposes of apportionment.¹ For the years at issue, the Tax Court concluded that the taxpayer's sales of stock of its subsidiaries constituted business income and therefore was properly includable in the sales factor denominator.

Background

The taxpayer (Oracle), a Delaware corporation with a California commercial domicile, develops database and application business software for computers. In the 1980s, Oracle began selling software to Oracle Japan, a Japanese corporation that was owned by two Oracle subsidiaries, Oracle Japan Holding, Inc. and Oracle International Investment Corporation. In 2000, after Oracle Japan became a publicly traded business in Japan, Oracle Japan Holding, Inc. sold 10 percent of its Oracle Japan stock. The exchange took place in Japan and the decision to sell the interest in Oracle Japan was made in California. There was no Oregon activity related to this sale. Oracle reported capital gains for these sales on its federal consolidated returns but not for its Oregon corporate excise (income) tax returns.

Another company (Liberate), formed in 1995 as a division of Oracle, was in the business of developing and licensing software. Before Liberate engaged in an initial public offering (IPO) of its stock in July 1999, Oracle owned more than 50 percent of Liberate stock. Over the next two years, Oracle sold some of its Liberate stock holdings and reported the capital gains for federal income tax purposes but not for Oregon corporate excise tax purposes. The Oregon Department of Revenue issued notices of assessment of tax on the gains from the sales of the Oracle Japan and Liberate stock.

Gain from Sale of Oracle Japan Stock

The first issue that the Oregon Tax Court addressed was whether the gain from the sales of stock in Oracle Japan should be excluded from the sales factor denominator for apportionment purposes.² For the tax years at issue, Oregon used a three-factor formula for apportioning business income, which was comprised of a property factor, a payroll factor, and a double3weighted sales factor.³ In calculating the Oregon sales factor,⁴ sales are statutorily defined as all of a taxpayer's gross receipts that are not allocated under Oregon law.⁵ Excluded from the definition of "sales" are "gross receipts arising from the sale ... of intangible assets, including but not limited to securities, unless those receipts are derived from the taxpayer's primary business activity."⁶ However, the term "sales" does include "net gain from the sale, exchange or redemption of intangible assets not derived from the primary business activity of the taxpayer but included in the taxpayer's business income."⁷

The Department contended that, under an Oregon administrative rule, the gain should be excluded from both the sales factor numerator and denominator of the apportionment formula because the sale of the Oracle Japan stock occurred outside Oracle's regular course of business (which was the sale of software).⁸ The Tax Court determined that the administrative rule cited by the Department conflicted with the statute allowing for the inclusion of net gains from intangibles that were not derived from the taxpayer's primary business activity but included in its business income. Therefore, the Tax Court declared the administrative rule invalid, concluding that the gain must be included in the sales factor denominator because the income was business income under the "functional test," even though it was not derived from the taxpayer's "primary business activity."

The Tax Court then considered whether it had the discretionary authority to exclude the gain from Oracle's sales factor anyway. Under Oregon law, a taxpayer may petition for, and the Department may permit, or the Department may require, that one of a number of alternative apportionment methods be used if application of the standard apportionment provisions does not fairly represent the taxpayer's business activities within the state.⁹ However, the Tax Court reasoned that this provision does not give itself the power to reapportion a taxpayer's income because this power is limited to the Department.

Gain from Sale of Liberate Stock

With respect to the gain derived from the sales of Liberate stock, the Tax Court considered whether such gain was unitary income, whether such gain was business income, and how such income would be treated for apportionment purposes. On the unitary issue, the Department claimed that following the Liberate IPO, Oracle and Liberate remained part of a unitary business during the period in which several sales of Liberate stock occurred. Oracle insisted that after the IPO, they were no longer unitary and that Oracle did not hold the stock as part of its unitary business.

Under the applicable Oregon statute, a unitary business is "a corporation or group of corporations engaged in business activities that constitute a single trade or business."¹⁰ Prior to the IPO, Oracle owned roughly 59 percent of Liberate's stock. Further, Liberate's business focus was on personal consumer products that used Oracle's software. Additionally, Liberate's board of directors included Oracle's CEO and CFO. These facts indicated centralized management, economies of scale, and functional integration – the three factors necessary under the U.S. Supreme Court's decisions in Container Corp.¹¹ and Mobil¹² to show that two corporations are engaged in a unitary business. Accordingly, the gains were considered to be generated by the unitary business.

The Tax Court then addressed whether the gains constituted business income. Under the functional test, business income "includes income from tangible and intangible property if the ... disposition of the property constitute[s] integral parts of the taxpayer's regular trade or business operations."¹³ Focusing on the term "disposition," the Tax Court reasoned that Oracle was in the computer software business and had purchased Liberate, a related hardware and software business.

Even if the character of its intangible property (the Liberate stock) changed to a nonbusiness use because of the IPO and change of Liberate's business model, the conditions required to be satisfied under the Oregon regulations¹⁴ to allow for a change from business to nonbusiness use were not met. The regulation at issue required that the property could be converted to nonbusiness use either through the passage of a sufficiently lengthy period of time (as explained in the regulation, five years) or if the asset was removed as an operational asset and was instead held by the taxpayer's trade or business exclusively for investment purposes. As neither of these conditions was satisfied, the Tax Court held that the gain from the sale of Liberate stock was business income. The Tax Court also summarily concluded that Oregon was not constitutionally barred from taxing the gains under the federal Due Process and Commerce Clauses.

However, with respect to the apportionment issue, the Tax Court held that the gains from the sale of Liberate stock should be included in the sales factor denominator (and excluded from the numerator) for the same reasons as the gains from the sale of Oracle Japan stock.

Commentary

With respect to the gain from the sales of Oracle Japan stock, the Department argued that the gain should be entirely excluded from the sales factor denominator of the apportionment formula. This position was the only option available to the Department as the gain would not have been sourced to Oregon if includible in the sales factor, since the sourcing rule governing the sale of intangibles required the sourcing of the gain to the jurisdiction in which the income3producing activity that created the gain from the sales took place (which was outside Oregon).¹⁵

On the gain from the sale of Liberate stock, the conclusions that the gain was considered unitary income, and business income, were not surprising. In addressing the unitary relationship between Liberate and Oracle, Oracle effectively refuted its own argument that the business operations of Liberate and Oracle were completely different, by acknowledging on its form 103K that "the Company has ... expanded its technology into a number of new business areas to foster long3term growth, including application servers, internet/electronic commerce, interactive media and network computing." Further, a finding of nonbusiness income was unlikely to come after the Department and the Tax Court took careful notice of how Oracle classified the gain as business income in California, but not in Oregon during the same tax years at issue. However, the Department's victory on classifying the gains as unitary and business income may well have been muted, as the apportionment treatment of the transactions might have diluted the Oregon apportionment factor enough to offset, or potentially overwhelm, the tax effect of including the gains in business income.

Footnotes

1 Oracle Corp. v. Department of Revenue, Oregon Tax Court, No. TC3MD 070762C, Jan. 19, 2012.

2 Prior to considering the apportionment issue, the Tax Court explained that during the years at issue, Oracle reported gains from the sales of Oracle Japan stock on its federal consolidated corporate income tax returns, but did not include such sales as business income on its Oregon returns. Oracle reasoned that the gains did not have a connection with Oracle's business activities in Oregon so the gains should not be included in its Oregon apportionable business income. The Department disagreed with such treatment, and while Oracle did not concede that the gain should have been included in business income, Oracle chose not to contest the Department's determination the gain was includable in business income.

3 Former OR. REV. STAT. § 314.650. Oregon currently uses a single sales factor apportionment formula.

4 OR. REV. STAT. § 314.665(1).

5 OR. REV. STAT. § 314.610(7).

6 OR. REV. STAT. § 314.665(6)(a).

7 OR. REV. STAT. § 314.665(6)(b).

8 See OR. ADMIN. R. 1503314.665(1)3(A)(5).

9 OR. REV. STAT. § 314.670.

10 OR. REV. STAT. § 317.705(2).

11 Container Corp. v. Franchise Tax Bd., 463 U.S. 159 (1983).

12 Mobil Oil Corp. v. Commissioner, 445 U.S. 425 (1980).

13 OR. REV. STAT. § 314.610(1).

14 See OR. ADMIN. R. 503314.610(1)3(A)(5)(a).

15 OR. REV. STAT. § 314.665(4).

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