United States: Oregon Supreme Court Holds Gain From Sale Of Public Utilities’ Assets Constitutes Apportionable Business Income

On March 7, the Oregon Supreme Court, in two separate decisions, held that the gain realized from the sale of two multistate telecommunications service providers' assets constituted apportionable business income rather than nonbusiness income.¹ In reaching these decisions, the Court deferred to the Oregon Department of Revenue's own interpretation of its rules implementing the statute governing the taxation of public utilities.

Background

In the first case, Crystal Communications, a multistate wireless cellular telecommunications service provider, held a license from the Federal Communications Commission (FCC) to operate in designated service areas in Oregon. Between 1990 and 1999, Crystal contracted with third parties to make improvements that were intended to enhance the value of the system for its eventual sale. In June 1999, after obtaining FCC approval, Crystal agreed to sell its assets relating to its wireless cellular telecommunications services to one of the third parties. Most of the sales proceeds were allocated to various intangibles (including the FCC license), but a small portion was allocated to other assets such as cellular towers and equipment. The sale proceeds were ultimately distributed to Crystal's nonresident shareholders and Crystal ceased operations. On its Oregon excise tax return, Crystal reported the gain from the sale of its FCC license as "nonbusiness income" that it allocated to Florida, its commercial state of domicile. Upon audit by the Department, the gain was reclassified as apportionable business income and Crystal challenged the reclassification. The Tax Court granted summary judgment in favor of the Department and Crystal appealed.

In the second case, CenturyTel, a multistate public utility and unitary business that provided both wireless and wireline telecommunications, sold its assets² related to its wireless services on August 1, 2002 for approximately $1.59 billion and used $1.179 billion of that amount to finance the acquisition of wireline assets. The remainder was used to pay off certain debts. On its 2002 state income tax returns, CenturyTel reported a capital gain of over $800 million from the asset sale as "nonbusiness income" allocable to Louisiana, its state of domicile. A Department audit resulted in an adjustment based on a reclassification of the sale as "business income" and CenturyTel sought review of the adjustment in Tax Court. The Tax Court found that the gain was apportionable income and CenturyTel appealed.

Apportionment of Utilities' Income

The primary question before the Oregon Supreme Court in both cases was whether the income from the sale of the taxpayers' assets constituted apportionable "business income."³ Under Oregon tax law, two separate statutory mechanisms exist for the purpose of apportioning income earned by multistate businesses. The allocation and apportionment provisions from the Uniform Division of Income for Tax Purposes Act (UDITPA) apply to businesses other than financial organizations and public utilities.⁴ Under the special allocation and apportion statute for multistate financial organizations and public utilities ("utilities apportionment statute"),⁵ the Department is granted the authority to determine whether the income from a multistate public utility should be segregated or apportioned among the states in which the utility conducts business.⁶ However, the utilities apportionment statute does not specify a formula for apportionment or provide a method for apportioning "income from business activity."

The Department has promulgated rules to implement the utilities apportionment statute, which incorporate by reference the methods of apportioning business income established under UDITPA and two definitions of "business income" under UDITPA.⁷ With respect to the method of apportionment, under UDITPA, "business income" of a multistate taxpayer is apportioned among the several states in which the taxpayer conducts business, whereas "nonbusiness income" is generally allocated to the state of the taxpayer's commercial domicile, or if the nonbusiness income derives from property, the property's situs.⁸

With respect to the definition of "business income," the Department's utilities apportionment rule provides that two definitions drawn from UDITPA apply under the utilities apportionment statute: (i) a statutory definition and (ii) a regulatory definition.⁹ First, based on Oregon's statutory definition, "business income" is "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, the management, use or rental, and the disposition of the property constitute integral parts of the taxpayer's regular trade or business operations."¹⁰ Under the Department's general apportionment rules, however, "business income" is defined as income which includes "[g]ain or loss from the sale, exchange or other disposition of real or tangible or intangible personal property ... if the property while owned by the taxpayer was used in the taxpayer's trade or business."¹¹

Crystal argued that the regulatory definition of "business income" was broader than the statutory definition of this term. After acknowledging that the gain from the asset sales constituted business income under the regulatory definition, Crystal contended that the gain was not business income under the statutory definition. In order to decide the proper treatment of Crystal's income, the Court was required to determine whether this regulatory definition of "business income" reached further than the statutory definition and was, therefore, invalid.

Transactional and Functional Tests

In a prior decision, the Oregon Supreme Court had explained that the statutory definition of "business income" derived from UDITPA is comprised of both a "transactional test" and a "functional test."¹² Under the transactional test, business income "means income arising from transactions and activity in the regular course of the taxpayer's trade or business."¹³ Under the functional test, business income "includes income from tangible and intangible property if the acquisition, the management, use or rental, and the disposition of the property constitute integral parts of the taxpayer's regular trade or business operations."¹⁴

Crystal argued that the gain was not business income under the transactional test or the functional test. Regarding the functional test, Crystal alleged that there was a "liquidation exception" that prevented its gain from being business income. The Department did not dispute Crystal's argument that the gain was not business income under the transactional test, but disagreed with Crystal that the gain was not business income under the functional test. According to the Department, there was no "liquidation exception."

The Department urged the Court to interpret UDITPA's functional test in the same way that the California Supreme Court interpreted this test in Hoechst Celanese Corp. v. Franchise Tax Board.¹⁵ Under this interpretation, a taxpayer's acquisition, management and disposition of property includes the taxpayer's power to control the acquisition, management and disposition of the property. In addition to requiring that the property be used in the regular course of operations, the property must be an integral part of the business. The Department argued that if the statutory definition is interpreted this way, the business income rule is not broader than the functional test. Alternatively, the Department argued that the Court should defer to the utilities apportionment rule because its construction is reasonable.

Definitions of "Business Income" Were Consistent

The Court agreed with the Department that the statutory and regulatory definitions of business income could be interpreted consistently with each other. According to the Court, the interpretation of the UDITPA definition of the functional test in Hoechst was plausible. Although the Hoechst court did not decide whether there was a liquidation exception to the functional test, the court's reasoning was inconsistent with recognizing a liquidation exception. By interpreting the UDITPA definition of business income in the utilities apportionment rule consistently with Hoechst, the Oregon Supreme Court determined that the Department reasonably gave effect to both definitions of business income included in the rule. Under this interpretation, both definitions of business income in the rule were broad enough to reach the taxpayer's gain from the sale of its FCC license.¹⁶

Having determined that the two definitions could be read together and without conflict, the Court addressed whether the Department's utilities apportionment rule was consistent with the utilities apportionment statute that it was intended to implement. The Court found consistency because of the statutory grant of authority to the Department to segregate or apportion income as long as its method "fairly and accurately [reflects] the net income of the business done within the state." In addition, nothing in the wording of the utilities apportionment statute disallowed the apportionment of gain from assets sold in the course of liquidation.

Commentary

This decision provides a thorough analysis of the business income determination to be applied to utilities and financial organizations in Oregon. Note that the Oregon Supreme Court expressly stated that its decision did not address the meaning of Oregon's statutory definition of "business income" in a case arising under UDITPA. Rather, the Court's opinion was limited to whether the Department reasonably interpreted the two definitions of "business income" in the utilities apportionment rule in a way that gave effect to both definitions. Courts have disagreed as to whether the functional test requires that, in the case of gain from the disposition of property, the taxpayer must be in a business that regularly disposes of the type of property in question. The Oregon Supreme Court followed the California Supreme Court's approach in Hoechst and held that the sale of an asset that has been an integral part of the business of a utility or financial organization constitutes business income. Although the Court determined that the liquidation exception did not apply to Crystal, the Court clearly stated that it has not yet determined whether, for businesses subject to UDITPA, the functional test reaches income from liquidating a business. Therefore, a blanket rule regarding the business / nonbusiness treatment of liquidations was not adopted by the Court.

In addition, it is important to note that the Court summarily dismissed as "premature" the taxpayer's argument that honoring both definitions of "business income" would result in different methods of apportionment of income of public utilities and financial organizations versus other businesses in violation of the Uniformity Clause of the Oregon Constitution. Because the Court has not decided whether the liquidation exception applies to the functional test under UDITPA, there was no reason to decide whether there is any such difference in treatment. Given the importance of this issue and the impact it may have on a taxpayer's state tax liability, however, it stands to reason that controversies involving the business / nonbusiness treatment of liquidating transactions will continue to be heard by state courts.

Footnotes

1 Crystal Communications, Inc. v. Department of Revenue, Oregon Supreme Court, SC S059271, March 7, 2013; CenturyTel, Inc. v. Department of Revenue, Oregon Supreme Court, SC S059502, March 7, 2013.

2 For federal tax purposes, this sale was treated as a "deemed liquidation and cessation" under IRC § 338(h)(10) and the Department accepted CenturyTel's IRC § 338(h)(10) election.

3 The Court engaged in a full, lengthy discussion of the applicable law in Crystal Communications, Inc. and referenced the discussion in CenturyTel, Inc. Because the CenturyTel opinion adopts the reasoning of Crystal, this SALT Alert focuses on the Crystal opinion.

4 OR. REV. STAT. §§ 314.605—314.675.

5 OR. REV. STAT. § 314.280.

6 Id. Note that the segregation method applies to nonunitary businesses and the apportionment method applies to unitary businesses.

7 OR. ADMIN. R. 150-314.280-(A), 150-314.280-(B).

8 OR. REV. STAT. §§ 314.625—314.645.

9 OR. ADMIN. R. 150-314.280-(B).

10 OR. REV. STAT. § 314.610(1). "Nonbusiness income" is "all income other than business income." OR. REV. STAT. § 314.610(5).

11 OR. ADMIN. R. 50-314.610(1)-(B)(2).

12 Willamette Industries, Inc. v. Department of Revenue, 15 P.3d 18 (Or. 2000).

13 Id.

14 Id.

15 22 P. 3d 324 (Cal. 2001), cert. denied, 534 U.S. 1040 (2001).

16 The Court explained that there was no dispute that the FCC license was integral to Crystal's business operations.

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