United States: Arizona Court Of Appeals Holds Definition Of "Business Income" Provides Two Separate Tests, No Liquidation Exception

The Arizona Court of Appeals has held in two recent cases that the state may tax corporate income as "business income" if either the transactional test or the functional test provided in the statutory definition is satisfied, and that there is no liquidation exception to the definition of business income.1 In the first case, Harris Corp., the Court also determined that the taxpayer's gains primarily associated with selling lines of business were properly classified as business income. In the second case, First Data Corp., the Court relied on its analysis from Harris and held that the gain from the taxpayer's sale of its wholly-owned subsidiary was business income even though a deemed asset sale occurred under federal law.

Background

Harris Corporation, a Delaware corporation with executive offices in Florida, provided voice, data and video telecommunications products and related services. For the relevant tax years, Harris and its subsidiaries filed Arizona corporate income tax returns on a consolidated basis.2 Harris treated the income, expenses and losses from its business operations as business income, but treated the gains from the disposition of product lines as non-business income. The Arizona Department of Revenue conducted an audit and issued a notice of proposed assessment. After Harris filed an appeal with the Arizona Tax Court, both parties filed motions for summary judgment on whether the proceeds of the transactions were business income. The Tax Court granted summary judgment in favor of the Department and the taxpayer timely appealed.

First Data Corporation, a Delaware corporation that was headquartered in Georgia, provided electronic payment services to its customers. In 1999, First Data sold a wholly-owned subsidiary and realized net proceeds of $725 million. First Data and the purchasing bank elected to treat the sale of the subsidiary's stock as a sale of assets under Internal Revenue Code (IRC) Section 338(h)(10). For federal income tax purposes, the subsidiary was deemed to have undergone a complete corporate liquidation with the distribution of the proceeds to its sole shareholder, First Data. The subsidiary reported the gain on its federal income tax return. For the 1999 tax year, First Data and its subsidiaries were a unitary business and filed an Arizona combined corporate income tax return. This return reflected First Data's treatment of the gain on the sale as non-business income. Following an audit, the Department reclassified the gain from the sale as business income and issued a notice of proposed assessment. First Data protested the assessment and timely appealed to the Arizona Tax Court. After both parties moved for summary judgment on the income classification issue, the Tax Court granted summary judgment in the Department's favor and incorporated its statutory analysis from the Harris case. First Data timely appealed.

Definition of Business Income

Arizona follows a modified version of the Uniform Division of Income for Tax Purposes Act (UDITPA) to apportion or allocate the income of multistate corporations to the state.3 The determination of whether income is business income or non-business income is crucial in dividing income among states. Business income generally is apportioned to Arizona based on a three-factor formula that consists of property, payroll and sales factors.4 Non-business income is allocated to a designated state based on certain factors. Arizona allocates non-business income such as capital gains from the sale of intangible property and interest income to the state where the taxpayer is domiciled.5 Other non-business income such as rents, royalties and capital gains from the sale of real or tangible personal property is allocated to the state where the property is located.6

Under Arizona law, which adopts the UDITPA definitions, "business income" is defined as "income arising from transactions and activity in the regular course of the taxpayer's trade or business and includes income from tangible and intangible property if the acquisition, management and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations."7 "Non-business income" is defined as "all income other than business income."8 In states that have adopted these UDITPA definitions, courts have recognized that "business income" includes a "transactional" test from the first clause9 and a "functional" test from the second clause.10 However, courts are divided on the interpretation of this statute. Some courts have held that corporate income is business income if it satisfies either the transactional or the functional test,11 but other courts have held that there is one transactional test and the second clause describes examples of income within this definition.12

The Arizona Court of Appeals held in Harris that the statutory definition of "business income" contains two clauses that use different language and therefore provide two distinct definitions or tests. Thus, corporate income qualifies as business income if either the transactional test or the functional test is satisfied. The Court disagreed with the taxpayer's argument that the second clause is simply a subset of the first clause. Also, the Court carefully considered the meaning of the second clause (the functional test). The Court rejected the taxpayer's argument that the use of "and" in the second clause requires that the disposition as well as the acquisition and management of the property must be integral parts of the taxpayer's regular trade or business. Thus, the words "acquisition, management and disposition" do not establish three separate requirements that each must be integrally related to the taxpayer's business under the functional test. According to the Court, this interpretation is consistent with the legislative purpose included in the legislative comments in UDITPA and the state's corresponding regulation.13 Also, the Court noted that this interpretation better reflects the realities of taxing an asset over time.

No Liquidation Exception

In Harris, the Court held that there is no liquidation exception to business income. The Court rejected the taxpayer's argument that final dispositions through liquidation do not qualify as business income under either the transactional or functional test. According to the Court, a liquidation exception is inconsistent with its interpretation of the business income definition, particularly the functional test.14 Under the functional test, a court must look beyond whether a transaction is conducted in the regular course of business and consider whether the use or disposition of the property forms an integral part of the taxpayer's business. Also, the Court determined that the use of the proceeds of the liquidation is irrelevant to the functional test. Furthermore, the taxpayer's interpretation would cause a lack of symmetry because assets would be depreciated and expenses deducted, reducing business income prior to disposition of the assets, but when the assets are sold, any gain would become non-business income under a liquidation exception.

Gains Properly Classified as Business Income

The Court in Harris applied the principles discussed above in determining that the taxpayer's gains received from the sale of assets constituted business income. As noted by the Court, most of these assets were undesired product lines. The Court specifically considered: (i) transactions by the taxpayer; (ii) the sale of a medical transcription product line; and (iii) transactions by the taxpayer's consolidated subsidiaries. In considering the taxpayer's sale of business lines, the Court rejected the taxpayer's argument that these were unique transactions that did not satisfy the transactional test. Because the taxpayer regularly acquired and disposed of product lines, the sales furthered the taxpayer's business and occurred in its course of buying and selling. The Court also rejected the taxpayer's argument that the functional test was not satisfied because ceasing business operations is not furthering business operations. The functional test was met because the taxpayer had used the assets to produce income in its regular trade or business. Similarly, gains from the sale of the medical transcription product line also were business income. The taxpayer's argument that gains resulting from a spin-off were non-business income was inconsistent with its earlier income characterizations. The gain was business income because the spin-off was part of a repositioning effort and strategy to increase shareholder value. Also, the taxpayer used the product line in its business when it held the asset.

Finally, the Court rejected the taxpayer's argument that the gains reported by its consolidated subsidiaries did not constitute business income. The taxpayer analyzed the transactions as though they were not performed by the parent company in the regular course of its telecommunications equipment business. The Court disagreed with this approach because it defeated the intent of the consolidated election. There was no basis for including subsidiaries in a consolidated return and then excluding all subsidiary income as non-business income because their business was unrelated to the parent company's business. The Court examined the transactions on a business-by-business basis and concluded that the subsidiaries each sold assets as part of their individual operations. Holding and selling assets was an integral part of each subsidiary's trade or business.

Deemed Asset Sale

In First Data, the Court expressly followed its opinion in Harris. However, because First Data concerned a deemed asset sale under IRC Section 338(h)(10),15 the Court was required to perform an additional analysis. The taxpayer argued that even states that have recognized a functional test provide a liquidation exemption when analyzing a Section 338(h)(10) election.16 The Court was not persuaded by these cases and noted that it had already rejected a liquidation exception in Harris. The presence of a Section 338(h)(10) analysis did not change the Court's analysis. The Court agreed with other courts that have rejected an exception to the business income definition even in light of a deemed asset sale under Section 338(h)(10).17 Also, the Court noted that state revenue departments, including the Arizona Department of Revenue,18 have found the gain from a Section 338(h)(10) election to be business income under their state's UDITPA statute.

In this case, First Data elected to treat the sale of its subsidiary's stock as a hypothetical sale of the subsidiary's assets under Section 338(h)(10). The subsidiary was part of the taxpayer's unitary business and reported the gain from the sale of the assets on the taxpayer's combined return. According to the Court, this gain satisfied the functional test and was properly classified as business income. Because the taxpayer had previously treated the income from the subsidiary's assets as arising in the regular course of business, the disposition of the assets constituted business income under the functional test.

Commentary

As indicated in these cases, there is continuing disparity among courts in states that have adopted UDITPA concerning the classification of income.19 The analysis performed in these cases is relevant to the other states that have adopted the UDITPA approach to determine business income. According to the Arizona Court of Appeals, the transactional and functional tests are independent of each other and there is no liquidating business exception. This is true even if there is a deemed sale under IRC Section 338(h)(10). The Court also provides a detailed analysis of whether specific transactions constitute business income. The business income determination is very fact-specific, but the cases provide guidance concerning the type of analysis that courts perform.

In Harris, the Court indicates that if a corporation reports sales of assets in a particular business line as business income, the sale of the business line itself results in business income. Both cases illustrate that it is difficult for a corporate taxpayer to claim that a sale of any of its business lines results in non-business income. However, in the limited situations where an asset sale does not satisfy the transactional or functional test, a taxpayer could still successfully argue that the gain from a sale constitutes non-business income. The Court in Harris discusses a ruling issued by the Arizona Department of Revenue that provides an example where one transaction produces business income and another transaction produces non-business income.20 In the example, the sale of a former manufacturing facility is allocable as non-business income because the income is not earned in the regular course of a trade or business.21 Note that this example does not involve the sale of an entire business line and that asset sales producing non-business income would seem to be relatively rare.

Article IV of the Multistate Tax Compact incorporates the UDITPA provisions. The Multistate Tax Commission (MTC) currently is considering significant amendments to Article IV that include a proposal to change the "business income" terminology to "apportionable income" and revise the definition. A recent Report of the Hearing Officer, which analyzes the proposed amendments, recommends a clarification that the transactional test and the functional test are independent of each other.22 Thus, this report acknowledges that clarity is needed regarding the operation of these tests.23

Footnotes

1 Harris Corp. v. Arizona Department of Revenue, Arizona Court of Appeals, No. 1 CA-TX 11-0006, Nov. 26, 2013; First Data Corp. v. Arizona Department of Revenue, Arizona Court of Appeals, No. 1 CA-TX 11-0008, Nov. 26, 2013.

2 The returns reflected three categories of income that were in dispute: (i) gains recognized on the contribution of assets to a joint venture; (ii) proceeds from the sale of a medical transcription business line; and (iii) royalties received from patent rights, along with income from the sale of stock and other assets by subsidiaries engaging in investment activities.

3 ARIZ. REV. STAT. §§ 43-1131—43-1150.

4 ARIZ. REV. STAT. § 43-1139(A).

5 ARIZ. REV. STAT. §§ 43-1136(C); 43-1137.

6 ARIZ. REV. STAT. §§ 43-1135(A), (B); 43-1136(A), (B).

7 ARIZ. REV. STAT. § 43-1131(1).

8 ARIZ. REV. STAT. § 43-1131(4).

9 The first clause provides "income arising from transactions and activity in the regular course of the taxpayer's trade or business."

10 The second clause provides "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."

11 Gannett Satellite Information Network, Inc. v. Department of Revenue, 201 P.3d 132 (Mont. 2009); Hoechst Celanese Corp. v. Franchise Tax Board, 22 P.3d 324 (Cal. 2001); Simpson Timber Co. v. Oregon Department of Revenue, 953 P.2d 366 (Or. 1998); Texaco-Cities Service Pipeline Co. v. McGraw, 695 N.E.2d 481 (Ill. 1998); Pledger v. Getty Oil Exploration Co., 831 S.W.2d 121 (Ark. 1992); District of Columbia v. Pierce Associates, Inc., 462 A.2d 1129 (D.C. 1983).

12 Phillips Petroleum Co. v. Iowa Department of Revenue, 511 N.W.2d 608 (Iowa 1993) (superseded by IOWA CODE § 422.32); Western National Gas Co. v. McDonald, 446 P.2d 781 (Kan. 1968) (superseded by KAN. STAT. ANN. § 79-3271(a)); General Care Corp. v. Olsen, 705 S.W.2d 642 (Tenn. 1986) (superseded by TENN. CODE ANN. § 67-4-2004).

13 See ARIZ. ADMIN. CODE R15-2D-503.

14 In Jim Beam Brands Co. v. Franchise Tax Board, 34 Cal. Rptr. 3d 874 (Ct. App. 2005), the California Court of Appeal explained that a liquidation exception cannot be reconciled with the functional test.

15 An IRC § 338(h)(10) election permits a sale of stock to be treated, for federal income tax purposes, as a sale of assets by the entity whose stock is being sold (the target corporation) to a hypothetical new corporation of the same name. The target corporation is deemed to have received a purchase price equal to the amount that was paid by the purchaser to the parent corporation as consideration for the purchase of the target corporation's stock. The target corporation is then deemed to have made a liquidating distribution to its shareholders.

16 American States Insurance Co. v. Hamer, 816 N.E.2d 659 (Ill. App. Ct. 2004); ABB-C-E Nuclear Power, Inc. v. Director of Revenue, 215 S.W.3d 85 (Mo. 2007); Canteen Corp. v. Commonwealth, 818 A.2d 594 (Pa. Commw. Ct. 2003); McKesson Water Products Co. v. Director, 23 N.J. Tax 449 (N.J. Tax Ct. 2007).

17 Newell Window Furnishing, Inc. v. Johnson, 311 S.W.3d 441 (Tenn. App. 2008); Centurytel, Inc. v. Department of Revenue, 297 P.3d 1264 (Or. 2013).

18 Corporate Tax Ruling 98-2, Arizona Department of Revenue, July 23, 1998.

19 Note that Arizona continues to use the UDITPA definitions of "business income" and "nonbusiness income." ARIZ. REV. STAT. § 43-1131(1), (4).

20 Corporate Tax Ruling 94-12, Arizona Department of Revenue, Nov. 15, 1994.

21 Corporations A, B, C, D and E file a federal consolidated return and elect to file as an affiliated group in Arizona. Corporation A manufactures mobile homes that are marketed by Corporation B and financed by Corporation C. Corporation D operates a chain of pet food stores. Corporation E invests in and markets commercial real estate. Corporations A, B and C constitute a single business and Corporations D and E constitute two other separate businesses. Corporations A, B and C do not engage in any real estate activities or transactions with Corporation E. If Corporation A sells a former manufacturing facility that has been vacant and unused for nine years, the income from the sale would be allocable nonbusiness income. However, the sale of a shopping center by Corporation E would constitute business income because it is in the regular course of Corporation E's business.

22 For a detailed discussion of the proposed amendments and this report, see GT SALT Alert: Report Released on Proposed Amendments to Multistate Tax Compact's Division of Income Provisions.

23 Most likely, the MTC will eventually decide to revise the approach for apportioning and allocating income. Note that the MTC's Executive Committee is scheduled to consider the report at a meeting on December 12, 2013. The MTC could take steps to follow the Hearing Officer's guidance, retain its own drafted language, or strike a compromise between the two approaches.

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