United States: California State Board Of Equalization Rules On Business / Nonbusiness Income Treatment Of Proceeds

The California State Board of Equalization (SBE) recently ruled on the business / nonbusiness income classification of proceeds received by a taxpayer following two significant transactions.1 With respect to the revenue streams generated after one transaction, the SBE reversed a determination of the California Franchise Tax Board (FTB) and determined that dividend income and the gain from the sale of publicly traded stock received by the taxpayer pursuant to its sale of a business should be classified as nonbusiness income and allocated outside California. However, with respect to income recognized by the same taxpayer from equity and debt interests (including the gain recognized from a reacquisition of stock) generated after a second transaction, the SBE sustained the FTB's prior determination, concluding that such revenue streams were properly classified as business income that was subject to apportionment.

Background

In 2002 and 2003, ConAgra Foods, Inc. (ConAgra) sold its fresh beef and pork operations and its chicken processing business in two separate taxable transactions. The first transaction occurred in 2002 with the sale of the beef and pork operations to a new joint venture, S&C Holdco, Inc. (Swift Foods). The second transaction occurred in 2003 with the sale of the chicken processing business to Pilgrim's Pride Corporation (Pilgrim's Pride).

The appeal concerned the proper classification and sourcing treatment of income that ConAgra earned, in tax years ending on May 31, 2004, May 31, 2005 and May 31, 2006 that related to the transactions. Specifically, the proceeds at issue included stock and notes that ConAgra received in connection with the Swift Foods and Pilgrim's Pride transactions, as well as the treatment of amounts earned in connection with loans to Monfort Finance Company (Monfort), a former subsidiary of ConAgra, on a line of credit in connection with the Swift Foods transaction.

ConAgra filed refund claims on original and / or amended tax returns for the tax years ending in 2004 and 2005. The SBE had jurisdiction to review the claimed refunds for these tax years based on the denial of the refund claims. For the tax year ending in 2005, following an audit and protest, the FTB issued a notice of action proposing additional tax, which ConAgra timely appealed. For the tax year ending in 2006, ConAgra timely appealed another FTB notice of action that partially denied ConAgra's claim for refund.

Distinction Between Business and Nonbusiness Income

If a taxpayer derives income from multiple states, a determination must be made whether the income is classified as business income or nonbusiness income. Business income is apportioned among multiple states, but nonbusiness income is allocated to one state.2 Under California law, the basis for determining whether income is business income is to ascertain whether the income-producing property is an integral part of the taxpayer's regular trade or business operations. A California statute defines "business income" 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.3 "Nonbusiness income" is defined as all income other than business income.4

A regulation provides further guidance for determining whether income is business income. Gain or loss from the sale, exchange or other disposition of property constitutes business income if the property was used in the taxpayer's trade or business.5 Interest income is business income if the underlying intangible arises out of the regular course of the taxpayer's trade or business operations or where the purpose for acquiring and holding the intangible is related to or incidental to the taxpayer's trade or business operations. Dividends are business income if the underlying stock arises out of or was acquired in the regular course of the taxpayer's trade or business operations or where the purpose for acquiring and holding the stock is related to or incidental to the taxpayer's trade or business operations.

Stock in Publicly-Owned Company Produced Nonbusiness Income

The SBE determined that ConAgra's income associated with the Pilgrim's Pride stock that it received for selling its chicken processing business was nonbusiness income because the stock was not an integral part of ConAgra's regular trade or business operations. ConAgra sold its chicken processing business to Pilgrim's Pride, in return for cash and shares of Pilgrim's Pride stock valued at approximately $246 million. The stock represented a minority interest in Pilgrim's Pride, a large public company with shares traded on the NASDAQ stock market. The value of the Pilgrim's Pride stock was determined through an independent appraisal. The table below provides information on the sale by ConAgra and resulting income.

ConAgra and Pilgrim's Pride entered into a supply agreement which established Pilgrim's Pride as its preferred provider of poultry products, with sales made on arm's-length terms. Also, ConAgra's ability to sell its Pilgrim's Pride stock was restricted by a registration rights agreement that also required Pilgrim's Pride to register the stock for sale on public stock markets. ConAgra and Pilgrim's Pride were managed and operated independently, with no sharing of officers or directors.

During the tax years at issue, ConAgra received dividends on its shares of Pilgrim's Pride stock and recognized gain when it sold the shares.

Not an Integral Part of Regular Business and Operations

ConAgra received the stock when it exited its chicken processing business by selling the business to Pilgrim's Pride in a taxable transaction. The fair market value of the stock received in the transaction was determined through an independent appraisal taking into account the price of Pilgrim's Pride's publicly-traded stock, with the application of discounts (e.g., to reflect restrictions on trading). When ConAgra acquired the Pilgrim's Pride stock, it ended its participation in its former chicken business interest and obtained a minority interest in an independent publicly-owned company. There was no evidence suggesting that the Pilgrim's Pride stock allowed ConAgra to exercise continued management or control over any assets that it sold to Pilgrim's Pride. ConAgra sold its Pilgrim's Pride stock as soon as it was able to do so, and, primarily as a result of the substantial appreciation in the price of the publicly traded stock of Pilgrim's Pride (and also as a result of dividends), ConAgra recognized substantial income.

Based on these facts, the SBE ruled that the Pilgrim's Pride stock was not an integral part of ConAgra's regular business and operations and that the income received by ConAgra's sale of the stock was nonbusiness income subject to allocation rather than apportionment.

Equity and Debt Interest in Joint Venture Resulted in Business Income

According to the SBE, ConAgra's income from the equity and debt interests in a newly formed private joint venture that it received from selling its beef and pork operations was business income because the interests were an integral part of ConAgra's regular business and operations. ConAgra contributed its fresh beef and pork operations, including its subsidiary Monfort which operated cattle feed lots, to Swift Foods. The contribution of assets was made under a new joint venture organized by a private equity firm.

The table below presents the sale by ConAgra, payment by Swift and the resulting income received by ConAgra.

Post-Sale Activity

Integral Part of Regular Business and Operations

ConAgra obtained equity and debt interests in a newly formed private joint venture that was formed to hold ConAgra's fresh beef and pork operations, which constituted all or substantially all of the operating assets of the new joint venture. ConAgra provided debt financing for the new venture and continued to use fresh beef and pork from the operations as an integral part of its packaged food business. As such, the SBE ruled that ConAgra's income from debt and the gain from the equity interests constituted integral parts of ConAngra's regular trade or business operations and qualified as business income under California law.6

ConAgra's sale of its Monfort cattle operations to the joint venture was entirely sellerfinanced by ConAgra, and ConAgra continued to fund cattle operations through a $350 million line of credit that would be repaid as cattle and assets were sold. The joint venture contemplated that ConAgra would manage and wind down the cattle operations. In fact, when the cattle operations did not generate sufficient funds to repay the funding, ConAgra reacquired the Monfort stock and sold it. The SBE interpreted these facts to indicate that ConAgra's equity and debt interests in the joint venture materially contributed to its production of business income. Overall, the SBE ruled each form of ConAgra's earned interest income and gains associated with the sale of its beef and pork operations were deemed to be business income based on the statutory definitions and were subject to apportionment.

Commentary

The SBE's ruling helps clarify when certain types of income should be considered apportionable business income or allocable nonbusiness income under California law. Because the ruling considers both business and nonbusiness income, it addresses the factors that must be considered in making the determination of whether incomeproducing property is an integral part of a taxpayer's regular trade or business. ConAgra owned a significant amount of Pilgrim's Pride stock, but the stock did not provide the power to exercise management or control over any of the assets that it sold. Thus, the stock was not considered to be an integral part of ConAgra's business. In contrast, the equity and debt instruments associated with the creation of the Swift Foods joint venture materially contributed to the production of ConAgra's income. As shown by this ruling, the business / nonbusiness income determination is very fact-specific. The ruling did not address the sourcing rules that should be used, but presumably the allocation resulted in sourcing outside California and the apportionment resulted in a large amount of sourcing to California. Although this ruling is positive for some taxpayers, it may not be favorable for other taxpayers depending on the facts and circumstances.

This ruling is the latest example in a string of recent decisions in various states, challenging the notion that has been advanced by different revenue departments that all income of a corporation is presumed to be apportionable business income. Furthermore, this ruling helps to reiterate that the concept of direct allocation of nonbusiness income remains valid and is likely becoming even more important as private equity firms or similar organizations continue to make minority investments in strategic companies. It may be advisable for corporations that have assumed that all income derived from large-scale transactions must be considered business income, even post-transaction income, to rethink that assumption in light of the analysis applied by the SBE.

Footnotes

1 In re ConAgra Foods, Inc., California State Board of Equalization, Nos. 597512, 785058, 799162, Aug. 25, 2015. Note that this ruling is not to be cited as precedent. This ruling apparently has become final because there is no indication that a petition for rehearing was filed within 30 days of the ruling.

2 CAL. REV. & TAX CODE §§ 25123–25128.

3 CAL. REV. & TAX CODE § 25120(a).

4 CAL. REV. & TAX CODE § 25120(d).

5 CAL. CODE REGS. tit. 18, § 25120(c)(2), (3), (4).

6 CAL. REV. & TAX CODE § 25120(a).

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