For purposes of state corporate taxation, the determination of whether income is classified as "business" or "nonbusiness" can have significant tax implications. The U.S. Supreme Court recently addressed this issue in Meadwestvaco Corporation, Successor in interest to Mead Corporation v. Illinois Department of Revenue, 553 U.S. --- (April 15, 2008).
In this case, the taxpayer, an Ohio corporation with its headquarters in Ohio, had sold one of its business divisions (the Division) with headquarters located in Illinois. Although the Division's regular business activities were subject to Illinois income tax, the taxpayer took the position that the gain on the Division's sale constituted "nonbusiness" income that was not subject to Illinois tax. As nonbusiness income, the taxpayer allocated the gain to Ohio (the taxpayer's state of domicile) for state income tax purposes.
In Meadwestvaco, the Court was asked to address whether Illinois constitutionally had the right to tax as business income a significant capital gain realized by an out-of-state corporation on the sale of one of its business divisions based on the state's apportionment factors. If the gain were determined to be nonbusiness income, the gain would not be subject to tax in Illinois, and the taxpayer would have a right to a refund of Illinois income tax and penalties totaling approximately $4 million.
In its decision, which did not resolve the issue, the Supreme Court concluded that the state appellate court had failed to address the "key" factor needed for resolution - whether the Division and the taxpayer were a "unitary business."
Although the Illinois trial court determined that the Division was not a unitary part of the taxpayer's business, it concluded that the state could tax the taxpayer's capital gain on an apportioned basis. In affirming the trial court's decision, even though the Illinois appellate court had determined that the Division served an "operational" function in the taxpayer's business, the appellate court failed to address the issue of whether the Division and the taxpayer were a "unitary business." The Supreme Court therefore remanded the case back to the state appellate court to consider whether the Division and the taxpayer's business were unitary.
Shaping the legal issues required to reach a conclusion, the Supreme Court's opinion notes that a state's power to tax out-of-state activities is derived from the application of the Commerce Clause and Due Process Clause of the U.S. Constitution. Since the Division was doing business in Illinois, the Due Process requirement had been met - there was a definite minimum connection between Illinois and the transaction it sought to tax. To meet the requirement of the Commerce Clause, the inquiry shifted from whether the state may tax to what it may tax. The Supreme Court noted that it had developed the "unitary business principle" to answer just such a question.
Under this principle, a state need not "isolate the intrastate income-producing activities from the rest of the business" but "may tax an apportioned sum of the corporation's multistate business if the business is unitary." A court must determine whether the intrastate and interstate activities form part of a single unitary business. Thus, where the value of what a state wants to tax is derived from a "unitary business" operated both in and out of state, the state can tax on an apportioned basis (generally, a state's apportionment factors include sales, property, and compensation in the state) versus an attempt by the taxing state to isolate the value attributable to the operation of the business within the state. On the other hand, if the value to be taxed by the state is derived from a "discrete business enterprise," the state cannot tax even an apportioned share of that value. Although it may be easy to identify the principle to be applied, it has been difficult for state courts to define when a business is "unitary." Towards this end, courts have determined that where the asset at issue served an "operational" function, such a finding was instrumental in addressing the constitutional relevant conclusion that the asset was a unitary part of the business being conducted in the taxing state rather than a discrete asset to which the taxing state had no claim.
Where the asset in question is another business, the Supreme Court described the "hallmarks" of a unitary relationship as "functional integration, centralized management, and economies of scale." In Meadwestvaco, the state trial court concluded that these "hallmarks" were lacking and concluded that the Division was not part of the taxpayer's business. The salient facts in the case included the following:
- although subject to the taxpayer's oversight, the taxpayer did not manage the day-to-day affairs of the Division
- the headquarters of the taxpayer and the Division were located in different states, with the taxpayer and the Division having their own management teams
- the two businesses maintained separate manufacturing, sales, and distribution facilities, as well as separate accounting, legal, human resources, credit and collections, purchasing, and marketing departments
- the taxpayer's involvement, generally, related to approving the Division's business plan and any significant corporate transactions (such as capital expenditures, financings, mergers and acquisitions, or joint ventures)
- the taxpayer and the Division were not required to purchase from each other and, if they did, there were no discounts, etc.
As noted above, although the state appellate court concluded that the business division served the "operational function" in the taxpayer's business, it failed to determine whether the business division that was sold and the taxpayer were a "unitary business."
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