January 16, 2008
Boundary Flare-Up: U.S. Supreme Court Revisits Constitutional Limitation on States’ Power to Tax -- MeadWestvaco Corp. v. Illinois Dep’t of Revenue.
By Julie E. McGuire and Thomas C. Welshonce
Julie McGuire graduated first in her class from Carnegie Mellon University (B.S. Management Science and Mathematics, 1980), and first in her class from the Duquesne Law School (J.D., 1985), where she was an Editor of the Duquesne Law Review. A highly-respected corporate tax lawyer with an international practice, she is also a Certified Public Accountant. Tom Welshonce, a 2004 Order of the Coif graduate of the University of Pittsburgh's law school, was the Lead Articles Editor of The Journal of Law and Commerce. He focuses on multi-jurisdictional transactions, and assists with ADR in the U.S. and abroad. McGuire and Welshonce are lawyers with Hull McGuire PC.
This morning, January 16th, the United States Supreme Court will hear oral arguments in the case of Mead Corp. v. Illinois Dep’t of Revenue, 861 N.E.2d 1131 (Ill. App. Ct. 2007), appeal denied, 862 N.E.2d 235 (Ill. 2007), cert. granted sub nom. MeadWestvaco Corp. v. Illinois Dep’t of Revenue, 128 S. Ct. 29 (U.S. Sept. 25, 2007) (No. 06-1413). The Court has granted certiorari in only a handful of tax cases this term. In MeadWestvaco, it will revisit its long line of cases defining constitutional boundaries on the States’ power to tax corporate income. MeadWestvaco will be the first case since the Court’s 5-4 decision in Allied-Signal, Inc. v. Director, Div. of Taxation, 504 U.S. 768 (1992) to mark and enforce the constitutional boundaries at stake.
The Boundaries: “Unitary Business” Or “Operational” Function
Businesses no longer operate from a single location in a single state; they now operate globally. Physical, geographical state borders no longer define where a state’s power to tax ends. The question: what part of a company’s global income may be taxed by (or “apportioned” to) a particular state, when most of the income is earned outside of the state’s traditional borders? The struggle has always had two sides: states want to tax a piece of all of a taxpayer’s income, and taxpayers want to pay tax only on income that can be attributed to benefits received by the taxing state. The need for neutral boundary-setting now is critical.
The Supreme Court has long held, under the due process clause and commerce clause of the Constitution, that the entire net income of
a corporation may be fairly apportioned among the states for tax purposes by well-reasoned apportionment formulas that do not violate constitutional boundaries. The Court has defined two boundaries beyond which a state may not reach in taxing corporate income. The income must either (i) be part of taxpayer’s “unitary business income” or (ii) arise from an “operational” function. Otherwise, the state cannot reach the income.
The Supreme Court declared in Mobil Oil Corp. v. Comm'r of Taxes, 445 U.S. 425 (1980) that the “linchpin of apportionability” is the unitary business principle. This principle establishes what income can be taxed, and how far a state can reach in taxing income generated outside of its borders. The unitary business principle, as applied by the Supreme Court, determines what part of a corporation’s activities form part of a single unitary business. When a unitary business is found to exist in a particular state, then that state may tax a portion of the corporation’s entire unitary business – even those transactions that seem to have nothing to do with that particular state. But a state may not tax any piece of a corporation’s income that is derived from “unrelated business activity” which constitutes a “discrete business enterprise” outside of that state. In Mobil Oil, the Court found that dividends received from Mobil’s foreign subsidiaries were taxable by Vermont because Mobil could not prove that its subsidiaries’ foreign operations were distinct in any business or economic sense from Mobil’s petroleum sales activities in Vermont. Instead, the Court found indicia of a unitary business: (1) functional integration, (2) centralization of management and (3) economies of scale. Based on those factors, the Court held that Mobil and its subsidiaries constituted a single unitary business. Vermont could therefore constitutionally tax a piece of that unitary income.
In contrast, but under the same unitary business principle – and applying the same three factors – the Court found that no unitary business existed in ASARCO, Inc. v. Idaho State Tax Comm'n, 458 U.S. 307 (1982). In ASARCO, certain foreign subsidiaries were found to be discrete business enterprises and not part of ASARCO’s unitary business. Therefore, Idaho could not tax dividends received from these subsidiaries. In the early 1980’s, the Court also decided both F.W. Woolworth Co. v. Taxation & Revenue Dep't, 458 U.S. 354 (1982) (New Mexico could not tax income in the case of a non-unitary business) and Container Corp. of Am. v. Franchise Tax Bd., 463 U.S. 159 (1983) (California could impose tax when a unitary business was found). The facts in each case were determinative.
Ten years later, in 1992, New Jersey argued in Allied-Signal, 504 U.S. at 784, that the unitary business principle should be rejected outright – and that the Supreme Court should overrule its earlier cases that defined the constitutional boundaries for states’ taxation of corporate income. In a 5-4 decision, the Supreme Court rejected New Jersey’s arguments, and affirmed its earlier decisions.
In Allied-Signal, the taxpayer was a Delaware corporation domiciled in Michigan with some operations in New Jersey. New Jersey attempted to tax the corporation’s sale of a 20% interest in a subsidiary that the corporation had held for over two years. The Court found that no unitary business existed based on the same three factors (functional integration, centralization of management, and economies of scale) discussed in the Court’s earlier decisions. Since no unitary business existed, New Jersey could not tax the gain based on the unitary business theory. And while the Court acknowledged that the unitary business theory was not the only constitutional justification for tax, a second much narrower (and little discussed) justification – existing when the assets serve an “operational” function – could not be found in the facts. The Court stated that an operational function might be found, for example, where the income is (1) interest earned on short-term deposits in a bank if that income forms part of the working capital of the corporation’s unitary business or (2) an interim use of idle funds accumulated for the future operation of the taxpayer’s business operation. Importantly, the Court found that the corporation’s gain arising from the sale of its 20% interest in its subsidiary, held for over two years, could not amount to a short term investment of working capital analogous to a bank account or a certificate of deposit. In such a case, the gain could not have been found to arise from an operational function.
Following Allied-Signal, the constitutional boundaries are clear: a state may not tax until the facts show (i) income being part of a unitary business or (ii) income arising from an operational function. Despite this clear framework, the states continue to struggle over boundaries.
Illinois, 2007: The Struggle Over Boundaries Continues
Earlier this year, Illinois confronted these constitutional boundaries in Mead, 861 N.E.2d at 1131. Mead, an Ohio corporation, is a producer and seller of paper supplies. In 1968, Mead purchased Data Corporation for $6 million. Data Corporation, at the time, was in the business of developing ink jet printing systems and computerized information retrieval technologies. By 1973, Data Corporation became Lexis/Nexis, and over the next 20 years, developed into one of the world’s leading electronic retrieval systems for law, news and business information.
Between 1968 and 1993, Mead treated Lexis/Nexis at times as a separate subsidiary and at times as a corporate division. However, Mead and Lexis/Nexis maintained separate day-to-day business operations and did not share personnel or make joint purchases. Lexis/Nexis had its own headquarters separate from those of Mead. There was no centralized manufacturing or warehousing, and no favorable intercompany transactions. Mead did, however, approve major capital expenditures for Lexis/Nexis.
In December 1994, Mead sold Lexis/Nexis for approximately $1.5 billion. Mead excluded the gain from its taxable Illinois income. After an audit, Illinois taxed the gain, finding that Mead and Lexis/Nexis were unitary businesses. Mead protested, and the Illinois trial court concluded that (i) Mead and Lexis/Nexis were not unitary businesses, but (ii) under Illinois’ internal tax law, Mead’s sale of Lexis/Nexis was a liquidation of property “essential to [Mead’s] regular trade or operations,” and Illinois could tax a portion of the gain. Mead appealed to the Appellate Court of Illinois.
Constitutional boundaries – marking Illinois’ power to tax – were at stake.
Initially, the Illinois Appellate Court acknowledged the idea of boundaries. In fact, the court recognized that a state can constitutionally tax only (i) where there is a unitary relationship between the payor and payee or (ii) where the asset serves an operational function. The court also acknowledged the trial court’s record and opinion holding that no “unitary business” existed between Mead and Lexis/Nexis based on the three Mobil Oil factors. Despite this, the Appellate Court (i) declined to rule on the unitary business issue and instead (ii) held that Lexis/Nexis served an operational function for Mead, and that Illinois could tax the sale.
In finding an operational function, the court emphasized the following factors:
Mead was 100% owner of Lexis/Nexis. Although Mead did not have day-to-day control over Lexis/Nexis, its involvement with Lexis/Nexis was more than merely passive. Mead developed Lexis/Nexis by contributing capital support until it become profitable. Further, Mead continued to approve major capital expenditures by Lexis/Nexis. It also manipulated Lexis/Nexis’ business organization, treating it as either a division or a corporate subsidiary, depending on what was more beneficial to Mead. Additionally, Mead retained tax benefits and control over Lexis/Nexis’ excess cash.
Mead, 861 N.E.2d at 1140.
These facts, the Appellate Court suggested, are indicators that the gain arose from an operational function. But the Supreme Court has held that income arising from an operational function must be analogous to a short term investment of working capital. Specifically, in Allied-Signal, the Supreme Court held that gain on an investment of more than two years did not arise from an operational function. Mead’s investment in Lexis/Nexis lasted more than twenty years. Did Illinois cross the constitutional boundary?
Overstepping the Boundaries?
In short, none of the facts considered by the Illinois Appellate Court are relevant to a finding that the Lexis/Nexis gain arose from an operational function. The Illinois Appellate Court adopted the trial court’s findings that (i) Lexis/Nexis served an operational purpose, in that Lexis/Nexis represented a significant business segment of Mead; (ii) Mead considered the Lexis/Nexis business important in Mead’s strategic planning; and (iii) the operational purpose allowed Mead to limit the growth of Lexis/Nexis if only to limit its ability to expand or to contract through its control of capital investment. This operational purpose, the Appellate Court seemed to hold, defines the constitutional boundaries and allows Illinois to tax the gain.
The court crossed the boundaries. Operational purpose is irrelevant. Rather, Allied-Signal requires a finding by the court that the gain arose from a short term investment of idle funds (i.e., an operational function). And though semantically similar, operational purpose is simply not the same – when constitutional boundaries are being defined – as finding that income arose from an operational function.
Moreover, the court confused the unitary business concept with the operational function concept, blending the critical facts. In its finding of an operational function, the court relied on facts typically discussed in an analysis of a unitary business: (1) functional integration, (2) centralization of management and (3) economies of scale. Yet the court declared that it was not ruling on whether a unitary business existed.
In any case, operational purpose is also irrelevant to a finding of a unitary business. The ASARCO Court rejected Idaho’s argument that “corporate purpose should define unitary business” and constitutional boundaries. In short, Idaho had argued that “intangible income should be considered a part of a unitary business if the intangible property (the shares of stock) is ‘acquired, managed or disposed of for purposes relating or contributing to the taxpayer’s business.’” The Supreme Court in ASARCO rejected Idaho’s argument outright:
This definition of unitary business would destroy the concept. The business of a corporation requires that it earn money to continue operations and to provide a return on its invested capital. Consequently, all of its operations, including any investment made, in some sense can be said to be ‘for purposes related to or contributing to the [corporation’s] business.
ASARCO, 458 U.S. at 326.
Illinois has overstepped the existing constitutional boundaries that clearly require that either (i) a unitary business exist or (ii) the income arise from an operational function. And any discussion of internal law as to “business” and “nonbusiness” income is unnecessary. That issue is simply not reached.
Will the Boundaries Shift?
MeadWestvaco is the Court’s opportunity to enforce the long-established constitutional boundaries that define a state’s reach and power to tax. But Illinois, together with other states, will likely urge the Court to reconsider and reverse its earlier cases and shift the constitutional boundaries. Has the Court shifted in its thinking since its 5-4 decision in Allied-Signal in 1992? Will the boundaries be redefined? The Court’s decision will send a strong message either way.
Note: An additional issue before the Appellate Court of Illinois but not discussed here was whether gross receipts from Mead’s sale of financial instruments should have been included in the calculation of the sales factor in the apportionment formula on Mead’s 1994 Illinois tax return.
Hull McGuire PC has offices in Washington, D.C., Pittsburgh and San Diego and practices in the areas of taxation, international law, corporate planning and transactions, intellectual property, commercial litigation, employment practices, natural resources and legislative affairs.
Posted by Julie McGuire and Tom Welshonce at January 16, 2008 12:59 AM