The concept of “instant unity” is a matter of timing: After a merger or acquisition, when do the combining businesses shed their separate identities and become a single, “unitary” business for state income tax purposes? Can unitary treatment commenceinstantly following closing of the merger or acquisition? The answer is “yes,” and with appropriate planning and the advice of knowledgeable counsel, this can lead to significant tax savings for businesses that spot this issue in advance.
The issue is of particular interest where a struggling business is acquired by a profitable one. Unitary treatment—ideally, instant unity—can provide an opportunity for state income tax savings during the post-merger period. Treatment of entities as “instantly unitary” permits the combined business to use the losses of the struggling business to offset the gains of the acquirer. But, instant unity will only be accepted by the taxing authorities where the taxpayer is able to present arguments and marshal facts supporting the position that the businesses became unitary right away. The default view of state tax authorities will be that an acquired business does not become “unitary” until a certain amount of time has passed, during which the operations gradually become integrated.
The origins of the concept of a “unitary business” can be traced back to the late 19th century, when localities sought to value railroads’ property for property tax purposes. How does one value a piece of land in the middle of the United States that has a part of a transcontinental railway cutting through it? Comparing that land to nearby parcels won’t capture the land’s value, nor is it possible to value it by somehow using separate accounting for railroad profits derived just from that land. The approach taken was to value all of the railroad’s land, and then divide that amount among its parts.
A similar problem exists where a corporate group with multiple entities in several states engages in a coordinated business, sometimes including a vertically integrated business. Often, separate accounting does not capture the value contributed to the business by its various parts. Transfer pricing for transactions between related entities can also pose challenges. For many states, the solution is to combine the income of all entities in the corporate group that engage in the business, offset income and losses, and apportion the combined income to the various states.
For example if a business (perhaps employing several separate entities) manufactures a product in State A, but sells it only in States B and C, it may receive revenue only in States B and C. Unitary treatment can allow State A to tax an apportioned share of the income of the combined business. Income and losses from the entire unitary business is combined in a combined report that ignores corporate form or structure and the state in which the income or losses occur. The combined income is then apportioned to the various states in which income-producing activities took place, using formulary apportionment. So, notably, losses of an entity with operations only in State A can be offset against gains of an entity with operations only in State B if they are part of a single unitary business.
The legal standard for what qualifies as a “unitary business” is notoriously vague, in part because the concept does not lend itself to bright lines. In Butler Brothers v. McColgan,17 Cal. 2d 644 (1941), affd., 315 U.S. 501 (1942), the California and United States Supreme Courts employed the “three unities test,” which looked to unity of ownership, unity of operation, and unity of use. Subsequent tests have looked to “contribution and dependency”—where parts of a business are unitary if one part depends upon or contributes to the operation of the other (Edison Cal. Stores, Inc. v. McColgan, 30 Cal. 2d 472 (1947)) and to whether the business is functionally integrated enterprise whose parts are characterized by “substantial mutual interdependence and a flow of value.”Container Corp. v. Franchise Tax Bd., 463 U.S. 159, 178-79 (1983). As applied to combining businesses, unitary treatment and instant unity will be more likely where:
- There are significant ties between the acquiring entity and the target prior to the acquisition;
- Planning for integration occurs prior to closing;
- Integration occurs immediately after the acquisition;
- There quickly are flows of capital between the entities (or other flows of value); and,
- Other indicia of unity are rapidly present.
The question of instant unity is fact-intensive. Thus, it can be important to spot the issue early on so that evidence can be obtained and preserved. An audit of the issue may not occur until years after the business combination, at which time evidence has been lost, memories have faded, and a timeline of key events has become difficult to recreate.
For these reasons, M&A tax advisors (including federal tax lawyers) and in-house counsel should be aware of the instant unity issue. It is of particular relevance in the not-uncommon situation where a successful business acquires a struggling one. In a perfect world, the acquirer could be advised that intercompany funding, early replacement of the acquired company’s officers, and early takeover of management decisions will facilitate favorable tax treatment. More realistically, tax considerations may not drive such events. But even then, if the issue is spotted early and experienced counsel are retained, a taxpayer can locate and preserve evidence supporting its position and greatly improve the odds of obtaining considerable tax savings.