The Tennessee Supreme Court has held in Blue Bell Creameries, LP v. Roberts that capital gains resulting from a one-time stock redemption transaction between a taxpayer and its holding company as part of a business reorganization were apportionable business earnings subject to Tennessee excise tax. The Court further held that the state’s excise tax assessment was constitutional under the “unitary business principle.”
The taxpayer is a Delaware limited partnership with its principal place of business in Texas. The taxpayer was formed by its holding company, Blue Bell Creameries, USA, Inc., to produce, sell and distribute ice cream in Tennessee and other states. The holding company underwent a corporate reorganization to qualify as an S corporation for federal tax purposes and transferred all of the assets of the former operating entity to the taxpayer in exchange for a limited partnership interest in the taxpayer. In order to qualify as a subchapter S corporation, it was necessary for the holding company to reduce the number of its shareholders. Certain shareholders of the holding company contributed their stock to the taxpayer in exchange for equivalent ownership interests in the limited partnership. The holding company then immediately redeemed that stock at its appraised market value, which resulted in a capital gain of nearly $120 million to the taxpayer. According to the taxpayer, the reorganization allowed the holding company and its subsidiary entities, including taxpayer, to reduce costs and expenses associated with public securities reporting requirements and reduce federal taxes.
On the taxpayer’s Tennessee excise tax return, it classified the capital gains from the stock redemption transaction as non-business earnings, which are not subject to apportionment and Tennessee excise tax. The Department of Revenue disagreed and classified the capital gains as apportionable business earnings subject to excise tax.
The taxpayer sued to challenge the excise tax assessment on the capital gains. Both parties filed motions for summary judgment. The trial court held in favor of the taxpayer on the grounds that the taxpayer’s business was not unitary with the business of the holding company and, therefore, Tennessee’s taxation of the capital gains resulting from the stock redemption transaction was unconstitutional under the Due Process and Commerce Clauses of the U.S. Constitution. The Court of Appeals affirmed. The Commissioner applied for and was granted discretionary review by the Supreme Court.
On January 24, 2011, the Supreme Court reversed the judgment of the Court of Appeals and entered summary judgment in favor of the Department. The Court held that the taxpayer’s capital gains from the stock redemption transaction were properly characterized by the Department as apportionable business earnings subject to Tennessee excise tax. The Court further held that the taxpayer’s business activities were unitary with the holding company and, therefore, the excise tax assessment on the capital gains was constitutional.
In reaching its decision, the Court first examined the issue of whether the capital gains from the stock redemption transaction were business or non-business earnings under Tennessee’s version of the Uniform Division of Income for Tax Purposes Act (“UDITPA”). Under Tennessee’s version of UDITPA, earnings may be classified as business earnings using either a “transactional test” or a “functional test.” Because the earnings in this case were capital gains from a one-time, extraordinary transaction, the earnings did not arise from transactions or activities in the regular course of the taxpayer’s ice cream business and the Court easily concluded that the capital gains were not business earnings under the transactional test.
Turning to the alternative functional test, the Court found that under the statutory definition of business earnings, the issue of whether the disposition of the taxpayer’s property constituted “an integral part of the taxpayer’s regular trade or business operations” depends upon the meaning of the term “integral,” which is uncertain under Tennessee law. The Court turned for guidance to the decisions of other states adopting the functional test under UDITPA, but found that those decisions are not uniform and the application of the functional test may depend on the nature of the property involved. The Court narrowed its focus to those decisions that had applied the functional test to earnings derived from investments and adopted California’s approach, holding that earnings derived from a taxpayer’s property are business earnings “if the taxpayer’s control of the property contributes materially to the taxpayer’s production of business earnings.”
Applying California’s functional test to the capital gains resulting from the taxpayer’s stock redemption transaction, the Court held that even though the transaction itself did not affect the taxpayer’s production, sale or distribution of ice cream, the acquisition and sale of the stock as part of the reorganization had the effect of reducing expenses that detracted from the taxpayer’s earnings from the sale of Blue Bell ice cream in Tennessee and, therefore, “contributed materially” to the production of business earnings from the sale of Blue Bell ice cream.
The Court then turned to the issue of whether Tennessee’s tax assessment was constitutional under the Due Process and Commerce Clauses of the United States Constitution, which limit the state’s ability to reach outside its border and tax income earned outside the state. To address this issue in the context of income earned by a multi-state business enterprise, the United States Supreme Court has developed the “unitary business principle” to define the limits of the state’s ability to tax an apportioned share of the income earned. Here, even though the taxpayer and the holding company were separate business entities, the Court concluded that the two businesses were unitary in that the holding company had no discrete business operations of its own and both businesses derived their income from a single underlying activity, the sale of Blue Bell ice cream. As a result, the Tennessee Supreme Court held that Tennessee’s taxation of the capital gains from the stock redemption transaction was permissible under the U.S. Constitution. Blue Bell Creameries, LP v. Roberts, --- S.W.3d ---, 2011 WL 198514 (Tenn. Jan. 24, 2011).