In ABB C-E Nuclear Power Inc. v. Director of Revenue (“ABB C-E Nuclear Power”), the Missouri Supreme Court recently held that $227 million of gain from a deemed sale of assets under IRC § 338(h)(10) was nonbusiness income for Missouri corporate income tax purposes. As such, none of the gain was subject to tax in Missouri. A Utah district court reached a similar result several days earlier in Chambers v. Utah State Tax Commission (“Chambers”).
These decisions are the latest in a series of cases discussing the proper characterization of gains from actual and deemed asset sales and liquidations for state income tax purposes. Most courts, like those in Missouri and Utah, have concluded that such gains constitute nonbusiness income. However, some courts have based this conclusion on a strict interpretation of the statute defining “business income,” while other courts have taken the position that liquidation gains are not business income despite a broad construction of the statute.
Different Interpretations of Statute Defining “Business Income”
Many states, including Missouri and Utah, have adopted the definition of “business income” in the Uniform Division of Income for Tax Purposes Act (“UDITPA”).
Under that definition, business income means:
…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 operation. (emphasis added)
Most courts have interpreted this definition to include two separate “tests” for determining whether income is business income: the “transactional” test and the “functional” test. However, several courts have held that the UDITPA definition includes only the transactional test.
The transactional test is based on the non-italicized language above and would treat gain as business income if the taxpayer regularly engages in the type of transaction producing the gain. Courts have consistently held that “income arising from ‘extraordinary’ events such as a ‘complete liquidation and cessation of business’ cannot satisfy the transactional test.” Thus, any gain on a deemed asset sale under IRC § 338(h)(10) should not constitute “business income” under this test.
The functional test, which is based on the italicized language in this definition, has been construed differently by different courts. In Chambers, the Utah district court noted that, under the plain language of the statute, gain from the sale of property is business income only if “the acquisition, management, and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations.” Thus, the court believed that the disposition of the property, and not merely the acquisition or ownership of the property, must be an integral part of the taxpayer’s regular operations to satisfy the functional test. Since the deemed asset sale under IRC § 338(h)(10) was not an integral part of the taxpayer’s regular trade or business, the court held that the gain from that sale was not business income. The Missouri Supreme Court, while not as explicit in its reasoning, similarly found that the deemed asset sale was not “a disposition of the sort that constituted an integral part of [the taxpayer’s] ordinary business.”
Most courts have adopted a broader understanding of the functional test under UDITPA. For example, in Laurel Pipe Line Co. v. Commonwealth, the Pennsylvania Supreme Court held that “[i]ncome meets the functional test if the gain arises from the sale of an asset which produced business income while it was owned by the taxpayer.” Similarly, in Texaco-Cities Service Pipeline Co. v. McGaw, the Illinois Supreme Court stated that “[t]he functional test classifies as business income all gain from the disposition of a capital asset if the asset was ‘used by the taxpayer in its regular trade or business operations.’” However, despite these broad interpretations of the functional test, most courts have nevertheless concluded that gains from actual or deemed liquidations or partial liquidations should be treated as nonbusiness income.
To date, only one court – the California Court of Appeal in Jim Beam Brands Co. v. Franchise Tax Board – has held that gain from an actual or deemed liquidation is business income under a UDITPA-type statute. In this case, the court rejected the strict constructionist approach favored by the Missouri and Utah courts in ABB C-E Nuclear Power and Chambers, based on the California Supreme Court’s broad construction of the functional test in Hoechst Celanese Corp v. Franchise Tax Board. The court also refused to recognize a liquidation exception to the functional test, holding that such an exception looks to the nature of the transaction, rather than the relationship between the property sold and the taxpayer’s regular trade or business operations, which Hoechst and other California decisions have held should be the focus of the functional test.
State Responses to Decisions Treating IRC § 338(h)(10) Gains as Nonbusiness Income
States have responded in several different ways to the cases holding that IRC § 338(h)(10) gains (and gains from actual asset sales and liquidations) are nonbusiness income under the functional test. Some states, such as New Mexico and Ohio, have explicitly defined “business income” to include income from the liquidation of a business.
Other states have taken a less direct approach. For example, Pennsylvania modified its definition of “business income” to provide that it includes “income from tangible and intangible property if either the acquisition, the management or the disposition of the property constitutes an integral part of the taxpayer’s regular trade or business operations.” The substitution of the disjunctive “or” for the conjunctive “and” may make this new definition sufficiently broad to sweep in at least some IRC § 338(h)(10) gains, as long as the acquisition or management of the property disposed of constituted an integral part of the taxpayer’s regular trade or business. However, this definition still contains enough ambiguities – particularly, the meanings of the words “management” and “integral” – to make application of the rule difficult in many cases.
Perhaps to avoid such complications, Pennsylvania inserted a “catch-all” provision that business income also “includes all income which is apportionable under the Constitution of the United States.” Illinois and North Carolina have similarly amended their statutes to define “business income” in this manner. However, these statutes, while ostensibly quite broad, do not resolve the question of whether IRC § 338(h)(10) gains are nonbusiness income. Rather, they leave it to courts to decide whether the U.S. Constitution requires that such gains be apportioned among all the states in which the taxpayer does business.
The Constitution, of course, is not clear on this point. The U.S. Supreme Court has generally held that only income of a unitary business is apportionable.20 And at least one court, in recognizing the liquidation exception to the functional rule, relied on the principle that a liquidation is “not in furtherance of the unitary business, but rather [is] a means of cessation.”
Thus, perhaps the Constitution does mandate that liquidation gains are nonbusiness income. If that is the case, then even the direct approach taken by New Mexico and Ohio (i.e., defining business income to include such gains) would be to no avail.
Where the state legislatures have not acted, some state revenue departments have issued their own rulings or other guidance stating that gain from deemed asset sales under IRC § 338(h)(10) constitutes “business income.” Taxpayers should be aware that, although administrative interpretations of a statute are normally entitled to at least some deference, they are not conclusive. Indeed, given the inherent ambiguity in UDITPA-type statutes and the potential constitutional issues involved, taxpayers have strong arguments that – notwithstanding any administrative pronouncement to the contrary – IRC § 338(h)(10) gains should be treated as nonbusiness income.
Double Taxation or Nowhere Income for Taxpayers?
The fact that IRC § 338(h)(10) gains (and gains from actual sales and liquidations) may be treated as business income in one state and nonbusiness income in another raises the potential for both double taxation or no taxation for taxpayers operating in multiple jurisdictions.
For example, if the target’s assets are located in a state that treats the gain from the deemed asset sale as nonbusiness income, then that state would likely seek to tax the entire amount of such gain. In addition, if the target has nexus with other states that treat that gain as business income, then those states would also attempt to tax the gain on an apportioned basis. However, the state in which the assets are located may not permit a credit for the taxes paid to the other states if the statutes in those states do not clearly provide that the gain is characterized as business income. Because most states do not have such explicit statutory provisions, the risk of double tax is significant.
On the other hand, if the assets are located in a state that treats the gain as business income, then that state would impose tax only on an apportioned amount of the gain. And if the target has nexus with a state that treats the gain as nonbusiness income, then the taxpayer would not be subject to tax on the part of the gain that would otherwise be apportioned to that state. (Gain that is not subject to tax in any state is often referred to as “nowhere income.”) To the extent that state law is unclear regarding the treatment of IRC § 338(h)(10) gains, taxpayers should generally seek to characterize those gains as business income in the states in which the assets are located and as nonbusiness income in all the other states. In some cases, taxpayers may also be able to limit the possibility of double taxation or increase amounts of nowhere income through planning.