The allocation or apportionment of income from a capital gain transaction has been the subject of several U.S. Supreme Court, and hundreds of lower court, decisions. On January 16, 2008 the U.S. Supreme Court heard oral argument in a case that state tax practitioners hope will add some clarity to an area of law that has grown increasingly convoluted. MeadWestvaco Corp. v. Illinois Dept. of Revenue, Dkt. No. 06-1413 (September 25, 2007). The oral arguments in this case were emblematic of the type of confusion that has dogged courts for many years. In Mead, the Illinois Appellate Court held that the gain from the sale of Mead’s Lexis/Nexis (“Lexis”) division resulted in apportionable income. During an oral argument that was at times hard to follow, several very important state tax principles were described, discussed and debated. This Legal Alert describing Sutherland’s observations of the oral argument will be published in the BNA Weekly State Tax Report on January 18, 2008.
Background – Traveling Through Illinois
MeadWestvaco (“Mead”) was an Ohio corporation that conducted business in several states, including Illinois. Mead primarily produced and sold forest products, including paper and office supplies. In 1968, Mead purchased Data Corporation, an Ohio-based company whose focus was developing ink jet printing technologies and the development of a computerized full text information retrieval system. Data Corporation’s computerized retrieval technology grew to become a major aspect of its business and later became known as Lexis. In 1994, Mead sold Lexis for a significant profit.
Mead contended that the gain was allocable (and not apportionable) because: (1) Mead and Lexis did not have a unitary relationship, and (2) Mead’s ownership of Lexis served an investment function (and not an operational function) under Allied-Signal’s operational versus investment function test. At trial, Mead successfully argued that the Lexis gain was not unitary income, but the Cook County Circuit Court held that the Lexis gain was properly classified as apportionable income because Lexis served an operational function. Mead Corp. v. Dept. of Revenue, No. 00 CH 7854 (Ill. Cir. Ct. Dec. 2, 2002). Mead appealed the Circuit Court decision to the Illinois Appellate Court, First Judicial District, Sixth Division where the appellate court affirmed the circuit court’s decision. Mead Corp. v. Illinois Dept. of Revenue, 861 N.E.2d 1131 (Jan. 12, 2007). Having determined that the income was correctly classified as serving an operational purpose, the appellate court did not reach the question as to whether Mead and Lexis were in the same unitary business. The Illinois Supreme Court denied Mead’s petition of review. Mead Corp. v. Illinois Dept. of Revenue, 222 Ill.2d 609, 862 N.E.2d 235 (Jan. 24, 2007). On April 20, 2007, Mead filed a Petition for a Writ of Certiorari to the U.S. Supreme Court and certiorari was granted by the U.S. Supreme Court on September 25, 2007.
Unitary Business Principle and Operational v. Investment Function Test: Allied?
Nexus for Nexis?
Counsel for Mead led the oral arguments by asserting that the Illinois appellate court’s application of Allied-Signal “radically expanded” the operational function test. Counsel argued that ownership (Lexis was 100% owned by Mead) alone is not enough to satisfy the operational function test – more is required. The justices immediately interjected with a bevy of questions regarding exactly which state has the authority to tax the gain – “Who can a state tax?” “Which state can tax the gain?” “What would Ohio (Mead’s commercial domicile) tax?” “What did Ohio tax?” “What would Illinois tax if it was the commercial domicile?” These questions led to more questions but few answers regarding the treatment in taxing Mead’s gain.
Sutherland Observation: Historically, the Court has analyzed each state’s apportionment practices individually and not with regard to how a transaction would be treated in another state. For example in Moorman Manufacturing Co. v. Bair, Director of Revenue of Iowa, 437 U.S. 267 (1978), the Court wrestled with a constitutional challenge to Iowa’s single sales factor formula where the taxpayer contended that some portion of the income from Iowa sales was generated by Illinois activities. In its holding, the Court indicated that the treatment of a transaction, or the rule applied, in another state is not relevant to analysis of the taxpayer’s tax or taxable income in the state being challenged. Instead, each state must be analyzed independently. Therefore, it was surprising to hear the Justices raise a multitude of questions regarding how the Lexis gain was taxed in Ohio and other states. Counsel for Mead and Illinois also clearly seemed surprised by this line of questioning in articulating how Ohio would tax the transaction.
Form of Ownership…Tax Planning…Do they Matter?
Justice Ginsberg raised several questions concerning Mead’s connection with Lexis, and Lexis’ connection with Illinois. Mead’s ownership of Lexis alternated between a subsidiary and a division. Justice Ginsberg questioned whether there had ever been a finding upholding the allocation of a gain from the sale of assets. Counsel for Mead asserted that the form of ownership – division v. subsidiary – should not dictate taxation. However, questions by Justices Breyer and Souter regarding certain tax savings or planning that may have been involved in the transaction led to the statement that if the companies were “operationally close enough to produce great tax savings, then why not great enough to allow for gain to be taxed.”
Sutherland Observation: In its reply brief filed with the Court, the Illinois Department of Revenue focused on whether a unitary relationship existed between Mead and Lexis. It is unclear as to whether that question was before the Court, though it raised four indicia of a unitary relationship: 1) Mead’s contribution of capital support; 2) Mead’s approval of Lexis capital expenditures; 3) Mead’s ownership of Lexis as a division; and 4) Mead’s retention of cash benefits produced by Lexis. Predicating a unitary finding based on these four factors arguably creates a broader unitary business test than previously articulated by the Court in cases such as Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425 (1980) and Container Corp. of America v. Franchise Tax Bd., 463 US 159 (1983).
Is the Test “Unitary”?
A good portion of the oral arguments and discussion centered around the relationship between Mead and Lexis and whether the unitary argument had been waived or was ripe for review. In the lower court decisions in Illinois, Mead successfully argued in the Cook County Circuit Court that the Lexis gain was not unitary income. Because the appellate court determined that the income was correctly classified as serving an operational purpose, it saw no reason to make a determination about the unitary nature of the relationship. Thus, the unitary relationship was not addressed in the appellate court decision. Both counsel for Illinois and Mead conceded when questioned by the Justices that if Mead and Lexis had a unitary relationship then Illinois would have authority to tax the gain of the sale of Lexis’ assets. Several of the Justices raised the question of whether the case should be remanded to revisit whether Mead and Lexis were unitary.
However, Justice Breyer’s commentary on the unitary analysis and Allied-Signal proved the most interesting. Using the Court’s earlier railroad cases as an example, Justice Breyer stated that when a railroad operates in 50 states, it is very difficult for Illinois to determine its value in the state because that value depends on its value everywhere. The unitary analysis is applied to determine whether the in-state portion of the railroad contributes to the whole business. Justice Breyer observed that “there is no second test” – referring to the Allied-Signal operational/investment function but then stated that whether there are two tests or whether the second test swallows the first test “at that point, I get totally lost.”
Sutherland Observation: Justice Breyer’s statement that there may not be a second test (i.e. Allied-Signal operational/investment function test) was very surprising. While the U.S. Supreme Court has not decided another apportionment versus allocation case since its decision in Allied-Signal in 1992, state courts across the country routinely analyze apportionment/allocation using: (1) a unitary analysis; and (2) the operational/investment function test set forth in Allied-Signal. Justice Breyer’s comments would suggest that this may not be the proper analysis – that maybe the only test is unitary and there is no second test. This begs the question of what role, if any, Allied-Signal plays in the apportionment analysis. While some commentators have opined that the Court might further articulate and define how the terms “operational function” and “investment function” should be used and when the test should apply, it seems equally plausible that the Court could rule that this test is merely a sub-part of the unitary analysis.
Prediction – The Crystal Ball Says…?
At the conclusion of oral arguments it was difficult to tell which way the Justices would swing. While they were very active in their inquisition of Mead’s Counsel, they were equally if not more intense in their questioning of Counsel for Illinois. Furthermore, the wide array of questions leaves a lot of territory and numerous issues for the Court to focus on in its decision. Because the Court is not required to issue its decision within a certain time period, for now we will have to wait and speculate as to the possible course of the decision.
Sutherland Observation: At the conclusion of the arguments it seemed that there were at least four possible outcomes:
- Find in favor of Mead;
- Find in favor of Illinois;
- Provide further guidance on the operational/investment function analysis (further define the terms operational/investment function, limit the application of Allied Signal or something else) set forth in Allied-Signal and remand to the lower court to revisit whether Mead and Lexis were unitary and/or whether Lexis served an operational or investment function based on additional Supreme Court guidance; or
- Remand the case to allow the lower courts to decide whether Mead and Lexis-Nexis were unitary.
A finding in favor of Mead could lead to a narrower application of the operational v. investment function test, and a finding in favor of the state could yield a broader application. While oral arguments often do not provide a reliable indication of the Court’s disposition of a case, yesterday’s oral argument, which some compared to a free-for-all, did not produce any clear indications of the outcome. In an informal poll of practitioners and other attendees of the oral arguments yesterday at the Sutherland/BNA state tax roundtable lunch, the majority of the participants believed that the Court would provide further articulation of the Allied Signal test and a remand of the case to allow the lower court to review whether Mead and Lexis-Nexis were unitary.