- Also In This Issue:
- Hercules and Firstar: Nondomiciliary Taxpayers Successfully Defend Nonbusiness Income Treatment Before the Minnesota Supreme Court
- Once Again, South Carolina Breaks New Ground on Hotly Debated Nexus Issues
- California's Deduction for Dividends Received from Insurance Companies Held Unconstitutional
- California Business Property Tax: Reported Costs Are Not Necessarily Fair Market Value
In two recent cases, the Minnesota Supreme Court reversed the state's Tax Court and held that capital gains, arising in one case from the sale of stock and in the other from the sale of out-of-state office property, were nonapportionable, nonbusiness income, not taxable by Minnesota. These decisions were surprising to many observers, both within and without Minnesota, primarily for two reasons. First, the Minnesota Department of Revenue had in recent years treated nearly all gains as apportionable business income. And, second, the state's Tax Court upheld the Department's business income treatment in both of these cases. After several decades in which no business/nonbusiness cases were heard by the Minnesota Supreme Court, the Department may have assumed &emdash; wrongly, as it turns out -- that the Minnesota Supreme Court would allow it unfettered discretion. To the contrary, the Minnesota Supreme Court has followed fairly closely the mandate of Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768, 787 (1992), and issued a clear statement that gains will not be treated as apportionable business income without a demonstrable close connection to the taxpayer's regular business operations..
Hercules Decision
Hercules Inc. v. Commissioner of Revenue, 575 N.W.2d 111 (Minn. 1998), concerned the treatment of the more than $1 billion capital gain on a 1987 sale by Hercules of its stock in Himont, Inc., a polypropylene resin manufacturing company. Hercules formed Himont in 1983 with an unrelated Italian company, Montedison S.p.A. Hercules had contributed to Himont all of its tangible and intangible assets from the polypropylene resin manufacturing business in which it had previously been engaged. Initially, the parties had intended that Hercules and Montedison would each have a 50% interest in Himont, and the company had been established so that neither of the creators could exercise sole control. Because the value of Hercules' original contributions exceeded those of Montedison, the parties entered into various financial arrangements to equalize the contributions and to maintain the equal 50% interests, including the issuance of a $70 million note by Himont to Hercules.
After it created Himont, Hercules was no longer engaged in the business of manufacturing polypropylene resin. However, it continued to use the resin as a raw material in its film and fiber manufacturing businesses. Hercules purchased resin from Himont at a negotiated discount, which Himont's witness testified would have been offered to any other company that purchased a similar volume. Even after its sale of Himont stock, Hercules continued to purchase resin from Himont's successor under the same price structure. Hercules also provided administrative services to Himont, including advertising, legal, tax, audit, and treasury services. The prices for the services were demonstrated to be not materially different from those charged by unrelated companies.
In 1987, Himont offered shares to the public in an initial public offering, and Hercules' and Montedison's ownership interests each fell to 38.7%. Hercules and Montedison maintained those interests until September 1987, when Hercules sold all of its Himont stock to Montedison, in response to Montedison's threat of a hostile takeover of Hercules itself if Hercules did not agree to the sale.
Hercules treated the gain on the 1987 sale as nonapportionable, nonbusiness income, and the Minnesota Commissioner of Revenue tried to recharacterize the gain as business income. The Commissioner argued that "the relationship [between Hercules and Himont] was operational and unitary and as a result, the gain on the sale of stock is properly included in the Minnesota income subject to apportionment." The Commissioner relied heavily on the facts that Hercules continued to purchase polypropylene resin from Himont and to use the resin as a raw material, and that Hercules provided administrative services to Himont. The Tax Court upheld the Commissioner's position.
The Minnesota Supreme Court reversed. First, the court analyzed the Minnesota statute, Section 290.17, subd. 3, which requires a corporation's income "derived from carrying on a trade or business" to be apportioned. Hercules, 1998 WL 105446, *3. The court found that there was "minimal statutory guidance as to what it means for an intangible asset to be connected to a trade or business." According to the court, the only statutory definition was in Section 290.17, subd. 6, which provides that "intangible property is employed in a trade or business if the owner of the property holds it as a means of furthering the trade or business." For guidance, the court then looked to its interpretations of Minnesota's prior statute, which had been based on UDITPA, and to the court's own decisions in Great Lakes Pipe Line Co. v. Commissioner of Taxation, 138 N.W.2d 612 (Minn. 1965), and Montgomery Ward & Co. v. Commissioner of Taxation, 151 N.W.2d 294 (Minn. 1967). In both of those cases, the court stated, "investment of excess assets in intangibles was an integral part of the corporations' day-to-day financial operations." The court found the circumstances of Hercules' stock ownership of Himont to be very different. The stock interest had been held for more than four years, as an investment, and was sold only in response to a hostile takeover threat. The court found "no indication that Hercules wanted or needed the proceeds from the Himont gain to provide operating funds." Therefore, under the Minnesota statute, the gain was insufficiently connected to Hercules' day-to-day business to be treated as business income under the statute.
The court then analyzed Minnesota's attempt to tax the gain in light of the Due Process Clause, finding that apportionment of the gain would be unconstitutional. It noted, under Allied-Signal, in order for income from an intangible asset to be apportionable, the Due Process Clause requires that either the taxpayer and the payor corporation must have a unitary business relationship, or the intangible asset must have served "an operational rather than an investment function." Hercules, 1998 WL 105446, *4, citing Allied Signal, 504 U.S. at 787. The court found "scant evidence" of any unitary relationship between Hercules and Himont, noting that intercompany services and resin purchases were conducted on an arm's-length basis. The court also noted that Hercules could never exercise control over Himont's management, since it never owned more than 50% of the stock. It also found that ownership of the Himont stock did not create an operational relationship, differentiating Hercules' treatment of its Himont stock from the two examples given by the United States Supreme Court in Allied-Signal, 504 U.S. at 787: the Himont stock was not used as a short-term investment comparable to a bank account or certificate of deposit; and it was not used as a hedge against a fluctuating supply of polypropylene resin, since the resin was widely available on the world market during the 1980s, and Hercules continued to buy resin from Himont after the sale at the same price.
Therefore, the court held both that the gain from the sale of Himont stock was nonbusiness income, not apportionable to Minnesota, and that, in any case, apportionment of the gain would violate the Due Process Clause.
Firstar Decision
In Firstar Corporation v. Commissioner of Revenue, 575 N.W.2d 835 (Minn. 1998), the income in question arose from the sale of office property located in Wisconsin. Firstar Corporation is a bank holding company, headquartered in Wisconsin, that had built an office building in downtown Milwaukee. The majority of the space was leased to unrelated entities, although Firstar and its subsidiaries also leased space. Firstar sold the property in 1988 and generated a gain representing nearly 20% of the taxpayer's combined gross receipts for the year. Firstar used the proceeds to retire debt, to pay taxes, to pay dividends to shareholders, and to allow new acquisitions of banks. Firstar contended that the gain was nonapportionable, nonbusiness income. The Commissioner apportioned the income, and the Tax Court upheld the Commissioner's actions, holding that the gain "had more than a minimal relationship to [Firstar's] day-to-day operations." Firstar, 1998 Minn. LEXIS 150, *15.
Once again, the Minnesota Supreme Court reversed. The court first examined the language of Minnesota's statute, including its legislative history, noting that the UDITPA definition previously incorporated in the statute had been repealed in 1987. The court found that, despite the repeal, the statute still differentiated between business and nonbusiness income and still contained essentially the same criteria. It concluded "that Minnesota's current definition of business income is not any more expansive than the definition contained in UDITPA, despite the 1987 repeal." Firstar, 1998 Minn. LEXIS 150, *7.
The court then observed that various UDITPA jurisdictions have considered whether there is one test or two for business income: the "transactional test," under which the controlling factor is the nature of the particular transaction, and the "functional test," which focuses on whether the asset produced business income while it was owned by the taxpayer. See "Business Income: One Test or Two," State & Local Tax Insights, June 1997. The court stated that it found "the transactional test more helpful," and it relied upon the three factors articulated by the Tennessee Supreme Court in Union Carbide Corp. v. Huddleston, 854 S.W. 2d 87, 92-94 (Tenn. 1993): the frequency and regularity of similar transactions; former business practices; and subsequent use of the proceeds. The court found that Firstar had never before sold commercial office property, and that it had largely used the proceeds for purposes unrelated to its regular course of business, except for acquisition of new banks. Here, however, the court held that, since the sale of the property was a "once-in-a-corporate-lifetime" event, "the fact that a portion of the proceeds went to the acquisition of new banks cannot by itself convert the gain into business income." The court noted particularly the "irregular nature" of the transaction, and stated that, if this gain met the definition of business income, it was "hard-pressed to think of any situation in which a taxpayer's income would not be classified as business income." Firstar, 1998 Minn. LEXIS 150, *15.
Because it concluded that the gain was nonbusiness income, not apportionable to Minnesota under the statute, the court in Firstar did not reach the constitutional issues.
Analysis
Minnesota's Supreme Court has now placed itself firmly with the courts of a number of other states that have rejected the ever-expanding definitions of "business income" propounded by many state taxing authorities. See, e.g., Union Carbide Corp. v. Huddleston, 854 S.W. 2d 87 (Tenn. 1993); Phillips Petroleum Co. v. Iowa Dep't of Revenue & Fin., 511 N.W.2d 608 (Iowa. 1993); Ross-Araco Corp. v. Commonwealth, 674 A.2d 691 (Pa. 1996). On the other hand, Minnesota's view is not unanimous. For example, the Supreme Court of Illinois recently held that Illinois recognized both the transactional test and the functional test for business income, and refused to treat as nonbusiness income a company's disposal of over 90% of its pipeline business, primarily on the ground that the pipeline assets had created business income while the taxpayer owned them. Texaco-Cities Serv. Pipeline Co. v. McGaw, 1998 Ill. LEXIS 366 (Apr. 16, 1998).
The decisions in Hercules and Firstar combine to cover many of today's most hotly disputed apportionment issues, such as the split among the states over whether there is only one test for business income (i.e., the transactional test) or whether the UDITPA statutory language includes a second, functional test, and the continuing debate over how to interpret Allied-Signal. Even though Minnesota repealed its UDITPA-based statute in 1987, the court's express finding that the state's current statutory definition is "not any more expansive" than the UDITPA definition may make it difficult for other states to limit the effect of the decision solely to Minnesota's statute.
The decision in Hercules is believed to be the first decision by a state supreme court to apply the "operational" language in Allied-Signal narrowly. The Minnesota Supreme Court seemed to view the so-called "operational" test as covering only the two specific examples given by the United States Supreme Court &emdash; the short-term investment of idle funds and the Corn Products hedge against business risks. Perhaps this decision will help to restrict the expansive application of the "operational" test by many auditors, since taxpayers frequently observe a tendency of some auditors to define as "operational" any gain that has any relationship to a taxpayer's business operations.
In Firstar, however, the court focused on the frequency of similar transactions and the use of the proceeds in determining whether the income was apportionable business income under the statute. It is worth noting that in Allied-Signal the United States Supreme Court dismissed the relevance of these criteria in determining whether income could constitutionally be apportioned. The Court expressly held that "the mere fact that an intangible asset was acquired pursuant to a long-term corporate strategy of acquisitions and dispositions does not convert an otherwise passive investment into an integral operational one." Allied-Signal, 504 U.S. at 788. The Court also denied any role to an inquiry into the use of the proceeds, finding that the New Jersey Supreme Court, which had upheld apportionment of the gain in Allied-Signal, had erred in relying on the fact that the taxpayer intended to use the proceeds in question to acquire another company that would have been operated as part of the taxpayer's unitary business. Id. at 789. Since the Minnesota Supreme Court concluded that Firstar's proceeds were nonbusiness income, it did not analyze the constitutional issues. Had it done so, it might have followed Allied-Signal to conclude that apportionment would be unconstitutional, since the fact that a portion of the gain was used to acquire additional banks would, under the above-quoted language from Allied-Signal, provide no evidence that the passive investment in the property had been converted into an "integral, operational" business use.
Conclusion
Since the decisions in Hercules and Firstar, the Department of Revenue appears to be reconsidering its position, and reevaluating its treatment of gains from sales of intangibles. Given the clear direction from the Minnesota Supreme Court in these two cases, taxpayers with business/nonbusiness issues in Minnesota should press their advantage. Similar cases are, of course, moving through the courts of many other states, including several cases involving the treatment of the Hercules gain itself, which are pending in a number of states, including Maryland, where the issue was argued to the state's highest court, its Court of Appeals, in early June. Because of the Minnesota Supreme Court's broad language, the decisions in Hercules and Firstar are expected to have a significant effect on cases moving up to the highest courts of other states.
Morrison & Foerster LLP represented the taxpayer in Hercules.
This newsletter addresses recent state and local tax developments. Because of its generality, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.