State & Local Tax Blog

Major Defeat Dealt to States Seeking to Apportion Income Using the “Operational Function Test”

The U.S. Supreme Court issued a very interesting ruling affirming its earlier decisions related to the taxation of “unitary businesses”.  (See MeadWestvaco Corp. v. Illinois Department of Revenue, U.S. Supreme Court, Dkt. 06-1413, vacating the Illinois Appellate Court, April 15, 2008).
In this case, Mead had sold Lexis-Nexis for a $1Billion gain. That gain was allocated to Ohio by Mead. Illinois audited them and took the position that the gain should have been apportioned to IL. IL made the argument at the trial court (which agreed with the State) that although the businesses weren’t unitary, the asset (Lexis-Nexis) was used in an “operational function”, it should be apportioned. This “operational function” concept has arisen in a couple of recent US Supreme decisions. It has apparently given the states the idea that there is no such thing as allocable income anymore because all they have to do is argue that the asset involved was used in an operation function and they can apportion it. Of course, only the extraterritorial states want to make this argument. But the Supremes in this case, say the IL court erred in their interpretation of this test. See below for their commentary:

“As the foregoing history confirms, our references to “operational function” in Container Corp. and Allied-Signal were not intended to modify the unitary business principle by adding a new ground for apportionment. The concept of operational function simply recognizes that an asset can be a part of a taxpayer’s unitary business even if what we may term a “unitary relationship” does not exist between the “payor and payee.” See Allied-Signal, supra, at 791-792 (O’Connor, J., dissenting); Hellerstein, State Taxation of Corporate Income from Intangibles: Allied-Signal and Beyond, 48 Tax L. Rev. 739, 790 (1993) (hereinafter Hellerstein). In the example given in Allied-Signal, the taxpayer was not unitary with its banker, but the taxpayer’s deposits (which represented working capital and thus operational assets) were clearly unitary with the taxpayer’s business. In Corn Products, the taxpayer was not unitary with the counterparty to its hedge, but the taxpayer’s futures contracts (which served to hedge against the risk of an increase in the price of a key cost input) were likewise clearly unitary with the taxpayer’s business. In each case, the “payor” was not a unitary part of the taxpayer’s business, but the relevant asset was. The conclusion that the asset served an operational function was merely instrumental to the constitutionally relevant conclusion that the asset was a unitary part of the business being conducted in the taxing State rather than a discrete asset to which the State had no claim. Our decisions in Container Corp. and Allied-Signal did not announce a new ground for the constitutional apportionment of extrastate values in the absence of a unitary business. Because the Appellate Court of Illinois interpreted those decisions to the contrary, it erred.”

How did the IL courts err? Well, this is where it gets interesting. If it were just an asset, they would have been fine, I guess. But this was not just an asset, but another business. Therefore, this “operation function test” doesn’t apply. You must apply the unitary test. I’m not sure I understand the distinction. But here it is in their words:

“Where, as here, the asset in question is another business, we have described the “hallmarks” of a unitary relationship as functional integration, centralized management, and economies of scale. See Mobil Oil Corp., 445 U. S., at 438 (citing Butler Brothers v. McColgan, 315 U. S. 501, 506-508 (1942)); see also Allied-Signal, supra, at 783 (same); Container Corp., supra, at 179 (same); F. W. Woolworth Co. v. Taxation and Revenue Dept. of N. M., 458 U. S. 354, 364 (1982) (same).

So on that basis they vacated the appellate court’s decision. They did point out that although the trial court had concluded that Mead and Lexis-Nexis were not unitary, that issue wasn’t considered in the appeal. The appellate court was invited to consider that question on remand.

Since the trial court already determined that they weren’t unitary, it seems logical that IL will lose this case. We will be interested to see how it turns out.

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