Oral argument: Jan. 16, 2008
Appealed from: Appellate Court of Illinois, First District, Sixth Division (Jan. 12, 2007)
TAX, APPORTIONMENT, DUE PROCESS, INTERSTATE COMMERCE, ACQUISITIONS
In 1968, Mead Corporation, now known as MeadWestvaco, ("Mead") an Ohio corporation that deals mainly in paper products, bought Data Corporation. Mead made the purchase because Data Corporation owned ink-jet printing technology which Mead was interested in acquiring. Data Corporation's business also included an information technology component which, during the time it was owned by Mead, developed into Lexis/Nexis, a leading provider of electronic legal, business and news research tools. In 1994, Mead sold Lexis/Nexis for just over $1 billion in gain. The question in this case is which state or states have the legal authority to tax the gain that Mead realized on that sale. The Illinois Department of Revenue argues that Lexis/Nexis and Mead were a unitary business, or alternately, that Lexis/Nexis was an operational asset of Mead, and that in such situations, the power to tax the gain should be apportioned between the states in which Mead and Lexis/Nexis did business. Mead argues that Lexis/Nexis was only a passive investment, and that therefore Illinois should have no power to tax its sale. The Appellate Court of Illinois ruled in favor of the Illinois Department of Revenue, and the Illinois Supreme Court declined to hear the case. While much of the case turns on the characterization of the relationship between Mead and Lexis/Nexis, this case could have important implications for the apportionment among the states of the right to tax the gains realized by the sale of a business.
Is the attempt by Illinois to tax the approximately $1 billion gain realized by Petitioner when it sold its investments in Lexis/Nexis in 1994 (which it acquired in 1968 for $6 million and which functioned for 26 years as an independent, nonunitary business) in direct conflict with the decisions of the Court in Allied-Signal, Inc v. Director, Division of Taxation, 504 U.S. 768 (1992), F.W. Woolworth Co. v. Taxation & Revenue Department of New Mexico, 458 U.S. 354 (1982) and the Due Process and Commerce Clauses of the United States Constitution?
Is a subsidiary company properly categorized as an operational asset or as a passive investment for tax apportionment purposes when it has been fully owned by its parent company over the long term, operated mostly independent of oversight from and in a different industry than the parent company,?
The Illinois Tax Act
The Illinois Income Tax Act ("the Act") allows the state to tax a nondomiciliary corporation that conducts business in Illinois on business income that is derived from, or "apportioned to", its business in Illinois. The Mead Corporation v. Illinois Dep't of Revenue et al. 861 N.E.2d 1131, 1138 (Ill. Ct. App. 2007). Under the Act, taxable business income includes income from intangible property, such as a corporation's subsidiaries. However, apportionment is subject to the constitutional limits of the Due Process and Commerce Clause: income from intangible property is only apportionable if the business and the intangible property are so closely connected that they can be considered a single entity ("a unitary business"), or if the intangible property is necessary to the operation of the business ("an operational function"). Mead, 861 N.E.2d at 1139-39.
The current controversy stems from Mead Corporation's 1994 sale of its subdivision, Lexis/Nexis for $1.5 billion, and whether Illinois may tax Mead, an Ohio corporation, on the gain from the sale. Mead, 861 N.E.2d at 1136.
Mead Corporation and Lexis/Nexis
In 1968, Mead acquired Data Corporation for its printing technology; Data eventually grew into Lexis/Nexis, an electronic publishing company. Mead, 861 N.E.2d at 1135. The legal relationship varied over time, with Lexis/Nexis merging into Mead in 1980, separating from Mead in 1985, and again merging into Mead in 1993. Id. Mead made capital contributions to Lexis/Nexis, approved significant capital expenditures such as a computer expansion and search system upgrades, and influenced Lexis/Nexis' selection of directors and management. Id. Mead also removed funds from Lexis/Nexis' accounts and controlled investment of those funds, though the proceeds went solely to Lexis/Nexis. Id. at 1135. However, the two companies did not conduct favorable transactions, or conduct business exclusively, with each other. Brief for Petitioner at 9-10. Mead and Lexis/Nexis ran separate day-to-day business operations, did not share production or distribution facilities, and had separate employees and headquarters. Id. Mead included Lexis/Nexis in its unitary business group pursuant to a settlement with the Illinois Department of Revenue, though Mead disagreed with that treatment. Mead, 861 N.E.2d at 1135.
Mead's ownership ended with its 1994 sale of Lexis/Nexis. In its Illinois tax return, Mead included income from Lexis/Nexis in its Illinois apportionable business income, but excluded the gain of over $1 billion dollars from selling Lexis/Nexis. Mead, 861 N.E.2d at 1136. Mead instead classified the gain as "nonbusiness," or investment, income making it non-taxable under the Act. Id. Illinois viewed the gain as business income, and sent Mead a deficiency notice for $4 million in taxes. Mead paid the deficiency under protest, and filed a complaint seeking an injunction in 2001. Id.
The trial court rejected Illinois' assertion that Mead and Lexis/Nexis were a unitary business, but found that the gain was apportionable business income because Lexis/Nexis served an operational function. Mead, 861 N.E.2d at 1137. On appeal, Mead argued apportionment was unconstitutional because Lexis/Nexis served an investment, not operational, function. Id. at 1139-40. The Appellate Court of Illinois affirmed, finding that Mead's ownership and involvement indicated Lexis/Nexis had an operational function; based on that finding, it did not reach the unitary business issue. Id. at 1140. MeadWestvaco, as the company is now known, petitioned for certiorari after the Illinois Supreme Court refused to hear its appeal. Mead now argues that the appellate court erred in determining that Lexis/Nexis served an operational function. Brief for Petitioner at 30. Illinois maintains that the trial court erred in ruling that Mead and Lexis/Nexis were not unitary, and even if they are not, that the income is apportionable because Lexis/Nexis was controlled and managed by Mead. Brief for Respondent at 35, 41.
The Supreme Court granted certiorari to decide on the correct treatment of the gain from the sale.
While this case involves the fact-intensive question of the nature of the relationship between Lexis/Nexis and Mead, a number of important legal and economic issues are also at play. When making its decision, the Court may consider whether it is setting up a situation which will subject multistate corporations to the double taxation, as well as the incentives its decision could create for corporations considering future acquisitions.
The Potential for Double Taxation
Mead argues that the decision below could expose it to double taxation. Mead's position is that all of the income from its sale of Lexis/Nexis is taxable in Ohio and, if the Court holds that part of that sum is also taxable in Illinois, then they could end up being taxed on that portion of the sale twice, once in each state. Brief for Mead, at 52. While this is clearly a financial concern for Mead, double taxation, at least in some cases, is not a constitutional issue per se. In Mobil Oil v. Comm'r of Taxes, 445 U.S. 425 (1980), the Court held that a state's method of apportionment is not unconstitutional simply because it, in conjunction with the methods of another state, may subject a corporation to double taxation. However, Mead points out that preventing double taxation is a goal which seems to drive a number of the Court's decisions in this area. Brief for Mead, at 51, citing Oklahoma Tax Comm'n v, Jefferson Lines, Inc, 514 U.S. 175 (1995 and Trinova Corp v. Michigan Department of Treasury 498 U.S. 358 (1991).
Even if creating a situation where double taxation is possible is not a constitutional problem, it is certainly not a desirable outcome, and therefore represents a concern the Court is likely to at least consider. However, there are real questions about whether double taxation is actually at issue in this case. While Mead argues that a ruling against it may result in double taxation, it seems as if this is unlikely in practice. Mead admits that the state of Ohio has not taxed the entirety of its gain from the sale of Lexis/Nexis, and the danger of double taxation is thus only theoretical. Brief for Mead, at 53, n 13. The Illinois Department of Revenue explains that this partial taxation occurred because Ohio, like Illinois, classified the gain from the sale as apportionable and therefore each state only taxed its share. Brief for Illinois Department of Revenue, at 50-51. In addition, the Multistate Tax Commission argues that double taxation is unlikely because of the existence of the Multistate Tax Compact, an agreement that forty-seven states have signed on to, and which the Commission was formed to implement. Brief of Multistate Tax Commission as Amicus Curiae in Support of Respondents, at 2. The Compact works to ensure that tax burdens are fairly apportioned between the states, without double taxation. Id. The Commission goes even further in arguing that double taxation in this case is only possible if the Court accepts Mead's argument that the capital gain is fully taxable in Ohio. Id., at 30-31.
Walt Disney Company, in an amicus brief, argues that a ruling against Mead would create incentives against mergers and responsible investments. Brief for the Walt Disney Company as Amicus Curiae Supporting Petitioner at 22. The brief points out that many multistate companies do exactly what Mead did: buy a company which has some components that are attractive to it, and then sell the rest of the purchased company when the time is right. Id. Disney argues that this is a productive behavior which is good for the economy, and allowing income gained from these type of sales to be apportioned for tax purposes would disincentivize it. Id., at 22-23. Furthermore, Disney adds that if the court considers the factors that Illinois argues should be considered to determine that Lexis/Nexis served an operational function in Meads business, it will provide disincentives for companies to responsibly maintain their investments. Id., at 23-24. Disney argues that the limited oversight and cash management that Mead engaged in only makes it a responsible investor, and that making those activities indicative of taxability would discourage companies from having any oversight of companies they hold as investments. Id. The Illinois Department of Revenue responds to this argument by pointing out its speculative nature and reiterating its position that Mead's interest in Lexis/Nexis was more than a mere investment. Brief for Illinois Department of Revenue, at 53-54.
Constitutional Limits on a State's Taxation Powers
A state's ability to tax the income of a company incorporated in another state is limited by the Due Process clause, which provides that citizens may not be deprived of "life, liberty, or property without due process of law," and the Commerce Clause, which gives Congress the power to regulate interstate commerce. Courts must balance the right of a state to tax domestic business and property and the right of companies conducting interstate commerce to be free of "severe multiple taxation" by states. See CRS Annotated Constitution at 221-22; Allied-Signal, Inc. v. Director, Division of Taxation 504 U.S. 768, 778.
In a series of cases, the Court fleshed out the conditions under which a state may tax a nondomiciliary corporation, one incorporated outside the state levying the tax. States might violate the constitution by taxing income attributable to a nondomiciliary's multistate income (income derived from activities in more than one state). In Allied-Signal, the Court held that if a state sought to tax the activity of a nondomiciliary, "there must be a connection to the activity itself, rather than a connection to the [taxpayer]." Allied-Signal, 504 U.S. at 778. In transactions involving intangible assets, states may apportion when there is either (1) a "unitary business relationship" between the payor and payee, meaning that the companies could be viewed as a single entity or (2) the intangible asset served an operational function, meaning that a subsidiary served some integral function integral to the business of the parent. Id., at 787.
The Illinois Statute
At the time of Mead's sale of Lexis/Nexis, the Illinois Income Tax Act ("the Act") defined taxable "business income" to include income from transactions involving intangible property if "the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business." The Mead Corporation v. Illinois Dep't of Revenue et al. 861 N.E.2d 1131, 1141 (Ill. Ct. App. 2007). Under the Act, income from disposition of a intangible asset is business income if it is a gain from disposing of assets the taxpayer used in regular trade of business operations. Id. Illinois may tax a nondomiciliary corporation on business income apportionable to its business in Illinois, as determined by a formula. Brief for the Respondent at 10.
Did Mead Directly Conduct Business in Illinois Due To Lexis/Nexis' Activities?
Illinois contends that the gain from selling Lexis/Nexis was taxable, regardless of the unitary business finding, because Mead conducted business in Illinois through Lexis/Nexis. Brief for the Respondent at 19. The state depends on International Harvester Co. and J.C. Penney for the proposition that states may tax an investor on income from in-state business, even if both the investor and the company were out-of-state domiciliaries. Id. Under this theory, Mead, the investor, could constitutionally be taxed on the gain because Lexis/Nexis benefited from the protection of Illinois law when it conducted business there. Id. at 20. Illinois points to Lexis/Nexis' substantial business and physical presence in Illinois, and then to Mead's identification of electronic publication as a business function in public filings and statements, its control over Lexis/Nexis, and the restructurings through which Mead reaped tax advantages. Id. This argument entirely bypasses the unitary business test; Illinois claims the sale was outside the scope of Allied-Signal and ASARCO, because unlike in those cases, Mead actively conducted Lexis/Nexis' business. Id. at 25-26.
Mead argues that Allied-Signal establishes that the sale of an intangible asset by a nondomiciliary corporation is taxable only if the unitary business or operational function tests are met. Mead cites other states' high court decisions to support its contention that a nonunitary asset's economic contributions to the unitary business alone cannot satisfy the operational function test. This implies that in order for a state to constitutionally apportion income, the relationship between the two companies must meet one of the two tests. Contrary to Illinois' argument, the mere fact that Mead owned a nonunitary asset that did business in Illinois is insufficient to subject it to taxation by the state. See Brief for Petitioner at 47.
Were Mead and Lexis/Nexis A Unitary Business?
Illinois argues that the trial court erred in ruling Mead and Lexis/Nexis were not a unitary business. Mead, 861 N.E.2d at 1137. Under Container Corporation v. Franchise Tax Bd., the "flow of value" between the parent and subsidiary should be the focus of the unitary business inquiry, and this was amply satisfied by Mead's provision of capital contributions and its control over Lexis/Nexis' capital expenditure, management, and fund investments. Id. at 35-36. Illinois distinguishes Woolworth, ASARCO, and Allied-Signal, in which no unitary business was found. In Woolworth, the subsidiary financed itself, and oversight was limited to dividend and debt decisions, while in Allied-Signal and ASARCO the corporation was a minority owner of the subsidiary, in contrast to Mead's 100% ownership. Brief for the Respondent at 38-39.
Mead contends that factors such as separate lines of business, separate brands, and lack of operational oversight and integration made it and Lexis/Nexis nonunitary. Brief for Petitioner, at 28. The inclusion of Lexis/Nexis in its unitary business on its Illinois tax returns was pursuant to a dispute settlement, and not probative. Brief for Petitioner, at 40-41. Additionally, other corporations filing amicus briefs argue that the company's reports and 10-K statements are improper evidence of whether a subsidiary is part of the parent, because they are dictated by accounting rules. Brief of Amicus Curiae for Gannett Corporation, at 14-16; Brief for Walt Disney Corporation at 18. Moreover, Mead argues that ASARCO requires that transaction income result from "functional integration, centralization of management, [or] economies of scale" - none of which the sale accomplished. Id. at 28 (quoting ASARCO, 458 U.S., at 317).
Was Mead more than a Passive Investor in Lexis/Nexis?
Mead asserts that Allied-Signal requires Illinois to prove Mead and Lexis/Nexis met the operational test, because the companies were not unitary. Otherwise, Illinois would violate constitutional limits in its apportionment. Brief for Petitioner at 27-28. The test is an exception to the unitary business requirement: income from a nonunitary asset is apportionable if the asset supports the company's regular business in a substantial, continuous way. Id. at 25-26, 29. Mead argues the appellate court erred in finding an operational function because it incorrectly relied on factors demonstrating ownership, such as Mead's ownership percentage, statements in public filings, and oversight of investments and capital expenditures. Id. at 38-40. According to Mead, collapsing the two tests into a single test eliminates the requirement of nexus between the in-state activity and the nonunitary asset. Id. at 17-18, 45. Removing the distinction would make all out-of-state subsidiary income apportionable by mere ownership. Id. at 40, 46-49.
Mead relies on F.W. Woolworth v. Taxation & Revenue Department of the State of New Mexico to prove that the factors the appellate court considered are really applicable to the unitary business standard. Ownership should not have greater weight under the operative function test because the Court in Woolworth rejected ownership as probative of unitary business. Brief for Petitioner at 39. The company characterizes its "occasional oversight" of corporate functions and its potential ability to operate Lexis/Nexis merely as indicative of ownership, not of any contribution to Mead's paper and office products business. Id. at 38-40. Mead claims Allied-Signal's operational function test requires that income from the nonunitary asset was used as "working capital of the corporation's unitary business." Id. at 44 (quoting Allied-Signal, 504 U.S. 787-88). It distinguishes its oversight of Lexis/Nexis' investments, occasional participation in its direction (including the restructurings), and its public statements as control exercised by a passive investor, rather than the level of control that amounts to operational use. Id. at 34-35, 38-40. Thus, the sale of Lexis/Nexis fails the operational function test because Lexis/Nexis itself served no operational function; the sale is analogous to the sale of nonunitary stock in Allied-Signal and subsidiaries in Woolworth. Brief for Petitioner at 32.
Illinois contends the scope of the operational function test is broader than Mead claims, and that such function may exist even where the companies conduct different lines of business. Brief for the Respondent at 41-42. According to Illinois, Mead's alteration of Lexis/Nexis' corporate form showed control beyond that of a passive investor and netted Mead large tax savings. Mead's use of the gain from the sale for its own purposes further demonstrates the sale was a transaction that served Mead's business and thus satisfies the operational function test. Id. at 41-42. More significantly, Illinois argues that considering the same facts for both tests is appropriate because Allied-Signal established that both tests are meant to distinguish assets that serve an investment function from those serving an operational one. Id. at 43. Thus, the tests are alternative means of proving that the constitutional requirement of "minimum contacts" is satisfied, not wholly separate lines of analysis. Id. at 43-44. Though the state concedes that ownership alone would be insufficient, its argues that the ways in which Mead controlled Lexis/Nexis were above and beyond that of a passive investor, and that a court should not be limited to considering those facts solely in the unitary business inquiry. Id. at 44-45.
This case, while delving deep into the specifics of the relationship between Mead and Lexis/Nexis, also will provide the Court with the opportunity to reexamine when states have the authority to tax multistate corporations doing business in their borders. As such, it may have an important impact on the way some of the largest corporations run, especially in the area of mergers and acquisitions. The Court's decisions will likely affect the way in which corporations conduct oversight of their wholly owned subsidiaries, and may even make them question entering that relationship at all.
Edited by: Richard Beaulieu
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