Opinion
No. COA99-1267
Filed 5 December 2000
Taxation — nonbusiness income — functional test — partial liquidation — totality of circumstances
The trial court erred by classifying income received from the complete sale of one of plaintiff multi-state corporation's operating divisions as business income for purposes of taxation in North Carolina under N.C.G.S. § 105-130.4, and this case is remanded for entry of summary judgment in favor of plaintiff, even though a straightforward application of the functional test reveals that plaintiff's regular course of business was devoted to the sale and manufacture of consumer products whereas the pertinent operating division constituted the fine jewelry division of this business making it an integral part of plaintiff's trade or business, because: (1) when the taxable income results from something other than a liquidation of the asset, courts apply the functional test in a straightforward manner, focusing exclusively on whether the asset was integral to the corporation's regular business; (2) when the asset is sold pursuant to a complete or partial liquidation, courts focus on more than whether the asset is integral to the corporation's business and concentrate on the totality of circumstances including the nature of the transaction and how the proceeds are used; (3) the transaction in the instant case can be categorized as a partial liquidation, meaning the totality of circumstances is used to apply the functional test; and (4) the totality of circumstances reveals that the income generated from the liquidation constitutes nonbusiness income based on the facts that plaintiff's entire fine jewelry division was sold, the sale marked the cessation of plaintiff's involvement in that line of business, and the proceeds from the sale were not reinvested in the company to pay off debts or meet other needs, but were immediately distributed to plaintiff's sole shareholder.
Judge HUNTER dissenting.
Appeal by plaintiff from order entered 9 June 1999 by Judge Henry W. Hight, Jr. in Granville County Superior Court. Heard in the Court of Appeals 12 September 2000.
Wilson Iseman, L.L.P., by G. Gray Wilson and Robert C. Bowers, for plaintiff-appellant.
Attorney General Michael F. Easley, by Assistant Attorney General, Kay Linn Miller Hobart, for defendant-appellee.
The narrow issue on appeal is whether income received from the complete sale of one of plaintiff's operating divisions should be classified as business or nonbusiness income for purposes of its corporate tax returns. Plaintiff Lenox, Inc. is a New Jersey-based corporation that does business in several states, including North Carolina. It is engaged in the business of manufacturing and selling various consumer products. Defendant is the North Carolina Secretary of Revenue. In 1970, Lenox formed "Art Carved" as a separate and distinct operating division devoted exclusively to the manufacture and sale of fine jewelry. As a separate and distinct operating division, Art Carved had its own president and chief financial officer. It also managed its accounts payable and accounts receivable independent of Lenox. In 1988, Lenox sold Art Carved for $118,341,000. This marked the complete cessation of Lenox's involvement in the sale and manufacture of fine jewelry. The proceeds from the sale were not reinvested by Lenox but were distributed entirely to its one shareholder, Brown Forman Corporation. The sale created a taxable capital gain for Lenox in the amount of $46,700,194.
Lenox initially paid taxes only in New Jersey on this capital gain. After reviewing Lenox's tax returns, defendant concluded Lenox owed taxes in North Carolina for the sale and assessed Lenox with a capital gains tax of $71,908, which Lennox paid under protest. Lenox then filed this tax refund action to recover the $71,908 it claims it was erroneously taxed. The trial court upheld the tax, and Lenox now appeals.
North Carolina derives its statutory scheme for taxing multi-state corporations from the Uniform Division of Income for Tax Purposes Act ("UDITPA"). 7A U.L.A. 331 (1985). Specifically, we and other UDITPA states divide the income of a multi-state corporation into two classes: "business income" and "nonbusiness income." "Business income" is apportioned among all the states in which the corporation does business and is taxed by each state according to a particular statutory formula. N.C. Gen. Stat. § 105-130.4(I) (1999). "Nonbusiness income" is allocated to, and taxed by, only one state — the state with which the income-generating asset is most closely associated (in this case, New Jersey). N.C. Gen. Stat. § 105-130.4(h). Defendant argues the sale proceeds are "business income" for which Lenox must be taxed in North Carolina. Specifically, defendant contends Art Carved was an integral part of Lennox's regular manufacturing business, thereby satisfying the statutory definition of "business income." Lenox counters that, because the sale and liquidation of Art Carved marked the end of Lenox's involvement in the manufacture and sale of fine jewelry, the sale proceeds are more properly classified as "nonbusiness income."
Our statute defines business income as follows:
"Business income" means income arising from transactions and activity in the regular course of the corporation's trade or business and includes income from tangible and intangible property if the acquisition, management, and/or disposition of the property constitute integral parts of the corporation's regular trade or business.
N.C. Gen. Stat. § 105-130.4(a) (1). Nonbusiness income is defined as "all income other than business income." N.C. Gen. Stat. § 105-130.4(a) (5). We conclude the sale of Art Carved generated nonbusiness income and therefore reverse the trial court.
The seminal case in North Carolina with respect to the application of the business income — nonbusiness income dichotomy is Polaroid Corp. v. Offerman, 349 N.C. 290, 507 S.E.2d 284 (1998), cert. denied, 526 U.S. 1098, 143 L.Ed.2d 671 (1999). In that case, our Supreme Court undertook to clarify what is included within the statutory definition of business income. Joining the majority of other UDITPA states, our Court concluded the definition sets forth two separate tests. (A small minority of UDITPA states interpret the statute to provide for only one test. Id. at 295, 507 S.E.2d at 289.) According to Polaroid, the first part of the statutory definition, which focuses on "income arising from transactions and activity in the regular course of the corporation's trade or business," sets forth the so-called "transactional test." Id. As its name connotes, the transactional test looks to the particular transaction generating the income to determine whether that transaction was done in the ordinary and regular course of business. Id. "[T]he frequency and regularity of similar transactions, the former practices of the business, and the taxpayer's subsequent use of the income" are all central to this inquiry. Id. The parties are in agreement that the sale of Art Carved did not generate business income under the transactional test. This transaction was not an ordinary one but an extraordinary one by which Lenox divested an entire division.
The issue here is over the second half of the definition of business income. That half, which focuses on "income from tangible and intangible property if the acquisition, management, and/or disposition of the property constitute integral parts of the corporation's regular trade or business," sets forth the so-called "functional test." Id. Under this test, the extraordinary nature or infrequency of the transaction is irrelevant. Id. at 296, 507 S.E.2d at 289. Rather, the focus is on the asset or property that generated the income. Id. at 306, 507 S.E.2d at 296. If the asset or property was integral to the corporation's trade or business, income generated from the sale of that asset is business income, regardless of how that income is received. Id.
On the surface, this would appear to be a straightforward application of the functional test. Lenox's regular course of business was devoted to the sale and manufacture of consumer products. Art Carved constituted the fine jewelry division of this business. Accordingly, Art Carved was an asset that was integral to Lenox's trade or business, thereby seemingly satisfying the functional test.
However, application of the functional test in UDITPA states has not always been this straightforward. Although these courts uniformly hold, as our Supreme Court did, that the functional test simply focuses on whether the asset itself was integral to the corporation's regular trade or business, their analyses hinge on other factors as well, including the type of transaction that generated the income. A chronological survey of these cases will help illustrate this reality. Although this survey is quite extensive, we feel it necessary in order to fully understand how various courts have applied the functional test. We only look to cases that have explicitly applied the functional test; cases either rejecting that test or failing to state upon which test they are relying (even if factually analogous) will not be discussed.
One of the first cases employing the functional test (or at least relying on the second part of the statutory definition) was McVean Barlow, Inc. v. New Mexico Bureau of Revenue, 543 P.2d 489 (N.M.Ct.App. 1975). In that case, a corporation engaged in the business of laying pipelines liquidated part of its business. Id.at 490. Specifically, it sold off its "big-inch" pipeline business, continuing operation in only its "little-inch" business. Id. The court held the income from this partial liquidation was nonbusiness income. Id. at 492. Although the court relied on the second half of the definition in its analysis, it paid more attention to the nature of the transaction than to how the asset had been used in the business. The court reasoned:
In the present case, taxpayer was not in the business of buying and selling pipeline equipment and, in fact, the transaction in question was a partial liquidation of taxpayer's business and a total liquidation of taxpayer's big inch business. The sale of equipment did not constitute an integral part of the regular trade or business operations of taxpayer. This sale contemplated a cessation of taxpayer's big inch business.
Id.
The D.C. Circuit was one of the next courts to apply the functional test. In District of Columbia v. Pierce Associates, Inc., 462 A.2d 1129 (D.C. Cir. 1983), that court dealt with whether a corporation's receipt of insurance payments from one of its flooded manufacturing plants was business income. That court held the payments generated business income under the functional test. Id. at 1132. In so holding, the court engaged in a straightforward analysis of the functional test, focusing exclusively on whether the flooded manufacturing plant was an integral part of the corporation's regular trade or business. Id.
A few years later, Pennsylvania took its turn addressing the issue. In Welded Tube Co. v. Commonwealth, 515 A.2d 988 (Pa.Commw. 1986), a corporation had sold off one of its two manufacturing facilities pursuant to a corporate reorganization. Id. at 990. The Commonwealth Court concluded the sale generated income under both the transactional and functional tests. Id. at 994. However, in its analysis, the court focused on the nature of the transaction (noting that it did not result in the cessation of corporate activities in that business) and how the sale proceeds were used (noting that all the proceeds were distributed within, either to satisfy debts or support its other facility). Id.
In Pledger v. Getty Oil Exploration Co., 831 S.W.2d 121 (Ark. 1992), the Arkansas Supreme Court concluded that a corporate subsidiary's receipt of interest on a promissory note between it and its parent amounted to nonbusiness income. Id. at 125. In applying the functional test, the court engaged in a rather straightforward analysis, focusing on whether the promissory note was integral to the corporation's regular trade or business. Id.
A Pennsylvania court again considered the matter in Laurel Pipe Line Co. v. Commonwealth, 642 A.2d 472 (Pa. 1994). In that case, the company engaged in a partial liquidation, completely selling off one of its pipeline operations. Id. at 473. The Pennsylvania Supreme Court concluded the sale generated nonbusiness income. Id. at 477. In applying the functional test, that court once again focused on factors other than how the property was used by the corporation, relying instead on the "totality of the circumstances." Id. Specifically, the court reasoned:
In our view, the pipeline was not disposed of as an integral part of Laurel's regular trade or business. Rather, the effect of the sale was that the company liquidated a portion of its assets. This is evidenced by the fact that the proceeds of the sale were not reinvested back into the operations of the business, but were distributed entirely to the stockholders of the corporation. Although Laurel continued to operate a second, independent pipeline, the sale of the Aliquippa-Cleveland pipeline constituted a liquidation of a separate and distinct aspect of its business.
Id. at 475.
Next, in Dover Corp. v. Department of Revenue, 648 N.E.2d 1089 (Ill.App.Ct. 1995), an Illinois court concluded that both royalties received from licenses and royalty income received from patent infringements constituted business income. Id. at 1097. In so doing, the court engaged in a straightforward analysis of the functional test, focusing on the fact that the royalties were used to further its business. Id. A year later, in Ross-Araco Corp. v. Commonwealth, 674 A.2d 691 (Pa. 1996), the Pennsylvania Supreme Court held that a construction company's sale of an undeveloped tract of land was nonbusiness income. Id. at 697. However, contrary to what it had done just two years prior in Laurel Pipe Line, that court undertook a straightforward application of the functional test, relying simply on the fact that the property sold was never used in the company's construction business. Id.
Proceeds from the sale of leasehold interests was at issue in Kroger Co. v. Department of Revenue, 673 N.E.2d 710 (Ill.App.Ct. 1996). The Illinois court concluded the sale generated business income under the functional test. Id. at 716. In so doing, the court focused exclusively on whether the leasehold interests themselves were integral parts of the company's regular trade or business. Id. Next, the Oregon Supreme Court considered whether monies received from the federal government's condemnation of a portion of a corporation's land was business income. Simpson Timber Co. v. Department of Revenue, 953 P.2d 366 (Or. 1998). Although the court never employed the term "functional test," it did rely upon the second half of the definition in concluding the monies constituted business income because the condemned land was integral to the company's business. Id. at 369-70.
The next case to apply the functional test was Texaco-Cities Service Pipeline Co. v. McGaw, 695 N.E.2d 481 (Ill. 1998). There, a company partially liquidated its assets, selling off a non-operational pipeline and the associated real estate. Id. at 483. The Illinois Supreme Court ultimately held the sale generated business income. Id. at 487. However, in applying the functional test, the court did not concentrate exclusively on how the property had been used; it relied on the totality of the circumstances. Specifically, it noted that the sale did not mark the cessation of the company's activity in that line of business. Id. at 486-87. The court also pointed out that the sale proceeds were reinvested in the company, as opposed to being distributed to its shareholders. Id. at 487.
Our own Supreme Court then entered the fray. In Polaroid, the Court concluded that damages received from certain patent infringements were business income. Polaroid, 349 N.C. at 315, 507 S.E.2d at 301. In so doing, the Court engaged in a straightforward analysis of the functional test, focusing on whether the income-generating asset (i.e., the patents) was integral to the corporation's regular trade or business. Id. at 306, 507 S.E.2d at 295-96. Thereafter, that Court concluded the reversion of a surplus from an employee pension plan constituted nonbusiness income. Union Carbide Corp. v. Offerman, 351 N.C. 310, 317, 526 S.E.2d 167, 171 (2000). In so holding, the Court simply considered whether the assets of the pension plan were used to generate income in the regular course of business; they were not. Id. at 315-17, 526 S.E.2d at 170-71. Finally, in Hoechst Celanese Corp. v. Franchise Tax Board, 90 Cal.Rptr.2d 768 (Ct.App.), petition for review granted, 996 P.2d 1151 (2000), the California Court of Appeals similarly held that the reversion of a surplus from an employee pension plan constituted nonbusiness income. Id. at 779. That court also applied the functional test in a straightforward manner, focusing on the fact that the pension plan was not integral to the corporation's regular business. Id. at 778-79.
The foregoing survey can be synthesized as follows. When the taxable income results from something other than a liquidation of the asset, courts apply the functional test in a straightforward manner, focusing exclusively on whether the asset was integral to the corporation's regular business. But, as McVean Barlow, Welded Tube, Laurel Pipe Line, and Texaco-Cities demonstrate, when the asset is sold pursuant to a complete or partial liquidation, courts focus on more than whether or not the asset is integral to the corporation's business. Instead, they concentrate on the totality of the circumstances, including the nature of the transaction and how the proceeds are used. In this regard, whether the liquidation results in a complete cessation of the company's involvement in that line of business is particularly relevant. Cessation ultimately justified treating the gains as nonbusiness income in McVean Barlow and Laurel Pipe Line, whereas non- cessation justified classification as business income in Welded Tube and Texaco-Cities.
Although neither the UDITPA nor the North Carolina statutes explicitly distinguish between liquidations and other situations, this distinction has not gone unnoticed by the courts. In Polaroid, our Supreme Court observed in a footnote:
We do note, however, that cases involving liquidation are in a category by themselves. Indeed, true liquidation cases are inapplicable to these situations because the asset and transaction at issue are not in furtherance of the unitary business, but rather a means of cessation.
Polaroid, 349 N.C. at 306 n. 6, 507 S.E.2d at 296 n. 6. And the Alabama Supreme Court recently made a similar observation: "Moreover, even courts applying the functional test have excepted true liquidations from its application." Uniroyal Tire Co. v. State Dep't of Revenue, No. 1981928, 2000 WL 1074041, at *11 (Ala. 2000).
Defendant tries to distinguish the above cases on the ground that our statute is slightly different than the UDITPA and other states' version. Specifically, our statute defines business income as including "income from tangible and intangible property if the acquisition, management, and/or disposition of the property constitute integral parts of the corporation's regular trade or business." N.C. Gen. Stat. § 105-130.4(a) (1) (1999) (emphasis added). The UDITPA and other states' version only uses "and" instead of "and/or" in defining business income. 7A U.L.A. 331 (1985). Defendant thus argues that, in North Carolina, satisfaction of the functional test only requires that either the acquisition, management, or disposition of the asset be integral to the business, whereas in other states, all three — the acquisition, management, and disposition — must be integral. Although our statutory distinction perhaps evinces a slightly broader meaning of the functional test, the distinction was irrelevant for purposes of Polaroid, 349 N.C. at 294 n. 3, 507 S.E.2d at 288 n. 3, and we find the distinction to be irrelevant here.
With this framework in mind, we now proceed to the case at hand. First, the transaction here can be categorized as a partial liquidation. By selling off Art Carved, Lenox divested its fine jewelry division. Accordingly, this case falls within the framework of McVean Barlow, Welded Tube, Laurel Pipe Line, and Texaco-Cities, and we therefore look to the totality of the circumstances in applying the functional test. Here, Lenox's entire fine jewelry division was sold, and the sale marked the complete cessation of Lenox's involvement in that line of business. While Lenox continues to manufacture and sell other consumer products, it no longer manufactures and sells fine jewelry. The proceeds from the sale of Art Carved were not reinvested in the company to pay off debts or meet other needs but were immediately distributed to Lenox's sole shareholder. This case is thus quite analogous to McVean Barlow and Laurel Pipe Line, both of which classified the proceeds of sales as nonbusiness income. Given the totality of the circumstances here, we hold that the income generated from the liquidation of Art Carved constitutes nonbusiness income. We therefore reverse the trial court and remand for entry of summary judgment in favor of plaintiff.
Reversed and remanded.
Judge WALKER concurs.
Judge HUNTER dissents.