A case currently before the U.S. Supreme Court could have huge implications for state tax law when it's decided in late spring.

MeadWestvaco v. Illinois Department of Revenue, argued before the high court in January, is one of the most significant state tax cases in a decade, according to Donald Griswold, a partner in the Washington office of Reed Smith LLP. "It's rare that the Supreme Court takes on a state tax case," he said.

"Mead was a paper company that years ago paid $6 million for a tiny little computer company -- Data Corp. -- that had software that allowed the retrieval of information. They turned it into LexisNexis, and sold it for over a $1 billion dollars in 1994," Griswold said. "Whenever there's that much gain, taxpayers and states line up on opposite sides to decide who gets to tax it."

"The Commerce Clause of the Constitution and the Due Process Clause in the 14th Amendment require that a state can only tax income derived from sources within the state," explained Pat Derdenger, a partner in the Phoenix office of law firm Steptoe & Johnson LLP. "How do you apply that to a multi-state corporation doing business in 40 states?"

MeadWestvaco's brief stated the question as whether "the attempt by Illinois to tax the approximately $1 billion gain realized by petitioner when it sold its investment in LexisNexis in 1994 (which it acquired in 1968 for $6 million and which functioned for 26 years as an independent, non-unitary business), [is] in direct conflict with the Due Process and Commerce Clauses of the U.S. Constitution and the decisions of the Court."

Constitutional principles govern because Mead is an Ohio company, Griswold said. "Over time, under due process, cases say there has to be sufficient connection between Mead and Illinois before due process is satisfied and Illinois can jump over its borders and tax this," he said.

SLICING THE PIE

Under the Uniform Division of Income for Tax Purposes Act, non-business income is allocated to a specific state, whereas business income is apportioned to states using a three-factor formula.

Most states with income taxes have enacted UDITPA or a modified version of it, according to Derdenger. "The three-factor formula takes into account payroll, property and sales. For example, payroll within the state is the numerator, and total payroll is the denominator. Likewise, they calculate property in the state over total property, and sales into the state versus total sales. This allows them to come up with an apportionment factor that they use to apportion total income into the state, so they can tax a slice of it," he said.

"Stock in a subsidiary corporation is an intangible asset, so under the UDITPA rule, if gain or loss on the sale of the stock is non-business income, it is allocated to the domiciliary state of the parent that sold the stock," said Derdenger. "That may be fine for large states that are populated with corporations that have their headquarters there, but what about the vast majority of states that don't have Fortune 500s headquartered or domiciled there -- how do they get their piece of the action?"

"They say that the gain on the sale of the subsidiary corporation gives rise to business income, which they apportion using the three-factor formula," he said. "That's the issue here. Illinois takes the position that LexisNexis stock owned by Mead gave rise to business income, and so it should be apportioned to Illinois."

In a 1992 decision in Allied-Signal, the Supreme Court held that New Jersey could tax gain on the sale of Bendix, a wholly owned subsidiary, only if the stock was a part of Allied Signal's unitary business or if the stock of the subsidiary served an operational purpose.

Because Mead and LexisNexis did not constitute a unitary business, Illinois was entitled to tax Mead on the gain only if the transaction served an operational function, in which case it could apportion the gain among the states where Mead conducted its business.

The Illinois courts determined that the operational test had been satisfied because of seven factors, according to Derdenger: Mead owned 100 percent of LexisNexis; Mead made heavy capital investments in the early years of LexisNexis; Mead took advantage of certain tax advantages resulting from its ownership; Mead took LexisNexis' excess cash and invested it on behalf of LexisNexis; Mead had to approve major transactions; Mead changed LexisNexis from a division to a subsidiary and back several times, and it was a subsidiary when it was sold; and Mead included LexisNexis in the Form 10-K that it filed with the Securities and Exchange Commission.

"If you look at these seven factors, you'll see that Nos. 2 through 7 flow out of the fact that Mead owned 100 percent of LexisNexis," said Derdenger. "The Illinois courts have completely ignored Allied-Signal. They're saying that there will always be an operational purpose if you have 100 percent ownership in the subsidiary," he said. "What's the difference between you or I buying Google a number of years ago, and then selling it? There is no operational function that was served with the acquisition or holding of LexisNexis; rather, it was an investment that panned out quite nicely."

He concluded that if the Supreme Court should hold for Illinois, it would have to overturn Allied-Signal or dilute it by giving a very broad definition to operational function.

Given the fact that the composition of the court has not changed dramatically since Allied-Signal was decided, Derdenger is optimistic that the high court will overturn the Illinois decision.

On the basis of comments made by several justices during oral argument, the court may decide to remand the case back to the Illinois appellate court, according to Reed Smith's Griswold. "They may remand to determine if this is overall a unitary business," he said.

George Farrah, a CPA and executive editor for state tax and accounting at BNA, agreed. "Most people at the BNA state tax roundtable luncheon following oral argument believed the court would provide further articulation of the Allied-Signal test and remand the case to the lower court to review whether Mead and LexisNexis were unitary," he said.

"The justices seem to be focusing on the relationship between the unitary business test and the operational function test, and it seems that some may want to revisit the question of whether or not Mead and LexisNexis were unitary," observed Daniel T. Schibley, senior writer and analyst at CCH's State Tax Department. "There is some suggestion that there aren't two separate tests, but that the operational function test may be part of the unitary test. This has the potential to be a very important decision if it answers these questions, but if it simply remands to the lower court, then we may not get the kind of definitive answer that people in the state tax world are hoping for."

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