Corporate Close-Up: When Is Ownership of a Subsidiary’s Stock Integral to a Taxpayer’s Trade or Business?


Recent court decisions in California and Indiana illustrate the challenges corporate taxpayers face in determining whether gain from the sale of subsidiary stock is apportionable business income or nonbusiness income. Both cases involved application of the functional test to decide if the stock sold was integral to each taxpayer’s primary trade or business.

During the years at issue in the cases, the states applied the UDITPA transactional and functional tests to determine whether or not to categorize income as apportionable business income. Under the transactional test, income is apportionable if it arises from transactions and activity in the regular course of the taxpayer’s trade or business. The courts agreed the sales of subsidiary stock in both cases did not occur in the regular course of business. Thus, the gain was not apportionable income under the transactional test.

Income from tangible and intangible property was apportionable under each state’s functional test that applied to the taxpayers’ transactions if the acquisition, management, and disposition of the property constitute integral parts of a regular trade or business. Income that arises from the disposition of an asset that was integral to the taxpayer’s business will satisfy the functional test, regardless of whether the disposition was a “regular” occurrence in the business.

Solid Ruling in Indiana Case

In the case of E.I. DuPont de Nemours & Co. v. Indiana Dept. of Rev., the Indiana Tax Court “made a solid ruling” that a manufacturing company’s gain from the sale of a pharmaceutical subsidiary was nonbusiness income, said Mark Loyd, Partner and Tax and Employee Benefits Department Chair at Bingham Greenebaum Doll LLP in Louisville, Ky., co-author of the Indiana Corporate Income Tax Navigator (subscription required), and contributing author of the Indiana Pass-Through Entity Navigator (subscription required).

DuPont, together with its subsidiaries and affiliates, primarily engages in a variety of industrial, agricultural, and chemical manufacturing businesses worldwide. For a period of time, DuPont also owned an interest in a pharmaceutical company that operated independently, developing, manufacturing, and selling human pharmaceutical products. Upon the sale of the pharmaceutical company, DuPont recognized gain of more than $4 billion, which DuPont characterized as nonbusiness income and which the Indiana Department of Revenue, on audit, reclassified as business income. Because the subsidiary operated as an independent, autonomous business and DuPont played no role in its management, one of the three legs on which the functional test stands, the court held that the gain was properly treated as nonbusiness income.

Unitary Business Analysis

In support of its ruling, the Indiana Tax Court also determined that DuPont and the pharmaceutical company were not unitary. The court found that the two companies were neither functionally integrated nor centrally managed, and did not benefit from economies of scale. Instead, they operated independently and at arm’s-length, and DuPont exercised no more than occasional oversight typical of a prudent investor. Accordingly, a finding of nonbusiness income results from the application of the functional test to “a classic example of a non-integrated, non-unitary business and is likewise consistent with Allied-Signal," Loyd said. (In Allied-Signal, the U.S. Supreme Court ruled that income from the disposition of intangible property is not apportionable if the relationship between the taxpayer and the business represented by the intangible property is not unitary and acquisition of the property did not serve an operational function.)

California Decision

In an unpublished opinion in Fidelity Nat’l Info. Services, Inc. v. California Franch. Tax Bd., a California appellate court ruled that the trial court was in error when it failed to apply the functional test specifically at the time of the stock sale. The appellate court reasoned that it is possible for an asset that was once integral to a taxpayer’s business to become a nonbusiness investment before its sale.

The appellant (Fidelity) was one of the world’s largest financial technology processors for banks. To reduce IT costs, Fidelity acquired a 29 percent interest in a foreign IT company with the intent to develop a “go-to-market” strategy to provide joint services to customers. With the stock purchase, Fidelity gained three seats on the IT company’s 10-member board, and certain Fidelity board members served as members of the IT company’s committees. The two companies also entered into a master service agreement under which the IT company would provide IT services under preferential terms. The arrangement did not go as planned, and Fidelity eventually sold its stock in the IT company for a gain, which it reported on its California return as nonbusiness income and which the Franchise Tax Board reclassified as business income.

Fidelity argued at trial that it acquired stock of the IT company for investment purposes because it knew the master service agreement would cause the IT company’s stock price to rise. The trial court rejected that argument, concluding that the stock purchase was not just a simple investment, but an attempt by Fidelity to obtain a competitive advantage through lower IT costs and a joint market strategy. Thus, the stock was integral to the appellant’s primary business and gain from the sale of the stock was business income under the functional test.

Fidelity also asserted that, even if the IT stock was initially an integral part of Fidelity’s unitary business, the stock was a nonbusiness investment long before its sale. The trial court ruled it was not required to apply the functional test at specific moments in time. The appellate court, however, found this ruling to be in error and remanded the case to the trial court to determine if the IT stock continued to be an integral part of Fidelity’s business at the time of its sale. Although the decision appears to be in Fidelity’s favor, the appellate court thought it likely that the trial court would conclude the stock remained integral to Fidelity’s business.

Continue the discussion on LinkedIn: how have courts in your state applied unitary business principles when finding income is non-apportionable under the functional test?

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