Corporate Close-Up: State Tax Agency Loses Bid to Use Unitary Business Theory to Classify Investments as ‘Business Income’

A central tenet in state taxation is that a multistate corporation must apportion business income to the states in which it operates and allocate nonbusiness income to the state in which it is based. A key factor that most states use for determining whether an activity constitutes business income is if the income derives from the taxpayer’s regular trade or business. An additional factor that the Oregon Tax Court recently considered was whether the activity in question comprises a part of the taxpayer’s unitary business.

There are typically two tests that states use to define income as business income: the functional test and the transactional test. Some state courts, such as Alabama in Uniroyal Tire Co. v. Ala. Dept. of Rev., 779 So.2d 227 (Ala. 2000), have previously determined that the state does not impose a functional test. Colorado also ruled in Atlantic Richfield v. State, 601 P.2d 628 (Colo. 1979) that they did not need to determine if Colorado indeed imposed a functional test. However, several of those states, including Alabama and Colorado, have passed laws dictating that both tests must apply. Oregon includes a functional test as well as a transactional test in its analysis of income.

States have reached varying results when considering whether to include income from investments in business income, including the Missouri Supreme court ruling in MINACT, Inc. v. Dir. Of Rev. in 2014.

The Oregon Tax Court’s decision illuminates the important concept that when determining business income for multistate entities, departments of revenue and courts must consider the business of the taxpayer as a whole, rather than just its business in that particular state, when classifying income for apportionment purposes. To meet one of the tests for determining if income is business income in Oregon, the income must arise from a transaction taking place in the taxpayer’s regular course of business, and the regular course of business must be determined by looking at the taxpayer’s unitary business across its multistate enterprise. That the income arises from the taxpayer’s unitary business is what allows states to tax income made in other states. In this particular case, the Oregon Tax Court found that the state’s department of revenue overstepped in saying the acquisition, management and sale of other companies was part of the taxpayer’s unitary business, rather than investment income, and that income from two particular investments should therefore be included in business income. The court disagreed after concluding that the activity should be characterized as nonbusiness income that was not taxable in Oregon, and granted a major win for Fidelity.

In Fidelity National Financial, Inc. v. Department of Revenue, Oregon Tax Court, Fidelity appealed a decision by the Oregon Department of Revenue that classified income gained from the sale of its interest in Sedgwick Holdings, Inc., and its income from American Blue Ribbon Holdings, LLC, as business income, some of which would be apportioned to Oregon. Fidelity argued that the sale of interest and income from investment in these two companies were not within its regular course of business and should not be included in calculation of business income. Oregon’s Department of Revenue responded that Fidelity’s regular course of business included the acquisition, management and sale of other companies, and therefore the income from these sales could be properly classified as business income.

Oregon has two tests in Oregon Revenue Statute 314.610(1) in determining if income is considered business income: the functional test and the transactional test. Under the functional test, when the acquisition, management, use or rental and disposition of property are an integral part of a taxpayer’s regular trade or business operations, the sale of an asset or income from an asset that was integral to the taxpayer’s business will satisfy the test and be classified as business income. However, the Oregon Department of Revenue conceded that it could not classify the income from the sale of interest in Sedgwick as business income under the functional test, and held substantially the same position for the income from Blue Ribbon.

By contrast, in the MINACT case in 2014, the Missouri Supreme Court concluded that income from investment assets held in a “rabbi trust” is business income because it was meant for compensation of employees. The income was therefore meant to serve the operational purpose of attracting and retaining employees who would perform the company’s regular business, and therefore is an integral part of the taxpayer’s business, satisfying the functional test. Here, Oregon conceded that it could not make the argument that the income in question was an integral for operational purposes.

Under the transactional test, income that arises from transactions and activity in the regular course of the taxpayer’s trade or business is considered business income. The Tax Court noted that they must consider the issue keeping the unitary business principle in mind, and that while a capital transaction can be included in apportionable business income if it serves an operational function related to the entity’s operations in Oregon (as previously decided by the Oregon Supreme Court in Pennzoil Co. v. Or. Dept. of Rev., 33 P.3d 314 (Or. 2001)), a transaction only for investment purposes is not included in business income, even if it is financially beneficial to the entity for future business purposes.

The Tax Court noted that a guiding principle is that a taxpayer’s trade or business for purposes of determining business income is its unitary business, part of which is conducted in Oregon. The court noted that it had previously referenced the fact that Oregon’s definition of business income, taken from the Uniform Division for Income Tax Purposes Act, flows out of the unitary business principle in Pennzoil Co. v. Dept. of Rev., 15 OTR 101, 107 (2000) aff'd, Pennzoil, 332 Or 542, (quoting Container Corp. v. Franchise Tax Bd., 463 US 159, 166 (1983)). Fidelity described its unitary business as the nation’s largest title insurance writer and operator, which would leave the sale of interest in Sedgwick and income from Blue Ribbon outside the scope of the regular course of business. The department argued that the unitary business included these types of sales of stakes and investment in companies.

The court agreed with Fidelity, saying that the sales in this case were not so inextricably mixed with Fidelity’s title insurance business to separate the gain from the sale of interest in Sedgwick from the company’s revenues generated by Oregon activity. The court ruled the same related to the income from Blue Ribbon, saying that the trade Fidelity conducts in Oregon is its title insurance business, and that including the income from Blue Ribbon for apportionment purposes would be inappropriate. This left the court to conclude that the income was properly reported as nonbusiness income from the Sedgwick sale in 2010 and from the Blue Ribbon investment in 2010 and 2011.

The full text of the court’s opinion is available here:$All)/BA58DA9FD15AC43188257F3B00679A77/$File/Fidelity140440DFNLDE.pdf

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: Should investment income be included in business income for apportionment purposes?

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