Corporate Close-Up: With Upsurge in M&As, Varying State Tax Laws Pose Traps for the Unwary

There has been a noted upsurge mergers and acquisitions in 2014 both worldwide and in the U.S. In terms of structuring these deals for U.S. federal tax purposes, one of the most common forms used in a domestic acquisition is the I.R.C. § 338(h)(10) election, which offers significant income tax advantages at both the federal and state levels . While nearly all of the states adopt I.R.C. § 338(h)(10), important questions regarding the state tax treatment of M&A transactions remain, such as:

  •  Will the transaction be characterized as one that generates business or nonbusiness income?
  •  Will the seller and a target meet a state’s definition of a unitary business?
  •  How will the assets be characterized for inclusion in the target’s sales factor?

When the purchaser and seller jointly make a I.R.C. § 338(h)(10) election following a qualifying stock purchase of target’s stock, the target corporation is deemed to have sold all of its assets to a “new target” and to have distributed the proceeds to the seller in a deemed liquidation. The seller winds up with the proceeds without having paid tax on any built-in gain on the target’s stock and the purchaser receives target’s assets with a stepped-up basis. The single level of federal income tax imposed on the sale of target’s assets to the purchaser is the reason why the I.R.C. § 338 (h)(10) election is so widely used in domestic acquisitions.

Almost all states now recognize the I.R.C. § 338 (h)(10) election and conform to the characterization of the transaction both with respect to the deemed liquidation by the target and the asset sale by the target to the new target. However, the conversion of what is actually a sale of stock by one corporation into a sale of assets by another brings a variety of state income tax concepts into play in characterizing, sourcing and taxing the sale at the state level.

Traditional state income tax rules, embodied in UDIPTA, distinguish between business income that is apportionable based on the activities of the taxpayer in a state and non-business income that is allocable to the state in which the taxpayer is commercially domiciled. In determining whether income is business or non-business, the U.S. Supreme Court has consistently employed both the transactional and functional tests originally found in UDIPTA. Income is business income under the transactional test where the underlying transaction occurs in the regular course of the taxpayer’s trade or business and, generally, excludes cessation or liquidations of a business. Under the broader functional test, business income is that income from property where the acquisition, management or disposition of the property constitute integral parts of the taxpayer’s trade or business.

State courts, such as New Jersey in McKesson Water Products Co. v. N.J. Div. of Taxn., 23 N.J. Tax 449 (2007) and Missouri in ABB C-E Nuclear Power Inc. v. Missouri Dir. of Rev., 215 S.W.3d 85 (Mo. 2007), have often placed significant weight on the liquidation of target’s business in the I.R.C. § 338 (h)(10) election and found that this results in nonbusiness income. In contrast, most state taxing authorities view the sale of target’s assets as business income as seen in Arizona Corporate Tax Ruling 98-2 and in North Carolina Corporate Income Tax Directive CD-02-3.

But, ostensibly, only income of a unitary business can be apportioned. Where seller and target don’t have the requisite functional integration, centralization of management and economies of scale, seller and target’s activities should not be aggregated for purposes of apportioning the gain on the sale of target’s assets in an I.R.C. § 338 (h)(10) election. In a sale of stock that is, for federal tax purposes, a hypothetical sale of assets followed by a liquidation and distribution, is it the sale of stock by the seller or the sale of assets by the target that controls the characterization of the income for state income tax purposes? The U.S. Supreme Court noted this issue in a footnote in MeadWestvaco Corp. v. Illinois Dept. of Rev., 553 U.S. 16 (2008) where it questioned whether apportionable gain from the sale of Lexis, had there been a unitary relationship, should have been apportioned using Lexis’ factors instead of Mead, the seller. Though Lexis was a division of Mead at the time of sale, this issue should be prevalent when an I.R.C. § 338 (h)(10) election is utilized.

If the sale of assets by target constitutes apportionable business income then, under UDIPTA, it should follow that those proceeds will be included in target’s apportionment factors. Compare the results in North Carolina Corporate Income Tax Directive CD-02-3, where the proceeds are excluded on the grounds that the assets themselves were not acquired for purposes of being sold in in the course of target’s trade or business, with the results in Virginia Ruling of the Commissioner PD 91-317 and Arizona Corporate Tax Ruling 98-2, where the proceeds are included in the sales factor. Further, depending on how the proceeds are allocated under the federal purchase price allocation, the inclusion of the proceeds in the sales factor will also vary when states source classes of income such as intangible income differently. Amongst the most granular issues, where combined reporting is required for the seller and target, whether the state calculates tax on a pre- or post-apportionment basis and whether state NOLs are available on an individual taxpayer or group basis could also alter the resulting tax.

In the end, the answers for all of these issues vary widely from state to state depending on the specific facts and circumstances surrounding target and seller’s business, the mechanics of statutes and case law. The potential impact on state tax liability should be modeled carefully prior to closing a deal in which an I.R.C. § 338(h)(10) election will be employed.

By Christopher Bailey

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