On April 15, 2008, the Supreme Court of the United States decided unanimously that the “operational function” test for apportionable income articulated in Allied-Signal must be applied narrowly to assets used in the taxpayer’s business, but not to the relationship between business entities or businesses. MeadWestvaco Corp. v. Illinois Department of Revenue, No. 06-1413 (decided April 15, 2008). The Illinois Appellate Court had ruled that Illinois could tax an apportioned share of Mead’s gain on the sale of its wholly owned Lexis/Nexis business division, despite the trial court’s factual determination that Mead and Lexis/Nexis were not unitary, on grounds that Mead’s investment in Lexis/Nexis served an “operational purpose” in Mead’s business within the meaning of Allied-Signal v. Director of Taxation, 504 U.S. 768 (1992). The MeadWestvaco Supreme Court opinion is available here.
The Supreme Court vacated the decision of the Illinois Appellate Court, stating that the lower court erred by considering the operational test after determining that Mead and Lexis/Nexis were not unitary. The Supreme Court ruled that the concept of operational function was not intended to modify the unitary business principle by adding a new ground for apportionment, and that “when the asset in question is another business” the hallmarks of a unitary relationship continue to be functional integration, centralized management and economies of scale. This result went far beyond Mead’s argument—that Mead’s investment in Lexis/Nexis was a purely passive investment and did not serve an “operational function” in Mead’s business within the meaning of Allied-Signal.
“Operational Function” Not Applicable to Relationship Between Businesses
According to the Supreme Court, the concept of “operational function” simply recognizes that specific assets—but not other businesses—can be part of a taxpayer’s unitary business even if there is no unitary relationship between the payor and payee. The Supreme Court reviewed the examples in Allied-Signal of assets that served an operational function, i.e., a short-term bank deposit, where the taxpayer is not unitary with its banker, and a commodities hedging contract, where the taxpayer is not unitary with its counterparty to the hedging transaction. In contrast, the “fundamental error” in the Illinois Appellate Court’s decision was to consider whether Lexis/Nexis served an operational purpose in Mead’s business after determining that Lexis/Nexis and Mead were not unitary.
The Supreme Court’s decision appears to be a significant victory for multistate corporate taxpayers. However, although the significance of the “operational function” has been curtailed, the fight for Mead may be far from over. As the Supreme Court noted, on remand the Illinois Appellate Court may take up the question of whether Mead and Lexis/Nexis should be considered a unitary business, contrary to the trial judge’s factual finding. The lower court may also revisit the issue of whether a distinction exists between a sale of separate subsidiary and a sale of a division. Nevertheless, Mead now has the distinct advantage in this litigation, given the trial judge’s factual determination that Mead and Lexis/Nexis were not unitary based upon the “hallmark” indicia of functional integration, centralized management and economies of scale.
Possible Application of International Harvester
The Supreme Court concluded its opinion with a tantalizing comment on “source of income” tax regimes, although the Supreme Court declined to decide whether Illinois should have jurisdiction to tax the gain by reason of the fact that Lexis/Nexis did substantial business in Illinois. This “source of income” argument was raised for the first time in the Supreme Court by the Illinois Attorney General and by the Multistate Tax Commission as amicus curiae, based largely on cases such as International Harvester Co. v. Wisconsin Department of Taxation, 322 U.S. 435 (1944). The concept also bubbled to the surface in questioning by Justices Ginsburg and Scalia during oral argument. The argument almost certainly has been waived by Illinois. In any event, the Supreme Court as a practical matter may have prevented reconsideration of this argument on remand by its comments in a footnote that, if Lexis/Nexis’ presence in Illinois were the basis for Illinois’ tax upon the gain, Lexis/Nexis’ factors rather than Mead’s factors should be used to apportion the gain, which would be inconsistent with Illinois’ statutory scheme.
In declining to rule on the source of income issue, the Supreme Court also noted that a decision on the merits might affect the laws of states such as New York and Ohio, which tax certain investment income based upon the presence of the payor in the state, and since neither New York nor Ohio “was on notice that the constitutionality of its tax scheme was at issue” and had not appeared in the case, the question “is best left for another day.” Nevertheless, if the Supreme Court’s dictum puts a reconsideration of the International Harvester precedent and the “source of income” statutes into play, the MeadWestvaco decision may be remembered as an especially important result for multistate corporate taxpayers.