High Court Curbs Taxation on Subsidiary Sale

In the wake of the decision, it seems certain that Illinois won't be able to collect taxes on the sale of Lexis/Nexis shares.
Robert WillensApril 21, 2008

Can a state tax a part of the capital gain realized by a non-domiciliary corporation on the sale of stock of a subsidiary? That was the issue in a case entitled MeadWestvaco Corp. v. Illinois Department of Revenue US_(2008). The Supreme Court concluded that the decision of the Appellate Court, permitting such taxation, was premised upon an incorrect principle and remanded the case to the lower court for further proceedings consistent with the High Court’s ruling.

It seems certain that, on remand, the appeals court will find in favor of the taxpayer in light of the fact that the Supreme Court has eviscerated the basis on which the lower court assessed the tax in the first instance.

In 1968, Mead, an Ohio corporation, paid $6 million to acquire the stock of Data Corp., which owned an inkjet printing technology and a full-text, information-retrieval system. The latter operation, based in Illinois, flourished and became Lexis/Nexis.

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In 1994, Mead sold Lexis/Nexis for some $1.5 billion and realized over $1 billion in capital gains. For Illinois taxation purposes, Mead contended that the capital gain qualified as “non-business income” that should be allocated in its entirety to Mead’s domiciliary state, Ohio. By contrast, the state of Illinois said that the capital gain constituted “business income” subject to apportionment by Illinois.

The facts revealed that Lexis/Nexis was subject to Mead’s oversight, but Mead did not manage its day-to-day affairs. Mead was headquartered in Ohio while a separate management team ran Lexis/Nexis out of the latter’s headquarters in Illinois. The businesses maintained separate manufacturing, sales, and distribution facilities, as well as separate accounting, legal, human resources, credit and collections, purchasing, and marketing departments.

Mead’s involvement with Lexis/Nexis was generally limited to approving Lexis/Nexis’s annual business plan and any “significant corporate transactions.” In fact, Lexis/Nexis purchased most of its paper from suppliers other than Mead and, in general, neither entity was a “significant customer” of the other.

On these facts, the trial court in Illinois concluded that Lexis/Nexis and Mead did not constitute a “unitary” business. Nonetheless, Illinois could tax an “apportioned share” of Mead’s capital gain because “Lexis/Nexis served an operational purpose in Mead’s business.”

The appellate court affirmed the trial court’s decision. It said that Lexis/Nexis served an “operational function” in Mead’s business. As a result, an apportioned part of Mead’s capital gain could be subjected to Illinois taxation because: Lexis/Nexis was wholly-owned by Mead; Mead had exercised control over Lexis/Nexis in various ways and Mead had consistently described itself as engaged in “electronic publishing”.

Unitary Business

The Supreme Court, in an opinion authored by Justice Alito, noted that where, as here, there is no dispute that the taxpayer has done some business in the taxing state, the inquiry shifts from whether to what (the state may tax). To answer this question, the Supreme Court has developed the so-called “unitary-business principle.” Under that principle, a state may tax an apportioned sum of the corporation’s multi-state business, but only if the business is found to be unitary.

In other words, a state could tax an apportioned share of the value of the (unitary) business instead of isolating the value attributable to the operation of the business within the state. Conversely, if the value the state wished to tax derived from a discrete business enterprise the state could not tax even an apportioned share of that value.

The High Court acknowledged that, in some cases, courts have found it difficult to identify exactly when a business is unitary. For this reason, and to give some recognition to the manner in which business is contemporarily conducted, the Supreme Court had observed in its prior jurisprudence that an asset could form part of a taxpayer’s unitary business if it served an operational function (as opposed to an investment function) in that business. Accordingly, a state may include within the apportioned income of a non-domiciliary company interest earned on short-term deposits in a bank located in another state, if that income forms part of the working capital of the corporation’s unitary business.

That would be the case, notwithstanding the absence of a unitary relationship between the corporation and the bank. That said, the Supreme Court then noted that its references to operational function were not intended to modify the unitary business principle by adding a new ground for apportionment. Instead, the concept of operational function simply recognizes that an asset can be part of a unitary business even if a unitary relationship does not exist between the payer and payee. Thus, in the Mead example, it is clear that the taxpayer is not unitary with its bank (in which its deposits are housed), but rather the deposits (which produced the income the state sought to tax) were unitary with the business.

Vacated and Remanded

Consider that in the Mead example, the asset in question is another business. Also note that the “hallmarks” of a unitary relationship are as follows: functional integration; centralized management and; economies of scale. Because each of these indicators was lacking, the trial court found that Lexis/Nexis was not a unitary part of Mead’s business. The appellate court in Illinois, however, made no such determination. Relying on its “operational function theory” it reserved judgment on the unitary business question.

In light of the fact that the appellate court’s decision was vacated, and the case was remanded to such court for further proceedings, the Supreme Court noted that “…the court may take up this question (of whether a unitary business existed) on remand …”

Illinois invited the Supreme Court to recognize a new ground for the apportionment of intangibles based upon the state’s contacts with the capital asset rather than with the taxpayer selling or disposing of that asset. Illinois believed that Lexis/Nexis’s own contacts with the state justified the apportionment of Mead’s capital gain.

In short, the state asked the High Court to allow for taxation of a non-domiciliary corporation’s capital gain where the corporation generating the income (here, Lexis/Nexis) has its own connection with the taxing jurisdiction. The court declined the state’s invitation on procedural grounds.

But this issue will surface again as the unitary-business principle continues to evolve. The Supreme Court noted that, among others, New York State and Ohio have adopted taxing systems which focus not on the selling taxpayer’s nexus with the taxing jurisdiction but, instead, with the connection of the asset sold to such taxing jurisdiction.

Thus, undoubtedly, the Supreme Court will be called upon, perhaps in the near future, to comment upon the constitutionality of these formats. In light of the fact that the Court shows no signs of jettisoning the unitary-business principle, the long-term outlook for these alternative taxing systems seems to be, at best, uncertain.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for

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