The Missouri Administrative Hearing Commission has determined that capital gains from the sale of a taxpayer's interest in a commercial explosives business that was considered a one-time extraordinary event and the interest earned on those capital gains were considered nonbusiness income for Missouri corporate income tax purposes.1 As nonbusiness income, the capital gains and interest were allocable to Connecticut, the state of the taxpayer's commercial domicile, instead of Missouri.
Background
Ensign-Bickford Industries, Inc. ("EBI"), a corporation headquartered and domiciled in Connecticut, owned several subsidiaries, including Applied Food Biotechnology, Inc. (AFB) and Ensign-Bickford Company ("EBCo"). AFB was a Missouri-based company engaged in the manufacture and sale of pet food flavor enhancers, while EBCo was a Connecticut-based company engaged in the commercial explosives business with no facilities, employees, or property in Missouri. Other subsidiaries of EBI were engaged in business activities that generally supported the commercial explosives business, with none of their facilities, employees or property located in Missouri.
During 2000, EBI's board decided to sell EBCo's commercial explosives business. In 2003, EBI and the shareholders of a Norwegian company (Dyno Nobel) entered into an agreement under which EBI contributed substantially all of its commercial explosives assets in exchange for approximately 26 percent of the ownership of Dyno Nobel. EBI did not participate in the management of Dyno Nobel, and only had the right to name two of the nine members of Dyno Nobel's board of directors. Following a change in business structure from a corporation to a limited liability company (LLC) in 2005, Dyno Nobel was sold to a third party for cash. The sale resulted in a long-term capital gain to EBI of $247,243,200.
On the 2005 Missouri consolidated corporation income return, AFB (the reporting taxpayer at the time) elected three-factor apportionment pursuant to the Multistate Tax Compact (Compact) and reported the long-term capital gain of $247,243,200 and associated interest of $958,006 as nonbusiness income. AFB allocated these items to Connecticut and therefore did not pay tax to Missouri on such amounts. In 2007, the Missouri Director of Revenue issued a notice of deficiency, which showed a tax due of $2,543,264 due to the inclusion of the gain and associated interest in taxable income. EBI filed amended returns for 2005 and 2006 noting the change in reporting taxpayer, and stating that additional interest income received in 2006 related to the Dyno Nobel transaction was nonbusiness income allocable to Connecticut.
Capital Gain and Interest Constituted Nonbusiness Income
Ultimately, the Commission concluded that neither the capital gain from the sale nor the interest accrued in 2005 and 2006 constituted business income under the Compact. In reaching this conclusion, the Commission considered provisions of the Compact, transactional and functional tests for business income, as well as constitutional, consolidated return, and partnership law analysis.
Business and Nonbusiness Income Provisions in Compact
Article IV of the Compact (as statutorily adopted by Missouri) defines the term "business income" as "income arising from transactions and activity in the regular course of the taxpayer's trade or business and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations."2 Nonbusiness income is defined as "all income other than business income."3 The Compact requires all business income to be apportioned, and all nonbusiness income to be allocated via a series of sourcing rules.4
The Commission determined that the gain on the sale and interest was nonbusiness income because the property generating the gain was not acquired, Dyno Nobel managed the property, and the disposition of the property did not constitute an integral part of EBI's regular trade or business operations. The Commission cited to several cases decided in Missouri and other jurisdictions to support the characterization of the capital gain and interest as nonbusiness income, including ABB C_E Nuclear Power, Inc. v. Director of Revenue,5 Pledger v. Illinois Tool Works, Inc.,6 Blessing/White, Inc. v. Zehnder,7 Lenox, Inc. v. Tolson,8 and Union Carbide Corp. v. Huddleston.9
Transactional and Functional Tests for Business Income
The Commission applied the transactional and functional test analysis utilized by the Missouri Supreme Court in ABB C_E Nuclear Power to determine whether the income in question was business income. The transactional test determines whether the gain is attributable to a type of business transaction in which the taxpayer regularly engages.10 The functional test determines whether the gain is attributable to an activity that constitutes an integral part of the taxpayer's regular business.11
The Director argued that the transactional test was met because EBI did not completely liquidate its commercial explosives business. However, the Commission determined that the transaction was not one regularly engaged in by EBI. Instead, the transaction from which the income was derived was considered to be a sophisticated, one-time transaction designed to keep the combined explosives business intact and operational until a buyer could be found.
The Commission also found that the transaction in question failed the functional test. The fact that the disposition of EBI's commercial explosives business was accomplished through a multi-step, multi-year process did not make the business an integral part of its regular business. Therefore, the transaction qualified as a "one-time, extraordinary event" similar to ABB C_E.
Constitutional Analysis
The Due Process and Commerce Clauses require "some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax."12 Therefore, these constitutional standards prevent the states from taxing "extraterritorial value," though states can tax an apportioned share of the value generated by the in-state and out-of-state activities of a multistate enterprise if those activities formed part of a unitary business.13
EBI alleged that the "hallmarks" of a unitary relationship, which are functional integration, centralized management, and economies of scale, did not exist.14 As a result of the pre-sale transactions as agreed to by the parties in the 2003 agreement, EBI went out of the commercial explosives business, vesting its interests in that business in Dyno Nobel (as an LLC). EBI had no management powers and did not participate in Dyno Nobel during the time between the original transaction with Dyno Nobel and the sale of the ownership interest in Dyno Nobel.
Though there was centralized management, EBI only participated in its management peripherally. While EBI chose two of the nine-member board of Dyno Nobel, EBI did not participate in day-to-day management, and the headquarters of Dyno Nobel remained in Norway. Finally, the Commission determined that the economies of scale test was not relevant in determining unity in this case.
Consolidated Return and Partnership Law
The Director proposed that an exchange of value occurred when filing a consolidated return,15 thus satisfying the unitary business requirement.16 However, the taxpayer's in- state and out-of-state activities were completely different. The in-state activities related exclusively to the manufacture and sale of pet food flavor enhancers, while the out-of-state activities in question related to commercial explosives. Therefore, the exchange of value concept did not apply.
Lastly, the Director argued that the taxpayer and Dyno Nobel entered into a partnership and by doing so, converted their business into a unitary business. However, the Commission held that the entity created, Dyno Nobel Holding AS, was a Norwegian LLC and the fact that the LLC was taxed as a partnership did not make it a partnership, any more so than the tax election of a domestic LLC converted it into a partnership.
Commentary
The decision by the Commission to classify the capital gain and interest as nonbusiness income is not surprising considering that Missouri recognizes there are circumstances under which income from certain distinctive transactions can be nonbusiness income, as in ABB C_E. It stands to reason that a transaction designed to divest the taxpayer of its primary line of business that had no activity in Missouri, leaving the taxpayer with a completely unrelated business located in Missouri would be deemed to generate nonbusiness income in a jurisdiction following the Compact.
Even though a nonbusiness income determination was reached in this instance, the facts and circumstances giving rise to nonbusiness income are not that common. Accordingly, the Commission's decision, which is subject to appeal, should not be construed to broaden the situations under which nonbusiness income reporting is appropriate. One can expect that state tax authorities will continue to take the position that the vast majority of transactions generate business income rather than nonbusiness income. Even so, a finding of nonbusiness income is not always helpful to the taxpayer. EBI assuredly would not have been arguing in favor of nonbusiness income treatment if their headquarters were located in Missouri instead of Connecticut.
Footnotes
1 Ensign_Bickford Industries, Inc. v. Department of Revenue, Missouri Administrative Hearing Commission, No. 09-0709 RI, Nov. 30, 2011.
2 MO. REV. STAT. § 32.200 (Art. IV.1.(1)).
3 MO. REV. STAT. § 32.200 (Art. IV.1.(5)).
4 MO. REV. STAT. § 32.200 (Art. IV.1.(4), (9)).
5 215 S.W.3d 85 (Mo. Banc 2007).
6 812 S.W.2d 101 (Ark. 1991).
7 768 N.E.2d 332 (Ill. App. 2002).
8 548 S.E.2d 513 (N.C. 2001).
9 854 S.W.2d 87 (Tenn. 1993).
10 Id.
11 Id.
12 Allied_Signal, Inc. v. Director, Div. of Taxation, 504 U.S. 768 (1992); Miller Bros. Co. v. Maryland, 347 U.S. 340 (1954).
13 MeadWestvaco Corp. ex rel. Mead Corp. v. Illinois Dept. of Revenue, 553 U.S. 16 (2008).
14 Id.
15 Luhr Bros. v. Director of Revenue, 780 S.W.2d 55 (Mo. Banc 1989).
16 Container Corp. of America v. Franchise Tax Board, 463 U.S. 159 (1983).
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