United States: Oregon Tax Court Finds Gain From Stock Sale Properly Treated As Apportionable Business Income

The Oregon Tax Court recently ruled that the gain from the sale of stock in an unrelated business by a non-Oregon corporation met the functional test to qualify as business income and was properly subject to Oregon corporation excise (income) tax as apportionable income.¹ The Court also upheld the imposition of penalties because the taxpayer lacked substantial authority to treat the income as nonbusiness income.

Background

The taxpayer, a Washington-based business, owned and operated television and radio stations in various states during the 2003-2008 corporation excise tax years in controversy. The taxpayer and its parent corporation, also a Washington-based business, were engaged in a unitary business and filed consolidated Oregon corporation excise tax returns as a unitary group from 1999 to 2008.

The case concerned the Oregon tax treatment of the taxpayer's sale of stock in Safeco Corporation, an unrelated business. Safeco was legally domiciled in Washington and engaged in the property and casualty insurance business directly or through subsidiaries. The taxpayer originally acquired Safeco stock in 1923. The taxpayer received dividends from the holding of Safeco stock throughout the tax years at issue. These dividends were commingled with other funds, which were used to pay expenses, including the expenses of the taxpayer's broadcasting business.

In addition, the taxpayer entered into a variety of financial transactions involving the Safeco stock, and ultimately disposed of all of its Safeco shares in several transactions. In March 2002, the taxpayer entered into a financial transaction which collateralized some of its shares of Safeco stock. The proceeds from this transaction were used for general corporate purposes, to repay debt, and to finance construction projects. Further, the taxpayer entered into a financial transaction during 2004, which included as a condition the placement of certain legal restrictions on the taxpayer's ability to use its Safeco stock. The terms of the transaction also restricted the use of any proceeds from the sale of the Safeco stock. The Safeco stock was not pledged as security for these financial instruments and the financial instruments remained outstanding and subject to the restrictions throughout the tax years at issue.

In December 2007, the taxpayer sold some of its shares of Safeco stock, which resulted in a recognized gain for federal income tax purposes of approximately $32.6 million. In January 2008, the taxpayer used the net proceeds from the Safeco stock sale to fund the purchase of additional radio stations. In June and July 2008, the taxpayer sold its remaining shares of Safeco stock, which resulted in a tax gain of approximately $127.1 million.

On its originally filed Oregon corporation excise tax returns for the tax years at issue, the taxpayer reported the dividends from Safeco stock as apportionable business income. In contrast, on its originally filed 2007 and 2008 Oregon corporation excise tax returns, the taxpayer classified the gains from the sale of Safeco stock in 2007 and 2008 as nonbusiness income allocable outside Oregon. The taxpayer subsequently filed amended returns for 2006, 2007, and 2008 reclassifying the dividends from Safeco as nonbusiness income.

At issue in this case was: (i) whether the apportioned taxation by Oregon on the gain from the disposition of Safeco stock was consistent with Oregon law and the limitations on state taxation imposed by the U.S. Constitution; and (ii) whether the taxpayer was liable for a related penalty pursuant to Oregon law.

Business Income

In determining whether the income from the sale of the Safeco stock constituted apportionable business income, the Oregon Tax Court looked to the controlling Oregon allocation and apportionment provisions derived from the Uniform Division of Income for Tax Purposes Act (UDITPA), which apply to businesses other than financial organizations and public utilities.² With respect to the method of apportionment, under UDITPA, "business income" of a multistate taxpayer is apportioned among the several states in which the taxpayer conducts business, while "nonbusiness income" is generally allocated to the state of the taxpayer's commercial domicile, or if the nonbusiness income derives from property, the property's situs.³

Based on Oregon's statutory definition, "business income" includes "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, the management, use or rental, and the disposition of the property constitute integral parts of the taxpayer's regular trade or business operations."⁴ "Nonbusiness income" is "all income other than business income."⁵ More specifically, under the Department's general apportionment rules, "business income" is defined as income which includes "[g]ain or loss from the sale, exchange or other disposition of real or tangible or intangible personal property ... if the property while owned by the taxpayer was used in the taxpayer's trade or business."⁶

Transactional and Functional Tests

In a prior decision, the Oregon Supreme Court had explained that the statutory definition of "business income" derived from UDITPA is met if either a "transactional test" or a "functional test" is satisfied.⁷ Under the transactional test, business income "means income arising from transactions and activity in the regular course of the taxpayer's trade or business."⁸ Under the functional test, business income "includes income from tangible and intangible property if the acquisition, the management, use or rental, and the disposition of the property constitute integral parts of the taxpayer's regular trade or business operations."⁹

The combination of the statutory and constitutional tests was found to be consistent with the language included in the Department's rules, which states:

Thus, the Tax Court focused on determining whether the taxpayer's Safeco stock served an operational or investment function for the unitary business of the taxpayer.

Citing Allied-Signal,¹¹ the Tax Court considered the application of the unitary business principle. Specifically, a unitary relationship between an operating business (the taxpayer's media business) and an intangible interest in a discrete business (the Safeco stock) exists when the ownership of the asset serves an operational instead of an investment function.¹² The business or enterprise at issue does not have to be unitary with the business represented by the intangible asset in order for the asset to serve the operational function necessary to conclude that apportionment of the income meets the statutory and constitutional requirements. In such cases, the Tax Court noted, taxation of the gain from the sale of such asset on an apportioned basis does not violate federal constitutional limitations.

Also, based on the language in Allied-Signal and ASARCO,¹³ the U.S. Supreme Court determined that intangible assets held as investments of necessary working capital have an operational function and the income from the investments is apportionable business income. The Tax Court interpreted the U.S. Supreme Court's analysis in those cases to support the conclusion that the pledge of an intangible asset indicates that the asset is employed in an operational function, especially where the pledge is made in connection with obtaining financing for the unitary business operations of the taxpayer.¹⁴ The U.S. Supreme Court has also found that a parent corporation's guarantee of its subsidiaries' debt was a factor that could be used to conclude it demonstrated the requisite flow of value to come to a unitary business determination.¹⁵ Similarly, the Tax Court determined that in the reverse fact pattern, where the pledge of stock results in a flow of value from the stock to the business of the pledger, at least where the borrowed funds are used to finance the business of the pledger, a similar flow of value exists.

Based on the fact that the taxpayer, in the years prior to the sale of Safeco stock, twice engaged in financing transactions relating to the Safeco stock, the Tax Court considered the substance of those transactions to determine if they involved the use of the Safeco stock in an operational capacity. For the 2003 tax year and until November 2004, the stock was collateralized to secure funds used in the taxpayer's general business. Thus, for that specific time period, the Tax Court found that the Safeco stock was used for operational purposes. As to the remainder of the tax years at issue, the Tax Court looked to the financing vehicles obtained during 2004 which placed significant restrictions on the use of the Safeco stock by the taxpayer and the employment of proceeds from any sale of the asset. Specifically, the indenture contained what is generally referred to as a negative pledge.¹⁶ Finding that no constitutional significance could be found in the decision of borrowers and lenders to use negative pledge covenants rather than affirmative pledges of an asset, the Tax Court determined that it must treat the pledge in the same manner as an affirmative pledge for constitutional purposes.¹⁷ Also, the Tax Court cited the specific terms of the indenture requiring that the proceeds from the sale of the Safeco stock must either be used to operate and expand the unitary business of the taxpayer or to support an offer to retire the notes.

Ultimately, the Tax Court rejected the taxpayer's argument that reliance upon the terms of its covenants to reach a determination was "simply a thinly veiled rehash of the corporate purpose or betterment arguments rejected by this court and the U.S. Supreme Court." The Tax Court countered that the U.S. Supreme Court has rejected the idea that where an asset only serves to increase the net worth of an enterprise or increase general creditworthiness, or where the asset was acquired for a business purpose, that those facts alone support a conclusion that the asset has an operational function.¹⁸ Instead, a specific functional connection between the asset in question and the business carried on in a taxing state must be evident.

In this instance, the Tax Court found that the Safeco stock was not just an asset on the balance sheet of the taxpayer. Instead, the stock was an asset that, through the covenants in the indenture and the financing obtained through those covenants, was specifically devoted to and employed in the unitary television and radio business of the taxpayer. Having determined that the Safeco stock served an operational purpose for the taxpayer's unitary business, gains from its sale, as well as related dividends, were properly treated as apportionable business income by Oregon.¹⁹

Imposition of Penalty

Under Oregon law, the taxpayer is responsible for payment of the assessed penalty if substantial authority did not exist for its treatment of the gain on the sale of Safeco stock as nonbusiness income.²⁰ Though the taxpayer cited cases related in a general manner to the constitutional restraints placed on Oregon regarding taxation of a gain from the sale of intangible assets, the Tax Court summarily rejected the taxpayer's position as not having substantial authority. Finding that the taxpayer had no substantial authority for its position, the Tax Court upheld the imposition of penalties.

Commentary

This decision provides a thorough and detailed analysis of a business/nonbusiness income determination by the Oregon Tax Court. It is interesting that the Tax Court engaged in a quasi-unitary analysis to determine whether income from the sale of an unrelated business asset qualified as business income under the functional test. All available facts surrounding the use of the intangible asset which generated the gain at issue by the unitary group seemed relevant to this determination. The negative pledge, in particular, associated with the asset appeared to be a crucial factor.

Taxpayers who have entered into debt agreements or other financial instruments which include legal restrictions on their use of assets should certainly be aware of Oregon's position in this case. Specifically, negative pledges associated with intangible assets owned by unitary groups filing in Oregon could lead to a conclusion that these assets serve an operational function and any associated income, including dividends and sales proceeds, could be treated as apportionable business income by Oregon.

The Tax Court did not address how to source the income from the sale of the business for apportionment factor purposes. Under Oregon law, receipts from the sale of intangible assets are generally excluded from this computation, unless those receipts are derived from the taxpayer's primary business activity.²¹ However, the net gain from the sale of intangible assets not derived from the taxpayer's primary business activity is specifically included in the apportionment factor calculation.²² Taxpayers seeking to source income from the sale of assets should refer to these statutes, as well as further guidance provided by case law addressing this issue. Specifically, the Oregon Supreme Court has affirmed an Oregon Tax Court decision holding that a taxpayer's gross receipts from the sale of goodwill should be excluded from the sales factor used to compute its Oregon corporate excise tax liability.²³ The Court rejected the Tax Court's conclusion that "intangible assets" means only "liquid assets," and held that the term carries its ordinary meaning. Also, the Oregon Tax Court has previously held that gains from the taxpayer's sales of its subsidiaries' stock must be included in the taxpayer's Oregon sales factor denominator and excluded from the numerator for purposes of apportionment.²⁴

Footnotes

 1 Fisher Broadcasting Co. v. Dep't. of Rev., Oregon Tax Court, No. TC 5167, Apr. 19, 2015.

2 OR. REV. STAT. §§ 314.605-314.675.

3 OR. REV. STAT. §§ 314.625-314.645.

4 OR. REV. STAT. § 314.610(1).

5 OR. REV. STAT. § 314.610(5).

6 OR. ADMIN. R. 150-314.610(1)-(B)(2).

7 Willamette Industries, Inc. v. Department of Revenue, 15 P.3d 18 (Or. 2000).

8 Id.

9 Id.

10 OR. ADMIN. R. 150-314.610(1)-(A)(5)(c).

11 Allied-Signal v. Dir., Tax. Div., 504 U.S. 768 (1992).

12 Id.

13 ASARCO Inc. v. Idaho State Tax Comm'n, 458 U.S. 307 (1982).

14 In ASARCO, for example, the U.S. Supreme Court found a clear indication that the use of an asset to secure bond financing would support a finding that the asset had been employed in an operational capacity.

15 Container Corp. of America v. Franchise Tax Bd., 463 U.S. 159 (1983).

16 A "negative pledge" is defined as an unsecured loan agreement provision requiring the borrower to obtain the current lender's consent before obtaining any secured loan. Black's Law Dictionary.

17 The Tax Court found that the actual behavior of borrowers and lenders and legal doctrines that have arisen to protect the negative pledgee render the differences between an affirmative pledge and a negative pledge to be more theoretical than practical. Secured Transactions Inside Out: Negative Pledge Covenants, Property and Perfection, Carl J. Bjerre, 84 Cornell L Rev 305 (1999).

18 The Tax Court noted several facts as insufficient evidence of the Safeco stock serving an operational function, including: (i) the stock increased the net worth of the taxpayer; (ii) the stock was acquired for a business purpose; (iii) the income from the stock was commingled with the general corporate funds of the taxpayer; and (iv) the stock was held for future use or proceeds from the sale of the stock were used in the business of the taxpayer.

19 As additional support for this conclusion that the stock served an operational purpose, the Tax Court referenced the actions of the directors and management of the taxpayer in refusing "persistent and serious entreaties from a shareholder group to liquidate the investment and distribute the proceeds to the shareholders of the taxpayer."

20 OR. REV. STAT. § 314.402.

21 OR. REV. STAT. § 314.665(a).

22 OR. REV. STAT. § 314.665(b).

23 Tektronix, Inc. v. Department of Revenue, 316 P.3d 276 (Or. 2013). See GT SALT Alert: OregonSupreme Court Finds Goodwill Proceeds Excludable from Sales Factor.

24 Oracle Corp. v. Department of Revenue, Oregon Tax Court, No. TC-MD 070762C, Jan. 19, 2012.

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