Title: Pennzoil Co. v. Dept. of Rev.
Citation: N/A
Docket Number: S47561
State: Oregon
Issuer: Oregon Supreme Court
Date: October 4, 2001

FILED:  October 4, 2001
IN THE SUPREME COURT OF THE STATE OF OREGON

PENNZOIL COMPANY AND SUBSIDIARIES,
	Appellants,
	v.
DEPARTMENT OF REVENUE,
State of Oregon,
	Respondent.
(OTC 4301; SC S47561)

	On appeal from the Oregon Tax Court.*
	Carl N. Byers, Judge.
	Argued and submitted March 2, 2001.
	Paul H. Frankel, of Morrison &amp; Foerster LLP, New York, New
York, argued the cause for appellants.  Carol Vogt Lavine and
Timothy R. Volpert, of Davis Wright Tremaine LLP, Portland, filed
the briefs for appellants.
	Marilyn J. Harbur, Assistant Attorney General, Salem, argued
the cause for respondent.  With her on the briefs was Hardy
Myers, Attorney General.
	Before Carson, Chief Justice, and Gillette, Durham, Leeson,
Riggs and De Muniz, Justices.**
	DE MUNIZ, J.
	The judgment of the Tax Court is affirmed. 


*15 OTR 101 (2000).
	**Balmer, J., did not participate in the consideration or
decision of this case.
		DE MUNIZ, J.
		The issue in this tax case is whether proceeds that
taxpayer Pennzoil Company (Pennzoil) received in settlement of a
tort judgment constitute business income under Oregon's tax code
and, if so, whether apportionment of that income is
constitutionally permissible.  The Tax Court held that the
proceeds were apportionable business income.  Pennzoil Co. v.
Dept. of Rev., 15 OTR 101 (2000).  For the reasons that follow,
we affirm.  
		The facts are drawn from the parties' stipulations and
the Tax Court's findings.  In January 1984, Pennzoil agreed to
purchase 3/7 of Getty Oil (Getty) stock.  In return, Getty agreed
to place Pennzoil officers in key positions on the Getty board of
directors.  The agreement provided that Pennzoil and the Getty
Trust would be the sole owners of Getty, holding 3/7 and 4/7 of
the company respectively.  Another term of the agreement provided
for the two shareholders to divide Getty's assets if Pennzoil and
the Trust could not agree on a plan to restructure the company;
those assets included Getty's substantial and proven oil and gas
reserves. 
		A short time later, Pennzoil was surprised by a public
announcement that Texaco had acquired all of Getty's stock. 
Pennzoil first sued Getty for specific performance in Delaware. 
After losing that action, Pennzoil sued Texaco in Texas for
tortious interference with a contract.  In that action, Pennzoil
claimed damages based on the loss of its bargain with Getty in an
amount equal to the cost of finding and developing one billion
barrels of oil reserves.  A jury awarded Pennzoil more than $11.1
billion, including $3 billion in punitive damages.  Texaco filed
for Chapter 11 bankruptcy protection and, following a period of
negotiation, Pennzoil agreed to accept $3 billion in satisfaction
of the outstanding judgment. 
		Pennzoil received the settlement proceeds under a
carefully structured payment plan, initially investing the money
in high-grade securities. (1)  Pennzoil segregated the securities 
from ordinary operating business accounts so that it could avoid
classification as an "investment company" under federal
securities law and take advantage of a federal tax exemption for
income received by "involuntary conversion."  The latter strategy
was only partially successful.  The Internal Revenue Service
(IRS) applied the exemption to part of the proceeds, but decided
that approximately $2.1 billion was taxable income for 1988.  The
question here is whether Oregon may apportion, for tax purposes,
that $2.1 billion.
		Pennzoil's only activity in Oregon during the 1988 tax
year was the operation of a facility designed to blend, package,
and distribute motor oil and related automotive products.  None
of Pennzoil's Oregon employees played a role in the Texas
litigation or the negotiations that followed.  In 1988, and the
two years preceding, the Oregon facility operated at a reported
loss.  Pennzoil's 1988 Oregon tax return treated the settlement
proceeds as nonbusiness income.  However, the Department of
Revenue (department) disagreed and assessed an additional
corporate excise tax based on Oregon's share of the $2.1 billion. 
These proceedings ensued.  
		The Tax Court held that the proceeds were business
income, subject to apportionment under ORS 314.650 (1987), (2)

 because:  (1) the income arose from Pennzoil's agreement with
Getty Oil; (2) Pennzoil's purpose in negotiating the Getty
contract was to acquire some of Getty's oil reserves; (3)
Pennzoil is in the business of acquiring and developing oil and
gas reserves; (4) negotiating the contract with Getty was
therefore in the regular course of Pennzoil's business; (5) the
transaction with Getty was inherently an integral part of
Pennzoil's regular business; and (6) income arising from that
transaction was apportionable as business income under the
Uniform Division of Income for Tax Purposes Act (UDITPA), ORS
314.605 to 314.670 (1987). 
		Pennzoil challenges the Tax Court's ruling in three
assignments of error.  First, Pennzoil asserts that the Tax Court
erred in determining that the proceeds were "business income." 
Second, Pennzoil asserts that the Due Process and Commerce
Clauses of the United States Constitution prohibit Oregon from
taxing the proceeds.  Finally, Pennzoil asserts that the Tax
Court erred by apportioning the proceeds under ORS 314.670 (1987)
in a manner that grossly and unconstitutionally distorts
Pennzoil's activity in Oregon.  
		We begin with Pennzoil's statutory argument.  See
Stelts v. State, 299 Or 252, 257, 701 P2d 1047 (1985) (pertinent
statutes are considered before state and federal constitutions). 
Income earned outside Oregon may be apportioned if it is
"business income."  However, "nonbusiness income" that is earned
elsewhere may not be apportioned. (3)  Pennzoil asserts that the
proceeds are "nonbusiness income" and, therefore, not subject to
apportionment.  "Nonbusiness income" is defined as "all income
other than business income."  ORS 314.610(5) (1987).  "Business
income" is 
	"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." 
ORS 314.610(1) (1987).
		Previously, this court has recognized that ORS
314.610(1) has two parts:  (1) income derived from "transactions
and activity in the regular course of the taxpayer's trade or
business[;]" and (2) income derived from 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."  Willamette Industries,
Inc. v. Dept. of Rev., 331 Or 311, 316, 15 P3d 18 (2000).  Each
part involves a separate test:  part one requires a
"transactional test" and part two requires a "functional test." 
If the income in question satisfies either test, then it may be
apportioned as "business income."  Id.  
		Under the transactional test, "business income" is
"income arising from transactions and activity in the regular
course of the taxpayer's trade or business."  The first question,
therefore, is:  What transaction or activity gave rise to the
disputed income?  See Hoechst Celanese Corporation, v. Franchise
Tax Board, 106 Cal Rptr 2d 548, 563, 22 P3d 324 (2001) (nature of
transaction or activity that gave rise to income is critical
factor); Western Natural Gas Co. v. McDonald, 202 Kan 98, 101,
446 P2d 781 (1968) (same).  In addressing that question, we may
consider the frequency or regularity of the transaction and how
the income created by the transaction is used.  Kemppel v. Zaino,
91 Ohio St 3d 420, 422, 746 NE2d 1073 (2001);  Hoechst, 106 Cal
Rptr 2d at 563.  
		Here, the parties do not agree on what transaction or
activity gave rise to the settlement proceeds.  Pennzoil contends
that the settlement proceeds arose from Texaco's tortious
interference with the contract between Pennzoil and Getty.  The
department, however, asserts that the agreement itself gave rise
to the proceeds.  The Tax Court agreed with the department,
concluding that 
	"it does not matter whether the contract was sold,
stolen, condemned, interfered with, or canceled; the
income realized from it by Pennzoil was income 'arising
from' that contract." 
15 OTR at 109 (emphasis added).
		Pennzoil challenges the Tax Court's decision, arguing
that that court ignored several important facts, including:  (1)
Texaco's agreement to indemnify Getty for any litigation arising
out of the earlier deal between Getty and Pennzoil; (2) Texaco's
bankruptcy; and (3) Texaco's creditors opposition to Pennzoil's
efforts to enforce the judgment.  Those facts, Pennzoil contends,
illustrate that Texaco's conduct gave rise to the jury award and,
ultimately, the settlement proceeds.  
		For many years, courts determining the tax consequences
of income received through litigation or settlement have asked: 
"In lieu of what were the damages awarded?"  See, e.g., Raytheon
Production Corporation v. Commissioner of Internal Revenue, 144
F2d 110, 113 (1st Cir 1944) (discussing that recoveries that
represent a reimbursement for loss of profits are "income"); see
also Getty v. Commissioner of Internal Revenue, 913 F2d 1486,
1490 (9th Cir 1990) (maintaining that any accession to wealth
received by taxpayer is presumed to be gross income includable in
taxpayer's return); accord Simpson Timber Company v. Dept. of
Rev., 326 Or 370, 375, 953 P2d 366 (1998) (condemnation proceeds
treated as income from voluntary sale of asset held by taxpayer
for purpose of producing "business income").  Substantial
evidence supports the Tax Court's finding that Pennzoil sought
damages against Texaco based on the loss of its contract with
Getty.  See ORS 305.445 (setting out substantial evidence
standard of review).  We conclude that Pennzoil received the
settlement proceeds in lieu of its agreement with Getty and that
the agreement gave rise to the disputed income.  
		The second question under the transactional test is: 
Did the agreement with Getty occur in the "regular course of
[Pennzoil's] trade or business?"  Again, we may consider the
frequency or regularity of the transaction, and how Pennzoil used
the resulting income.  Kemppel, 91 Ohio St 3d at 422, Hoechst,
106 Cal Rptr 2d at 563.  Pennzoil contends that the agreement
with Getty was for stock, a transaction that Pennzoil
characterizes as infrequent, irregular, and not in the course of
its trade or business.  
		The department, on the other hand, observes that during
Pennzoil's action against Texaco, Pennzoil repeatedly emphasized
that the reason for its agreement with Getty was to gain access
to Getty's oil reserves.  That objective was reflected by a
provision requiring Getty's assets to be distributed in the event
that the two shareholders could not agree on a plan to
restructure the company.  Because Pennzoil's purpose was to
acquire access to (or possession of) Getty's oil reserves, the
department argues, it is reasonable to conclude that Pennzoil
made the agreement in the regular course of its business, i.e.,
extracting, processing, and selling petroleum, natural gas and
minerals.
		The frequency or regularity of a given transaction or
activity may be considered but is not determinative of whether
that transaction is in the "regular course of the taxpayer's
trade or business"; neither is the manner in which the taxpayer
spends income created by that transaction.  Thus, even if it is
rare for Pennzoil to purchase stock in other oil companies -- an
argument weakened by the fact that Pennzoil used the settlement
proceeds to acquire nine percent of Chevron Oil, Katz, 22 Cal App
4th at 1362 -- we are persuaded that steps taken to acquire an
interest in established oil reserves are steps taken in the
"regular course of [Pennzoil's] trade or business."  The Tax
Court's finding that Pennzoil sought and received damages from
Texaco based on the cost of developing one billion barrels of oil
reserves supports that conclusion.  We conclude that the proceeds
are business income under the transactional test.  Accordingly,
it is unnecessary to apply the functional test.  
		Having resolved the statutory question, we turn to
Pennzoil's second assignment of error.  Pennzoil argues that
Oregon's apportionment of the proceeds violates limitations
imposed under the Due Process and Commerce Clauses of the United
State Constitution.  Under those clauses, states may tax income
that is earned elsewhere only if there is "some definite link,
some minimum connection, between [the taxing] state and the
person, property or transaction it seeks to tax."  Miller
Brothers Co. v. Maryland, 347 US 340, 344-45, 74 S Ct 535, 98 L
Ed 744 (1954).  The constitutional parameters for taxing
nondomiciliary corporations are defined by the unitary business
principle that permits states to "tax a corporation on an
apportionable share of the multistate business carried on in part
in the taxing State."  Allied Signal, Inc. v. Director, Division
of Taxation, 504 US 768, 778, 112 S Ct 2251, 119 L Ed 2d 533
(1992).  
		The unitary business principle supports a basis for
apportionment.  Specifically, states may apportion capital
transactions that serve an operational function.  Allied Signal,
504 US at 787.  Taxpayers challenging apportionment must prove
that "the income was earned in the course of activities unrelated
to [those carried out in the taxing] State."  Id. (quoting Mobile
Oil Corp. v. Commissioner of Taxes of Vt., 445 US 425, 439, 100 S
Ct 1223, 63 L Ed 2d 510 (1980) (brackets in original)).  
		Pennzoil argues that its unitary business was
unaffected by the agreement with Getty or by Texaco's
interference with the agreement and that the disputed income has
no role in Pennzoil's Oregon operations.  We are not persuaded. 
As already explained, the agreement between Pennzoil and Getty
generated $2.1 billion of income that Texaco paid in lieu of
Pennzoil's right to acquire an interest in Getty's oil reserves. 
The acquisition of oil reserves is related -- indeed is vitally
important -- to the continued blending and distribution of motor
oil in Oregon.  See Corn Products Refining Co. v. Commissioner,
350 US 46, 50, 76 S Ct 20, 100 L Ed 29 (1955) (taxpayer's
purchase of corn futures to insure adequate supply of raw
material was "vitally important to the company's business"). 
Pennzoil has failed to meet its burden.  The disputed income
arose from activity that serves an operational function and,
therefore, Oregon may apportion that income.  
		Pennzoil's third and final assignment of error asserts
that its 1988 assessed tax liability in Oregon is
unconstitutional because it is out of proportion with the amount
of business it actually did in the state.  Pennzoil argues that
formulary apportionment of the proceeds is per se
unconstitutional, because it results in a tax liability that is
approximately 844% larger than it would have been under a
separate accounting method. (4)  As we understand Pennzoil's
argument, Oregon must sever large capital transactions from
unitary business income, because state apportionment of business
income is limited to business income generated within the state. 
In other words, Pennzoil argues that the unitary business
principle does not apply to large capital transactions.  
		Our answer to Pennzoil's argument mirrors the Tax
Court's.  First, we disapprove of the separate accounting method
that Pennzoil advocates.  Indeed, the difficulty in applying a
separate accounting method to a multistate business is the very
reason for apportionment and the unitary business principle.  
Second, if Oregon could sever a single capital transaction from
unitary business income simply because apportionment of that
income would result in distortion, then there would be little
point in maintaining the unitary business principle.  Pennzoil's
unitary business succeeded in 1988 largely because of the
settlement proceeds received from Texaco.  In 1988, Pennzoil
conducted part of its unitary business in Oregon.  As a result,
Oregon is entitled to apportion the settlement proceeds as
unitary business income.  
		The judgment of the Tax Court is affirmed.



1. 	Pennzoil eventually used the proceeds to purchase about
nine percent of Chevron Oil's common stock.  See Katz v. Chevron
Corporation, 22 Cal App 4th 1352, 1362, 27 Cal Rptr 2d 681 (1994)
(shareholder derivative suit challenging corporate directors'
defensive strategy in dealing with Pennzoil's purchase of 31.5
million shares for $2.1 billion). 

2. 	ORS 314.650(1) (1987) provides:
		"(1) All business income shall be apportioned to
this state by multiplying the income by a fraction, the
numerator of which is the property factor plus the
payroll factor plus the sales factor, and the
denominator of which is three."
3. 	Under UDITPA, "nonbusiness income" is allocated
entirely to the state in which it was earned.  ORS 314.625 to
314.645 (1987). 

4. 	In support of its argument, Pennzoil relies on Hans
Rees' Sons v. North Carolina ex rel Maxwell, 283 US 123, 51 S Ct
385, 75 L Ed 879 (1931), in which the Supreme Court held that,
although the taxpayer's business was unitary, the statutory
apportionment method operated "unreasonably and arbitrarily,"
because it attributed to the taxing state "a percentage of income
out of all appropriate proportion to business transacted" in the
state.  Id. at 135. 
		Modernly, Hans Rees' is of limited value because
Oregon, like the majority of states, has a multi-factor
apportionment formula and, so far, the Court has refused to test
the application of a multi-factor apportionment formula to a
unitary multistate business by the principles of separate
accounting.  See Development in the Law -- Federal Limitations on
State Taxation of Interstate Business, 75 Harv L Rev 955, 1015
(1962) (discussing judicial treatment of apportionment formulas).