Opinion ID: 1165094
Heading Depth: 2
Heading Rank: 2

Heading: Stock Dividends From Foreign Subsidiaries as Business Income.

Text: In addition to deducting gross-up from its taxable income on the New Mexico income tax return, as discussed in the first point, Woolworth deducted the cash stock dividends paid to it by its subsidiaries. The Department restored this income, apportioned it as business income and made an additional assessment. Woolworth appealed the ruling to the Court of Appeals, which reversed the Department's ruling. In examining the propriety of the Department's action, there are three basic questions: (1) whether dividends from Woolworth's foreign subsidiaries are business income under Section 7-4-2(A), N.M.S.A. 1978 and are thus properly apportioned and assessed by the Department, or whether the dividends are nonbusiness income and thus allocable only to the state in which Woolworth has its commercial domicile; (2) whether this state's allocation of the dividends from foreign subsidiaries violates Woolworth's right of due process, because of being taxation of income not earned in New Mexico; and (3) whether the Court of Appeals improperly shifted the burden of proof of certain factors relevant to these issues. The Department cites the following evidence favorable to its position on these issues: Woolworth owns a majority or all of the stock in its subsidiaries, has the power of total control if it cares to exercise it, has an international vice president that is responsible for overseeing its foreign subsidiaries, has interlocking directors with some of the subsidiaries, includes the subsidiaries in its overall financing and planning and would be derelict in its obligations to its shareholders if it did not oversee the operations of these companies. The managing directors of the subsidiaries are selected by Woolworth. The dividends paid are determined by Woolworth. There is a substantial exchange of business information, a teletype communication system and travel back and forth of executive personnel between the parent and its affiliates. Any substantial borrowing or other major decisions require approval of Woolworth. There is some flow back and forth of goods and financial resources. Management responsibilities are given to the foreign corporations only commensurate with the development of their abilities to act independently of the parent. In the past Woolworth has furnished investment capital and has made loans to its subsidiaries, but there were no debts outstanding at the time in question here. The dividends here were placed in Woolworth's general operating fund. Woolworth introduced considerable evidence to support its contention that its foreign subsidiaries are independent of the parent and not part of a unitary enterprise and, therefore, the dividends received from them could not be constitutionally apportioned and assessed in New Mexico. We do not detail this evidence since we are considering the substantiality of evidence supporting the Department's decision, although all of the evidence has been assessed by the Court.
To overturn the Department's decision we must find that it is arbitrary, capricious or an abuse of discretion, not supported by substantial evidence or otherwise not in accordance with the law. § 7-1-25, N.M.S.A. 1978 (Repl.Pamp. 1979). Regrettably, it needs to be said that the State did a very poor job of inquiring into and developing the facts in this case. Mr. William D. Dexter, General Counsel for the Multistate Tax Commission and the author of the amicus brief in this cause, has said: One of the most vexing problems facing the states and the business community in application of state income tax laws is the development of appropriate attribution rules for the taxation of income derived from intangible property interests by multistate-multinational corporations and their intertwined, affiliated and subsidiary corporations. (Footnote omitted.) Dexter, Taxation of Income from Intangibles of Multistate-Multinational Corporations, 29 Vand.L.Rev. 401, 401 (1976). A bit of history is appropriate to an understanding of the New Mexico statutory scheme for dealing with this problem. In recent years, the case law on the tests to determine apportionability within a given state of foreign or out-of-state income of multinational or multistate corporations has been developing along two parallel lines. Before the promulgation of the Uniform Division of Income for Tax Purposes Act (UDITPA), the unitary business concept was developed to meet the due process challenge. This principle calls for a determination as to whether a number of business operations having common ownership constitute a single or unitary business or several separate businesses for tax purposes and it depends upon whether they are of mutual benefit to one another and each operation is dependent on or contributory to others. Great Lakes Pipe Line Co. v. Commissioner of Taxation, 272 Minn. 403, 138 N.W.2d 612 (1965). The cases hold that, in order to meet due process constraints, there must be some minimal connection between the interstate business activities generating the income and the states seeking to tax that income. See Moorman Mfg. Co. v. Bair, 437 U.S. 267, 98 S.Ct. 2340, 57 L.Ed.2d 197 (1978). The other line of cases looks at UDITPA and the rules passed in conjunction therewith and attempts to answer the questions by a literal reading of the statutes and rules. UDITPA was promulgated by the Conference of Commissioners on Uniform State Laws in 1957 in response to the apportionment problem. 7A Uniform L.Ann. 91 (1978). New Mexico adopted the Uniform Act in 1965. 1965 N.M. Laws, ch. 203, codified in §§ 7-4-1 to 21, N.M.S.A. 1978. In 1967 the New Mexico Legislature enacted the Multistate Tax Compact. 1967 N.M. Laws, ch. 56, codified in §§ 7-5-1 to 7, N.M.S.A. 1978. The stated purposes of this legislation are to facilitate determination of the tax liability of multistate taxpayers, promote uniformity and convenience and avoid duplicative taxation. § 7-5-1, N.M.S.A. 1978. The Multistate Tax Commission in 1973 recommended regulations to be used in attributing corporate income among the states under UDITPA and these regulations were later adopted in New Mexico. N.M. Inc.Tax Regs. The purpose here is to provide a system by which each state in which a multistate corporation does business can obtain its fair share of income taxes and no more. We read the statutes as calling for a method of allocation which is fairly calculated to assign to New Mexico that portion of the net income reasonably attributable to the business done in this state. See Butler Bros. v. McColgan, 315 U.S. 501, 62 S.Ct. 701, 86 L.Ed. 991 (1942). Under UDITPA, all business income is apportioned to the state under a formula set forth in Section 7-4-10. Section 7-4-19 provides for equitable adjustment if the apportionment of taxable income does not fairly represent the extent of the taxpayer's business activity in the state. The figure resulting from the apportionment is then assessed for taxation by the state. Nonbusiness income, is generally allocable to the commercial domicile of the taxpayer under the Act. § 7-4-5. Thus the determination of whether the dividends received by Woolworth from its foreign subsidiaries are business income under UDITPA is crucial. The advantage to Woolworth if it prevailed nationwide on its claim that gross-up and dividends from stock in foreign subsidiaries are deductible from gross income, as being nonbusiness income, is quite obvious, considering that this income would be apportionable only to the state of the corporation's commercial domicile, New York, where no income taxes are charged. Nationwide, Woolworth would get a tax windfall on $65,000,000 of income for this tax period. UDITPA defines business income and nonbusiness income as follows: A. business income means 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;       D. nonbusiness income means all income other than business income; § 7-4-2, N.M.S.A. 1978. N.M.Inc.Tax Regulation 17(a) expounds on the meaning of business income: In essence, all income which arises from the conduct of trade or business operations of a taxpayer is business income.          [T]he critical element in determining whether income is business income or nonbusiness income is the identification of the transactions and activity which are the elements of a particular trade or business. In general, all transactions and activities of the taxpayer which are dependent upon or contribute to the operation of the taxpayer's economic enterprise as a whole constitute the taxpayer's trade or business and will be transactions and activity arising in the regular course of, and constitute integral parts of, a trade or business. N.M.Inc.Tax Regulation 17(b)(4) provides: Dividends are business income where the stock with respect to which the dividends are received arises out of or was acquired in the regular course of the taxpayer's trade or business operations or where the purpose for acquiring and holding the stock is related to or incidental to such trade or business operations. The Court of Appeals, in Tipperary Corp. v. New Mexico Bur. of Rev., 93 N.M. 22, 595 P.2d 1212 (Ct.App. 1979), cert. denied, 92 N.M. 675, 593 P.2d 1078 (1979), analyzed Section 7-4-2(A), N.M.S.A. 1978, and divided the definition of business income into two parts: (1) transactions and activity in the regular course of a taxpayer's trade or business, and (2) situations where acquisition, management and disposition of property constitute integral parts of the taxpayer's regular trade or business operations, citing McVean & Barlow, Inc. v. New Mexico Bureau of Rev., 88 N.M. 521, 543 P.2d 489 (Ct.App. 1975), cert. denied, 89 N.M. 6, 546 P.2d 71 (1975). The Court then decided Tipperary on the first part of the definition, ruling that the evidence showed that a sale of oil and gas leases was an activity in the regular course of Tipperary's business. Dexter, supra, 29 Vand.L.Rev. 401 (1976), calls the first prong a transactional test and the second prong a functional or use test. In Tipperary, the Court also adopted from Judge Wood's concurring opinion in Champion, supra, a three-prong test to determine whether income arises from transactions in the regular course of business: (1) the nature of the particular transaction, (2) former practices of the business entity, and (3) how the income is used. See Qualls v. Montgomery Ward & Co. Inc., 266 Ark. 207, 585 S.W.2d 18 (1979); Sperry and Hutchinson Co. v. Department of Revenue, 270 Or. 329, 527 P.2d 729 (1974); Great Lakes, supra . We hold that there is substantial evidence here to meet all the tests required in Tipperary. The income arose from activities of Woolworth in the regular course of its business. The income was acquired and managed as an integral part of its regular business operations. § 7-4-2(A). The purpose for acquiring and holding the stock is related to its business operations. N.M.Inc.Tax Regulation 17(a). The three-prong Tipperary test is fully met by the evidence in favor of apportionability. B. Constitutionality of Including the Dividends as Business Income. Having determined that the dividends are business income apportionable under the New Mexico statutes, we now must examine whether the State's assertion of apportionability is constitutional. The United States Supreme Court, in the case of Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425, 100 S.Ct. 1223, 63 L.Ed.2d 510 (1980), decided after the Court of Appeals' decision in our case, has answered a number of our questions. In Mobil the Commissioner of Taxes in Vermont ruled that dividend income from Mobil's foreign subsidiaries and affiliates should be included in the tax base. Mobil claimed that this action unconstitutionally subjected the corporation to multiple taxation. The Supreme Court of Vermont found a sufficient nexus between the corporation and the State of Vermont to justify an apportioned tax on the dividends. The United States Supreme Court affirmed the decision, holding that the tax does not violate the due process clause or the commerce clause and does not impose a burden on foreign commerce. The Court in Mobil recognized some general principles: It long has been established that the income of a business operating in interstate commerce is not immune from fairly apportioned state taxation. (Citations omitted.) [T]he entire net income of a corporation, generated by interstate as well as intrastate activities, may be fairly apportioned among the States for tax purposes by formulas utilizing in-state aspects of interstate affairs. Northwestern States Portland Cement Co. v. Minnesota, 358 U.S., [450] at 460 [79 S.Ct. 357 at 363, 3 L.Ed.2d 421]. For a State to tax income generated in interstate commerce, the Due Process Clause of the Fourteenth Amendment imposes two requirements: a minimal connection between the interstate activities and the taxing State, and a rational relationship between the income attributed to the State and the intrastate values of the enterprise. (Citations omitted.) The requisite nexus is supplied if the corporation avails itself of the substantial privilege of carrying on business within the State; and [t]he fact that a tax is contingent upon events brought to pass without a state does not destroy the nexus between such a tax and transactions within a state for which the tax is an exaction. Wisconsin v. J.C. Penney Co., 311 U.S. 435, 444-445 [61 S.Ct. 246, 250, 85 L.Ed. 267] (1940). Id. at 436-37, 100 S.Ct. at 1231. Mobil, however, contended that its dividend income must be excepted from the general principle of apportionability because it lacks a satisfactory nexus with Mobil's business activities in Vermont. Id. at 437, 100 S.Ct. at 1231. But the Court ruled that the foreign source of the income would not preclude its taxability so long as the intrastate and extra-state activities formed part of a single unitary business. See also Exxon Corp. v. Wisconsin Dept. of Revenue, 447 U.S. 207, 100 S.Ct. 2109, 65 L.Ed.2d 66 (1980); Butler Bros., supra . The Court stated that separate accounting may fail to account for contributions to income resulting from functional integration, centralization of management, and economies of scale. These factors of profitability arise from the operation of the business as a whole and it becomes misleading to characterize the income of the business as having a single identifiable `source'. Supra 445 U.S. at 438, 100 S.Ct. at 1232. The Court further stated: [T]he linchpin of apportionability in the field of state income taxation is the unitary-business principle. In accord with this principle, what appellant must show, in order to establish that its dividend income is not subject to an apportioned tax in Vermont, is that the income was earned in the course of activities unrelated to the sale of petroleum products in that State. Bass, Ratcliff & Gretton [266 U.S. 271, 45 S.Ct. 82, 69 L.Ed. 282] forecloses the contention that the foreign source of the dividend income alone suffices for this purpose.       Nor do we find particularly persuasive Mobil's attempt to identify a separate business in its holding company function. So long as dividends from subsidiaries and affiliates reflect profits derived from a functionally integrated enterprise, those dividends are income to the parent earned in a unitary business. One must look principally at the underlying activity, not at the form of investment, to determine the propriety of apportionability. Superficially, intercorporate division might appear to be a more attractive basis for limiting apportionability. But the form of business organization may have nothing to do with the underlying unity or diversity of business enterprise. Had appellant chosen to operate its foreign subsidiaries as separate divisions of a legally as well as a functionally integrated enterprise, there is little doubt that the income derived from those divisions would meet due process requirements for apportionability. Cf. General Motors Corp. v. Washington, 377 U.S. 436, 441 [84 S.Ct. 1564, 1568, 12 L.Ed.2d 430] (1964). Transforming the same income into dividends from legally separate entities works no change in the underlying economic realities of a unitary business, and accordingly it ought not to affect the apportionability of income the parent receives.    Where the business activities of the dividend payor have nothing to do with the activities of the recipient ..., due process considerations might well preclude apportionability, because there would be no underlying unitary business. (Emphasis added and footnotes omitted.) Id. 445 U.S. at 439-42, 100 S.Ct. at 1233-34. The Court was similarly unpersuaded by Mobil's contention that the Vermont tax imposes a burden on foreign commerce, reasoning that this argument attempted to focus attention on the effect of foreign taxation when the effect of domestic taxation is the real issue. The Court held that the only inquiry of constitutional dimension is the familiar question whether taxation by apportionment at home produces significantly greater tax burdens than taxation by allocation. Id. at 447, 100 S.Ct. at 1236. The Court ruled that Mobil had failed to demonstrate any sound basis, under either the due process clause or the commerce clause, for establishing a constitutional preference for allocation of its foreign source income to the state of commercial domicile. See Exxon, supra . The Court distinguished Japan Line, Ltd. v. County of Los Angeles, 441 U.S. 434, 99 S.Ct. 1813, 60 L.Ed.2d 336 (1979), relied on by Woolworth here. Thus, under Mobil, the key question in determining the constitutionality of the allocation of Woolworth's dividends from foreign subsidiaries as apportionable business income, is whether those dividends were income earned in a unitary business. Our Court of Appeals has previously addressed this issue in Champion, supra, where the income in question was from renting an unneeded portion of its office building, short-term investments of operating capital and profit from the sale of timber. Champion claimed that the income was not part of its multistate unitary business. The Court of Appeals held that the income was business income since it was obtained from normal and customary practices of the corporation, and stated: A multi-state business is a unitary business for income tax purposes when operations conducted in one state benefit and are in turn benefited by operations in another state. [Citing Great Lakes, supra . ] If its various parts are interdependent and of mutual benefit so as to form one integral business rather than several business entities, it is unitary. Webb Resources, Inc. v. McCoy, 194 Kan. 758, 766, 401 P.2d 879, 886 (1965). Id. 88 N.M. at 413, 540 P.2d at 1302. Generally, unitary business means a business, the component parts of which are too closely connected and necessary to each other to justify division or separate consideration as independent units. Maxwell v. Kent-Coffey Manufacturing Co., 204 N.C. 365, 168 S.E. 397, 399 (1933), aff'd without opinion, 291 U.S. 642, 54 S.Ct. 437, 78 L.Ed. 1040 (1934); see Butler Bros., supra ; Great Lakes, supra . Woolworth's investments in its foreign subsidiaries exceeded those of the parent corporation. The possession of large assets by subsidiaries is a business advantage of great value to the parent; it may give credit which will result in more economical business methods; it may give a standing which shall facilitate purchases; it may enable the corporation to enlarge the field of its activities and in many ways give it business standing and prestige. Flint v. Stone Tracy Co., 220 U.S. 107, 166, 31 S.Ct. 342, 355, 55 L.Ed. 389 (1911); see Montgomery Ward & Co. Inc. v. Commissioner of Taxation, 276 Minn. 479, 151 N.W.2d 294 (1967); Great Lakes, supra . The Supreme Court of New Jersey has considered the precise question as here and concluded that Woolworth's is a unitary business and that its foreign dividends are business income. F.W. Woolworth Co. v. Director of Div. of Taxation, 45 N.J. 466, 213 A.2d 1 (1965). On the due process issue and in conformity with Mobil, we hold that, for income tax considerations, there is substantial evidence in this record that Woolworth was conducting a unitary business with its foreign subsidiaries and that there is a sufficient nexus between the corporation and the State of New Mexico to justify an apportioned tax on these dividends. The income is obviously related to the mutual activities of the parent and its affiliates. The control over the subsidiaries, the interdependence, the history of the relationships, the placing of the money in the general operating account, all point to functional integration and reveal an underlying unitary business for our purposes here. We reverse the Court of Appeals on this point. Mobil, supra ; Am. Smelting & Refining v. Idaho St. Tax Com'n, 99 Idaho 924, 592 P.2d 39 (1979). Woolworth's claims as to violations of the commerce clause have no validity and are fully answered in Mobil.