Opinion ID: 1161101
Heading Depth: 3
Heading Rank: 3

Heading: Whether OBS's Apportionable Income Should Include the Income of the Related Investment Companies

Text: The DOR hearing officer concluded that OBS had not proven that investment income (consisting of interest, dividends, and capital gains) earned by corporations within OBS's unitary group was not operational business income. The hearing officer therefore included that income in OBS's apportionable tax base. The superior court reversed, holding that the investment income was not business income because it was not used as operating capital in OBS's shipping business and because it was earned through investment activities unrelated to Alaska. DOR argues on appeal that the investment income should be included in OBS's apportionable tax base. [23] Two tests govern our resolution of this issue: (1) the statutory test set out in the Alaska tax statutes to determine if the investment income was business income, and (2) the constitutional test adopted by the United States Supreme Court in Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768, 787-88, 112 S.Ct. 2251, 2263, 119 L.Ed.2d 533 (1992), to determine if the income was used for an investment or an operational purpose. [24] OBS states that the only investment income at issue is that of its related investment companies which the auditor included in OBS's unitary group. [25] DOR contends that at the hearing before DOR, OBS argued that none of its investment income was apportionable. Neither the DOR hearing officer nor OBS segregated the investment income of the shipping companies from the investment income of the investment companies within OBS's unitary group.
Taxing a corporation's entire taxable income ... derived from sources within the state, see AS 43.20.011(e), in part requires allocation and apportionment of income to in-state and out-of-state sources in accordance with AS 43.19, the Multistate Tax Compact (MTC). See AS 43.20.065 (A taxpayer who has income from business activity that is taxable both inside and outside the state or income from other sources both inside and outside the state shall allocate and apportion net income as provided in AS 43.19 (Multistate Tax Compact), or as provided by this chapter.). The MTC classifies corporate income from intangible property into two categories, business income and nonbusiness income. AS 43.19.010, art. IV, ¶ 1(a), (e). The MTC states that business income includes: [I]ncome 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. AS 43.19.010, art. IV, ¶ 1(a). A taxpayer's taxable Alaska income is its business income as apportioned according to the three-factor formula apportionment method. AS 43.19.010, art. IV, ¶ 9. [26] Nonbusiness income encompasses all income other than business income. AS 43.19.010, art. IV, ¶ 1(e). Under the MTC, nonbusiness income from capital gains from the sale of intangible property, interest, and dividends must be allocated to the taxpayer's commercial domicile; thus, if the taxpayer's commercial domicile is outside Alaska, the taxpayer's apportionable Alaska tax base does not include income generated from these sources. AS 43.19.010, art. IV, ¶¶ 4, 6(c), 7. The taxpayer's commercial domicile is the principal place from which the trade or business of the taxpayer is directed or managed. AS 43.19.010, art. IV, ¶ 1(b). If the income from dividends, interest, or capital gains from intangibles is business income as it is defined above, it is properly included in the taxpayer's apportionable tax base. Thus, whether ANITA taxes a corporation's out-of-state income depends in part on whether it is business income under the MTC. We must determine whether the hearing officer correctly applied Alaska's statutory tax standards to OBS's investment income. The Oregon Supreme Court in Sperry & Hutchinson Co. v. Department of Revenue, 270 Or. 329, 527 P.2d 729 (1974), was the first state supreme court to determine whether a corporation's interest income from investments constituted business income under UDITPA. See 1 Jerome R. Hellerstein & Walter Hellerstein, State Taxation § 9.10[1][a], at 9-48 (2d ed. 1993). The court there concluded that earnings from short-term securities held to satisfy the corporation's needs for liquid capital in its Oregon operations constituted business income, but that earnings from short-term securities held pending acquisition of other companies or favorable developments in the long-term money market, and long-term securities held for investment purposes, were non-business income. Id., 527 P.2d at 730-31. See also Lone Star Steel Co. v. Dolan, 668 P.2d 916 (Colo. 1983) (following Sperry & Hutchinson and holding that under UDITPA, interest income on short-term loans made by Lone Star to its parent company from surplus funds not immediately needed for Lone Star's operations was business income); Cincinnati New Orleans and Tex. Pac. Ry. v. Kentucky Dep't of Revenue, 684 S.W.2d 303 (Ky.App. 1984) (holding interest income earned by railroad company from short-term securities purchased with surplus cash from its railroad operations was business income). In the instant case, although the disputed income was generated from investments and New York is the domicile of OBS and the related investment corporations, the hearing officer found the disputed income was business income on the theory that the acquisition, management, and disposition of this intangible property (dividends, interest, and capital gains) constituted integral parts of the taxpayer's regular trade or business operations. The payors of this income were not members of OBS's unitary group, but were generally major, publicly-owned business entities, including AT & T, Bankamerica Corporation, Northwest Bancorp, Sears, Roebuck & Co., and Citicorp. The hearing officer reached her conclusion by examining OSG's annual reports to its stockholders; the affidavits of Alan Carus, [27] OSG's controller; and the minutes from OSG's board meetings. According to Carus, earnings totaling over $200 million were the primary source of investment funds OSG accumulated before it commenced its Alaska shipping activities. Proceeds, totaling about $17 million, from public stock offerings in 1970 and 1972 were another source. Carus also affied that the investments are not operationally related to OBS's Alaska shipping business, and that shipping income of the shipping subsidiaries, rather than investment income, was generally used to cover the costs of operation of the shipping operations. Carus stated that OBS intended to make these investments for investment purposes only, and that the income generated did not serve an operational function. Carus conceded that because dollars are fungible, it was impossible to say that no investment income strayed into use for OBS's operating costs; however, he also stated that it was highly unlikely that any significant amount of the investment income was invested in the companies' vessels that called in Alaska. He also affied that the overwhelming majority of the investment income was reinvested, and that the cost basis of the investment assets grew from $97 million at the beginning of the audit periods to $261 million at the end of the audit periods. The shipping subsidiaries that called in Alaska were self-sufficient, i.e., they generated sufficient revenues from their own operations to cover their expenses. He also affied that [n]one of the stocks, bonds, or other investment assets was used as collateral for any debt of the shipping subsidiaries. In determining that OBS's investment income was business income under AS 43.19.010, art. IV, ¶ 1(a), the hearing officer found that concrete evidence did not support Carus's statements that the investments were made for an investment function and that the shipping companies covered their operating costs with operating revenue (rather than investment income). [28] The hearing officer focused upon Carus's fungibility admission. Based in part upon that admission, the hearing officer concluded that OBS had not carried its burden of showing that its investment income constituted nonbusiness income. The Audit Division also relied on OSG's 1996 annual shareholders report. That report stated that OSG's strong and highly liquid financial condition provides a sound foundation for future progress.... [OSG's] significant cash flow has enabled [it] to reduce its long term debt to equity ratio to its lowest level ... and to continue to upgrade its fleet and to pursue opportunities as they arise. From this, the hearing officer concluded that [i]t is clear that building its financial strength was a key component of [OBS's] overall strategy to be in a position to pursue opportunities for expansion when they arose. The hearing officer therefore concluded that the acquisition, management and disposition of [OBS's] investments was an integral part of [OBS's] business since the investment decisions were obviously aimed at building its financial strength overall. In our view it is unwise to construe the two MTC categories, business income and nonbusiness income, without reference to the constitutional standard which has been established by decisions of the United States Supreme Court. The compatibility of these standards has been suggested by the Court in Allied-Signal. To avoid confusion and needless separate discussion of the MTC and constitutional standards, we will consider that one requirement for finding that income is business income under the MTC is that it is income which is taxable under the constitutional standard. We now discuss that standard.
The principle that a State may not tax value earned outside its borders rests on the fundamental requirement of both the Due Process and Commerce Clauses of the U.S. Constitution that `some definite link, some minimum connection' must exist `between a state and the person, property or transaction it seeks to tax.' Allied-Signal, 504 U.S. at 777, 112 S.Ct. at 2258 (quoting Miller Bros. Co. v. Maryland, 347 U.S. 340, 344-45, 74 S.Ct. 535, 539, 98 L.Ed. 744 (1954)). The Commerce Clause imposes this limitation because corporations would be subjected to severe multiple taxation which would negatively affect the national economy if each state were permitted to tax values earned outside its borders. Allied-Signal, 504 U.S. at 777-78, 112 S.Ct. at 2258. The minimum connection requirement of the Due Process Clause requires that when a state seeks to tax income earned by a multistate or multinational corporation from a particular activity, there must be a connection between the state and the activity, rather than a connection only to the actor whom the state seeks to tax. Id. at 778, 112 S.Ct. at 2258. The Supreme Court has held that when a nondomiciliary corporation doing some business within the state receives dividends from a subsidiary having no other connection with the state, the state may not constitutionally tax the dividend income unless the recipient taxpayer corporation and its underlying subsidiary payor were engaged in a unitary business. ASARCO Inc. v. Idaho State Tax Comm'n, 458 U.S. 307, 102 S.Ct. 3103, 73 L.Ed.2d 787 (1982). In Allied-Signal the Supreme Court reaffirmed the unitary business principle as the linchpin for determining whether a state may constitutionally tax the dividend income of a nondomiciliary corporation. [29] The Court went on to hold, however, that a unitary relationship between the payor of the intangible income (there, a corporate dividend) and the payee is not invariably a necessary prerequisite for apportionment of income to a nondomiciliary state. 504 U.S. at 787, 112 S.Ct. at 2263. The test is whether the capital transaction serve[s] an operational rather than an investment function. Id. As an example of an operational function, the Supreme Court cited short-term investments that provide working capital for a corporation, such as the 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. Id. at 787, 112 S.Ct. at 2263. The hallmarks of an acquisition that is part of the taxpayer's unitary business continue to be functional integration, centralization of management, and economies of scale. Container Corp. clarified that these essentials could respectively be shown by: transactions not undertaken at arm's length; a management role by the parent that is grounded in its own operational expertise and operational strategy; and the fact that the corporations are engaged in the same line of business. Allied-Signal, 504 U.S. at 789, 112 S.Ct. at 2264 (citing Container Corp. of Am. v. Franchise Tax Bd., 463 U.S. 159, 178, 180, 103 S.Ct. 2933, 2947, 2948, 77 L.Ed.2d 545 (1983)) (citations omitted). The taxpayer must prove by clear and cogent evidence that the state is seeking to tax extraterritorial values. See Container Corp. of Am., 463 U.S. at 175, 103 S.Ct. at 2945. In Container Corp. the Supreme Court noted that `[t]his burden is never met merely by showing a fair difference of opinion which as an original matter might be decided differently.... [W]e will [not] re-examine, as a court of first instance, findings of fact supported by substantial evidence.' Id. at 176, 103 S.Ct. at 2945-46 (quoting Norton Co. v. Department of Revenue, 340 U.S. 534, 537-38, 71 S.Ct. 377, 380, 95 L.Ed. 517 (1951)). See also Allied-Signal, 504 U.S. at 794, 112 S.Ct. at 2266 (O'Connor, J., dissenting) (citing Container Corp. and asserting that the taxpayer had not met its heavy burden of proving by clear and cogent evidence that its capital gains were not operationally related to its in-state business). The Court held in Allied-Signal that the mere fact that an intangible asset was acquired pursuant to a long-term corporate strategy of acquisitions and dispositions does not convert an otherwise passive investment into an integral operational one. Id. at 788, 112 S.Ct. at 2263-64. Applying Allied-Signal to the OBS evidence in context of the statutory business/nonbusiness income distinction, the hearing officer concluded that the income generated by OBS's related investment companies was operational and properly includable in OBS's apportionable tax base. [30] The DOR hearing officer also rejected assertions found in the supplemental Carus affidavit that the purpose of making the investments was for an investment function and not an operational function. The hearing officer stated that OBS's claims were not supported by any concrete evidence. The hearing officer found that given the fungibility of dollars, investment monies may have been used to fund the shipping companies within the unitary group, and that OBS had failed to meet its burden of showing that its income from investments clearly constitutes investment income. OBS contends that the facts relied upon by the hearing officer do not satisfy Allied-Signal's operational income test. It argues that evidence of commingling some investment income with income used for shipping operations is insufficient to show that the investment income is operational. Although Allied-Signal provides examples of the types of income that can properly be characterized as operational income, the Court there noted that determining whether income serves an operational or investment function is fact intensive. Id. at 785, 112 S.Ct. at 2262. In the case at bar, any commingling by OBS of investment income of its nondomiciliary investment companies with income used for the operational expenses of the shipping companies with vessels that called in Alaska appears to have been de minimis. See generally F.W. Woolworth Co. v. Taxation and Revenue Dep't, 458 U.S. 354, 363-64 & n. 11, 102 S.Ct. 3128, 3135 & n. 11, 73 L.Ed.2d 819 (1982) (All dividend income  irrespective of whether it is generated by a `discrete business enterprise'  would become part of a unitary business if the test were whether the corporation commingled dividends from other corporations.... (citation omitted) (emphasis omitted)). The Court held in Allied-Signal that out-of-state investment income may be taxed only when the investment amounts to the acquisition of capital for the corporation's unitary business, or when the investment is so short-term that it amounts to a bank account for the unitary business. 504 U.S. at 789-90, 112 S.Ct. at 2264. The hallmarks of an investment that becomes part of the unitary business are functional integration, centralization of management, and economies of scale. Id. at 789, 112 S.Ct. at 2264. The Court there concluded that the petitioner corporation's investment in the stock of a second corporation did not qualify as operational because the two corporations' activities were unrelated, and the first corporation did not even acquire a controlling stake in the second corporation. Id. at 788, 112 S.Ct. at 2263. The Court was careful to reiterate that how the investment income is used is irrelevant; it noted that even if those proceeds are used to acquire capital that becomes part of the unitary business, out-of-state investment income cannot be taxed unless the investment itself was run as part of [the] unitary business. Id. at 789, 112 S.Ct. at 2264. Income from investments that are not part of the unitary business may still be taxed if the income accrues from short term deposits in a bank and that income forms part of the working capital of the corporation's unitary business. Id. at 787, 112 S.Ct. at 2263. The Court found in Allied-Signal that stock held for over two years could not amount to a short term investment of working capital analogous to a bank account. Id. at 790, 112 S.Ct. at 2264. The hearing officer concluded that OBS's investment decisions were obviously aimed at building its financial strength overall. In our view, the hearing officer's definition of operational income would swallow the distinction between operational and investment income. See Allied-Signal, 504 U.S. at 784-85, 112 S.Ct. at 2261-62 (rejecting New Jersey's argument that since multistate corporations ... regard all of their holdings as pools of assets, used for maximum long-term profitability, ... any distinction between operational and investment assets is artificial). Further, Carus explicitly affied that none of the investment assets was used as collateral for any debt of the shipping subsidiaries. Because the hearing officer applied a standard that the Supreme Court rejected in Allied-Signal, and because we cannot say as a matter of law that OBS met its burden of proving that the investment income was not operational, we reverse the determination made by the DOR hearing officer. We remand so that OBS's investment income may be segregated as between investment or operational functions. On remand, the corporation's out-of-state investment income may be apportioned for state taxation only if either (1) the investment itself constitutes part of the corporation's unitary business (where unitariness is indicated by functional integration, centralization of management, and economies of scale), or (2) the investment is short term and the income is used to fund the unitary business, such that the investment is analogous to a bank account for the unitary business.