Opinion ID: 1161101
Heading Depth: 4
Heading Rank: 2

Heading: The constitutional standard: investment income versus operational income

Text: 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.