Opinion ID: 1057560
Heading Depth: 3
Heading Rank: 1

Heading: Validity of Excise Tax Assessment

Text: Taxpayer contends that the Department's excise tax on its capital gains from the Stock Transaction impermissibly classified the capital gains as business earnings contrary to Tennessee Code Annotated section 67-4-2004(1). Tennessee's excise tax on corporate earnings is based on the Uniform Division of Income for Tax Purposes Act (UDITPA), a model law drafted by the National Conference of Commissioners on Uniform State Laws. Gen. Care Corp. v. Olsen, 705 S.W.2d 642, 644 (Tenn.1986). The excise tax is assessed to net earnings, which are broadly defined as the income that the entity reports to the federal government. Tenn.Code Ann. §§ 67-4-2005 to -2007 (Supp.2000). To determine the excise tax due from an entity that conducts business activities that are taxable both inside and outside of Tennessee, the taxpayer must allocate or apportion its net earnings. Tenn.Code Ann. § 67-4-2010 (Supp.2000). Tennessee Code Annotated section 67-4-2011 (Supp.2000) provides the manner in which a taxpayer allocates its earnings, and Tennessee Code Annotated section 67-4-2012 (Supp.2000) provides the formula by which a taxpayer apportions its net earnings to determine its excise tax. The apportionment formula uses a ratio based on Tennessee's portion of the taxpayer's property, payroll, and sales and is thus deemed to represent the entity's earnings that are derived from Tennessee. Gen. Care Corp., 705 S.W.2d at 644. Apportionment is designed to obtain a rough approximation of the corporate income that is reasonably related to the activities conducted within the taxing State. Exxon Corp. v. Wisc. Dep't of Revenue, 447 U.S. 207, 223, 100 S.Ct. 2109, 65 L.Ed.2d 66 (1980) (internal quotations omitted); accord Gen. Care Corp., 705 S.W.2d at 644. The apportionment formula is applied to an entity's business earnings, which are defined as earnings arising from transactions and activity in the regular course of the taxpayer's trade or business or earnings from tangible and intangible property if the acquisition, use, management or disposition of the property constitutes an integral part of the taxpayer's regular trade or business operations. Tenn.Code Ann. § 67-4-2004(1). The apportionment formula is not applied to non-business earnings, which are defined as all earnings other than business earnings. Tenn.Code Ann. § 67-4-2004(14). Non-business earnings instead are allocated for tax purposes to the state in which the non-business earnings originated. Taxpayer specifically argues that its capital gains from the Stock Transaction were non-business earnings that are not subject to the excise tax. We determine whether earnings are business earnings and therefore apportionable when calculating the excise tax using either the transactional test or the functional test. Newell Window Furnishing, Inc., 311 S.W.3d at 446-47 (citing Assoc. P'ship I, Inc. v. Huddleston, 889 S.W.2d 190, 195-96 (Tenn.1994)). Both tests are derived from the statutory definition of business earnings. The transactional test classifies earnings arising from transactions and activity in the regular course of the taxpayer's trade or business as business earnings. Tenn.Code Ann. § 67-4-2004(1); Assoc. P'ship I., Inc., 889 S.W.2d at 195. The functional test classifies earnings from tangible and intangible property as business earnings if the acquisition, use, management or disposition of the property constitutes an integral part of the taxpayer's regular trade or business operations. Tenn.Code Ann. § 67-4-2004(1). The earnings at issue in this appeal were from a one-time, extraordinary transaction. Specifically, the capital gains arose from Taxpayer's acquisition and sale of 1,131 shares of stock. The capital gains do not qualify as business earnings pursuant to the transactional test because the earnings did not arise from transactions or activity in the regular course of Taxpayer's ice cream business. The Department therefore is entitled to judgment as a matter of law as to this issue only if the uncontested facts show that the capital gains qualify as business earnings pursuant to the functional test. In 1993, the General Assembly amended the definition of business earnings to explicitly include the functional test. 1993 Tenn. Pub. Acts 282 (current version at Tenn.Code Ann. § 67-4-2004(4)); see Assoc. P'ship I, Inc., 889 S.W.2d at 195 n. 3. The Court of Appeals applied the functional test in Newell Window Furnishing, Inc., 311 S.W.3d at 447. The intermediate appellate court clarified that the determinative issue of the functional test is not whether the disposition of the property is an integral part of the taxpayer's regular trade or business operations but whether the property being disposed of constitutes an integral part of the taxpayer's regular business. Id. The tax at issue in Newell Window Furnishing, Inc. was assessed on earnings from the sale of one hundred percent of a corporation's capital stock, which was deemed a sale of assets for the purpose of federal taxation. 311 S.W.3d at 445 (citing 26 U.S.C. § 338(h)(10)). It was uncontested by the parties that the property at issue was integral to the taxpayer's regular business. Id. The Court of Appeals therefore held that the gain realized from the sale of the stock was business earnings pursuant to the functional test. Id. Unlike the parties in Newell Window Furnishing, Inc., the Department and Taxpayer disagree as to whether the 1,131 shares of stock constituted an integral part of Taxpayer's ice cream business. Neither this Court nor the Court of Appeals has addressed how courts may determine whether property constitutes an integral part of the taxpayer's regular trade or business operations for the purpose of the functional test. Because the functional test is derived from the statutory definition of business earnings, our role is to ascertain and give full effect to the legislative intent in adopting the functional test. See State v. Marshall, 319 S.W.3d 558, 561 (Tenn.2010). When the statute's language is unambiguous, we find the legislative intent in the plain and ordinary meaning of the language. Id. The meaning of the phrase property constitut[ing] an integral part of the taxpayer's regular trade or business operations depends on the meaning of integral, which has multiple definitions. Integral may be defined as of, relating to, or serving to form a whole, as essential to completeness, or as organically joined or linked. Webster's Third New Int'l Dictionary 1173 (1993). These meanings are not interchangeable, and the precise meaning of the language an integral part of the taxpayer's trade or business operations is uncertain. The statutory definition of business earnings in Tennessee Code Annotated section 67-4-2004(1) also provides, however, that [t]his subdivision expresses the legislative intent to implement and clarify the distinctions between business and nonbusiness earnings, as found in the Uniform Division of Income for Tax Purposes Act, as generally interpreted by states adopting the act. Accordingly, we look for guidance to other jurisdictions that have adopted the UDITPA in applying the functional test. See Holiday Inns, Inc. v. Olsen, 692 S.W.2d 850, 853 (Tenn.1985). Courts are not uniform in their application of the functional test. See Walter Hellerstein, The Business-Nonbusiness Income Distinction and the Case for its Abolition, 92 Tax Notes 1701, 1714 (2001). Moreover, a court's application of the functional test may depend on the nature of the property being considered. Cf. McKesson Water Prods. Co. v. Dir., Div. of Taxation, 23 N.J.Tax 449, 457-62 (N.J. Tax Ct.2007) (surveying applications of the functional test in cases in which the taxpayer is deemed to have sold all of its assets and distinguishing an opinion that relied on a case involving a transfer of funds from a pension plan). The matter before us concerns Taxpayer's capital gains from its acquisition and sale of stock rather than gains from the acquisition and sale of tangible assets. We therefore consider opinions from jurisdictions applying the functional test to earnings derived from investments. Two state supreme courts have considered whether earnings obtained from investments in overfunded pension plans [5] are business earnings pursuant to the functional test. In Union Carbide Corp. v. Offerman, the North Carolina Supreme Court held that earnings obtained by a taxpayer from its overfunded pension plan constituted nonbusiness earnings. 351 N.C. 310, 526 S.E.2d 167, 171 (2000). The court held that for earnings from property to qualify as business earnings, there must be some indicia of the taxpayer's ownership of the property and the property must be essential to completeness of the taxpayer's regular trade or business. Id. The earnings from the overfunded pension plan did not satisfy these factors. The taxpayer, Union Carbide, merely was the plan's sponsor, not its owner. Id. at 170. Additionally, the assets from the pension plan were not essential to Union Carbide's regular business of producing and selling alloys and chemicals. Id. at 171. The court further observed that the assets [from] the pension plan were not used to generate income in the regular business operations. Id. The assets were not used as working capital or for collateral. Id. The assets were not actively traded, used to purchase equipment, or used to support research and development. Id. The assets therefore failed to constitute business earnings pursuant to the functional test as adopted by the North Carolina Supreme Court. The California Supreme Court applied the functional test differently when considering whether assets from an overfunded pension plan were business earnings in Hoechst Celanese Corp. v. Franchise Tax Bd., 25 Cal.4th 508, 106 Cal.Rptr.2d 548, 22 P.3d 324, 343 (2001). The court first determined that the functional test does not require legal ownership or title to the property for earnings from the property to be business earnings. Id., 106 Cal. Rptr.2d 548, 22 P.3d at 338. Instead, the language acquisition, management, and disposition of the property requires the taxpayer to (1) obtain some interest in and control over the property; (2) control or direct the use of the property; and (3) transfer, or have the power to transfer, control of that property in some manner. Id. The California Supreme Court next considered the plain meaning of the language in the functional test and determined that integral has multiple definitions. Id., 106 Cal.Rptr.2d 548, 22 P.3d at 339. Looking to the history of the distinction between business and nonbusiness earnings in the UDITPA, the California Supreme Court concluded that property is integral to the taxpayer's regular trade or business if the taxpayer's control and use of the property . . . contribute materially to the taxpayer's production of business income so that the property becomes interwoven into and inseparable from the taxpayer's business. Id., 106 Cal.Rptr.2d 548, 22 P.3d at 338-39. This definition of business earnings, the court observed, encompasses less than all the property that contributes to the business and thus avoids constitutional concerns. Id., 106 Cal. Rptr.2d 548, 22 P.3d at 339-40. It encompasses, however, more than property that is necessary or essential to the taxpayer's regular business and therefore includes gains from the sale of property no longer used in the taxpayer's trade or business, a scenario contemplated in the explanatory comments to the UDITPA. Id., 106 Cal.Rptr.2d 548, 22 P.3d at 340 (citing UDITPA, cmt. following § 1(a) (West, current through 2009), available at http://www.law.upenn.edu/bll/archives/ulc/fnact99/1920_69/udiftp57.pdf (last visited Jan. 5, 2011)). Using its construction of the functional test, the California Supreme Court determined that earnings from the overfunded pension plan were business earnings. The court observed that the taxpayer, Hoechst Celanese, exercised control over the plan and used the plan to retain current employees and to attract new employees. Id., 106 Cal.Rptr.2d 548, 22 P.3d at 343. Hoechst Celanese's management of the plan contributed materially to its business earnings by improving the efficiency and quality of its workforce generating the business earnings. Id. After careful review, we adopt the functional test promulgated by the California Supreme Court. We agree that the language acquisition, use, management or disposition of the property in the definition of business earnings suggests that the taxpayer must control, but not necessarily own, the property for earnings arising from that property to qualify as business earnings. Tenn.Code Ann. § 67-4-2004(1). We also agree with the California Supreme Court that property must contribute materially to the production of business income to constitute an integral part of taxpayer's regular trade or business operations. Hoechst Celanese Corp., 106 Cal.Rptr.2d 548, 22 P.3d at 338-39. This approach appropriately includes earnings from property that allows the taxpayer's business operations to prosper while excluding earnings from property that is incidental or unrelated to the taxpayer's business operations. We therefore hold that earnings from a taxpayer's property constitute business earnings pursuant to the functional test if the taxpayer's control of the property contributes materially to taxpayer's production of business earnings. Turning to the issue before us, the Department assessed the excise tax to Taxpayer's capital gains from its acquisition and sale of 1,131 shares of BBC USA stock. Taxpayer's acquisition and sale of the stock was a necessary step in the reorganization of the business entities that profit from the production, sale, and distribution of Blue Bell ice cream. The Stock Transaction did not affect Taxpayer's production, sale, and distribution of Blue Bell ice cream. Taxpayer's acquisition and sale of the stock, however, reduced expenses that detracted from the earnings arising from the sale of Blue Bell ice cream in Tennessee and elsewhere. This result was accomplished because the Stock Transaction completed the reorganization that allowed the business entitles profiting from the sale of Blue Bell ice cream to avoid costly public reporting requirements. The Stock Transaction and reorganization also removed one level of federal taxation on the earnings arising from the Blue Bell ice cream business. We hold that Taxpayer's acquisition and sale of the stock therefore contributed materially to the production of business earnings arising from the sale of Blue Bell ice cream and that Taxpayer's capital gains thus qualify as business earnings pursuant to the functional test. The Department has identified uncontested facts showing that it is entitled to judgment as a matter of law as to this issue.