Who Gets The Tax?

The U.S. Supreme Court case Meadwestvaco v. Illinois Dept. of Revenue (06-1413) accepted for review today isn’t glamorous, but the issue it resolves could have a real impact on Colorado’s state budget.  The question presented is when a state may tax capital gains from the sale of a subidiary of an out of state business.  The stakes in the transaction litigated alone are taxes on $1 billion of capital gains.

A ruling for Illinois favors most U.S. states, which have few big corporate deals, while a ruling for the company favors states like New York, which serve as headquarters for business that engage in many corporate deals.In order to tax a business, a state has to have some connection to that business. 

Federal law and the United States Constitution provide limited guidance to how state taxing authority should be apportioned.  The Constitution gives Congress little control over a state’s power to tax.  Neither party in the Supreme Court litigation cites a single federal statute relevant to the merits of the dispute in the case.  Even the only quasi-federal European Union vests more control over member taxing power than the United States Constitution vests in Congress. 

Prior U.S. Supreme Court precedents have clarified some of these gaps.  But, those cases have articulated fairly fact specific tests in this particular area.  The prior ruling flow from court created doctrines flowing from a substantive right to “due process” (separate and apart from the procedural right to contest the matter in the courts where the tax is claimed as the company did here) and from the “dormant commerce clause”, a court created doctrine that prohibits states from enacting laws that interfere with interstate commerce, even if Congress has not enacted any specific laws covering the subject.  These two non-obvious interpretations of the Constitution have been interpreted together to mean that state can only tax business activity that involves them, and to impose certain actual limits on what constitutes involvement.

In practice, income from business operations is usually apportioned among states, more or less by mutual agreement, based upon several factors, such as where it makes its sales, where its employees are located and where its assets are located, of which sales is often the primary factor.

In contrast, true investment income of a passive investor, like interest, dividends or capital gains in connection with the sale of publicly held securities or bank investments by a passive investor, are taxed only by the state where the investor resides.

The issue in this case is when the sale of a 100% parent owned subsidiary of a company should be treated like income from operations, which is shared based on factors like sales, employees and assets, and when it should be treated live the investment income of a passive investor.

A parent company usually takes a more active hand in the management of a subsidiary that it owns all of the stock in than a typical stock market investor, and the parent company’s involvement in its subsidiary, which runs the Lexis/Nexis legal research system, is no exception.

Illinois argued that the level of involvement that the parent company of Lexis/Nexis had in its subsidiary was enough to show an “operational relationship” with the subsidiary, and also notes that the parent and subsidiary file their Illinois taxes for years on a consolidated form, apportioning the taxes based upon Illinois sales.  This argument passed muster in the courts of Illinois.

The company argues that because the parent company’s paper products business was not integrated at all as a unitary business with the subsidiary’s computerized legal research business, that they qualify as mere investors.

While Ohio isn’t a party to the case, the company is fighting in part because it doesn’t want to face conflicting positions from different states resulting in double taxation.  Ohio probably wants to tax all of the income as investment income for itself, and has a plausible argument for doing so (and probably a lower tax rate than Illinois in this case).  Illinois, in contrast, wants a piece of the action itself.  Furthermore, if Illinois wins, every other state in the nation will soon be asking for its share, and the company would probably be bound by its loss in Illinois in the cases brought by states other than Illinois and Ohio.

It is hard to tell in advance, if the U.S. Supreme Court with defer to the trial court’s ruling, overrule just this particular case while keeping a fact specific test in place, or impose some new bright line rule to prevent billion dollar questions from arising.  But, whatever the outcome, Colorado’s budget, because it includes an income tax component, will be impacted.

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Andrew Oh-Willeke

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