On September 25, 2007, the U.S. Supreme Court granted certiorari in the case of MeadWestvaco Corp. v. Illinois Department of Revenue1, a case concerning $1 billion in capital gains realized by the petitioner when it sold the assets of a wholly-owned subsidiary in 1994, which had functioned as an independent and separately managed business for more than 25 years. The petitioner is appealing the decision of the Illinois Supreme Court in Mead Corp. v. Department of Revenue, Docket No. 103854, (Ill. September 24, 2007), which affirmed, without opinion, the decision of the First District Appellate Court of Illinois.
The primary issue concerns whether Illinois can require a taxpayer to apportion capital gains realized from the sale of a non-domiciliary, wholly-owned subsidiary that operated independently of the parent, even though the companies filed a unitary return in Illinois. Mead, Inc. (“Mead”) was an Ohio-based corporation that regularly transacted business in Illinois. In 1968, Mead purchased the Lexis/Nexis Corporation and made significant capital investments in the company over the years. Lexis/Nexis operated independently of Mead. It had separate management of day-to-day affairs, did not share manufacturing or warehousing of products, had no favorable inter-company transactions with its parent and had its own offices in a different city in Ohio. In 1988, the Illinois Department of Revenue (“the Department”) asserted, in an audit, that Mead and Lexis/Nexis were a unitary business. The Department argued that Mead treated Lexis/Nexis as a major business segment and not as merely an “investment.” In order to settle the audit, without acquiescing to the Department’s contentions, Mead voluntarily filed a unitary return with its Lexis/Nexis subsidiary for the period under audit. In 1994, Mead decided to sell the assets of Lexis/Nexis to another company and realized more than $1 billion in long-term capital gains. It reported the proceeds as non-business income and allocated the gain to its domiciliary state of Ohio. The audit findings of the Department concluded that the gain should be included in Mead’s apportionable income in Illinois for the 1994 tax year. The trial court agreed with Mead that it was not unitary with Lexis/Nexis but found that the sale of Lexis/Nexis represented the liquidation of a major business line that was “essential to the taxpayer’s regular trade.” Accordingly, the trial court held that the gain was apportionable business income.
On appeal, the First District Appellate Court held that the capital gain from the Lexis/Nexis sale was apportionable business income. Moreover, the Court held that apportionment was constitutionally permissible because Lexis/Nexis served an operational rather than investment function for Mead and had nexus in Illinois. The Court ruled, based on the reasoning in the Illinois First District Appellate Court case of Hercules2 and the U.S. Supreme Court case Allied-Signal3, that apportionment of income from a capital or intangible transaction by a multistate, non-domiciliary corporation is constitutional when a unitary business relationship exists between the payor and payee or when the intangible asset serves an operational function for the taxpayer (even if no unitary relationship exists).
Mead failed to prove to the Court that its Lexis/Nexis subsidiary was an investment and not an operational asset. Apportionment of the capital gain to Illinois was found to be constitutional for the following reasons: 1) Lexis/Nexis was deemed to be a significant business segment of Mead, and 2) Mead was the sole decision maker for capital investment, capital expenditures, and control of excess cash. Mead also retained the tax benefits associated with the subsidiary. The Court distinguished its reasoning from the reasoning in Hercules and Allied-Signal stating that the parent company’s control over management of the subsidiaries did not exist in those situations because the parent owned less than 50% of those subsidiaries. Finally, the Court also relied on the reasoning of a prior state case Texaco-Cities Service Pipeline Co.4, which held that all gains from disposition of a capital asset are considered business income if the asset disposed of was “used by the taxpayer in its regular trade or business operations.” The Court rejected Mead’s reliance on another state case Blessing/White5, wherein the Court ruled that a capital gain was non-business income. Unlike the facts in Blessing/White, in Mead’s case, the proceeds from the sale were not distributed to its shareholders but were re-invested in the parent.
Ryan will closely monitor this important state income tax case as it proceeds through the U.S. Supreme Court.
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