Tax Alert
April 2008
Authors:
Walter G. Van Dorn
617.951.9102
walter.vandorn@klgates.com
Martin S. Allen
617.261.3212
martin.allen@klgates.com
Cynthia Morgan Ohlenforst
214.939.5512
cindy.ohlenforst@klgates.com
K&L Gates comprises approximately 1,500
lawyers in 25 offices located in North
America, Europe and Asia, and represents
capital markets participants, entrepreneurs,
growth and middle market companies,
leading FORTUNE 100 and FTSE 100
global corporations and public sector
entities. For more information, please visit
www.klgates.com.
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Supreme Court Tax Opinion a Win for
Multi-State Businesses
In Meadwestvaco Corp. v. Illinois Department of Revenue, decided on April 15, 2008, the
Supreme Court decisively, and unanimously, blocked an attempt by the State of Illinois to
expand the concept of unitary taxation beyond the existing boundaries of what constitutes
a unitary business, notwithstanding the urging of the respondent Illinois and the 25 other
states (including Puerto Rico) that filed a brief as friends of the court. Other states such as
Texas, which has recently revised its franchise tax to require combined reporting by certain
unitary businesses, and California may be implicated as well. It may be advisable for
companies that have paid tax to such states in recent years to review their tax filings and
consider whether protective refund claims should be filed.
Unitary Taxation refers to a method whereby a state imposes its corporate income tax
on a multistate family of corporations where the parent corporation is headquartered or
“commercially domiciled” in another state. Traditionally, state corporate tax laws respected
the separate corporate identities of related corporations for purposes of imposing tax thereon.
Using the simple example of a parent and a wholly owned subsidiary, if the subsidiary was
incorporated or “doing business” in a particular taxing state, and the parent corporation
itself had no such contacts or “nexus” with that state, only the subsidiary would be subject
to tax by the state and the parent would not. With the advent of unitary taxation marked
by the Container Corporation case in the Supreme Court in 1983, unitary taxation as then
imposed by California was upheld as not violating either the Commerce Clause or the Due
Process Clause of the Constitution. Under the unitary method, where at least one member
of the corporate group is directly subject to a state’s taxing jurisdiction, the entire income
of the corporate group, if deemed unitary, becomes part of the tax base in that state, to the
extent reasonably apportioned to that state under a proper formula (such as a typical threepart formula based on sales, assets, and payroll within the state). The key determinant of
course is whether a “unitary business” was carried on by the various related corporations
in the group. Over the years a functional definition of “unitary” was developed by the
courts and by legislation in the states. As the court stated in the Meadwestvaco case now
under consideration, the “hallmarks” of a unitary relationship are functional integration,
centralized management, and economies of scale where the related corporations conduct
distinct businesses.
In this case, Mead Corporation, the parent, was an Ohio corporation headquartered and thus
“commercially domiciled” in Ohio that had been in the paper, packaging, and stationery
business for many years. In 1968 Mead acquired a corporation in the printing and information
retrieval business which over the course of time developed the well known electronic
research service known as Lexis. In 1994, the tax year in question in this litigation, Mead
sold the Lexis business to a third party, realizing over $1 billion in capital gain. The Lexis
subsidiary corporation had operated in Illinois and paid significant tax to Illinois over the
years on its ongoing operations. Mead had also paid substantial Illinois corporate tax on its
own separate and distinct paper business subject to Illinois taxation. Mead did not, however,
pay Illinois tax on its capital gain on the sale of the Lexis business, and Illinois assessed
Mead additional tax and penalties of approximately $4 million on the gain. The issue was
Tax Alert
then drawn as to whether Mead should be obligated to
pay the Illinois tax on the sale of the Lexis business on
the ground that the Lexis business and Mead’s other
business were unitary in nature.
The facts revealed that the Mead business and the Lexis
business were almost entirely separate and separately
conducted. “Neither business was required to purchase
goods or services from the other and neither received
any discount on the relatively insignificant goods or
services purchased from the other and neither was a
significant customer of the other.” Over the period of
Mead’s ownership of Lexis, Lexis existed as a wholly
owned subsidiary corporation for certain periods
of time and as an unincorporated division of Mead
for other periods of time, including 1994, the year
in question. Mead in fact treated Lexis as a unitary
business on its Illinois tax returns for the years 1988
through 1994 at the state’s insistence to avoid litigation.
That did not figure in the Court’s decision.
The tax refund case (the asserted tax having been paid
under protest) for the year 1994 was originally tried
in an Illinois trial court. That court concluded that a
unitary business between the two did not exist because
the two businesses were not functionally integrated
and enjoyed no economies of scale. However, the
trial court did not stop there, but, generating the legal
issue ultimately to be decided by the Supreme Court,
held that Illinois nevertheless could tax an apportioned
share of Mead’s capital gain because Lexis served an
“operational purpose” in Mead’s business. That was
because Lexis was considered in Mead’s strategic
planning, particularly in the allocation of resources,
and “allowed Mead to limit the growth of Lexis if
only to limit its ability to expand or contract through
its control of capital investment.” On appeal to the
Appellate Court of Illinois, the decision of the trial
court was upheld. That court further developed what
it saw as the “operational function” that Lexis served
in Mead’s business, evidenced by the ownership of
Lexis by Mead, the exercise of control over Lexis
by Mead in various ways and other indications that
Mead considered itself as engaged in electronic
publishing and informational retrieval, which were
the businesses conducted by Lexis. Significantly, the
Illinois Appellate Court did not decide whether Mead
and Lexis constituted a unitary business because it
found that Lexis served an “operational function” in
Mead’s business, in its view an adequate basis for
taxation standing by itself. After the Supreme Court
of Illinois denied review, the United States Supreme
Court took the case.
What the Court decided was that the concept of
“operational function” as applied by the Illinois Court
does not constitute a separate and independent basis for
taxing Mead’s gain on a unitary theory in the absence
of a unitary business. Although the taxpayer argued
in the Supreme Court that the Illinois court was not
justified in concluding that Lexis served an operational
function in Mead’s business, the Court declined to
address that argument. It went further and held that
it was an error for the Illinois courts even to consider
whether Lexis served “an operational purpose” once
it had been determined that Lexis and Mead were not
unitary.
The Court (Justice Alito) then embarked upon a
technical and historical analysis of the development
of the unitary-business concept and the broader history
of the law of multistate taxation under the Constitution
beginning in the nineteenth century. In the course of
that discussion it analyzed the landmark Allied Signal
case decided by the Supreme Court in 1992. In that
case, the Court held that New Jersey could not tax a
foreign corporation on a capital gain on the sale of a
minority interest in a subsidiary that had been subject
to tax in New Jersey, giving rise to the Allied Signal
Doctrine whereby investment gains are distinguished
from operating income for purposes of subjection to
taxation by a state other than the commercial domicile
of the selling corporation. The court reviewed the use
of the term “operational function” in the Container
Corp. and Allied Signal cases but flatly refused to treat
those statements as announcing a new ground for taxing
“extrastate values” in the absence of a unitary business.
In reviewing the history of its prior decisions, the Court
insisted that the use of the term “operational function”
was only material to a finding of a unitary business
and was never “a separate and independent basis” for
taxing Mead’s gain on a unitary theory in the absence
of a unitary business. Thus, the Illinois court decision
was nullified, and on a ground not distinctly articulated
by taxpayer’s counsel, whose main argument in this
respect was that no operational function or relationship
April 2008 | 2
Tax Alert
existed. However, because the Appellate court below
did not address the question of whether the Illinois
trial court was correct in deciding that there was no
unitary business, the Supreme Court stated that the
Illinois Appellate court may review that question on
remand. Thus, the possibility remains that the Illinois
courts may ultimately conclude that a unitary business
did exist, although, presumably, the Illinois Appellate
court would give some deference to the trial court’s
earlier fact-findings that one did not exist.
In reaching its decision the Court stated that it would
not consider the invitation of the State of Illinois and the
friends of the court to recognize a new ground for the
constitutional apportionment of intangibles based on
the taxing state’s contact with the in-state capital asset
(the Lexis business) rather than its contact with the
out-of-state taxpayer (Mead). The Court also observed
that the issue and outcome may impact the law of
other jurisdictions such as Ohio and New York, which
have both adopted the new ground for constitutional
apportionment (focusing on an operational function
served by the in-state entity) suggested above.
Given the current movement among various states
(such as Texas and Massachusetts) to enact so-called
combined reporting as a basis for state corporate
taxation that is closely related to unitary taxation, the
Meadwestvaco case would appear to have a limiting
effect on the reach of those statutes. The unanimity
of the decision would also suggest the Court’s more
general lack of receptivity to creative expansion of the
states’ taxing jurisdiction over multistate business.
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