Supreme Court Limits Companies' Out-Of-State Tax

Linda Greenhouse|The New York Times

A unanimous Supreme Court decision on Tuesday limited the ability of states to tax the income that companies with out-of-state headquarters earn from their investments in businesses in their home state.

The ruling vacated a decision of the Appellate Court of Illinois in a case that drew the attention of two dozen states and many multistate corporations.

The Illinois court had upheld the state’s right to tax the $1 billion in capital gains earned by the Ohio-based MeadWestvaco Corporation, on the $1.5 billion sale in 1994 of an Illinois-based subsidiary, the Lexis/Nexis online research service.

MeadWestvaco, arguing that Illinois did not have the right to reach across state lines to tax the passive income from what amounted to an arm’s-length investment, paid the $4 million tax bill under protest and sued for a refund.

Construction signs and barriers are seen to the side of The Supreme Court in Washington, Thursday, March 8, 2007. (AP Photo/Haraz N. Ghanbari)
Haraz N. Ghanbari

Although the amount of tax at issue was relatively small, given MeadWestvaco’s huge gain from an initial investment of $6 million in the Data Corporation, the company that became Lexis/Nexis, the principle at stake was considered an important one.

Over many years, the Supreme Court has developed rules to permit states to tax the portion of an out-of-state company’s revenue that reflects its home-state operations, while at the same time shielding multistate companies from duplicate taxation.

At the heart of the doctrine is what the court calls the “unitary business principle,” which requires before a state can impose its tax, a finding that the company’s in-state operations are part of a unified whole. The hallmarks of a unitary business, the court has held, are “functional integration, centralized management and economies of scale.”

The question for the court on Tuesday was whether an alternative route existed for states to capture revenue from businesses that were not unitary. The Supreme Court had raised this possibility with a passing reference in a 1992 opinion to tax liability generated by assets that served an “operational rather than an investment function” in a business. That ambiguous reference led some state courts to conclude that the justices had blessed an “operational function” test that paved the way to taxing multistate companies that did not qualify as unitary businesses.

That was an erroneous extrapolation, the high court said in an opinion by Justice Samuel A. Alito Jr. The earlier references to “operational function,” he said, “were not intended to modify the unitary business principle by adding a new ground” for taxation. Regardless of the details of a parent company’s relationship to its subsidiaries, the business had to be found unitary in the first place before a state could tax a part of the revenue.

In its opinion, MeadWestvaco Corporation v. Illinois Department of Revenue, No. 06-1413, the court left inconclusive the application of this principle to the actual dispute at hand. The trial court in Chicago had concluded that while MeadWestvaco and Lexis/Nexis were not a unitary business, Lexis/Nexis served an “operational purpose” in the larger business and that Illinois could therefore tax the capital gain.

The Appellate Court of Illinois agreed with the “operational purpose” conclusion, and therefore expressed no opinion on whether the business was unitary.

Vacating that decision, the Supreme Court said the state appeals court should now consider whether the business was unitary. Only if the answer was yes could the tax be upheld, the court said. While not reaching a conclusion on the unitary question, Justice Alito strongly suggested that the answer should be no. He pointed out that while MeadWestvaco is in the paper business, it did not require Lexis/Nexis to buy Mead paper, “and indeed Lexis purchased most of its paper from other suppliers.” Neither company even gave the other a discount on goods or services, Justice Alito said.

Beth S. Brinkmann, who argued the appeal for MeadWestvaco, said in an interview that the decision provided important guidance to lower courts by removing a source of confusion. At the most basic level, what businesses need is predictability,” she said.