State & local taxes: income apportionment and allocation after Mead.

• Author: Kwiatek, Harlan J.

IN MEAD WESTVACO CORP. V. ILLINOIS Dep't of Revenue (Mead), (1) the U.S. Supreme Court held that the operational function test was not intended to modify the unitary business principle by adding a new ground for apportionment. In so doing, the Court modified our understanding of Allied-Signal Inc. v. Director, Div. of Tax'n, (2) which some consider to have created a separate operational function test for apportionment absent a unitary relationship. Now that Mead has become part of the canon of U.S. Supreme Court state tax cases, state tax courts and revenue departments have started to apply the decision in determining whether an item of income is apportionable or allocable.

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Unitary Business Purpose vs. Operational Function Test

Since the Supreme Court issued its ruling in Allied-Signal, corporate taxpayers have struggled with the relationship between the unitary business principle and the operational function test. Under the unitary business principle, if at least one member of a corporate group is subject to a state's taxing jurisdiction, the entire income of the corporate group can become part of the group's apportionable tax base in that state if the group and the member are deemed unitary. The operational function test is used to determine whether an asset is part of the unitary corporate group, thus making income from a capital transaction involving the asset includible in the group's apportionable tax base. Under the operational function test, even if the payer and payee of a capital transaction do not have a unitary relationship with each other, the asset is part of a taxpayer's unitary business if it serves an operational function as opposed to an investment function.

On April 15, 2008, the Court clarified in Mead that the operational function test is not a separate test for finding apportionable income, stating that the test was "not intended to modify the unitary business principle by adding a new ground for apportionment," (3) but simply recognizes that an asset can be part of a taxpayer's unitary group even if there is not a unitary relationship between the payer and the payee in a capital transaction.

State tax courts and revenue departments can thus now look to the Mead opinion to determine whether an item of income is apportionable or allocable. Interestingly, two recent decisions that have considered Mead in their analysis did so in situations that did not mimic the Mead fact pattern and that involved the sale of a division doing business in the taxing state: One case involved a stock redemption, the other a Sec. 338(h)(10) transaction.

Blue Bell Creameries

With Mead as its guide, the Tennessee Court of Appeals recently concluded that capital gain income earned by a limited partnership in a stock redemption transaction with its majority shareholder, a holding company, was not apportionable because the entities were not unitary and the redemption did not serve an operational function. (4) A multistep reorganization occurred where the stated purpose was for the company to remain a private company for an indefinite time in order to make an S corporation election, reduce the number of shareholders to comply with the 75-shareholder limit under the S corporation rules then in effect, (5) and retire ineligible shareholders.

The predecessor of the taxpayer, Blue Bell Creameries, L.P., was a limited partnership with a Delaware holding company, Blue Bell Creameries, USA (BBC USA), as a general...