Unitary Business Principle Clarified

A recent addition to the Lexis database of Supreme Court decisions could spare the electronic legal research service’s former owner from a $4 million tax bill. In MeadWestvaco v. Illinois , the nation’s top court said an Illinois appellate court improperly applied the operational function test of the unitary business principle in concluding that MeadWestvaco Corp. (“Mead”) owed the state capital gains tax on a portion of its gain from the 1994 sale of Lexis/Nexis (“Lexis”).

Mead, which is domiciled in Ohio, earned an approximately $1 billion capital gain from the sale of its Lexis business division in 1994. Mead did not report any of the gain as business income on its 1994 Illinois tax returns. Illinois said the gain on the sale was business income subject to apportionment by Illinois because Lexis did substantial business in Illinois. The state assessed Mead approximately $4 million in taxes and penalties. Mead paid the tax under protest and filed suit in state court.

The trial court said Lexis and Mead were not a unitary business because they were not functionally integrated or centrally managed and enjoyed no economies of scale. The court concluded, though, that the state could tax an apportioned share of Mead’s capital gain because Lexis served an “operational purpose” in Mead’s business. The Appellate Court of Illinois affirmed (861 N.E.2d 1131 (2007)). After the Illinois Supreme Court refused to hear the case, Mead appealed to the U.S. Supreme Court.

Justice Samuel Alito, writing for a unanimous court, said the Illinois court misapplied the precedents of Allied-Signal (504 U.S. 768) and Container Corp. (463 U.S. 169). He wrote that the reference to “operational purpose” in those rulings was “not intended to modify the unitary business principle by adding a new ground for apportionment. The concept of operational function simply recognizes that an asset can be part of a taxpayer’s unitary business even if what we may term a ‘unitary relationship’ does not exist between the ‘payor and the payee.’ ” Alito cited an example from Allied-Signal that a state could apportion interest income of a non-domiciliary corporation earned on short-term deposits in a bank located in another state if that income forms part of the working capital of the corporation’s unitary business.

Alito said the Illinois trial court correctly applied the “hallmarks” of the unitary relationship of “functional integration, centralized management, and economies of scale.” The trial court said the relationship between Mead and Lexis lacked these elements. The Appellate Court relied on the operational function test to uphold the ruling but reserved judgment on whether the trial court correctly ruled on whether they were a unitary business. The Supreme Court said the Appellate Court could consider this on remand.

MeadWestvaco Corp. v. Illinois Department of Revenue, U.S. No. 06-1413, 4/15/08

Prepared by JofA staff member Jeffrey Gilman, J.D.