Try AOL NOW! Get 500 Hours FREE!
| You now may access and search eight years of articles from INSIDE NEW YORK TAXES, MULTISTATE TAX ANALYST, NEW YORK TAX HIGHLIGHTS, AND SALES AND USE TAX REVIEW by purchasing 30-day access to the CTPI State Tax Web Libraries for just $20 per Library of your choice. To read and search all articles from this Issue and eight years of articles in the Library, click here to go to the order form | Affiliate Network Memberships: We are members of the following Affiliate Networks. By linking to these fine retailers from this Page you will be showing support for our site and provide us with revenues to continue free selections from CTPI publications. Use Control D to bookmark this page. Try AOL NOW! Get 500 Hours FREE! |
Earnings from liquid long-term investments held for planned acquisitions constitute business income
Dividends and interest derived from a corporation's liquid long-term investments held pending the planned acquisition of companies engaged in a similar line of business as the corporation constitute business income. Although the corporation held the funds for almost seven years before making an acquisition, it had engaged in continuous negotiations with several acquisition candidates during this period. Thus, the company had shown that the acquisition, management, and disposition of the funds were an integral part of its trade or business.
Appeal of Consolidated Freightways, Inc. California Board of Equalization, September 14, 2000
In the 1980s, Consolidated Freightways, Inc., a freight transportation company domiciled in California, was in the process of sharpening its focus on the transportation business. The company had been involved in the manufacture and sale of trucks through its subsidiary, Freightliner Corporation. In July 1981, Consolidated sold Freightliner and its related credit business to Daimler-Benz for $280.9 million. After paying taxes and reducing some of its debt, Consolidated intended to use the remaining sale proceeds to acquire a company that would allow it to expand its market share in the transportation service business and to replace the earnings of Freightliner.
Pursuant to a plan to reinvest the sale proceeds within a year, Consolidated hired a consulting firm to assist it in developing and carrying out a redeployment plan. The consulting firm identified several options and listed acquisition candidates within each option. In 1982, Consolidated made an offer to acquire Air Express International, a major air freight forwarder. The company chose the international air freight market because of its growth and profit potential, its compatibility with the company's domestic market, and its ability to market itself as a full service business.
In early 1983, Consolidated reached an agreement in principle to buy Air Express International, but shortly thereafter the deal fell apart and the agreement was never finalized.
The search goes on: Consolidated pressed on with its efforts to find an acquisition. The corporation explored the possibility of acquiring Emery Air Freight, although it hesitated because of the high cost and continued to explore alternatives in the event negotiations failed. In 1984, Consolidated considered an equity position in Airborne Freight, with a view towards a possible acquisition.
By the end of 1986, Consolidated had many acquisition candidates in various stages of analysis. Finally, in 1989 -- eight years after the sale of Freightliner -- Consolidated bought Emery, using the sale proceeds to fund this acquisition.
Chasing higher returns: When the attempt to acquire Air Express International fell through in 1983, Consolidated realized that the acquisition of a suitable company would take longer than it had originally thought and that an immediate redeployment of the proceeds from the Freightliner sale was not likely to happen. At this time, short-term interest rates were low, making the higher yields associated with securities with longer maturities more attractive. Accordingly, Consolidated shifted $100 million from its $320 million in cash into long-term investments, e.g., treasury notes, municipal bonds and preferred stock, for a three-to five-year investment period. However, in seeking higher returns, Consolidated remained mindful of its fundamental strategy of keeping the sale proceeds in investments that were liquid, marketable, and immediately available (with no prepayment penalty) if an acquisition candidate was located.
The conflict: Consolidated reported the interest and dividends it earned on these long-term investments as apportionable business income. The Franchise Tax Board determined that these accounts produced nonbusiness income allocable entirely to California. An appeal to the California State Board of Equalization followed.
Applying functional test to liquid assets: In determining the nature of the investment income, the Board of Equalization focuses on the functional test, i.e., income is "business income" if the acquisition, management, and disposition of the income-producing property constitute integral parts of the taxpayer's regular trade or business operations. In applying the functional test to liquid asset accounts, the Board uses a two-prong approach: (1) the ''working capital'' test and (2) consideration of whether the funds have been earmarked for a specific business purpose.
Working capital test: The Board explains that "working capital" refers to a pool of liquid funds held to meet the reasonable needs of the business. When funds are held for this purpose, the earnings generated may be classified as business income.
In Consolidated's case, the company shifted $100 million from its short-term working capital accounts to longer-term investments at a time when the company was "flush with cash" and projected having over $500 million available for its daily business needs. As the Board notes, "[c]learly, there was no short-term business need for the funds." Therefore, the Board concludes that the earnings do not constitute business income under the working capital prong of the functional test.
Earmarked funds: The second prong of the functional test in the liquid asset account context considers whether the funds have been "earmarked for a specific future business need." If that specific future business need is for a "unitary business" use, the earnings may constitute business income. Based on a well-documented record, the Board finds that while Consolidated underestimated the time it would take to redeploy the sale proceeds, it "never abandoned its efforts to make [an] acquisition." The Board says that at any particular time between the sale of Freightliner in 1981 and the acquisition of Emery in 1989, Consolidated "engaged in continuous negotiations with one potential acquisition candidate after another." The Franchise Tax Board's assertion that nothing Consolidated did "can be construed as anything beyond exploration" is rejected.
In sum, the Board of Equalization finds that Consolidated had presented "strong evidence that these funds were earmarked for an acquisition target in the transportation industry." Accordingly, the Board concluded that Consolidated had met its burden of showing that the long-term investments generated business income.
• • •
MTA Observations:In the last issue, we analyzed an Illinois case (Home Interiors & Gifts, Inc.) in which the court found that interest from short-term investments constituted nonbusiness income, even though the invested funds were available for business operations. Like in Consolidated Freightways, the funds involved in Home Interiors were in excess of the company's working capital requirements. The difference in the resulting characterization of each companies' earnings was earmarking: Consolidated presented a convincing case that its funds were earmarked for the acquisition of other transportation companies, even though a number of years elapsed before the funds were actually used for the earmarked purpose.
(from Multistate Tax Analyst Vol. 12 No. 9, Corporate Tax Publishers, Inc.)