State & Local Tax Alert

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1 State & Local Tax Alert Breaking state and local tax developments from Grant Thornton LLP New Mexico Administrative Hearings Office Finds Interest on Payment-in-Kind Notes Constituted Non-Business Income The Chief Hearing Officer of the New Mexico Administrative Hearings Office recently granted a taxpayer s motion for summary judgment and held that interest income on payment-in-kind notes ( PIK Notes ), received by a taxpayer when it disposed of its grain merchandising line of business, constituted nonbusiness interest income that must be allocated to the taxpayer s state of domicile of Nebraska. This determination rested on the definition of business income contained in the Uniform Division of Income for Tax Purposes Act (UDITPA), as adopted by New Mexico, and the constitutional standards imposed by the Commerce and Due Process Clauses of the U.S. Constitution. 1 Background The taxpayer, ConAgra Foods Food Ingredients Co. Inc. (ConAgra), is a supplier of commercial food products and is member of the ConAgra Foods, Inc. (ConAgra Foods) consolidated federal group. The ConAgra Foods affiliated group included the Food and Ingredients reporting segment which was comprised, in part, of the Trading and Merchandising business. In the mid-2000s, ConAgra Foods had determined that it wanted to divest itself of the Trading and Merchandising business. Unlike ConAgra Foods core business, which focused on foods, the Trading and Merchandising business included grain merchandising, fertilizer distribution and trading natural gas and crude oil. Osparie Management ( Osparie ), a commodity investment management firm, purchased the Trading and Merchandising business in The purchase price for the business was comprised of cash, payment-in-kind notes and short-term financing. 2 Subsequent to the sale, ConAgra Foods and its affiliates and subsidiaries did not engage in any of the activities previously conducted by the Trading and Merchandising business, and the business was no longer included in ConAgra Foods consolidated financial statements. 3 Release date October 19, 2017 States New Mexico Issue/Topic Corporate Income Tax Contact details Saylor Sims Phoenix T E saylor.sims@us.gt.com Louise Gregory Denver T E louise.gregory@us.gt.com Jamie C. Yesnowitz Washington, DC T E jamie.yesnowitz@us.gt.com Chuck Jones Chicago T E chuck.jones@us.gt.com Lori Stolly Cincinnati T E lori.stolly@us.gt.com Priya D. Nair Washington, DC T E priya.nair@us.gt.com 1 In re ConAgra Foods Food Ingredients Co. Inc., No 17-39, New Mexico Administrative Hearings Office, September 15, The purchase price also included a four-year warrant to acquire a percentage of the issued common equity of a subsidiary formed to acquire the business. This warrant expired and was never exercised. 3 The proceeds from the sale were used by ConAgra Foods to fund a share repurchase, pay down its outstanding commercial paper borrowings and pay income taxes on the gain recognized on the transaction..

2 Grant Thornton LLP - 2 ConAgra Foods reported the tax gain recognized on the sale, including the face value of the PIK Notes, as apportionable business income and included it in the taxable incomes of the appropriate entities on New Mexico corporate income tax returns for the fiscal year ending May In contrast, ConAgra Foods reported the interest income earned on the PIK Notes as nonbusiness income sourced to ConAgra s commercial domicile in Nebraska. On audit, the New Mexico Taxation and Revenue Department reclassified the interest income as business income from the sale of a business line and held that it was subject to apportionment and New Mexico corporate income tax. This appeal of the Department s assessment to the Administrative Hearings Office followed. UDITPA and the Commerce and Due Process Clauses On appeal, the central issue before the Chief Hearing Officer was whether the interest income on ConAgra s PIK Notes was apportionable business income subject to New Mexico corporate income tax or whether the interest income constituted nonbusiness income subject to allocation. The determination of this issue turned on the definitions of business and nonbusiness income contained in UDITPA, as adopted by New Mexico, and the constitutional standards contained in the Commerce Clause and Due Process Clause. The Definition of Business Income Under UDITPA In examining UDITPA, the Officer explained that the model law provides the framework for the allocation and apportionment of income through its definition of business income, which is subject to apportionment, and nonbusiness income, which is subject to allocation. New Mexico, through its adoption of UDITPA, has codified UDITPA s definition of business income in N.M. Stat. Ann. Sec (A). As interpreted by the Officer, contained within this definition are three tests used to determine whether income is characterized as business income or nonbusiness income: a transactional test under which income is considered business income if the income arose from transactions and activity occurring in the regular course of the taxpayer s trade or business; a disposition test under which income is considered business income if the income arose from the disposition of a business or segment of a business; and a functional test under which income is considered business income if the income arose from tangible and intangible property if the acquisition, management or disposition of the property constitute an integral part of the taxpayer s regular trade or business operations. Income not characterized as business income under any of these tests is characterized as nonbusiness income. 4 In addition, Department regulations provide that interest income constitutes business income if the intangible on which the interest was received arises out of or was created in the regular course of the taxpayer's trade or business operations or where the purpose for 4 N.M. Stat. Ann. Sec (E).

3 Grant Thornton LLP - 3 acquiring and holding the intangible is related to or incidental to such trade or business operations. 5 Constitutional Standards for Apportionment Having established the statutory and regulatory framework for apportionment, the Officer explained that the UDITPA and state regulations governing the characterization of business and nonbusiness income are consistent with the Due Process and Commerce Clauses core standard for apportionment, the unitary business principle. Noting that the unitary business principle serves as a mechanism by which states may tax an apportioned share of a multistate entity s income earned outside its borders, the Officer traced the evolution of this principle as set forth in U.S. Supreme Court decisions. The Officer explained that Allied Signal 6 and Mead 7 establish two principles that govern when income is subject to apportionment: (1) if the income payor and the taxpayer are engaged in a unitary business; or (2) if the income-generating asset was used as part of the taxpayer s unitary business operations in the state seeking to tax the income. Interest Income on PIK Notes Not Apportionable Business Income Applying these principles, the Officer held that interest income from the PIK Notes constituted nonbusiness income under all three tests contained in UDITPA s definition of business income as well as the constitutional standards established by the Due Process Clause and Commerce Clause. The UDITPA Tests The Officer explained that the interest income failed both the transactional and the functional tests because the interest income did not arise from transactions and activity occurring in the regular course of the taxpayer s trade or business. ConAgra Foods trade or business consisted of the manufacture and distribution of commercial food products. The interest income received on the PIK Notes did not come from this trade or business, but instead arose from the Trading and Merchandising business unit that ConAgra had sold to Osparie. Turning to the disposition test, the Officer noted that this test served as the basis for the Department s initial audit and subsequent assessment. The Officer explained that the New Mexico legislature s intent behind the enactment of this test was to ensure that proceeds from the disposition of a line of business be considered apportionable business income under UDITPA. 8 The Officer conceded that a superficial application of this test might show that the interest income on the PIK Notes came from the disposition of the ConAgra s Trading and Merchandising business. However, the Officer explained that the 5 N.M. Admin. Code tit. 3, (D) U.S. 768 (1992) U.S. 16 (2008). 8 The disposition test was added to the New Mexico statute following a New Mexico Court of Appeals decision holding that income from the liquidation of a line of business was nonbusiness income as it arose from a one-time transaction that was not part of the taxpayer s line of business. McVean & Barlow, Inc. v. Bureau of Revenue, 543 P.2d 489 (N.M. Ct. App. 1975).

4 Grant Thornton LLP - 4 time frame that must be looked at when applying this test is when ConAgra disposed of its line of business. At that moment in time, ConAgra met the disposition test because it apportioned and paid tax on the sale of the business, including the face value of the PIK Notes. Having addressed the application of these three tests, the Officer looked to the landscape of cases in UDITPA and non-uditpa states addressing apportionment and allocation of interest income for the proposition that the characterization of interest income is not governed by the origin of the investment leading to the interest income itself but is instead governed by the relationship of the interest-bearing investment to the taxpayer s existing trade or business. 9 The Officer explained that after ConAgra completely divested itself of the Trading and Merchandising business and apportioned and paid tax on the business income it received on the disposition of that business, there was no meaningful relationship left between the PIK Notes and ConAgra s ongoing business. As a result, the interest income from the PIK Notes represented nothing more than investment income unrelated to the unitary business enterprise or ConAgra s line of business. Constitutional Standards Turning to the constitutional standard of the unitary business principle, the Officer explained that New Mexico could only tax the interest income earned on the PIK Notes if ConAgra and Osparie were engaged in a unitary business or if the PIK Notes were used as part of ConAgra s unitary business operations in New Mexico. The Officer found that neither condition was present in this matter. ConAgra and Osparie were unrelated business enterprises and there was nothing to indicate that a unitary relationship existed between the two. In support of this conclusion, the Officer pointed to the lack of functional integration, centralized management, economies of scale, or overlapping employees or corporate officers between ConAgra and Osparie. Furthermore, ConAgra cut off all ties with the Trading and Merchandising business and any new agreements that it entered into resulted from arm s length negotiations. 10 The Officer noted that apportionment is still permissible in the absence of a unitary business relationship if the asset resulting in the income is operational in nature, rather than serving an investment function. Following the determination that ConAgra and Osparie did not have a unitary business relationship, the Officer considered the operational concept. The Officer explained that, after the sale of the Trading and Merchandising business, the interest received on the PIK Notes was not integral to ConAgra s continuing business operations in New Mexico but instead represented an investment function. The Officer noted that ConAgra s regular business was not that of 9 Citing to J. Hellerstein & W. Hellerstein, State Taxation (3rd ed ). 10 The Officer rejected the Department s argument that a showing of unitary business was not required given that ConAgra had a physical presence in the state. The Officer explained that, while a physical presence serves to provide the requisite jurisdiction needed to tax an entity, it does not govern what amount New Mexico may constitutionally apportion in accord with the Commerce Clause and Due Process Clause Supreme Court jurisprudence.

5 Grant Thornton LLP - 5 holding, trading, exchanging PIK Notes or other sophisticated financial instruments, and there was no operational benefit related to the interest on the PIK Notes to ConAgra. Commentary While any determination by an administrative authority or a court that an item of income is characterized as nonbusiness income carries with it a level of importance, the Officer s decision is striking on a number of levels. The Officer s analysis involved the parsing of constitutional concepts, which resulted in a taxpayer-favorable result, and is something that is not often seen in an administrative manner. The Officer s distinct focus on the dispositional test as a tertiary means to examine business / nonbusiness income disputes was also significant, as courts and administrative authorities generally focus solely on the transactional and functional tests (though the dispositional test may be folded into the overall analysis). The Officer s decision has potential application to taxpayers in New Mexico and beyond that have sold distinctly defined business units in transactions where revenue streams continue to accrue in tax years following the sale. At first blush, it would appear to be intuitive that future revenue streams arising from transactions that clearly triggered business income likewise would be characterized as business income. The Hellerstein treatise is not in agreement, noting that the origin of an investment leading to interest income recognized at a future date is not by itself dispositive. The Officer s reliance on this treatise in this matter may give some comfort to taxpayers that often struggle to find support to resolve a state tax issue when the pure application of statute, regulation and case law leads to an uncertain result. Given this result, it may be advisable for taxpayers to evaluate whether these types of future revenue streams should be automatically characterized as business or nonbusiness income in the same manner as the underlying revenue from a disposition of a business unit, or whether the Officer s approach here might be considered a reasonable, and perhaps beneficial, alternative. The information contained herein is general in nature and based on authorities that are subject to change. It is not intended and should not be construed as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to or suitable for specific circumstances or needs and may require consideration of nontax and other tax factors. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Grant Thornton LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. No part of this document may be reproduced, retransmitted or otherwise redistributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, re-keying or using any information storage and retrieval system without written permission from Grant Thornton LLP. This document supports the marketing of professional services by Grant Thornton LLP. It is not written tax advice directed at the particular facts and circumstances of any person. Persons interested in the subject of this document should contact Grant Thornton or their tax advisor to discuss the potential application of this subject matter to their particular facts and circumstances. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed.