Arizona Court Of Appeals Holds Definition Of 'Business Income' Provides Two Separate Tests, No Liquidation Exception

The Arizona Court of Appeals has held in two recent cases that the state may tax corporate income as "business income" if either the transactional test or the functional test provided in the statutory definition is satisfied, and that there is no liquidation exception to the definition of business income.1 In the first case, Harris Corp., the Court also determined that the taxpayer's gains primarily associated with selling lines of business were properly classified as business income. In the second case, First Data Corp., the Court relied on its analysis from Harris and held that the gain from the taxpayer's sale of its wholly-owned subsidiary was business income even though a deemed asset sale occurred under federal law.

Background

Harris Corporation, a Delaware corporation with executive offices in Florida, provided voice, data and video telecommunications products and related services. For the relevant tax years, Harris and its subsidiaries filed Arizona corporate income tax returns on a consolidated basis.2 Harris treated the income, expenses and losses from its business operations as business income, but treated the gains from the disposition of product lines as non-business income. The Arizona Department of Revenue conducted an audit and issued a notice of proposed assessment. After Harris filed an appeal with the Arizona Tax Court, both parties filed motions for summary judgment on whether the proceeds of the transactions were business income. The Tax Court granted summary judgment in favor of the Department and the taxpayer timely appealed.

First Data Corporation, a Delaware corporation that was headquartered in Georgia, provided electronic payment services to its customers. In 1999, First Data sold a wholly-owned subsidiary and realized net proceeds of $725 million. First Data and the purchasing bank elected to treat the sale of the subsidiary's stock as a sale of assets under Internal Revenue Code (IRC) Section 338(h)(10). For federal income tax purposes, the subsidiary was deemed to have undergone a complete corporate liquidation with the distribution of the proceeds to its sole shareholder, First Data. The subsidiary reported the gain on its federal income tax return. For the 1999 tax year, First Data and its subsidiaries were a unitary business and filed an Arizona combined corporate income tax return. This return reflected First Data's treatment of the gain on the sale as non-business income. Following an audit, the Department reclassified the gain from the sale as business income and issued a notice of proposed assessment. First Data protested the assessment and timely appealed to the Arizona Tax Court. After both parties moved for summary judgment on the income classification issue, the Tax Court granted summary judgment in the Department's favor and incorporated its statutory analysis from the Harris case. First Data timely appealed.

Definition of Business Income

Arizona follows a modified version of the Uniform Division of Income for Tax Purposes Act (UDITPA) to apportion or allocate the income of multistate corporations to the state.3 The determination of whether income is business income or non-business income is crucial in dividing income among states. Business income generally is apportioned to Arizona based on a three-factor formula that consists of property, payroll and sales factors.4 Non-business income is allocated to a designated state based on certain factors. Arizona allocates non-business income such as capital gains from the sale of intangible property and interest income to the state where the taxpayer is domiciled.5 Other non-business income such as rents, royalties and capital gains from the sale of real or tangible personal property is allocated to the state where the property is located.6

Under Arizona law, which adopts the UDITPA definitions, "business income" is defined as "income arising from transactions and activity in the regular course of the taxpayer's trade or business and includes income from tangible and intangible property if the acquisition, management and disposition of the property...