Reduce out-of-state taxes: Give your affiliates arms-length terms

If your company has subsidiaries in other (U.S.) states, you need to think about whether those states can make you pay taxes on the income of other members of the corporate family. As a rule of thumb, the more separation there is between businesses, the lower the odds of being forced to pay out-of-state income taxes.

The U.S. Supreme Court hinted this week that doing inter-company business on arms-length terms may strengthen the case against out-of-state taxation. The parties to the case were Ohio-based MeadWestvaco Corporation ("Mead") and the state of Illinois. Mead realized $1 billion in capital gains when it sold off its Illinois subsidiary Lexis/Nexis.  Illinois taxing authorities assessed a $4 million state capital-gains tax.  Mead paid under protest and sued for a refund. 

The Supreme Court held unanimously that Illinois isn’t allowed to levy the tax unless it can prove on remand that Mead and its subsidiaries operated as a "unitary" business. I’m not a tax lawyer, so I won’t try to go into the details of Justice Alito’s (very readable) opinion.  The New York Times article thought it was noteworthy that Justice Alito specifically mentioned the arms’-length nature of Mead’s intercompany business dealings with its subsidiary Lexis/Nexis; the opinion says:

Lexis was subject to Mead’s oversight, but Mead did not manage its day-to-day affairs.

Mead was headquartered in Ohio, while a separate management team ran Lexis out of its headquarters in Illinois.

The two businesses maintained separate manufacturing, sales, and distribution facilities, as well as separate accounting, legal, human resources, credit and collections, purchasing, and marketing departments.

Mead’s involvement was generally limited to approving Lexis’ annual business plan and any significant corporate transactions (such as capital expenditures, financings, mergers and acquisitions, or joint ventures) that Lexis wished to undertake. In at least one case, Mead procured new equipment for Lexis by purchasing the equipment for its own account and then leasing it to Lexis.

Mead also managed Lexis’ free cash, which was swept nightly from Lexis’ bank accounts into an account maintained by Mead. The cash was reinvested in Lexis’ business, but Mead decided how to invest it.

Neither business was required to purchase goods or services from the other. Lexis, for example, was not required to purchase its paper supply from Mead, and indeed Lexis purchased most of its paper from other suppliers. Neither received any discount on goods or services purchased from the other, and neither was a significant customer of the other.

MeadWestvaco Corp. v. Illinois Dept. of Revenue, No. 06–1413, slip op. at 4 (U.S. Apr. 15, 2008) (extra paragraphing added)