United States

California: Gain from Sale of Minority Interest Was Business Income

Mar 21, 2016
From KPMG TaxWatch

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Recently, a California trial court ruled that a taxpayer’s gain on the sale of a minority interest in an IT company constituted business income apportionable to California. The taxpayer at issue was one of the world’s largest financial technology processors for banks. To reduce IT costs, the taxpayer acquired a 29 percent interest in an India-based IT company. The taxpayer planned to develop a “go-to-market” strategy with the IT company whereby they could provide joint service offerings. With the stock purchase, the taxpayer gained three seats on the IT company’s ten member board. In addition, certain of the taxpayer’s board members served as members on certain of the IT company’s committees.  At the time of the acquisition, the taxpayer and the IT company entered into a Master Services Agreement (MSA).  The taxpayer agreed to purchase not less than $150 million in IT services over a specified term and the IT company agreed to provide specified IT services under preferential terms. After a few years, the taxpayer realized that it could not control the “go-to-market” strategy with only a minority interest and explored acquiring 100 percent of the IT company. However, the parties could not agree on a price and eventually the taxpayer sold its equity for a gain. The taxpayer reported the gain on its California return as nonbusiness income. The Franchise Tax Board (FTB) disagreed with this characterization and the matter eventually made its way to the trial court.

Under California law, there are two tests for determining whether income is considered business income. Because the FTB did not “vigorously dispute” the taxpayer’s assertion that the gain was not business income under the transactional test, the court focused its analysis on the functional test. Under the functional test, as interpreted by California courts, income is business income if the acquisition, management, and disposition of income-producing property constitutes an integral part of the taxpayer's regular trade or business operations. The court agreed with the FTB’s assertion that the stock purchase and MSA were inextricably intertwined and the entire transaction should be considered as a whole in determining whether the income-producing property was integral to the taxpayer’s business.

The taxpayer’s position was that it acquired the equity in the IT company for investment purposes because it knew that the MSA would cause the company’s stock price to rise. Rejecting this assertion, the court determined that the purchase of the IT company’s stock served as more than a simple investment in another business.  Notably, after the investment, the taxpayer obtained a competitive advantage as it benefitted from reduced IT costs. The taxpayer also made the investment to protect against the IT company’s encroachment upon its client relationships and acquire some direction and control over the company’s Board. Finally, through the stock purchase, the taxpayer sought an operational advantage from the relationship through a potential joint “go-to-market” strategy. The court found it significant that when the taxpayer realized it could not control a “go-to-market” strategy under the current arrangement, it sought to acquire complete ownership of the IT company. After concluding that the gain on the sale of the stock constituted business income under the functional test, the court held that taxing the gain was permissible under constitutional standards. Notably, investment in the stock provided some operational value to the taxpayer. Finally, the FTB adequately demonstrated that the gross receipts should be excluded from the sales factor denominator under the exception for when a substantial amount of gross receipts arise from an occasional sale of a fixed asset or other property held or used in the regular course of the taxpayer’s trade or business. For more information on Fidelity National Information Services, Inc. v. California FTB, please contact John Harper at 213-593-6704. 

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The following information is not intended to be "written advice concerning one or more federal tax matters" subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.