SACRAMENTO, Calif. -In a decision that possibly will be tested in the U.S. Supreme Court, the California Supreme Court has ruled the state can tax Hoechst Celanese Corp. on $389 million in surplus assets it acquired after restructuring its pension fund.
Voting 6-1 earlier this month, California's highest court upheld a decision by State Superior Court that said income from a reversion of surplus pension assets constitutes business income apportionable to California and that subjecting that income to taxation in California is not a violation of the U.S. Constitution.
The California decision is contrary to a ruling last year by the North Carolina Supreme Court, which ruled surplus pension assets of Union Carbide Corp. did not contribute to the company's income, and therefore could not be taxed by the state.
George C. Spanos, deputy attorney general, who argued the Hoechst case on behalf of California, said he expects the decision to affect the outcome of similar cases. "Other states will look at the decision made in California because the definition of what constitutes business income has been debated on cases going back to the '40s," he said.
In the case of the surplus Hoechst pension assets, California was seeking to tax only 1.2% of the income. He pointed out the California justices made a point of disagreeing with the North Carolina ruling.
Eric J. Coffill and Carley Roberts, with the San Francisco law firm of Morrison & Foerster and who worked on the case for Hoechst, did not return calls asking for comment and whether they plan to appeal the decision to the U.S. Supreme Court.
May go to high court
Lou Mazawey, a tax specialist at the Washington-based Groom Law Group, said there was a 50-50 chance the case could go to the U.S. Supreme Court. "Not a lot of money is involved, but there is a conflict between the California and the North Carolina decisions," Mr. Mazawey said.
He also pointed out the decision wouldn't prevent companies from continuing to do pension plan reversions since the tax would be apportioned, and companies wouldn't be required to pay a double tax.
The Hoechst case dates from 1983, when what was then New York City-based Celanese Corp. decided to recapture the pension fund's surplus assets. To do so, it divided the pension fund into two separate trusts, one for active employees, the other for retired employees. It then purchased annuities to provide retirees the benefits owed them and, in 1985, terminated that plan. The $388.8 million in surplus assets reverted to the company, which placed them in its general fund to be used for general corporate purposes. In its 1985 federal tax return, Celanese reported income from the reversion as miscellaneous income. It reported the income as taxable business income in its 1985 New York State tax return and paid New York income tax on a small percentage of it. But in its 1985 California tax return, it did not apportion any part of the reverted income to California. The California Franchise Tax Board then imposed an additional franchise tax of $292,142 on the company plus interest based on the income from the reversion.
The company filed a protest with the board, but the tax was upheld. The company then appealed to the State Board of Equalization, which also upheld the tax. The equalization board, in its decision, said that the definition of "business income" created two tests, a transactional test and a functional test, and that the income from the reversion was business income under the functional test.
In 1985, Celanese paid $715,791.35 - comprising the original assessment plus interest - to the state. At the same time, it asked for a full refund, and argued that apportionment of the income to California violated the due process and commerce clauses of the U.S. Constitution. The firm merged with American Hoechst Corp. in 1987.
When the equalization board again denied the claim for the refund, the company filed its complaint with the Superior Court.
After a hearing, the Superior Court ruled in 1998 for the state. Hoechst appealed that ruling and, in December 1999, the Court of Appeal reversed the lower court's decision.
Passing or failing
While the Court of Appeal applied both a transactional and functional test, it concluded the reversion did not satisfy either test. That court found the reversion did not meet the transactional test because the reversion was an extraordinary event that did not occur in the regular course of Hoechst's business. It also found the reversion failed the functional test because Hoechst did not own or hold title to the pension plan assets that generated the income. (Under the pension plan's structure, the company had created a tax-exempt trust that invested the company's contributions.) Thus the court viewed the income from the reversion as non-business income that was subject only to Hoechst's commercial domicile in New York.
The state Supreme Court held the reversion did satisfy the functional test.
Under the functional test, corporate 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, the court wrote. It also noted Hoechst created the income-producing property - the pension plan and trust - in order to retain its current employees and to attract new employees. Even though Hoechst did not own or hold legal title to the pension plan assets, its control and use of the pension plan assets still contributed materially to its production of business income by improving the efficiency and quality of its work force. That, in turn, generated Hoechst's business income, the court wrote.
The court also wrote that its decision did not violate the company's constitutional rights because the pension plan and trust were a crucial part of its business operations in California. "Accordingly, subjecting an apportionable share of the reverted pension plan assets to taxation in California does not violate the federal due process clause," according to the ruling.