When a parent corporation sells the stock of its subsidiary to another corporation, Section 338(h)(10) of the Internal Revenue Code allows the seller and buyer to elect under to treat the stock sale as if the subsidiary sold all of its assets in a complete liquidation.
The subsidiary is deemed to have liquidated while owned by the seller, and it recognizes a gain or loss on the deemed sale of its assets.
In 1994, Canteen Holdings (Holdings) sold all of the stock of its subsidiary, I.M. Vending Inc., to Compass Holdings, Inc., an unrelated corporation. Canteen Corp., a food service business, was a subsidiary of I.M. Vending. Holdings and Compass then jointly filed an election with the IRS under IRC Section 338(h)(10) to have the sale of Vending’s stock treated as a sale of assets, as they were legally permitted to do.
For federal income tax purposes, Canteen was deemed to have sold all of its assets in the transaction and to have immediately distributed the proceeds to its parent – Vending – in complete liquidation, although Canteen never actually sold or disposed of its assets other than in the routine course of business.
Canteen filed its state net income tax and reported the gain from the deemed sale of assets as nonbusiness income. But the Department of Revenue instead treated the gain as business income, which increased Canteen’s tax liability./l/m
Canteen maintained the Board of Finance and Revenue erred in classifying the gain as business income. The corporation was denied both a resettlement of its tax liability with the Department of Revenue’s board of appeals and a review with the Board of Finance and Revenue. Canteen then appealed to the Commonwealth Court.
Pennsylvania Tax Treatment
The Board of Finance and Revenue’s classification of the Canteen sale as business income was correct because the Canteen sale was not an actual liquidation but rather a “deemed liquidation,” Kelley said.
In the legal fiction created by IRC Section 338, which treats a stock sale as a sale of assets, the deemed distribution of the sale proceeds from the subsidiary to the parent is tax-free and the parent company’s actual sale of the subsidiary’s stock is ignored for federal tax purposes.
But Kelley said that Pennsylvania is not bound to follow federal income tax treatment. Nor is federal tax treatment determinative of the status of the gain under Pennsylvania tax law, he said.
In fact, the judge said, the Pennsylvania Tax Code specifies that taxable income generated as a result of a IRC Section 338 election be treated as “business income subject to apportionment,” subject to Pennsylvania Corporate Net Income Tax. Any other result, Kelley said, “would deprive Pennsylvania of taxes to which is it legitimately entitled.”
Provided there is a sufficient nexus between a taxing state and a corporation, the state may tax the income of the business, by use of apportionment and allocation formulas, Kelley said. The classification of gain as business income or nonbusiness income is significant as it relates to Pennsylvania’s ability to apportion or allocate income to the state, he said.
Kelley also said a key factor in determining classification of income was the fact that no liquidation actually occurred in the sale of Canteen. The cases cited by Canteen which supported a determination of nonbusiness income involved transactions in which corporations were actually liquidated, Kelley said.
“While the gain or sale of assets in connection with the liquidation of a business, whether total or partial, normally constitutes nonbusiness income in Pennsylvania, this principle does not apply to a ‘deemed sale’ of assets in liquidation under [a] Section 338(h)(10) election,” the judge said. “The fiction of the sale of assets for federal tax purposes under Section 338(h)(10) has no bearing for purposes of Pennsylvania taxation.
“Pennsylvania is not precluded from examining the reality of the situation. The reality of the transaction was not a liquidation of assets, but the sale of stock. There has been no actual sale of Canteen’s separate company assets and no cessation of Canteen’s separate company business operations. On the day of and on the day after the sale, Canteen had the same assets, [and] its stock was still owned in full by the same parent company, Vending.”
Kelley also said that Canteen’s gain from the sale of I.M. Vending constituted business income under the “functional test,” one of two tests recognized by Pennsylvania to determine whether the gain from the sale of a corporation’s assets is business or nonbusiness income. The test treats a gain as business income “if the assets disposed of were used to generate business income, even if their sale is not a regular incident of the business.”
