Hercules Inc. v. Comptroller of the Treasury

RODOWSKY, Judge. The question in this case is whether the Due Process Clause of the Constitution of the United States permits Maryland to ¹⁰⁴ tax a portion of a capital gain that the petitioner, Hercules Incorporated (Hercules), realized in 1987 on the sale of its 37.5% stock interest in HIMONT Incorporated (HIMONT), a corporation created in 1983 when Hercules restructured part of its business. The Maryland Tax Court, the Circuit Court for Baltimore City, and the Court of Special Appeals in Hercules, Inc. v. Comptroller of the Treasury, 117 Md.App. 29 , 699 A.2d 461 (1997), all answered the question in the affirmative. We reverse for the reasons stated below.

Hercules is a Delaware corporation with its principal place of business in Wilmington, Delaware. As it describes itself in its 1987 annual report, Hercules “is a worldwide supplier of a broad line of natural and synthetic materials and products and related systems,” serving, inter alia, “the electronics, packaging, aerospace, food, synthetic fibers, automotive, graphic arts, adhesives, paper coatings, and personal-care industries.” Hercules’s principal business activity in Maryland during the relevant time period was the sale of industrial chemicals. Prior to 1983 one aspect of Hercules’s business was the manufacturing of polypropylene resin (PPL) from propylene, a petrochemical. Hercules used 10% to 15% of its PPL production in the manufacture of film and fibers, and it sold the balance of its PPL production on the open market.

Hercules failed to keep pace with the technology in the field so that its PPL production was not as efficient and profitable as that of the more technically advanced producers. Accordingly, as early as 1978, Hercules decided to divest itself of its PPL manufacturing business, but it had not found a purchaser by 1983. In 1983 Hercules and Montedison S.p.A. (Montedison), an Italian manufacturer that utilized state of the art technology, formed a joint venture.

Each company contributed its PPL manufacturing assets, Hercules contributed its North American marketing organization, and, apparently, Montedison contributed its European marketing organization. The PPL manufacturing plants owned by Hercules were in Louisiana and Texas. As the transferee of these assets the joint venturers created HIMONT, a Delaware corporation. ¹⁰⁵ Pursuant to their joint venture, Hercules and Montedison each owned 50% of HIMONT’s stock. At start-up on November 1,1983, HIMONT issued a promissory note to Hercules in the amount of $70 million, payable over five years at commercially competitive interest rates.

This obligation was designed to offset the amount by which Hercules’s initial capital contribution to the formation of HIMONT exceeded Montedison’s. By means of the formation of HIMONT the joint venturers completely divested themselves of their PPL manufacturing business, but Hercules continued to use PPL to manufacture film and fibers. Hercules (and Montedison) entered into a requirements contract with HIMONT under which HIMONT agreed to sell PPL to the parents of the venture at the open market price less a 2.5% “discount intended to recognize the fact that selling and other indirect expenses will be less for sales to the parents of the venture than that incurred in the open marketplace.” Hercules purchased between $117 and $146 million worth of PPL per year from HIMONT from 1984 to 1987. These purchases amounted to between 12% and 13% of HIMONT’s annual sales over this time.

At oral argument counsel for Hercules represented to this Court that Hercules’s purchases of PPL from HIMONT were “somewhere in the eighty percent range” of Hercules’s requirements. At the time of the initial formation of HIMONT, Hercules and Montedison were each entitled to appoint three directors to HIMONT’s six-member board of directors. Other than the three individuals who were so appointed by Hercules and who served only as directors in HIMONT, there were no common officers or employees of Hercules and HIMONT. When HIMONT was first created, it contracted for certain administrative services from Hercules and Montedison because HIMONT needed time to hire, train, and staff a complete administrative structure.

These administrative services were accounting, contracting, payroll, finance, and insurance. HIMONT decided what services it needed and made the policy decisions. Hercules and Montedison then supplied the manpower on a subcontracting basis to implement those deci ¹⁰⁶ sions. As time went on, the services provided to HIMONT by-Hercules declined as HIMONT built up its administrative structure.

In February 1987 HIMONT was taken public. The initial offering price for HIMONT stock was $28 per share. This offering raised over $379 million and diluted Hercules’s and Montedison’s ownership of HIMONT from 50% each to 37.5% each, while the public held 25%. After the public offering HIMONT’s board of directors was expanded to nine members.

Hercules had the right to appoint three of the nine directors. In September 1987 Hercules sold all of its stock in HI-MONT to Montedison at $59.50 per share, realizing a $1.3 billion gain from a total net proceeds of nearly $1.5 billion. The sale was precipitated, at least in part, by Montedison’s threat to make a hostile tender offer to the shareholders of Hercules. Hercules listed this capital gain on its 1987 Maryland Corporation Income Tax Return, and, after computing a statutory apportionment factor of .001434, paid $137,307 in Maryland state income taxes.

In 1991 Hercules filed an amended 1987 Maryland Corporation Income Tax Return, in which it excluded the $1.3 billion gain in computing the apportionment to Maryland. Hercules requested a tax refund of $132,562. In October 1992 this claim was denied by the respondent, Comptroller of the Treasury (the Comptroller). Hercules appealed this denial of refund to the Maryland Tax Court.

The hearing record before that agency consists of a stipulation of facts, certain documents, and the testimony of a former officer of Hercules. On January 3, 1995, the Tax Court affirmed the decision of the Comptroller, holding that there was “insufficient convincing evidence that the gain on the sale of Himont stock was the result of a discrete business enterprise unrelated to Hercules’ unitary activities.” Hercules moved the Tax Court to withdraw its opinion in order to permit a motion for reconsideration; the Tax Court, by an order entered January 27,1995, withdrew its order of January 3. After considering and denying Hercules’s motion for recon ¹⁰⁷ sideration, the Tax Court, by an order entered March 16,1995, reinstated its original order upholding the decision of the Comptroller. The Tax Court viewed the primary question to be whether the ownership and sale by Hercules of its stock in HIMONT was for “operational purposes.” That agency focused on two aspects of the Hercules-HIMONT relationship, (1) the consummation, by the sale of HIMONT stock, of Hercules’s “long-term corporate strategy for ‘... profitable disengagement from the [PPL] business’ ” 1 and (2) the requirements contract.

The agency concluded that “Hercules sought to disengage from the [PPL] manufacturing business in order to avoid unreliable markets for the purchase of raw materials, and to shift its corporate focus to that of a specialty chemical company. In the creation, nourishment, operation and sale of Himont, there was a significant flow of value both from Hercules to Himont and back from Himont to Hercules.” Hercules petitioned the Circuit Court for Baltimore City for judicial review. That court affirmed the agency decision. Hercules appealed to the Court of Special Appeals.

That court affirmed, reasoning that “the function of the creation of HIMONT and ultimate sale of HIMONT stock was not merely ¹⁰⁸ to increase the investor’s profitability in the usual sense of the term, but instead, was to transform the nature of the investor’s business.” Hercules, 117 Md.App. at 54 , 699 A.2d at 473 . Accordingly, it was held that the Tax Court properly determined that Hercules’s investment in HIMONT fell on the operational side of the line between an investment and an operational function. Id. This Court granted Hercules’s petition for a writ of certiorari as well as the Comptroller’s conditional cross-petition which questions the timeliness of Hercules’s petition to the circuit court for judicial review.

Additional facts will be presented, as necessary, in the resolution of these issues. I The Comptroller contends that Hercules failed to comply with Maryland Rule 7—203(a)(1), which requires that a party file for judicial review within thirty days of the date of the order of an administrative agency from which review is sought. The Tax Court issued its first order on January 3, 1995. That order was withdrawn on January 27, 1995.

The Tax Court reinstated its original order on March 16, 1995. Hercules petitioned for judicial review on March 24, 1995. The Comptroller argues by analogy to Hess v. Chalmers, 27 Md.App. 284 , 339 A.2d 706 , cert. denied, 276 Md. 744 (1975), a declaratory judgment case in which the operation of an order was stayed and then the stay was lifted. In Hess , the days elapsed prior to the stay were added to the days after the suspension was vacated in computing the time limit. “The countdown was resumed, not to start again from the beginning, but to take up where it left off.” Id. at 288 , 339 A.2d at 708 .

The Comptroller argues that twenty-three days had elapsed prior to the Tax Court’s withdrawal of its January 3 order, and that the clock therefore started at twenty-four after the filing of the March 16 order. This would make Hercules’s petition for review untimely by two days. ¹⁰⁹ The Comptroller’s argument, however, conflates the meaning of “stay” and “withdraw.” Prior to the expiration of the time for petitioning for judicial review, an administrative body has the power to strike its own order, which is what occurred here. Consequently, the March 16 order was the final order in the proceeding. Indeed, by means of a stamped legend the Clerk of the Maryland Tax Court gave notice that the parties had the right to “appeal” within thirty days “from the date of the above Order.” We now turn to the merits.

II “Under both the Due Process and the Commerce Clauses of the Constitution, a State may not, when imposing an income-based tax, ‘tax value earned outside its borders.’ ” Container Corp. of America v. Franchise Tax Bd., 463 U.S. 159, 164 , 103 S.Ct. 2933, 2939 , 77 L.Ed.2d 545, 552 (1983) (quoting ASARCO Inc. v. Idaho State Tax Comm’n, 458 U.S. 307, 315 , 102 S.Ct. 3103, 3108 , 73 L.Ed.2d 787, 794 (1982)). Hercules’s sales within Maryland during the critical time period—the 1987 tax year—were seven-tenths of 1% of its total sales. The taxpayer had sales of $14.1 million in Maryland, as compared to $2 billion overall. It owned $32,155 worth of machinery and equipment within the state and paid $82,820 in Maryland salaries; overall, Hercules owned $2.8 billion in assets and paid over $627 million in salaries and wages.

Uncontradicted testimony established that Hercules had no manufacturing facilities in Maryland and that the salaries paid in this state reflected individuals who lived in Maryland but commuted to Hercules’s home office in Wilmington, Delaware. In order to levy a tax upon Hercules’s capital gain from the sale of HIMONT stock, there must be some nexus linking this income to activities within the state. The necessary nexus usually “is satisfied by demonstrating the existence of unitary business, part of which is carried on in the taxing state.” NCR Corp. v. Comptroller of the Treasury, Income ¹¹⁰ Tax Div., 313 Md. 118, 132 , 544 A.2d 764, 771 (1988). Where the nexus exists, the Maryland tax on a corporation engaged in a multi-state business is governed by Maryland Code (1957, 1997 Repl.Vol.), § 10-402(c) of the Tax-General Article (TG), which requires that net income be apportioned to this state on the basis of a formula using property, payroll, and sales.

See Random House, Inc. v. Comptroller of the Treasury, 310 Md. 696, 697, 701 , 531 A.2d 683, 683, 685 (1987); see also NCR Corp., 313 Md. 118, 141-42 , 544 A.2d 764, 775 ; Xerox Corp. v. Comptroller of the Treasury, Income Tax Div., 290 Md. 126, 129-30 , 428 A.2d 1208, 1211 (1981); accord Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425 , 100 S.Ct. 1223 , 63 L.Ed.2d 510 (1980). The legislative purpose underlying this statute is to tax multi-state corporations doing business in Maryland to the bounds permitted by the United States Constitution. NCR Corp., 313 Md. at 146 , 544 A.2d at 777 . To that end, the question before us becomes one of federal constitutional, rather than of Maryland statutory, law.

In resolving that question, the burden is on the taxpayer to show “ ‘by “clear and cogent evidence” that [the state tax] results in extraterritorial values being taxed.’ ” Container Corp., 463 U.S. at 175 , 103 S.Ct. at 2945 , 77 L.Ed.2d at 559-60 . Hercules submits that the undisputed facts in this case meet that burden because the claimed connection to Maryland is too remote. In addition to its analysis of decisions of the Supreme Court of the United States, Hercules relies on Hercules Inc. v. Commissioner of Revenue, 575 N.W.2d 111 (Minn. 1998), where the Supreme Court of Minnesota held, inter alia, that that state could not constitutionally tax an apportioned part of the gain realized by Hercules on the very sale of stock that gives rise to Maryland’s attempt to tax an apportioned part of the same gain. 2 The Comptroller argues (1) that “Hercules’ creation and ownership of, relationship with, and ultimate sale of HIMONT served an operational function of ¹¹¹ Hercules” such as to constitute a portion of its unitary business and (2) that “the presence of a flow of value between Hercules and HIMONT establishes that they comprised a unitary business.” Creation and Ownership The Supreme Court has recently reemphasized its three-part test in determining whether a subsidiary is a part of the unitary business of the parent; those three elements are: (1) functional integration, (2) centralization of management, and (3) economies of scale. Allied-Signal, Inc. v. Director, Div. of Taxation, 504 U.S. 768, 783 , 112 S.Ct. 2251, 2260 , 119 L.Ed.2d 533, 549 (1992).

Looking to the period prior to HIMONT’s going public, and not to the year of the stock sale, the Comptroller submits the following argument, the relevance of which is questionable: “Hercules, as a 50% shareholder, controlled, in concert with Montedison, all aspects of HIMONT. Indeed, HIMONT’s by-laws expressly gave Hercules (and Montedison) veto power over such major corporate acts as adoption of budgets, adoption of long-range plans and objectives, disposal of large capital assets, and declaration of dividends.” The Supreme Court considered and rejected precisely this sort of argument in F.W. Woolworth Co. v. Taxation & Revenue Dep’t, 458 U.S. 354 , 102 S.Ct. 3128 , 73 L.Ed.2d 819 (1982). In F.W. Woolworth, the parent company owned all of the stock of three of the four foreign subsidiaries at issue, as well as a 52.7% interest in the fourth—a far greater level of ownership than that of Hercules in HIMONT in 1987. F.W. Woolworth elected all of the three wholly-owned subsidiaries’ directors, and had the “authority to operate these companies as integrated divisions of a single unitary business.” Id. at 362 , 102 S.Ct. at 3134, 73 L.Ed.2d at 826.

Moreover, the record demonstrated “some managerial links” between F.W. Woolworth and its subsidiaries; there were common directors with the parent company and frequent communications between the subsidiaries and the parent. Id. at 368, 102 S.Ct. at 3137, 73 L.Ed.2d at 830. ¹¹² Nevertheless, the Supreme Court reiterated that the proper test under the Constitution was not the potential of unitary control, but rather the actual, in fact unitariness or separateness of the subsidiary enterprises. Id. at 362, 102 S.Ct. at 3134, 73 L.Ed.2d at 826. See also ASARCO, 458 U.S. at 320-22 , 102 S.Ct. at 3111-12 , 73 L.Ed.2d at 798-99 (no unitary control where the parent owned 51.5% of the stock of the subsidiary and could have controlled the subsidiary’s management).

Thus, the Supreme Court found little functional integration between F.W. Woolworth’s subsidiaries and the parent company. F.W. Woolworth, 458 U.S. at 364, 102 S.Ct. at 3135, 73 L.Ed.2d at 828. The subsidiaries performed their functions “ ‘autonomously and independently of the parent company.’ ” Id. at 365, 102 S.Ct. at 3135, 73 L.Ed.2d at 828 (quoting undisputed