Glatfelter Pulpwood Co. v. Commonwealth of Pa.

• Decision Date: 04 May 2011
• Citation: 19 A.3d 572
• Parties: GLATFELTER PULPWOOD COMPANY, Petitionerv.COMMONWEALTH of Pennsylvania, Respondent.
• Court: Pennsylvania Commonwealth Court

19 A.3d 572

GLATFELTER PULPWOOD COMPANY, Petitioner

v.COMMONWEALTH of Pennsylvania, Respondent.

Commonwealth Court of Pennsylvania.

Argued April 6, 2011.Decided May 4, 2011.

George T. Bell, Harrisburg, for petitioner.Jonathan C. Edmunds, Harrisburg, for respondent.BEFORE: LEADBETTER, President Judge, and McGINLEY, Judge, and PELLEGRINI, Judge, and SIMPSON, Judge, and LEAVITT, Judge, and BROBSON, Judge, and McCULLOUGH, Judge.OPINION BY Judge PELLEGRINI.

Glatfelter Pulpwood Company (Taxpayer) petitions for review from an order of the Board of Finance and Revenue (Board) denying its request for a tax refund because its timberland sales gains meets the definition of “business income” under Section 401(3)2.(a)(1)(A) of the Tax Reform Code of 1971. ¹ For the reasons that follow, we affirm the Board's decision.

I.

According to the parties' Stipulation of Facts, Taxpayer is a wholly-owned subsidiary of P.H. Glatfelter Corporation, the parent company (Parent), which is a corporation that is organized under the laws of Maryland and maintains its headquarters in York, Pennsylvania. The Parent is engaged in the business of manufacturing specialty papers and engineered products and has timberlands located in Delaware, Maryland, Pennsylvania and Virginia. Taxpayer's sole business activity is the procurement of pulpwood either from harvesting company-owned timberland or by purchasing timberland from third parties for the specialty paper manufacturing operations of the Parent. Taxpayer operates the Parent's paper mill in Spring Grove, Pennsylvania.

Prior to 2003, Taxpayer obtained approximately 25% of the pulpwood needed for its Parent's paper manufacturing operations from company-owned timberland and procured approximately 75% of the needed pulpwood from purchases on the open market. In 2003, following an industry trend, Taxpayer made a corporate decision to divest certain of its timberland holdings with the effect of reducing the percentage of pulpwood procured from company-owned timberland from approximately 25% to approximately 5%. This was known as the “Timberland Divestiture Plan.” As a result, Taxpayer sold 5,000 acres of timberland in Delaware and 25,821 acres of timberland in Maryland. It sold most of its timberland in Maryland to The Conservation Fund, a non-profit Maryland corporation, and received in consideration a 10–year note in the amount of $37.9 million. It also entered into a supply agreement to purchase at market prices an annual amount of pulpwood averaging 34,425 tons per annum over the eight-year term of the agreement on the timberlands sold to The Conservation Fund. As of December 31, 2004, Taxpayer owned 14,364 acres of timberland in Delaware; 25,587 acres of timberland in Pennsylvania; 40,676 acres of timberland in Virginia; and 49 acres of timberland in Maryland.

During 2004, as part of the Timberland Divestiture Plan, Taxpayer sold 4,882 acres of timberland in Delaware for $56,586,000, realizing a net gain of $55,355,452 (“the 2004 Delaware Sale”). Taxpayer reported the 2004 Delaware Sale on its federal tax return as a sale or exchange of property used in a trade or business. The income generated by the sales of pulpwood from the business prior to the 2004 sale was reported to Pennsylvania as apportionable business income. Taxpayer distributed all of the net proceeds from the 2004 Delaware Sale to its Parent, which, in turn, used the proceeds to pay debt and pay dividends to its shareholders.

Taxpayer filed its 2004 corporate tax report omitting any inclusion of nonbusiness income and reporting a tax liability of $2,189,876. Taxpayer paid this liability and filed an amended corporate tax report claiming that the net gain from the 2004 company-owned timberland in Delaware was nonbusiness income to be allocated to Delaware. The amended corporate tax report reported a zero corporate net income tax liability. On settlement of Taxpayer's 2004 tax year, the Department of Revenue (Department) increased the apportionable business income from a ($3,044,914) net loss to $52,327,343 through denial of the nonbusiness income treatment of the net gain related to the 2004 timberland sale. As a result, the Department asserted additional corporate net income tax liability owed by Taxpayer in the amount of $2,205,211.

Taxpayer filed an appeal with the Board of Appeals seeking a refund of the 2004 corporate net income tax in the amount of $2,205,211 based on a claim of nonbusiness income treatment for the net gain from the 2004 Delaware Sale. The Board of Appeals refused Taxpayer's refund claim, and Taxpayer appealed to the Board again requesting nonbusiness income treatment for the net gain from the 2004 Delaware Sale. The Board denied Taxpayer's request because it found that the timberland sales gains met the definition of “business income” under Section 401(3) 2.(a)(1)(A) of the Tax Reform Code of 1971 and met the transactional test for business income:

because buying and selling timberland occurred in the regular course of [Taxpayer's] business. Welded Tube Co.,[ ²] supra. [Taxpayer] decided that it under utilized its timberlands and engaged in a series of timberland sales in 2003 and in 2004. The timberland sales gains meet the functional test for business income because the acquisition and management of timberlands constituted an integral part of [Taxpayer's] regular trade or business. 72 P.S. § 7401(3) 2.(a)(1)(A). All business income is apportioned under the Tax Reform Code. 72 P.S. § 7401(3) 2.(a)(9)(A). The Department correctly settled and apportioned [Taxpayer's] business income.

(Board's May 22, 2007 decision at 7.) This appeal by Taxpayer followed. ³

II.

For purposes of corporate net income tax, Pennsylvania classifies income into two groups: business income and nonbusiness income. “Business income” is defined as:

Income arising from transactions and activity in the regular course of the taxpayer's trade or business and includes income from tangible and intangible property if either the acquisition, the management or the disposition of the property constitutes an integral part of the taxpayer's regular trade or business operations. The term includes all income which is apportionable under the Constitution of the United States. ⁴ (Emphasis added.)

Income that is “apportionable” means that it is divided among states with some nexus to the business based on a formula. In Pennsylvania, the apportionment is based on payroll, property and sales. 72 P.S. § 7401(3) 2.(a)(9)(A).

In Welded Tube Company, this Court set forth two alternative independent tests by which to evaluate whether income was properly classified as business income or nonbusiness income.⁵ We stated that the “transactional” test was utilized for the first clause of the definition: gains were classified as business income when they were derived from a transaction in which the taxpayer regularly engaged, i.e., the test measured the frequency and regularity of similar transactions and past practices of the business. Also, the taxpayer's subsequent use of the income was relevant in determining whether the income was business income. Looking at the second clause of the definition of “business income,” the “functional” test was utilized: “in the view of other jurisdictions, by which earnings may be characterized as business income: income from ‘tangible and intangible property if the acquisition, management and disposition of the property constitute integral parts of the taxpayer's regular trade or business.’ Under this test, the gain arising from the sale of an asset will be classified as business income if the asset produced business income while it was owned by the taxpayer.” Welded Tube Company, 515 A.2d at 994. (Emphasis in original.) The extraordinary nature or infrequency of the transaction was irrelevant.

A.

Taxpayer contends that the sale of the timberland does not meet the transactional test because it does not regularly deal in the business of selling or speculating in real estate. Its regular and routine business is the procurement and sale of harvested pulpwood to its Parent. It points out that from 1970 through 2002, it made only incidental sales of timberlands, primarily in isolated transactions to “round off” tracts or to accommodate a neighboring landowner. Those sales amounted to a miniscule 0.21% of Taxpayer's timberland holdings per year. Therefore, while the routine sale of timber would be deemed business income, the 2004 Delaware Sale was not a transaction or activity in which Taxpayer “regularly” engaged and it should not be deemed apportionable business income under the transactional test. We agree and the Commonwealth does not contend otherwise that the 2004 Delaware Sale does not fall under the transactional test because it was a one-time event and cannot possibly meet the definition of regular and routine business.

B.

Taxpayer also argues that it does not fall under the functional test because to do so, the property itself would have to be an integral part of its regular trade or business. In this case, while the timber is integral to its regular business operations, the real estate itself is not. It argues, by example, that if it were to sell the Parent's corporate headquarters, that could conceivably fall within the functional test if the building was deemed an integral part of Taxpayer's trade or business. However, because the 2004 Delaware Sale is not an integral part of Taxpayer's regular trade or business, the gain on the transaction is not business income under the functional test either.

In order to fall under the functional test, “business income” is included if it comes from the management, acquisition or disposition of property which constitutes an integral part of Taxpayer's regular trade or business. In addition, “under this test, the gain arising from the sale of an asset will be classified as business income if the asset produced business income while it was owned by the taxpayer. The...