Polaroid Corp. v. Offerman

• Decision Date: 04 December 1998
• Docket Number: No. 70PA98.,70PA98.
• Court: North Carolina Supreme Court
• Parties: POLAROID CORPORATION v. Muriel K. OFFERMAN, Secretary of Revenue of the State of North Carolina.

507 S.E.2d 284

349 N.C. 290

POLAROID CORPORATION v. Muriel K. OFFERMAN, Secretary of Revenue of the State of North Carolina.

No. 70PA98.

Supreme Court of North Carolina.

December 4, 1998.

Alston & Bird, P.L.L.C. by Jasper L. Cummings, Jr., Raleigh, for plaintiff-appellee.

Michael F. Easley, Attorney General by Andrew A. Vanore, Jr., General Counsel; George W. Boylan, Special Deputy Attorney General; and Kay Linn Miller Hobart, Assistant Attorney General, for defendant-appellant.

Multistate Tax Commission by Paull Mines, General Counsel, Washington, DC, amicus curiae.

WYNN, Justice.

Plaintiff Polaroid Corporation ("Polaroid"), a Massachusetts corporation, develops, manufactures, and sells photographic equipment. As one of the world's predominant manufacturers of instant photographic equipment, Polaroid continually develops and refines methods of designing and marketing those products. Under this market-leading approach, Polaroid has obtained an extraordinary number of patents; however, it has never licensed its core technology to an unrelated third party.

In 1976, Polaroid sued Eastman Kodak Company ("Kodak") under 35 U.S.C. § 271(a) to enjoin Kodak's alleged infringement of Polaroid's patents and to recover damages caused thereby. Approximately nine years thereafter, the United States District Court for the District of Massachusetts ruled for Polaroid, enjoined Kodak, and reserved the issue of damages for later determination. See Polaroid Corp. v. Eastman Kodak Co., 641 F.Supp. 828 (D.Mass.1985),

aff'd,

789 F.2d 1556 (Fed.Cir.),

cert. denied, 479 U.S. 850, 107 S.Ct. 178, 93 L.Ed.2d 114 (1986).

Following a hearing in 1990, that federal district court resolved the damages issue by determining lost profits to be the primary measure of damages and, as required under 35 U.S.C. § 284, by using the alternative "reasonable royalty" measure to set a floor below which the damages could not fall. See Polaroid Corp. v. Eastman Kodak Co., 17 U.S.P.Q.2d 1711, 1991 WL 4087 (D.Mass.1991). Accordingly, the final order awarded Polaroid damages of $233,055,432 for "lost profits," an additional $204,467,854 for "lost profits" determined on the basis of a "reasonable royalty," and prejudgment interest in the amount of $435,635,685.¹

As stated, the Kodak lawsuit did not occur in North Carolina. None of Polaroid's property or personnel relating to the Kodak lawsuit were located in this state, nor were any of the infringed-upon patents utilized by Kodak. Moreover, Polaroid did not utilize the judgment proceeds in the regular course of its business in North Carolina. Indeed, the record indicates that Polaroid used the proceeds to pay income taxes, repay debt, redeem both preferred and common stock, and provide its employees with a special bonus.

In 1991, Polaroid classified the Kodak judgment for North Carolina corporate income-tax purposes as "nonbusiness income" under N.C.G.S. § 105-130.4(a)(1). Hence, Polaroid allocated the entire judgment to Massachusetts, the state of its commercial domicile. The North Carolina Department of Revenue, however, disagreed with Polaroid's classification of the award as nonbusiness income and therefore reclassified it as business income. This reclassification, in turn, increased Polaroid's North Carolina tax liability by $499,177. After Polaroid objected to the reclassification of the award as business income, an administrative hearing was held before the Secretary of Revenue, who upheld the Department of Revenue's decision. Thereafter, Polaroid tendered the requisite amount and filed this refund action under N.C.G.S. § 105-241.4.

The parties filed motions for summary judgment which were heard at the 9 December 1996 Civil Session of the Superior Court, Wake County, before the Honorable Narley L. Cashwell. Judge Cashwell, on 28 February 1997, granted the Secretary of Revenue's motion and denied Polaroid's. Thereafter, Polaroid appealed to the Court of Appeals, which reversed the trial court's decision and remanded to the trial court for summary judgment for Polaroid. See Polaroid Corp. v. Offerman, 128 N.C.App. 422, 496 S.E.2d 399 (1998)

.

On 2 April 1998, this Court granted the Secretary of Revenue's petition for discretionary review to decide whether the damages Polaroid received as a result of the Kodak lawsuit constitute business income under N.C.G.S. § 105-130.4(a)(1).

I. BACKGROUND

North Carolina is one of seventeen states which comprise the associate membership of the Multistate Tax Commission, an administrative agency of the Multistate Tax Compact ("Compact").² The Compact was created to promote uniformity and compatibility in significant components of state tax systems and to avoid duplicative taxation. In re Appeal of Chief Indus., 255 Kan. 640, 652, 875 P.2d 278, 286 (1994). One of the Commission's central goals is to promote uniformity in the states' taxation of interstate and foreign commerce. Additionally, uniformity among the states with respect to taxation of interstate and foreign commerce constitutes the basis behind the Compact's almost word-for-word incorporation of the Uniform Division of Income for Tax Purposes Act, 7A U.L.A. 331 (1985) ("UDITPA"). So, given North Carolina's commitment to the Compact and its goal of achieving uniform taxation nationwide, it is not surprising that this state's Corporate Income Tax Act is modeled after UDITPA. See N.C.G.S. § 105-130.4 (1989); National Serv. Indus. v. Powers, 98 N.C.App. 504, 391 S.E.2d 509, appeal dismissed and disc. rev. denied, 327 N.C. 431, 395 S.E.2d 685 (1990).

Under both the North Carolina Corporate Income Tax Act and UDITPA, a multistate or multinational corporation's net taxable income is divided into two classes: (1) business income which is apportioned among the Compact taxing states according to a three-part formula based upon property, payroll, and sales factors, N.C.G.S. § 105-130.4(i); and (2) nonbusiness income which is allocated in a manner whereby it is taxed only by the state with which the asset that generated the income is most closely associated, N.C.G.S. § 105-130.4(h). See National Serv. Indus., 98 N.C.App. at 506-07, 391 S.E.2d at 511.

Thus, at the threshold, a taxpayer must identify and segregate its "business" income from its "nonbusiness" income. Section 105-130.4(a)(1) of the North Carolina Corporate Income Tax Act defines business income as

income arising from transactions and activity in the regular course of the corporation's trade or business and includes income from tangible and intangible property if the acquisition, management, and/or disposition of the property constitute integral parts of the corporation's regular trade or business operations.³

Nonbusiness income, on the other hand, is defined as "all income other than business income." N.C.G.S. § 105-130.4(a)(5).

In the case sub judice, the parties disagree over the proper construction of the statutory definition of business income. Unquestionably, the first clause of N.C.G.S. § 105-130.4(a)(1) and UDITPA—which provides that business income is "income arising from transactions and activity in the regular course of the corporation's trade or business"—sets forth the "transactional test." Under the transactional test, to determine whether business income is derived from a transaction or activity in the regular course of the corporation's trade or business, one must consider the frequency and regularity of similar transactions, the former practices of the business, and the taxpayer's subsequent use of the income. See National Serv. Indus., 98 N.C.App. at 508-09, 391 S.E.2d at 512; Ross-Araco Corp. v. Commonwealth, Bd. of Fin. & Revenue, 544 Pa. 74, 76, 674 A.2d 691, 693 (1996); Union Carbide Corp. v. Huddleston, 854 S.W.2d 87, 92 (Tenn.1993). Therefore, the central inquiry under the transactional test revolves around the nature of the particular transaction giving rise to the income. See Union Carbide Corp., 854 S.W.2d at 92.

With respect to the statutory definition's second clause—which provides that business income "includes income from tangible and intangible property if the acquisition, management, and/or disposition of the property constitute integral parts of the corporation's regular trade or business operations"—the parties debate whether this clause simply modifies the first clause or whether it sets forth a second, independent test for business income.

Some state supreme courts read the second clause of UDITPA as simply modifying the first clause and therefore hold that the definition of business income under UDITPA contains only the transactional test. See, e.g., Phillips Petroleum Co. v. Iowa Dep't of Revenue & Fin., 511 N.W.2d 608 (Iowa 1993)

; In re Appeal of Chief Indus., 255 Kan. 640, 875 P.2d 278; Federated Stores Realty v. Huddleston, 852 S.W.2d 206 (Tenn.1992). However, after these decisions, the legislatures of those states promptly amended their respective tax statutes to explicitly include the functional test within their definition of business income. See Act of May 1, 1995, ch. 141, sec. 1, 1995 Iowa Acts 256, 256 (effective retroactive to 1 January 1995); Act of May 17, 1996, ch. 264, sec. 1, 1996 Kan. Sess. Laws 1868, 1868; Act of May 6, 1993, ch. 182, secs. 1, 2, 1993 Tenn. Pub. Acts 442, 442.

Other UDITPA states, however, recognized the second clause as encompassing a second independent test known as the "functional test." See, e.g., Pledger v. Getty Oil Exploration Co., 309 Ark. 257, 831 S.W.2d 121 (1992)

; Texaco-Cities Serv. Pipeline Co. v. McGaw, 182 Ill.2d 262, 230 Ill.Dec. 991, 695 N.E.2d 481 (1998); Simpson Timber Co. v. Department of Revenue, 326 Or. 370, 953 P.2d 366 (1998); Ross-Araco Corp. v. Commonwealth, Bd. of Fin. & Revenue, 544 Pa. 74, 674 A.2d 691. These states concluded either that the plain language of UDITPA includes the functional test or that the definition of business income is ambiguous, and therefore the respective state supreme courts had the right to construe the...