The opinion of the court was delivered by: Lasser
Central National-Gottesman, Inc. (Taxpayer) contests the denial by the Director of the Division of Taxation of Taxpayer's claims for refund of corporation business taxes for the years 1988, 1989 and 1990. Taxpayer contends that the portion of its income and gain which is derived from investments should not be included in income subject to tax by New Jersey because it is not unitary business income. Taxpayer is a New York corporation having its corporate headquarters during the years at issue in New York City. The corporation engages in two types of activities, (1) investment in publicly held securities and (2) operation of a forest products business consisting of the purchase and sale in bulk of pulp, paper, newsprint and paperboard and the wholesale distribution of printing-grade and writing-grade papers. Prior to 1984 the forest products business was conducted in a number of states and internationally but not in New Jersey. In 1984 Taxpayer purchased all of the stock of Lindenmeyr Paper Corporation (Lindenmeyr) a Delaware corporation having its headquarters in Long Island City, New York. Lindenmeyr engaged in the wholesale distribution of printing-grade and writing-grade papers in New York, New Jersey and other states. It filed CBT returns in New Jersey prior to and after its acquisition by Taxpayer in 1984.
In 1987 Taxpayer elected to become a Subchapter S corporation effective for the year 1988. Since a Subchapter S corporation may not have subsidiaries, Lindenmeyr and its subsidiaries were merged into Taxpayer in late 1987. Following the merger, Taxpayer continued its investment activities and pursued its forest products business in the single Subchapter S corporation.
During the years 1988, 1989 and 1990, Taxpayer held a substantial diversified investment portfolio consisting largely of publicly-traded securities. The value of the security portfolio exceeded $200 million during the period. Net profits from the investment portfolio were approximately $25,689,000 for 1988, $34,672,000 for 1989 and $3,063,000 for 1990. In its portfolio activities Taxpayer was a passive investor. It did not purchase control blocks of stock, nor was it a securities broker or dealer. The securities held were of companies unrelated to Taxpayer and Taxpayer did not participate in the business affairs of the issuers of the securities. Until 1988 Taxpayer employed in-house portfolio managers to make investment decisions, employing approximately 20 persons to conduct its securities investment activities, all of whom were located at its New York headquarters. Some of the employees managed the portfolio and others performed clerical record keeping, transaction verification and preparation of investment activity reports. Beginning in 1988 Taxpayer engaged the services of six or seven independent investment advisors to manage its portfolio. As a result, the number of Taxpayer's employees engaged in security investment activities decreased to approximately 10 who continued to perform investment record keeping functions at its corporate headquarters.
During the years in issue Taxpayer's gross revenues from its forest products business exceeded $1 billion and net profits were approximately $12 million for 1988, $14 million for 1989 and $8 million for 1990. The forest products business employed more than 600 people and had offices and warehouses in a number of states.
In connection with the 1988 Subchapter S merger and restructuring, the forest product business was separated from the investment business and $40 million of capital was allocated to the forest products division on its internal financial statements. Thereafter the forest products division obtained its own financing independent of Taxpayer's other financial resources. Taxpayer's forest products division had financing arrangements with four different institutional lenders and had arranged for three different industrial revenue bond issues in New Jersey, Massachusetts and Connecticut to finance the acquisition or construction of warehouse facilities in those states.
Although operated as divisions of the same corporation, Taxpayer has sought to maintain the investment division as a business activity separate from the forest products division. Separate bank accounts and separate books and records were maintained as well as separate computer systems. The staffs of the two divisions were kept separate. The forest products business had its own controller, executives, accounting department, credit department and sales force. The investment division had its own controller, accounting department, clerical employees and portfolio managers. Three or four of the most senior officers performed duties for both divisions. They did not make day-to-day investment decisions but merely reviewed the performance of the portfolio managers. The senior officers' salaries were allocated between the two divisions. The same employee benefit plans were available to employees of both divisions, but costs were proportionally allocated to the two divisions.
The assets and income of each division were maintained separately. Income from the forest products division was distributed to the shareholders as dividends and not added to the assets of the investment division.
In 1984 there was a permanent transfer of funds from the investment division to the forest products business for the purchase of Lindenmeyr. Before the Subchapter S merger in late 1987, a small amount of investment portfolio capital was occasionally loaned to the forest products business. In connection with the merger, the forest products division retained $40 million in capital on its books and returned approximately $17 million to the investment division accounts, the decision having been made that the capital of the forest products division would be limited to $40 million.
In 1988 D.F. Munroe Company was purchased with funds of the forest products division. At that time a letter of credit was obtained from Morgan Guarantee Trust to secure payments to an officer of D.F. Munroe in the amount of $8,425,000 under an employment and non-competition agreement. The letter of credit was obtained at a lower cost by permitting Morgan Guarantee to look to a portion of the assets of the investment division held in a Morgan Guarantee custody account in the event of default of the reimbursement obligation under the agreement and letter of credit. The face amount of the letter of credit represented approximately 4% of the value of the investment portfolio in 1988 and the investment portfolio was never called upon to make any payment relating to this obligation.
In 1988 Taxpayer made charitable contributions of approximately $513,000 in the form of appreciated securities of the investment division, a portion of which were allocated to the forest products division.
Taxpayer's headquarters functions and employee benefit programs were shared by the investment and forest products divisions, but their books and records reflected their allocable shares of the costs of the shared programs or functions. The senior officers whose compensation was allocated were the president, the general counsel, the treasurer, and the director of human resources.
Taxpayer contends that its investment and forest products divisions are separate and distinct activities combined only for the purpose of complying with the requirements of Subchapter S of the Internal Revenue Code, that the divisions are not functionally integrated and, since there is no nexus between the investment division and the State of New Jersey, and because the activities are not unitary, the income and assets of the investment division are not subject to tax by the State of New Jersey.
Director contends that Taxpayer's merger with the Lindenmeyr business which conducted business in New Jersey gave Director the authority to determine whether all of Taxpayer's assets have an operational connection with the activities Taxpayer conducts in New Jersey. Director contends that the operational use of the investment portfolio by the forest products division was continuing, not merely isolated occurrences. Director also asserts that the three-part test of unitary business (i.e., functional integration, centralization of management and economies of scale) applies, and that under this ...