Appeal from the Order of Commonwealth Court at No. 362 FR 2007 dated 5/31/11 overruling the exceptions and entering judgment of the 5/4/11 order that affirmed the decision of the Board of Finance and Revenue Order dated 5/22/07 at No. 0618748
The opinion of the court was delivered by: Mr. Justice McCAFFERY
CASTILLE, C.J., SAYLOR, EAKIN, BAER, TODD, McCAFFERY, ORIE MELVIN, JJ.
In this direct appeal, Glatfelter Pulpwood Company ("Appellant") challenges the Commonwealth Court's affirmance of the Board of Finance and Revenue's determination that Appellant's gains from the sale of a tract of Delaware timberland be characterized as "business income," subject to taxation in Pennsylvania. Upon review, we affirm the order of the Commonwealth Court.
The parties have stipulated to the relevant facts in this case, which we summarize as follows. See Stipulation of Facts, dated 10/01/10 (hereinafter "Stipulations"). Appellant, a corporation organized under Maryland law, with headquarters in Spring Grove, Pennsylvania, is a wholly-owned subsidiary of P.H. Glatfelter Corporation ("Parent"). Parent, a Pennsylvania corporation, the headquarters of which are in York, Pennsylvania, owns and operates a paper mill in Spring Grove, Pennsylvania, where it produces a variety of specialty paper products. Appellant's sole business activity is to procure pulpwood*fn1 for Parent's operations, at the lowest possible cost, from two sources, i.e., by growing trees on and harvesting trees from Appellant's own timberland, or by purchasing pulpwood from third parties on the open market. As of January 1, 2003, Appellant's timberland holdings were as follows: 25,821 acres in Maryland; 19,249 acres in Delaware; 28,595 acres in Pennsylvania; and 40,682 acres in Virginia. As part of its ongoing management practices for these timberlands, Appellant hires employees and independent contractors to plant, thin, and harvest timber and to monitor soil and water quality in order to maximize sustainable pulpwood yields. Except for isolated and unpredictable transactions, Appellant sells to Parent all the pulpwood procured, for use at Parent's Pennsylvania paper mill. Appellant reports all income generated by its pulpwood sales to Parent in Pennsylvania as apportionable business income.
In 2003, Appellant made a strategic corporate decision to sell certain of its timberland holdings, thereby decreasing the percentage of pulpwood procured for Parent from Appellant's timberlands. In 2004, as part of its timberland divestiture plan, Appellant sold 4,882 of its 19,249 Delaware acres for $56,586,000, realizing a net gain of $55,355,452. Appellant distributed all of the net proceeds from this sale to Parent, which used the distributed proceeds to pay down debt and to pay dividends to its shareholders.
As required by Delaware tax law, Appellant allocated 100% of the net gain from the Delaware timberland sale to Delaware, and paid Delaware corporate income tax on the gain in 2004.*fn2 Appellant reported the timberland sale on its federal tax return as a sale or exchange of property used in a trade or business. In its initial 2004 Pennsylvania corporate tax report, Appellant reported a corporate net income tax liability of $2,189,876, which it paid. Subsequently, Appellant filed an amended 2004 Pennsylvania corporate tax report asserting that its reported net gain on the 2004 Delaware timberland sale should have been considered as non-business income allocated to Delaware. Therefore, Appellant claimed, it actually suffered a net loss of $3,044,914 for the tax year, and its Pennsylvania corporate net income tax liability was zero. On settlement of the 2004 tax year, the Pennsylvania Department of Revenue (hereinafter "Department") declined to characterize Appellant's net gain from the Delaware timberland sale as non-business income, and concluded that Appellant's 2004 business income was $52,327,343. The Department attributed 42% of Appellant's income to Pennsylvania and, accordingly, assessed Appellant's corporate net income tax liability at $2,205,211.*fn3 See Stipulations at Â¶Â¶ 30-34; Glatfelter Pulpwood Company v. Commonwealth of Pennsylvania, 19 A.3d 572, 575, 581 (Pa.Cmwlth. 2011) (en banc).
Appellant filed an appeal with the Department's Board of Appeals, seeking a refund of its 2004 corporate net income tax in the amount of $2,205,211, based on its assertion that the gain from the sale of the timberland constituted non-business income. The Board of Appeals denied relief. Appellant then filed an appeal with the Board of Finance and Revenue (hereinafter "BF&R"), again requesting that the gain from the timberland sale be considered as non-business income. The BF&R denied the appeal, concluding, inter alia, that "the timberland sale[']s gains meet the functional test for business income because the acquisition and management of timberlands constituted an integral part of [Appellant's] regular trade or business," and the "Department correctly settled and apportioned [Appellant's] business income." Decision of BF&R, dated 5/22/07 at 7 (citing 72 P.S. Â§ 7401(3)2.(a)(1)(A)). On June 21, 2007, Appellant filed a timely petition for review in the Commonwealth Court seeking review of BF&R's decision.
The Commonwealth Court affirmed the decision of the BF&R in a published opinion. Glatfelter Pulpwood, supra at 572. Appellant then filed a direct appeal with this Court, presenting the following three issues:
a. Whether for Corporate Net Income Tax purposes the net gain realized from the sale and liquidation of the Taxpayer's timberlands situated in Delaware pursuant to an adopted Timberland Divestiture Plan constitutes "non[-]business income" to be allocated to Delaware, rather than apportioned to Pennsylvania, when in this instance the net income from the sale was distributed to the Taxpayer's shareholder and not used in the Taxpayer's regular business operations or activities?
b. Whether for Corporate Net Income Tax purposes the sale of the Taxpayer's timberlands located in Delaware is unrelated to its regular business operations carried on in Pennsylvania during the tax year which consisted of selling pulpwood to its parent?
c. Whether the taxation by the Commonwealth of 42% of the net gain on the sale of Taxpayer's timberlands situated in Delaware and taxed 100% by Delaware is unfair and unreasonable in violation of the Due Process and Commerce Clauses of the U.S. Constitution?
The issues presented are questions of law; accordingly, our standard of review is de novo and our scope is plenary. Safe Harbor Water Power Corporation v. Fajt, 876 A.2d 954, 966 n.12 (Pa. 2005). "Pennsylvania's corporate income tax is an excise tax on the privilege of earning income and, therefore, under the Commerce Clause of the United States Constitution, Pennsylvania may subject to taxation only that part of corporate income reasonably related to the privilege exercised in this Commonwealth." Canteen Corp. v. Commonwealth of Pennsylvania, 818 A.2d 594, 597-98 (Pa.Cmwlth. 2003) (en banc), aff'd, 854 A.2d 440 (Pa. 2004) (per curiam). The general procedure for calculating Pennsylvania's corporate income tax is set forth in the Tax Reform Code of 1971,*fn4 which, as a first step, classifies income as "business income" or "non-business income." The statutory definition of these terms will be discussed in the next paragraph, but initially it is important to recognize the substantial tax consequences of this classification. To calculate the tax on business income of a multistate corporation, the Commonwealth employs a formula based on the ratio of three factors, to wit, the corporation's payroll, property, and sales within Pennsylvania, to the corporation's total payroll, property, and sales, respectively. 72 P.S. Â§ 7401(3)2.(a)(9), (10), (13), (15); Commonwealth of Pennsylvania v. Gilmour Manufacturing Company, 822 A.2d 676, 677 (Pa. 2003). In contrast, "non[-]business income is allocated to the situs of the income producing property." Laurel Pipe Line Co. v. Commonwealth of Pennsylvania, Board of Finance and Revenue, 642 A.2d 472, 474 (Pa. 1994); see 72 P.S. Â§ 7401(3)2.(a)(4).
Business income is statutorily 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.
72 P.S. Â§ 7401(3)2.(a)(1)(A) (emphasis added).
The above statutory definition of business income was enacted in 2001. Prior to that time, the definition of business income read as follows: 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 the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations.
72 P.S. Â§ 7401(3)2.(a)(1)(A), repealed and revised in 2001 (emphasis added). Non-business income is statutorily defined as all income other than business income. The term does not include income which is apportionable under the Constitution of the United States.
72 P.S. Â§ 7401(3)2.(a)(1)(D).
In sum, the 2001 amendments modified the definitions of business income and non-business income as follows. Most relevantly to the instant case, the 2001 amendments changed the conjunction connecting "acquisition, management, disposition" in the definition of business income from "and" to "or." The 2001 amendments changed the definition of non-business income only by adding the second sentence. Finally, the General Assembly declared that the intent of the 2001 amendments to the statutory definitions of business income and non-business income was to "clarify existing law." 72 P.S. Â§ 7401, Historical and Statutory Notes (quoting Act 2001-23 Â§ 25).
To determine whether income is properly categorized as business or non-business income, this Court has adopted two alternative and independent tests: the transactional test and the functional test. Ross-Araco Corp. v. Commonwealth of Pennsylvania, Board of Finance and Revenue, 674 A.2d 691, 694 (Pa. 1996) ("In [Laurel Pipe Line Co., 642 A.2d at 474,] we adopted the transactional and functional tests used by the Commonwealth Court in [Welded Tube Company of America v. Commonwealth of Pennsylvania, 515 A.2d 988 (Pa.Cmwlth. 1994)].").
The transactional test is based on the first clause of the statutory definition of business income, i.e., "income arising from transactions and activity in the regular course of the taxpayer's trade or business." Under the transactional test, a gain is business income if "the corporation regularly engages in the type of transaction that produced the gain." Canteen Corp., supra at 598. "The transactional test measures the particular transaction against the frequency and regularity of similar transactions in the past practices of the business. The taxpayer's subsequent use of the income is also relevant in determining whether gain is business income." Ross-Araco, supra at 693.
The functional test is based on the second clause of the statutory definition of business income, i.e., "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." Under the functional test, a gain from the sale of an asset is business income if the corporation acquired, managed, or disposed of the asset as an integral part of its regular business. In addition in Ross-Araco, supra at 693, we stated that a gain was business income if the gain arose from the sale of an asset that produced business income while it was owned by the taxpayer.
"The extraordinary nature or infrequency of the transaction is irrelevant for purposes of the functional test." Id.*fn5
This Court has applied the transactional and functional tests in two prior cases, both of which were decided before the 2001 amendments to the definitions of business and non-business incomes. See Ross-Araco, supra, and Laurel Pipe Line Co., supra. In Ross-Araco, the issue was whether a corporation's $1,428,499 gain from the sale of a tract of land in New Jersey was business or non-business income. The corporation was in the construction business and did not regularly engage in the purchase or sale of real estate. Ross-Araco, supra at 692-93, 696-97. The land at issue was heavily wooded, remained "unimproved" during the corporation's ownership, was not rented, and did not produce any income. Id. at 692, 696-97. There was no evidence that the land was directly or indirectly involved in the corporation's investment activities, nor that it produced any investment income prior to the sale. Id. at 696. We affirmed the Commonwealth Court in holding that the gain from the sale of the land constituted non-business income, whether assessed by the transactional or functional test. Id. at 697.
In Laurel Pipe Line, the issue was whether an Ohio corporation's gain on the sale of an idle pipeline and related assets was business or non-business income. The corporation was in the business of transporting petroleum products from the Philadelphia area to Pittsburgh and to Cleveland, Ohio. Id. at 473. At some point, the corporation discontinued its operation of a pipeline from Aliquippa, Pennsylvania, to Cleveland, Ohio, and then, three years later, sold the idle pipeline, along with related assets, for a gain of $3,766,047, distributing the entire after-tax net proceeds to stockholders. Id. The parties agreed that the gain from the pipeline sale did not satisfy the transactional test, and the question before this Court was whether it satisfied the functional test. Id. at 474-75. Reversing the Commonwealth Court, we held that it did not.
In reaching this holding, we cited the pre-2001 definition of business income that was in effect at the time Laurel Pipe was decided, to wit, income from property if "the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations." Id. at 475 (quoting 72 P.S. Â§ 7401(3)2.(a)(1)(A)) (emphasis added in original opinion). Tracking the text of this definition, we concluded that "the pipeline was not disposed of as an integral part of Laurel's regular trade or business;" rather, we characterized the pipeline sale as "a liquidation of a ...