Antio: Washington Supreme Court Upholds Department of Revenue’s Efforts to Narrow B&O Tax Investment Deduction

Tax Legal Update

by Lane Powell

What Happened

In a 7-2 decision, the Washington Supreme Court upheld the Department of Revenue’s reversal of its long-standing interpretation of the Business and Occupation (B&O) tax investment deduction in Antio LLC v. Department of Revenue, Wash., No. 102223-9. Since the statute was amended in 2002, the Department had allowed the deduction for any investment income, so long as the taxpayer was not a banking, lending, or security business as defined in the 2002 legislation. This decision greatly narrows the deduction.

The majority’s ruling accepts the Department’s strained claim that a little-known and largely ignored two-page decision in 1976, O’Leary v. Department of Revenue, adopted an unusual and circular interpretation of the undefined term “investment.” The ruling then alleges that the Washington Legislature “did not abrogate” O’Leary’s purported definition of “investment” when it revised the statute in 2002 to expressly define the types of businesses ineligible for the investment income deduction. Consequently, even though the 16 investment funds involved in the case were the type of entities eligible for the deduction, the Court nevertheless held that the funds were ineligible to deduct their investment income because only “incidental investments of surplus funds” met the purported O’Leary definition of “investment.”

Background

For decades, nearly all taxpayers that are not one of the explicitly excluded banking, lending, or security businesses have relied on the B&O tax deduction found in Revised Code of Washington (RCW) 82.04.4281, to deduct investment income. This was consistent with the Department’s website which had long confirmed that “most mutual funds, private investment funds, family trusts, and other collective investment vehicles…are allowed the B&O tax deduction for amounts derived from investments.” As a result, the taxpayer community is in for quite a shock, as this new interpretation of the deduction greatly increases the B&O tax liabilities of a wide variety of taxpayers and creates significant uncertainty regarding the scope of the deduction.

How Did the Court Get to This Decision?

To try to understand this decision, we have to go back in time to an earlier version of the deduction and two cases at the core of the majority’s ruling.

Before 2002, the statute provided a B&O tax deduction for “amounts derived by persons, other than those engaging in banking, loan, security, or other financial businesses, from investments or the use of money as such.”(1) This deduction was first considered by the Court in 1976 in Sellen v. Department of Revenue. The case consolidated the claims of several businesses, including a general contractor, a brewer, two medical nonprofits, and a cemetery trust fund, and challenged the Department’s denial of the investment income deductions they reported on their tax returns.

• The contractor and the brewer “invested a small percentage of [their] revenues in short term investments.”
• The medical nonprofits maintained a reserve fund which invested in “savings deposits, commercial paper, stocks, bonds, and real estate notes and mortgages.”
• The cemetery trust had the power to invest in stocks, bonds, and bank deposits.(2)

In Sellen, the Court began its analysis by noting:

“The investment incomes clearly are amounts derived by persons…from investments or the use of money as such.’ Thus, respondents’ incomes are deductible unless respondents are ‘engaging in banking, loan, security, or other financial businesses.’”(3)

After noting that undefined terms should be accorded their ordinary meaning, the Sellen Court said “The words ‘financial businesses’ are not defined in the statute, and the common meaning of the phrase contemplates a business whose primary purpose and objective is to earn income through the utilization of significant cash outlays.” Since that was not the primary purpose or objective of any of the plaintiffs, the Court held that none of them were “financial businesses,” and they therefore qualified for the deduction. In short, the only question addressed by Sellen was the interpretation of the term “financial business,” not the meaning of the term investment.

Ten years later, the Court was presented with a second case involving the same statutory language, O’Leary v. Department of Revenue. That case involved a partnership that bought and sold apartment buildings. There the taxpayer claimed the investment deduction for interest income that it earned from installment sales contracts where the buyer paid over time with interest. The two-and-a-half-page opinion sloppily based its decision on the Sellen case, inaccurately citing it for the proposition that “an interpretation of ‘investment’ should be limited to the plain and ordinary meaning of the word.”(4)

Thus, when the O’Leary Court explicitly adopted the Sellen Court’s limitation of the statute’s application to “incidental investments of surplus funds,” it was actually adopting the Sellen Court’s interpretation of the term “financial business,” despite claiming not to consider whether O’Leary was engaged in a financial business.

The limitation of O’Leary was highlighted in 2000 in Simpson Investment Co. v. Department of Revenue. There, the Washington Supreme Court held that holding companies receiving dividends and other investment income from subsidiaries could not take the deduction because they were ineligible “financial businesses” noting that the term “financial business” encompassed more than “banking, loan, and security businesses.”(5) Unsurprisingly, the analysis used by the Court in Simpson to determine whether the holding company was a “financial business” focused on whether the investment activities were incidental to the activities of the business.(6)

In response to the Simpson decision, the Washington Legislature expressly rewrote the statute to allow the deduction to any company that was not one of the statutorily defined banking, lending, or securities businesses. In doing so, the Legislature found that the Simpson decision “could lead to a restrictive, narrow interpretation of the deductibility of investment income for [B&O] tax purposes.”(7) The Legislature did not stop there, but went on to state: “The legislature intends, by adopting this recommended revision of the statute [the current version of RCW 82.04.4281], to provide a positive environment for capital investment in this state, while continuing to treat similarly situated taxpayers fairly.”(8) Again, since this revision passed, most—if not all—taxpayers that qualified for the deduction used it, without objection from the Department.

Since 2002, the statute has provided a deduction for “amounts derived from investments,” and has only excluded those entities ineligible to claim the deduction, specifically the “banking,” “lending,” and “security” businesses, explicitly defined by statute.

What Does Antio Do?

In ruling for the Department, the Antio majority looked to O’Leary and determined that the term “investment” in RCW 82.04.4281 means “incidental investment of surplus funds.” To get to this conclusion, the Court added words the Legislature never used and interpreted the term “investment” contrary to its plain and ordinary meaning, despite O’Leary’s acknowledgement that the interpretation of an “investment” should be limited to the plain and ordinary meaning of the word.(9) While O’Leary’s sloppy mischaracterization of Sellen’s interpretation of “financial business” as an interpretation of “investment” reached the same result as Sellen (because O’Leary was an ineligible financial business under the prior version of the statute), it creates significant problems under the current statutory framework.

Here, the Court did not elaborate on the scope of its definition; rather, it held that the Antio entities’ investments in distressed debt instruments did not qualify as “investments” because the entities’ investment activities were more than an “incidental investment of surplus funds.” Suffice it to say, to qualify for the investment deduction after Antio, taxpayers will need to ensure any amount of “investment” income is an “incidental investment of surplus funds.” Taxpayers and the Department will now be forced away from the clear and predictable approach that has been used since the 1970s and move towards a facts-and-circumstances test that does not yet exist.

Notably, in reaching its decision, the Court did not give any weight to the fact that the Department’s website provided “most mutual funds, private investment funds, family trusts, and other collective investment vehicles…are allowed the B&O tax deduction for amounts derived from investments.” This is an important reminder for taxpayers that they cannot rely on what the Department says on its website.

What Does the Antio Decision Mean for You?

Ironically, the taxpayers most at risk of assessments are those that the Department’s own website said could take the deduction: mutual funds, private investment funds, family trusts, and other collective investment vehicles. From there, related and adjacent taxpayers should pay heed to this new decision and adjust their businesses and affairs, accordingly.

As with all taxes, there are a number of steps taxpayers can take to reduce or eliminate their potential liabilities going forward and we highly recommend that taxpayers take steps to analyze their potential exposure as soon as possible.

End of the Road

With respect to the application of law in this case, the Court’s decision likely represents the final word, although the parties have the right to request reconsideration of this decision within 20 days.

For questions, solutions, and next steps, please contact any member of Lane Powell’s State and Local Tax Team.

This article published with permission of Lane Powell. View the original article here.

(1) RCW 82.04.4281(1980) (formerly RCW 82.04.430(1)). 
(2) 87 Wn.2d at 879-80. 
(3) 87 Wn.2d at 882. 
(4) O’Leary, 105 Wn.2d at 682 (citing Sellen 87 Wn.2d at 883). As noted above, the Sellen Court’s invocation of the axiom that undefined statutory terms are accorded their ordinary meaning was actually presented on p. 882, not p. 883, and was made with respect to the interpretation of the phrase “financial business” not “investment” since the Court noted that the “investment incomes” at issue “clearly are amounts derived from…investments.” 
(5) Simpson Inv. Co. v. Dep’t of Revenue, 141 Wn.2d 139, 162, 3 P.3d 741 (2000) 
(6) Id. 
(7) Antio, LLC et al. v. Dep’t of Revenue, Wash. No. 102223-9, p. 1 (2004) (Gordon McCloud, J. dissenting) (citing LAWS OF 2002, ch. 150, § 1). 
(8) Id. at 1-2. 
(9) O’Leary, 105 Wn.2d at 682.