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Washington Supreme Court denies investment funds deduction for “amounts derived from investments”
December 2024
In brief
What happened?
On October 24, 2024, the Washington Supreme Court (Court) upheld the Court of Appeals decision in favor of the Department of Revenue (Department) in Antio LLC v. Department of Revenue. The Court of Appeals had determined that a group of investment funds, operating as limited liability companies (LLCs), were not eligible to deduct “amounts derived from investments” when calculating their Business and Occupation (B&O) taxes.
The Court held that the definition of “investments” established by their prior decision O’Leary v. Department of Revenue (O’Leary), was not abrogated by subsequent legislative amendments. Under O’Leary, the Court had limited ‘investments’ to include only those that were incidental to the main purpose of the taxpayer’s business. Consequently, the LLCs could not deduct income earned from their main business activities under the investment income deduction, affirming the decisions of the trial court and Court of Appeals.
Why does it matter?
The Court’s decision eliminates the ability of similarly situated taxpayers to deduct “amounts derived from investments” when determining their B&O taxable income, resulting in an increase in B&O tax. Additionally, since the decision interprets existing law, it is possible that the Department may apply this more limited definition of “amounts derived from investments” to prior tax years. Taxpayers may also have to navigate complex issues resulting from this decision such as sourcing the includable investment income and tiered partnership structures.
Actions to consider
Those deriving income from investments should determine whether the income qualifies for a B&O deduction under RCW 82.04.4281. To the extent the investment income is more than incidental, the impact of its inclusion may be taxable if attributable to Washington.
In detail
Background
Prior to 2002, RCW 82.04.4281(1) granted 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.”
In 1976, the deduction was addressed by the Court in Sellen v. Department of Revenue, where the taxpayers contested the Department’s disallowance of the investment income deduction. In Sellen, the Court understood that the amounts in question were derived from investments, so the Court analyzed whether the taxpayers engaged in “banking, loan, security, or other financial businesses.” ‘Financial businesses’ was not a defined term within a statute, so the Court looked to “the common meaning of the phrase” which “contemplates a business whose primary purpose and objective is to earn income through the utilization of significant cash outlays.” It was concluded that the taxpayers did not meet the definition of a banking, loan, security, or other financial businesses; therefore, their income qualified for the investment income deduction.
A decade later, the deduction was addressed again in O’Leary, where the Department disallowed the investment income deduction on interest payments a partnership received from real estate contracts. The Court analyzed whether the real estate contracts constitute an investment. ‘Investment’ is not a defined term within a statute, so the Court looked to Sellen which allowed the deduction because the income was “incidental investments of surplus funds.” In O’Leary, the Court distinguished investments by looking at “whether an investment is “incidental” to the main purpose of the business.” The Court concluded that the real estate contracts “were neither incidental investments nor were they made from surplus income of the partnership.”
In 2000, the next case to revisit the investment income deduction was Simpson Investment Co. v. Department of Revenue (Simpson). Simpson was a holding company that derived dividends from its subsidiaries, as well as investment income from multiple other sources. In Simpson, the Court concluded that investment income derived from other sources qualified for the investment income deduction because they were "incidental investments of surplus funds." In addition, the Court analyzed whether Simpson was a financial business. It was concluded that Simpson’s primary business activities were providing services to its subsidiaries; therefore, they do not meet the definition of a financial business.
As a result of the Simpson decision, the Washington legislature became aware that the term "other financial businesses" not only created “disagreement and litigation between taxpayers and the state,” but they were also concerned that the Simpson decision “could lead to a restrictive, narrow interpretation of the deductibility of investment income for business and occupation tax purposes.” In 2002, the legislatures revised RCW 82.04.4281, removing the term "other financial businesses."
Since 2002, the statute has provided a deduction for “amounts derived from investments,” and has only excluded banking, lending, and security businesses, as defined by statute. Guidance on the Department of Revenue’s website is consistent with this interpretation stating “[a] trader not meeting the characteristics of a broker, dealer, or broker-dealer is not a security business and would be eligible for the B&O tax deduction for amounts derived from investments. Additionally, most mutual funds, private investment funds, family trusts, and other collective investment vehicles are not a securities business, and are allowed the B&O tax deduction for amounts derived from investments.”
In Antio, the taxpayers, a group of investment funds, amended their B&O returns for tax years 2015 through 2018 and requested refunds of all B&O taxes paid. The taxpayers asserted that all of their income was deductible investment income under RCW 82.04.4281(1)(a). The Department of Revenue denied the refund claims. The taxpayers challenged this decision, but the Superior Court granted the Department’s motion for summary judgement. The taxpayers appealed to the Court of Appeals, which affirmed the Superior Court’s decision.
The Court of Appeals first noted that “[t]he plain language of RCW 82.04.4281(1)(a) seems to support the LLCs’ position;” however, the Court of Appeals then acknowledged that Washington Supreme Court’s O’Leary decision held that only investments that were “incidental to the main purpose of the taxpayer’s business … qualify for the investment income deduction.” Given the entirety of the LLCs income was investment income, the Court of Appeals concluded that it was not “incidental” and, therefore, did not qualify for the deduction under O’Leary.
Supreme Court decision
The Court’s analysis centered on legislative intent and statutory interpretation, specifically whether the 2002 legislative amendments modified, abrogated or upheld earlier interpretations. In O’Leary, which was decided in 1986, the Court defined “investments” narrowly, interpreting it as “incidental investments of surplus funds” and therefore inapplicable to a company’s primary business activities. The LLCs argued that the 2002 amendment effectively abrogated this narrow interpretation, allowing the deduction to be read more broadly.
The statute historically allowed investment deductions but only for those whose primary activity was not “financial.” Specifically, the prior version of the statute provided:
In computing tax there may be deducted from the measure of tax 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, and also amounts derived as dividends by a parent from its subsidiary corporations.
The Court’s restrictive interpretation of the term “investments” in O’Leary, as well as other prior cases limiting the scope of the entities that may qualify for the deduction, led the legislature to amend RCW 82.04.4281, removing “other financial businesses” from its exclusions. As noted by the Court, the legislative change was intended to “to reduce “uncertainty” caused by the vague phrase “other financial businesses” in the statute,” and to establish a “positive environment for capital investment” and fair treatment for businesses.
The taxpayers argued that the 2002 amendment changed the structure of the statute so dramatically that O’Leary’s definition is not relevant. The Court disagreed stating, “[t]o find that the legislature abrogated this court’s definition of investment, we must find clear legislative intent to do so.” The Court highlighted that the legislature did not provide a definition of investments in the amended statute, nor did it explicitly indicate an intent to address or amend O’Leary’s interpretation of the scope of the term "investment.”
Since the legislature neither indicated an intent to abrogate O’Leary nor specifically for a definition of investment in the 2002 amendments, under the principle of legislative acquiescence, the Court concluded that its definition of “investments” as explained in O’Leary was still in effect.
Observation: The impact of this decision may be significant for those who deducted “amounts derived from investment” when calculating their Washington taxable income. Those claiming the investment deduction pursuant to RCW 82.04.4281 should review their receipts to determine whether their investment income is incidental to their primary business activities.
Observation: To the extent investment income is no longer eligible for the deduction, it should be analyzed to determine the appropriate method of attribution. Washington attributes receipts based on a series of cascading steps, the first being based on the benefit derived; therefore, attribution could vary based on facts and circumstances.
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