Article

Washington Supreme Court upholds narrow interpretation of investment income deduction

Dec. 3, 2024 · Authored by Bryan Avery, Shannon Bonner, Kelly Nelson

The Washington (WA) State Supreme Court (the Court) upheld Washington Department of Revenue’s (DOR) narrow interpretation of the business and occupation (B&O) tax deduction for investment income with its decision on Antio LLC v. Department of Revenue (Antio). The Court found that deductible “investments” are those incidental to the taxpayer’s business, not those that are the reason the company is in business.

Background

The state of Washington has had an investment income deduction since 1935, which has changed over time due to various cases and legislative updates. Specifically, the Sellen v. Department of Revenue decision interpreted the phrase “other financial businesses,” the O’Leary v. Department of Revenue (O’Leary) decision defined the term “investments,” and the Simpson Investment Co. V. Department of Revenue decision refined the meaning of “other financial businesses,” addressing who could take the investment deduction. In 2002, the statute (RCW 82.04.4281) was amended to read:

(1) In computing tax there may be deducted from the measure of tax:

a) Amounts derived from investments;

b) Amounts derived as dividends or distributions from the capital account by a parent from its subsidiary entities; and

c) Amounts derived from interest on loans between subsidiary entities and a parent entity or between subsidiaries of a common parent entity, but only if the total investment and loan income is less than five percent of gross receipts of the business annually.

(2) The following are not deductible under subsection (1)(a) of this section:

a) Amounts received from loans, except as provided in subsection (1)(c) of this section, or the extension of credit to another, revolving credit arrangements, installment sales, the acceptance of payment over time for goods or services, or any of the foregoing that have been transferred by the originator of the same to an affiliate of the transferor; or

b) Amounts received by a banking, lending, or security business. (emphasis added).

The revised statute eliminated the phrase “other financial businesses” but did define “banking business,” “lending business” and “security business,” and “loan and extension of credit.” However, the statute did not define “investments.” As such, the statute appeared to provide a broad deduction for “amounts derived from investments” but for the explicit excluded taxpayers.

Antio decision

The case at issue was initiated by 16 related LLC investment companies led by Antio, LLC (the Taxpayers) that buy and sell distressed debt instruments. The Taxpayers generate all their income from owning or trading in these investments.

In 2019, the Taxpayers paid B&O tax on their income then applied for a refund for the past several years (January 2015 – December 2018) citing that 100% of their income was investment income. As such, they argued it should be fully deductible investment income under RCW 82.04.4281(1)(a) which allows a deduction for “amounts derived from investments.” Investments are not defined.

The DOR conducted an audit and denied the refund claim. The court of appeals affirmed the trial court’s denial finding that the Taxpayers can’t take the deduction for “amounts derived from investments,” citing the 1986 Washington Supreme Court ruling, O’Leary. The O’Leary decision deemed investments ‘incidental’ to the main purposes of a business as investments entitled to the B&O tax deduction. Here, the Taxpayers investment income was not incidental; rather, its entire business was investments in debt instruments. Further, the court of appeals disagreed with the Taxpayers argument that the subsequent amendments to the Washington statute, RCW 82.04.4281 (the Statute) nullified the O’Leary decision.

The Taxpayers asked the Washington Supreme Court to review the court of appeals’ decision.

The primary issue reviewed was whether the legislature revoked the O’Leary definition of “investments” when it amended the Statute. Taxpayers argued that the 2002 statutory amendment changed the structure of the statute so much that the O’Leary definition of “investments” was deemed irrelevant. In response, the Court stated “a change in the structure of a statute is not enough. A court must find clear legislative intent to abrogate a binding judicial decision like O’Leary.” However, upon review of the ‘intent section’ of the Statute, it did not express a “clear legislative intent to abrogate O’Leary’s definition of investments,” further evidenced by the fact the legislature chose to not define “investments” when the Statute was amended. This suggests that the legislature did not abrogate the O’Leary definition in 2002.

As such, the Court upheld the trial court and court of appeals decisions and determined that the O’Leary definition stands and the Taxpayers “may not deduct income earned from their main business activities under the investment income deduction.”

What’s next?

The Court’s decision affirms that Washington applies a narrow definition to the investment income deduction. The Department has indicated on its website that it will provide updated guidance after further analysis of the Antio decision. Taxpayers who have investment income and file in Washington should assess their eligibility for the investment income deduction, including previously filed returns. If your business has any questions, please reach out to your Baker Tilly state tax advisor.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.