Maryland procurement regulations on use of affiliates to avoid taxation on income from state contracts.

On October 15, 1997, Tax Executives Institute submitted the following comments to a joint committee of the Maryland General Assembly on proposed regulations relating to the tax treatment of royalty and similar deductions by companies doing business with the State of Maryland. The procurement regulations, which were issued by the Maryland Board of Public Works, would require State contractors to disclaim a deduction for royalties and similar payments to affiliated companies unless those affiliated companies reported those payments as income on a Maryland tax return. The propriety of the regulations was the subject of a October 16 hearing by the General Assembly's Joint Committee on Administrative, Executive, and Legislative Review. Following that hearing, the Joint Committee voted to recommend that the regulations be withdrawn.

On behalf of Tax Executives Institute, I am writing to voice the Institute's opposition to proposed regulations on "Procurement Methods: Contract Terms and Conditions: Use of Affiliates to Avoid Taxation on Income from State Contracts," which were issued this summer by the Board of Public Works and published in the Maryland Register on August 29, 1997. (The Joint Committee granted emergency status to the regulations on August 8, and such status is set to expire on February 8, 1998.) The proposed regulations -- COMAR 21.05.08.08, 21.07.01.026, and 21.07.03.26 -- would vitiate governing rules established for taxing enterprises doing business in the State and their affiliates, by requiring all State contractors to disclaim any right to "shift[] Maryland income to out-of-State affiliates who do not report this income to Maryland." Tax Executives Institute opposes the regulations for the following reasons:

* The regulations represent an effort by the Board of Public Works to arrogate to itself authority properly reserved to the General Assembly.

* The regulations deviate from well-established tax law principles concerning the taxation of corporate affiliates on a "separate company" basis. (Any changes to these rules should be adopted only after public debate and deliberation, not by administrative flat on an emergency basis.)

* If not withdrawn, the regulations will dampen the business climate in Maryland and impair the State's ability to attract competitive bids from vendors seeking to do business with the State.

Background

Tax Executives Institute is the professional association of corporate tax executives. Our 5,000 members are accountants, attorneys, and other business professionals who work for the largest 2,800 companies in North America; they are responsible for conducting the tax affairs of their companies and of ensuring their compliance with the tax laws. Hence, TEI members deal with the tax laws and with taxing agencies in the States on almost a daily basis. One of TEI's 48 local chapters, with more than 110 members, is located in the Baltimore-Washington metropolitan area. In addition, members from across the country work for companies with substantial activities (and frequently employees) in Maryland.

TEI is dedicated to promoting the uniform, equitable, and nondiscriminatory enforcement of the tax laws throughout the Nation, to reducing the costs and burdens of administration and compliance to the benefit of both the government and taxpayers, and to vindicating the Commerce Clause and other constitutional rights of business taxpayers. TEI believes that the professional training and experience of our members enables the Institute to bring an important, and balanced, perspective to the issues such as the propriety of the efforts of the Board of Public Works to effect changes in Maryland's tax rules by administrative action.

Discussion

States may choose from a range of options in developing their regimes for taxing a business enterprise and its affiliates, including those that hold intangible assets such as trademarks, trade names, and copyrights. For example, many States tax business enterprises on the "combined reporting" basis, treating all the members of a corporate group as a single entity for tax purposes. The State of Maryland, however, has elected not to combine the activities (and income) of related business units, but instead to tax each such business on a "separate entity" basis. Hence, under the rules adopted by the General Assembly, if a passive investment company (or a holding company) has no dealings (or nexus) with the State of Maryland, the State may generally not tax that company, even if it derives part of its income from, for example, licensing its trademarks or other intangibles to affiliated companies that are doing business within, and accordingly are properly taxable by, the State.(1)

Regrettably, in proposing the procurement regulations that are the subject of the Joint Committee's October 16 hearing, the Board of Public Works has chosen to ignore the statutory framework the legislature has enacted and attempted, by bureaucratic fiat, to fundamentally change Maryland's tax system (at least so far as it applies to companies doing business with the State) by requiring companies to disregard their corporate structures in filing Maryland income tax returns. Specifically, the regulations would impose a mandatory provision for all solicitations, contracts, and purchase orders to prohibit State contractors from "shifting" income to out-of-State affiliates by claiming a deduction for royalties or similar payments to the affiliates for trademarks, trade names, or other intangible property. This result would be accomplished by according the contractor a tax deduction for such payments only if the affiliated company files a Maryland income tax return and pays Maryland income tax under a formula reasonably apportioning the affiliated company's income to Maryland. Hence, a company doing business with Maryland that pays royalties to an affiliated company that lawfully is not subject to tax in the State would be denied a deduction that it is entitled to under Maryland's tax laws.

The proposed regulations should be withdrawn for a number of reasons. First, the regulations improperly proceed from the assumption that a business enterprise's decision to hold trademarks and other intangibles in separate companies must be motivated not by legitimate business purposes but by a desire to evade taxes. That assumption, however, has not been supported by any finding that state contractors have improperly used intercompany payments to perpetrate tax fraud upon the State. Indeed, corporate groups often choose to hold intangibles in separate affiliates in order to facilitate the exploitation and management of those intangibles, to shield the intangibles from liabilities associated with manufacturing and other activities, and to otherwise enhance and protect their intellectual property interests.

Second, in issuing the proposed regulations, the Board of Public Works has arrogated to itself the effective authority to make tax law for the State of Maryland. Even if such authority is to be exercised administratively -- and TEI firmly believes "the power to destroy" (as the U.S. Supreme Court put it 175 years ago in McCulloch v. Maryland) should remain vested in the General Assembly -- we submit it should be the Comptroller rather than the Board of Public Works who crafts any change. Hence, although taxpayers have in the past taken exception to the Department of Revenue's proposed treatment of royalties paid to affiliated companies, there is scarcely a question among taxpayers that the Department is the proper State agency to address any perceived abuses in this area. Undoubtedly, it is better qualified -- by training, experience, and legislative mandate -- than the Board of Public Works.(2) More fundamentally, we believe that, to the extent the Board wishes to proceed, it should disclaim any effort to usurp the General Assembly's authority and prerogative and rather seek to address the matter through legislation.

Third, the Board of Public Works' actions threaten to adversely affect Maryland's business climate, as well as the State's ability -- as a purchaser of goods and services -- to maximize its competitive position by attracting bids from numerous companies. By seeking to mandate the inclusion in State contracts of provisions having no bearing on the contractor's ability to perform (but potentially exacting a heavy tax price from State contractors and its out-of-state affiliates), the Board may discourage vendors from coming forward and significantly undermine Maryland's heretofore successful efforts to attract and retain business. The adverse effect, moreover, will not be confined to those enterprises that might otherwise seek to do business with the State, though the effect there may prove profound. Rather, it will extend to all companies that otherwise would take seriously the State's efforts to encourage business.

For the foregoing reasons, Tax Executives Institute respectfully recommends that the Joint Committee on Administrative, Executive, and Legislative Review withdraw its grant of emergency status for the Board of Public Works' procurement regulations and, indeed, to conclude that the regulations themselves should be withdrawn.

Tax Executives Institute appreciates this opportunity to present its view on the important issues addressed in the Board of Public Works' proposed regulations. If the Joint Committee should have any questions about the Institute's position, or if we can be of any further assistance, please do not hesitate to call Timothy J. McCormally, TEI's General Counsel and Director of Tax Affairs, at [phone].

(1) As explained in the text that follows, there is currently some dispute about how the State's current tax rules apply to royalty payments paid to out-of-State affiliates.

(2) There is at least one case currently underway in Maryland testing whether the State may disregard a legally distinct Delaware corporation that licenses intangibles to (and receives royalty payments from) an affiliated corporation doing business in the State. That the Board would seek to preempt the resolution of that case -- especially by granting the regulations emergency status -- is disconcerting inasmuch as the governing statute has been on the books in Maryland for several decades. Ironically, the Board of Public Works' action here may undermine the Comptroller's (concededly tenuous) legal position in that case, by suggesting what the taxpayer asserts -- that Maryland's current tax rules cannot be interpreted to disregard the taxpayer's corporate structure where that structure was utilized for sound business purposes.