Nexus through the presence of intangibles.

Most corporate taxpayers are familiar with the Supreme Court's decision in Quill Corp. v. North Dakota, 112 Sup. Ct. 1904 (1992), in which the Court held that a mail-order seller could not be required to collect a state's sales or use tax unless the seller had a physical presence in the state. The issue of whether the "physical presence" standard is applicable only to sales and use taxes has not been definitively answered. In part as a result, states that have been forced to forgo use tax revenue are attempting to impose income tax filing responsibility on companies deriving income through the presence of intangibles.

On July 6, 1993, in Geoffrey, Inc. v. South Carolina Tax Commission, No. 23886 slip op. 11993), the South Carolina Supreme Court held that a corporation had taxable nexus in the state because it derived royalty income from the licensing of its trademarks and trade names to Toys R Us in South Carolina. The court found sales made by Toys R Us through its retail outlets in the state created an account receivable and Geoffrey's licensing agreement with the company resulted the creation of a franchise. According to the court, the Quill "physical presence" test applied only to sales and use taxes; therefore, the presence in the state of the intangible account receivable and a franchise was sufficient nexus for the imposition of income tax on Geoffrey. Geoffrey was appealed to the Supreme Court, which declined to review it.

Assuming for argument's sake that the Supreme Court in Quill did intend to establish the "physical presence" test only for sales and use taxes, it does not necessarily follow that a mere economic presence or the presence of intangibles in a state will confer nexus under the Commerce Clause of the U.S. Constitution. The Supreme Court distinguished nexus requirements under the Due Process and Commerce Clauses in Quill; any purposeful exploitation of a market is sufficient under Due Process, but the Commerce Clause requires a "substantial presence." It is possible that a substantial presence may be found through activities not requiring a physical presence, but the Court did not define "substantial presence." Could, for example, the creation of an account receivable be considered substantial? if so, any merchant who has a customer in a state, despite the fact that the merchant may have made no efforts to exploit the market or solicit the sale, would be taxable in that customer's state.

The receipt of royalties raises another issue. Would any owner of an intangible (e.g., an author whose work is copyrighted) have nexus in a state where a customer buys a copy of his book? Remember, the Geoffrey decision was based on specific facts. Geoffrey was a holding company with no function other than to hold the trademarks and trade names of its parent, and to license them back to its parent for use in the parent's retail operations in the various states. The licensing agreement was, according to both the state and Geoffrey, a franchise agreement. It is entirely possible that arrangements that do not create a franchise would be considered in a different light and could lead to a different result.

Florida has proposed a change in its regulations that would allow it to impose its income tax on a corporation engaging in "selling or licensing the use of intangible property in Florida; for example, licensing the use of a trade name or trademark to a franchise." The use of the word "franchise" in the proposed regulation could be read as signifying an intent to find nexus only in franchise operations. A proposed Texas regulatory change is broader based and would allow the state to impose its franchise tax on corporations using intangible property in the state generally. To date, none of these regulations have been tested.

Many states are examining their statutes to determine whether they can assert jurisdiction to impose an income tax on companies that merely allow instate use of their intangibles. It is not yet known whether such a claim would withhold Supreme Court scrutiny, and it is well to remember that Geoffrey is only the law of South Carolina, not the law of the land.