State developments in intangible property.

Recent court and administrative decisions in Maryland, Massachusetts and New Mexico have asserted issues related to unitary and economic nexus, "phantom corporation" claims and modification of the traditional apportionment formula for companies receiving related-party income from intangibles.

Maryland

The Maryland Circuit Court affirmed three taxpayer victories on March 17, 2000: MCI Int'l Telecommunications Corp., Crown Cork & Seal, and SYL, Inc. In affirming the Maryland Tax Court, it was determined that the affiliated entities, with no physical presence in the state, do not have unitary or economic nexus in Maryland.

MCI, in the business of providing international telecommunications to its affiliates and other customers, was receiving and paying service and management fees; it had no physical presence (i.e., payroll, property or switches) in Maryland. The comptroller argued that MCI was not a substantial entity and its existence was only a means by which the in-state affiliate (parent) could divert taxable income to an out-of-state entity. The court concluded that, under the unitary nexus theory, the comptroller could not assert that an out-of-state entity (MCI) had nexus based on the in-state presence of an affiliate, because the entity was not a "phantom corporation" (i.e., it had economic substance and was established for valid business purposes). In addressing the economic substance and business purpose issues, the court noted that, "in this technologically advanced era, ... [i]t is conceivable that, for legitimate business purposes, a seemingly insignificant affiliate (i.e., one employee and/or one computer) can exist which generates substantial income yet have little or no expense." The court also affirmed that MCI had no direct nexus with the state and that the in-state affiliate's factors could not be attributed to the entity for apportionment purposes.

In SYL and Crown Cork & Seal, the entities were formed as Delaware holding companies, to hold and manage intangible assets (including trademarks, tradenames and patents), which were licensed back to Maryland-affiliated entities for an agreed-on royalty fee. The comptroller determined in both SYL and Crown Cork & Seal, that the tax-paying entities were shell or "phantom corporations" with no economic substance. The comptroller asserted nexus, based on the unitary, in-state activity of an affiliate (parent), which would permit the state to attribute the parent's nexus and apportionment factors.

The court concluded in SYL and Crown Cork & Seal that the taxpayer was "not just a book entry corporation." It maintained offices, corporate and financial records, bank accounts, employees, a board of directors, officers, etc., and had valid business purposes. In rejecting the argument that Delaware holding companies are tax-avoidance vehicles, the court agreed with the Tax Court that tax avoidance (as opposed to tax evasion) is a legitimate business purpose. The court also rejected the argument that the companies had nexus in Maryland based on Geoffrey, Inc., 437 SE2d 13 (1993), which was determined not to apply in Maryland.

Massachusetts

SYL, which won a taxpayer victory in Maryland, was denied a deduction of royalties paid by its parent, Syms, to a Delaware holding company (Syms Inc., Mass. App. Tax Bd., 1/14/00). In a similar decision, Massachusetts ruled against Sherwin-Williams in denying claimed deductions for royalty payments made to its wholly owned intangible holding company subsidiary (Sherwin-Williams Inc., Mass. App. Tax Bd., 1/14/00). The Commissioner contended on audit that in both Syms and Sherwin-Williams, the formation of the entities and transactions lacked economic substance and lacked a valid business purpose, and that the Department may exercise discretionary authority to disallow the deduction. (The full opinions in Syms and Sherwin-Williams have not been published.)

New Mexico

The New Mexico Taxation and Revenue Department won an administrative decision claiming that Kmart's subsidiary, Kmart Properties, was liable for the New Mexico corporate income, franchise and gross receipts tax (Kmart Properties, Inc., New Mexico Tax'n and Rev. Dep't, 2/1/00). Kmart had established a Michigan-based subsidiary, Kmart Properties, and transferred to it the corporation's trademarks and tradenames, such as the Kmart logo.

The hearing officer determined that, even though Kmart Properties had no employees or property in New Mexico, it had the minimum contacts under the Due Process Clause when it "purposefully availed itself of the benefits of an economic market in the forum state," citing Quill Corp. v. North Dakota, 504 US 298 (1992). Kmart Properties availed itself of New Mexico's economic market, because it licensed highly valuable intangible property for use by the parent in New Mexico retail stores and was dependent on this use for its stream of royalty income.

In analyzing whether Kmart Properties had substantial nexus with New Mexico for Commerce Clause purposes, the hearing officer found that the contractual relationship between the subsidiary and the parent under the license agreement created the physical presence required to subject the subsidiary to tax in New Mexico. The hearing officer disagreed with the finding in Geoffrey that Quill applied only in the sales tax context, finding no rational basis to distinguish between sales and income taxes under the Commerce Clause. Kmart Properties did establish economic substance and valid business purpose, and its royalty rate and agreement were held to be arm's length.

New Mexico's standard three-factor apportionment formula was modified by the department of revenue (DOR), and upheld by the hearing officer in apportioning the Kmart Properties income. The modification entailed the elimination of the property and payroll factors, and adjustment of the sales factor to include the Kmart Properties royalty income in New Mexico divided by its total royalty income. This was supported by New Mexico's adoption of the Multistate Tax Commission's special rule for apportionment of business income from intangible property. This provides (in part) that, when the income-producing activity for business income from intangible personal property can be readily identified, the DOR may adjust the apportionment formula if the application of the standard (three-factor) formula does not fairly represent a taxpayer's New Mexico business activities.

Conclusion

Companies using intangible property with related parties in a multi-state environment need to:

* Substantiate and support valid business purpose and economic substance;

* Apply arm's-length licensing and royalty rates;

* Identify proper apportionment and sourcing of income by state, and

* Review, by state, for Geoffrey economic nexus positions.

FROM DAVID L. HUIZENGA, CPA, MST, CHARLOTTE, NC