On March 24, the Maryland Court of Appeals, the state's highest court, held that two out-of-state intangible holding companies had corporate income tax nexus with Maryland because they were considered to have no real economic substance as business entities separate from their parent company.1 According to the Court, the imposition of tax on the intangible holding companies satisfied both the Due Process and Commerce Clauses of the U.S. Constitution. Also, the Court upheld the Maryland Comptroller's use of the parent company's apportionment factor to determine the Maryland income of the holding companies. The apportionment formula was authorized by the unitary business principle and satisfied the internal consistency and external consistency tests. In reaching this decision, the Court of Appeals affirmed prior decisions by the Court of Special Appeals and the Tax Court.
Background
The parent company, Gore, was a manufacturer with a physical presence in Maryland that created two intangible holding companies (Gore Enterprise Holdings, Inc. (GEH), a royalty company created in 1983, and Future Value, Inc. (FVI), an investment company created in 1996). GEH and FVI were incorporated in Delaware and lacked a physical presence in Maryland. GEH licensed its patent portfolio to Gore in exchange for a 7.5 percent royalty of the sales price of all products that Gore sold in the U.S. FVI earned interest income by investing in and managing Gore's excess cash and capital. Gore deducted both its royalty payments to GEH and its interest payments to FVI from its taxable income.
GEH and FVI did not file Maryland corporate income tax returns and as Delaware entities, their intangible and interest income derived from their transaction with Gore fell under Delaware's exemption of passive income. Moreover, the intangible and interest income were not taxable in separate reporting states (in which Gore was doing business) that lacked related-party expense addback rules.
In 2006, the Comptroller audited Gore, GEH and FVI for tax periods 1983 to 2003, determining that the subsidiaries were subject to the Maryland corporation income tax.
The Comptroller used Gore's Maryland apportionment ratio to apportion its Maryland income and expenses and applied it to GEH and FVI's federal taxable income derived from Gore, excluding any income that did not originate from Gore. Based on its position that the two subsidiaries had substantial connections and nexus with Maryland under unitary business principles, the Comptroller assessed over $26 million against GEH and over $2.6 million against FVI. The Comptroller also made an alternative assessment of tax against Gore based on the denial of the deduction for royalty and interest payments, on the basis that Gore had not sufficiently established these amounts as ordinary and necessary business expenses.
A hearing officer in the Comptroller's office upheld the assessments and upon appeal, the Maryland Tax Court affirmed the tax assessments based on its conclusion that the two subsidiaries had nexus with Maryland because they lacked real economic substance as business entities separate from Gore.2 The subsidiaries subsequently appealed to a circuit court, which found that Gore and GEH were not in a unitary business and that Gore and FVI conducted transactions at arm's length, reversing the Tax Court's decision and cancelling the assessments against both subsidiaries. Following an appeal by the Comptroller, the Court of Special Appeals reversed the circuit court and held that the subsidiaries had nexus with Maryland because they were unitary with Gore.3 The Court of Special Appeals endorsed the Tax Court's original decision that upheld the Comptroller's assessment. The subsidiaries appealed this decision to the Court of Appeals.
Out-of-State Intangible Holding Companies Subject to Maryland Tax
In affirming the Tax Court and the Court of Special Appeals, the Court of Appeals held that the subsidiaries had nexus with Maryland because they lacked real economic substance as business entities separate from the parent company. The Court of Appeals began its analysis by examining what it characterized as the "bedrock constitutional principles" that must be satisfied before an out-of-state entity is subject to Maryland tax.4 The Due Process Clause of the U.S. Constitution requires minimal contacts with the state in order to subject the entity to taxation within the state,5 while the Commerce Clause requires that an entity have substantial nexus before it may be taxed by a state.6
Unitary Business Principle Clarified
The unitary business principle authorizes the state to tax the portion of value that the business derived from its operation within the state.7 The Court of Appeals clarified what the unitary business principle allows. Although this principle may be used to tax an apportioned sum of the multistate income, the "principle does not confer nexus to allow a state to directly tax a subsidiary based on the fact that the parent company is taxable and that the parent and subsidiary are unitary."8 If the taxpayer disputes its nexus with Maryland, the unitary business principle cannot be used to satisfy the Due Process and Commerce Clauses. After the state satisfies the constitutional requirements to impose a tax on a corporation in question, the unitary business principle allows the apportionment of income.9
No Economic Substance as Separate Business Entities
The Court of Appeals considered a case, Comptroller of the Treasury v. SYL, Inc., which it had previously decided that was similar to the instant case.10 SYL concerned Maryland's ability to tax two different companies that had little obvious connection to the state, but were subsidiaries of parent companies that had significant business ties with Maryland. After examining the structure and operation of the two subsidiaries, the Court held in SYL that the constitutional requirements were satisfied because the subsidiaries "had no real economic substance as separate business entities."11
According to the Court of Appeals, the Tax Court properly held that Maryland could tax GEH and FVI consistent with the reasoning in SYL. The Tax Court used the correct legal standard by determining that GEH and FVI were subsidiaries with no real economic substance as separate business entities.12 As part of its analysis, the Tax Court noted that the subsidiaries were each engaged in a unitary business with Gore. The Court of Appeals explained that even though the unitary business principle and economic substance inquiry are distinct tests, there was no reason that the factors that indicate a unitary business cannot also be relevant in determining whether subsidiaries have real economic substance.
The Court of Appeals rejected the subsidiaries' attempts to distinguish SYL from the instant case. First, the subsidiaries argued that they were created for legitimate business reasons. In rejecting this argument, the Court explained that the motivation behind creating entities, although invoked in SYL, is not dispositive. Second, GEH and FVI argued that unlike the subsidiaries in SYL, they engaged in activities that highlighted their substance as entities separate from their parent. The Court acknowledged that GEH and FVI participated in more substantive activities than the subsidiaries in SYL, as GEH acquired patents from third parties, licensed patents to third parties and paid substantial fees for outside legal counsel and other services. However, the Court concluded that the "window dressing" did not provide GEH and FVI with economic substance as separate entities. Finally, the subsidiaries contended that all of their transactions with Gore were at arm's length or market rates. However, the Court explained that this fact "does not dispel the inescapable conclusion that GEH and FVI did not have economic substance as separate business entities."
Separate Reporting Requirement Not Violated
The Court of Appeals rejected the subsidiaries' argument that the Comptroller usurped the legislative function by transforming Maryland from a separate reporting state to a unitary (combined) reporting state. According to the subsidiaries, the Tax Court improperly treated them as a unitary business because they did not have the necessary connection with Maryland to be taxed as independent entities. The Court of Appeals rejected this argument and reiterated that the subsidiaries' lack of economic substance, rather than the unitary business principle, supported the nexus determination. Because the unitary business principle cannot be used to support the constitutional taxation of GEH and FVI as individual entities, there was no inconsistency in the Tax Court's finding of nexus under SYL and Maryland's separate reporting requirement.
Corporate Form Not Disregarded
The subsidiaries unsuccessfully argued that the Tax Court's ruling was an improper disregard for the corporate form under Maryland law. The Court of Appeals concluded that the subsidiaries' argument would prevent courts from considering the realities of the relationship between a parent and subsidiary in determining the amount of income that may be fairly traced to Maryland. This principle would require a complete rejection of SYL. Furthermore, SYL does not require a disregard of the unique corporate existence of either the parent or subsidiary. The Court explained that the Comptroller was taxing GEH and FVI independently, subject to Maryland's separate reporting requirements.
Federal Patent Rights Not Transformed
The Court disagreed with the subsidiaries' argument that the Tax Court's use of SYL improperly transformed the scope of federal patent rights. This argument concerned a statement by the Court of Special Appeals that a patent is "used" when a licensee manufactures or sells a product covered by that patent. The logic behind a patent being "used" was also reflected in SYL, where the Court cited a case, Geoffrey, Inc. v. South Carolina Tax Commission, finding nexus based on the use of trademarks in the state.13 The subsidiaries' argument was based on the legal difference between patents and trademarks. Under this argument, a patent is completely severable from the sale of the covered product, but trademarks are inseparable from their covered product. The Court concluded that there was nothing in the inherent nature of patents that precluded their "use" by Gore. For purposes of taxation, the Court concluded that there is no distinction between patents and trademarks.
Apportionment Factor Properly Applied
The Court of Appeals held that the Comptroller properly applied Gore's Maryland three-factor apportionment factor to GEH and FVI's income to calculate the subsidiaries' tax obligations. The subsidiaries unsuccessfully argued that the Comptroller ignored a regulation requiring taxpayers earning income from intangibles to apportion such income through a two-factor apportionment formula based on a ratio of in-state to everywhere property and payroll.14 Based on the language of the apportionment statute and regulation, the Court rejected this argument. Both the apportionment statute and the regulation allow the Comptroller to alter the apportionment formula as necessary.15 The use of Gore's apportionment factor was necessary to fairly represent the subsidiaries' activities in Maryland, since apportionment under the two-factor formula would have resulted in zero tax liability which did not represent that subsidiaries' Maryland activity.
The subsidiaries also argued that the apportionment formula was unfair because they did not have property or payroll in Maryland. In rejecting this argument, the Court explained that the Comptroller's use of an apportionment formula was authorized by the unitary business principle. The Due Process and Commerce Clauses limit the unitary business principle and require (1) showing the existence of a unitary business that is at least partially conducted in the taxing state and (2) demonstrating a rational relationship between the taxing state and the intrastate values of the taxpayer's business.16 The Court of Appeals concluded that the Tax Court correctly held that Gore and the subsidiaries were engaged in a unitary business. The subsidiaries therefore had the burden of showing that the income they wanted to exclude was from unrelated business activity that was a discreet business enterprise.17 The Court of Appeals followed the U.S. Supreme Court's analysis that employs both internal consistency and external consistency tests.18 The subsidiaries did not dispute the internal consistency test, but argued that under the external consistency test, the apportionment formula was unfair and out of proportion to the business they conducted in Maryland. The Court of Appeals disagreed and summarily held that the apportionment formula reflected a reasonable sense of how the subsidiaries' income was generated.
Commentary
This ground-breaking decision attempts to clarify the analysis to be used when determining whether Maryland can tax the income of out-of-state holding companies. Given the fact that this decision was issued by Maryland's highest court and clearly expresses the analysis to use when making a nexus determination for out-of-state holding companies, this case will likely be considered by courts in other states. Although the decision affirms the holdings of both the Tax Court and the Court of Special Appeals, it relies on the Tax Court's analysis. In making the nexus determination, the Tax Court based its conclusion on a finding that the subsidiaries lacked real economic substance as separate business entities. In contrast, the Court of Special Appeals based its nexus determination on a unitary business relationship. The Court of Appeals followed the approach used by the Tax Court and clarified that the unitary business principle cannot solely be used to satisfy the nexus requirements under the Due Process and Commerce Clauses. The unitary business principle does not concern jurisdiction, but allows the apportionment of the income of entities that are already deemed to be taxable. Thus, according to the Maryland Court of Appeals, the economic substance analysis is key in determining whether out-of-state subsidiaries have nexus with the taxing state.
While the Court clearly states that the existence of a unitary relationship between a parent and a subsidiary cannot drive a nexus determination for the subsidiary, the Court's reliance on a distinctive economic substance test required to be met for a subsidiary to be treated as a separate business entity calls into question what level of economic substance a subsidiary must have to be considered an independent entity. Apparently, transactions that are made at arm's length or market rates may not be enough if such transactions are with direct affiliates. The Court's analysis implies that significant levels of transactions with third parties, and a separate set of officers and directors may be necessary for a controlled subsidiary to have economic substance under the Maryland conception of the term.
Note that Maryland adopted related-party addback rules for the 2004 tax year and thereafter so that the Comptroller could effectively eliminate the tax benefit that Gore, GEH and FVI and other similar corporate structures had historically received due to the operation of the separate return rules.19 But even so, the decision may be used to target entities engaged in other activities beyond the holding of intangibles as not having enough economic substance to stand on their own, as well as entities that claim an exception from the related-party addback rules. In any event, one can expect more subsidiaries that are closely related to their corporate parents to be scrutinized by the Comptroller, and potentially tainted by the characterization of "not enough economic substance."
Perhaps just as concerning as the economic substance determination was the Court's affirmation of the Comptroller's use of Gore's apportionment factors, which included a substantial amount of Maryland property and payroll, as a means to calculate GEH and FVI's Maryland corporation income tax liability. The Comptroller has broad discretionary authority to make adjustments in the area of apportionment when the existing apportionment factor regime does not clearly reflect a taxpayer's income. But the Comptroller's adjustment in this case produced a result similar to the combined reporting on a unitary basis required in numerous states. Notably, Maryland has not adopted combined reporting to date, despite numerous attempts in the state legislature. The Comptroller's efforts to effectively reach that result through this type of adjustment make it clear that separate reporting is not a consistent policy on which parent corporations subject to tax in Maryland with closely related subsidiaries located outside Maryland can rely.
Footnotes
1 Gore Enterprise Holdings, Inc. v. Comptroller of the Treasury; Future Value, Inc. v. Comptroller of the Treasury, Maryland Court of Appeals, No. 36, March 24, 2014.
2 W.L. Gore & Assoc., Inc. v. Comptroller of the Treasury, Maryland Tax Court, Nos. 07-IN-OO-0084, 07-IN-OO-0085, 07-IN-OO-0086, Nov. 9, 2010.
3 Comptroller of the Treasury v. Gore Enterprise Holdings, Inc.; Comptroller of the Treasury v. Future Value, Inc., 60 A.3d 107 (Md. Ct. Spec. App. 2013). For a discussion of this case, see GT SALT Alert: Maryland Court of Special Appeals Holds Intangible Holding Companies Have Corporate Income Tax Nexus.
4 See Quill Corp. v. North Dakota, 504 U.S. 298 (1992).
5 Under the Due Process Clause, the out-of-state business must have a '"minimal connection' between the interstate activities and the taxing State, and a rational relationship between the income attributed to the State and the intrastate values of the enterprise." Mobil Oil Corp. v. Comm'r of Taxes of Vermont, 445 U.S. 425 (1980) (citations omitted).
6 In Complete Auto Transit Inc. v. Brady, 430 U.S. 274 (1977), the U.S. Supreme Court developed a four-part test to determine whether a state's imposition of a tax satisfies the Commerce Clause. To meet the test, the tax must (1) be applied to an activity with a substantial nexus with the taxing state, (2) be fairly apportioned, (3) not discriminate against interstate commerce and (4) be fairly related to the services provided by the state.
7 MeadWestvaco Corp. ex rel. Mead Corp. v. Illinois Dep't of Revenue, 553 U.S. 16 (2008).
8 Emphasis in original.
9 The Court noted that Professor Walter Hellerstein, a noted professor in the area of state and local taxation, advances this same position in published thought leadership. See Walter Hellerstein, A Unitary Business is the "Linchpin of Apportionability," Not Nexus, State Tax Notes, March 18, 2013.
10 825 A.2d 399 (Md. 2003).
11 Emphasis added by Court.
12 As summarized by the Court of Appeals, the Tax Court's opinion contained a list of findings that "highlighted the subsidiaries' dependence on Gore for their income, the circular flow of money between the subsidiaries and Gore, the subsidiaries' reliance on Gore for core functions and services, and the general absence of substantive activity from either subsidiary that was in any meaningful way separate from Gore."
13 437 S.E.2d 13 (S.C. 1993).
14 MD. REGS. CODE tit. 03, § 04.03.08.
15 MD. CODE ANN., TAX-GEN § 10-402(d); MD. REGS. CODE tit. 03, § 04.03.08(F)(1).
16 NCR Corp. v. Comptroller of the Treasury, 544 A.2d 764 (Md. 1988).
17 Id.
18 Container Corp. v. Franchise Tax Board, 463 U.S. 159 (1983). Under the internal consistency test, if the apportionment formula were applied by every jurisdiction, it would result in no more than all of the taxpayer's income being taxed. Under the external consistency text, the factor or factors in the apportionment formula must actually reflect a reasonable sense of how the income is generated.
19 See MD. CODE ANN., TAX-GEN § 10-306.1.
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