United States: New Jersey Supreme Court Rejects Physical Presence Nexus Standard In "Lanco Inc. V. Director, Div. Of Taxation"

In a unanimous decision issued today*, the New Jersey Supreme Court held that New Jersey could impose its Corporation Business Tax ("CBT") on an out-of-state corporation without a physical presence in New Jersey. Lanco, Inc. v. Director, Div. of Taxation, Docket No. A-89-05 (N.J. October 12, 2006). The decision affirms a 2005 New Jersey Superior Court (Appellate Division) decision and represents the first time since Geoffrey, Inc. v. South Carolina Tax Comm’n, 437 S.E. 2d 13 (S.C. 1993) that the highest court in a state has firmly concluded that the Quill physical presence nexus standard does not apply for corporate income tax purposes.¹

Lanco, Inc. ("Lanco") was a Delaware-based corporation that owned and managed certain intangible property, such as trademarks, trade names, and service marks. Lanco has no offices, employees, or tangible personal property in New Jersey. Lanco’s only connection to New Jersey was that it licenses its intangible property to Lane Bryant, Inc. ("Lane Bryant"), Lanco’s retail apparel affiliate with stores in New Jersey. Lane Bryant paid Lanco a royalty for its use of Lanco’s intangible property.

On audit, the Director of the New Jersey Division of Taxation ("Director") determined that the mere existence of the license agreement between Lane Bryant and Lanco subjected Lanco to the New Jersey CBT. Lanco appealed that determination. In reviewing the dispute in 2003, the New Jersey Tax Court ("Tax Court") held that subjecting Lanco to the CBT violated the U.S. Constitution because Lanco was not physically present in New Jersey, and therefore did not meet the "substantial nexus" requirement of the dormant Commerce Clause. Lanco, Inc. v. Director, Div. of Taxation, 21 N.J. Tax 200 (N.J. Tax Ct. 2003).

In reaching its holding that physical presence is required to establish substantial nexus, the Tax Court provided a thorough review of the case law addressing Constitutional nexus. The leading case in this regard, Quill Corp. v. North Dakota, 540 U.S. 298 (1992), applied a physical presence standard for use tax purposes. The Tax Court held that Quill was applicable to corporate income taxes because, in its view, it would be illogical to apply a physical presence nexus test to one type of tax and not to another. The Tax Court discounted the persuasive effect of Geoffrey, Inc. v. South Carolina Tax Comm’n, 437 S.E. 2d 13 (S.C. 1993), where the South Carolina Supreme Court did not require physical presence to satisfy substantial nexus requirements for income tax purposes.

On appeal, the New Jersey Superior Court (Appellate Division) reversed the Tax Court. Lanco, Inc. v. Director, Div. of Taxation, 879 A.2d 1234 (N.J. Super. 2005). The Superior Court—persuaded by Geoffrey and cases from jurisdictions that followed Geoffrey—held that the physical presence standard of Quill only applied to sales and use taxes, and that physical presence nexus was not required for income taxes. Consequently, New Jersey did not violate the Commerce Clause by applying the CBT to Lanco despite its lack of physical presence in New Jersey.

The Superior Court failed to specifically articulate its reason for rejecting the physical presence test in the context of an income tax. Rather, the decision relied on two cases holding that physical presence was not required for income tax purposes: A&F Trademark Inc. v. Tolson, 605 S.E. 2d 187 (N.C. Ct. App. 2004), and Louisiana Sec’y, Dep’t of Revenue v. Gap (Apparel), Inc., 886 So.2d 459 (La. Ct. App. 2004).

In a brief per curiam opinion, the New Jersey Supreme Court unanimously agreed with and affirmed the Superior Court’s "thorough and thoughtful opinion." Additionally, the Supreme Court concluded, "we do not believe that the Supreme Court [in Quill] intended to create a universal physical-presence requirements for state taxation under the Commerce Clause." Lanco is now remanded to the Tax Court for additional proceedings, and it is unknown if the taxpayer intends to appeal the decision to the United States Supreme Court.

New Jersey tax law provides an apportionment "throwout" rule that provides that if receipts would be assigned to a state, possession, territory of the United States, or a foreign country in which the taxpayer is not subject to tax on or measured by profits, income, business presence, or business activity, that taxpayer must exclude or throw out such sales from the taxpayer’s sales factor denominator. N.J.S.A § 54:10A-6. This throwout rule operates to increase the taxpayer’s New Jersey presence as represented in the taxpayer’s apportionment factor.

Based on the Lanco decision, taxpayers may be able to apply the lower threshold of the economic presence nexus standard to determine whether they are subject to tax in another state, possession, territory of the United States or a foreign country. Hence, taxpayers with sales subject to the throwout rule may find that the Lanco decision has some beneficial impact. © 2006 Sutherland Asbill & Brennan LLP. All Rights Reserved.

Sutherland Observation: The Superior Court Appellate Division’s opinion—which was essentially adopted by the New Jersey Supreme Court—is not expressly limited to instances involving a related party, such as an intangible holding company. The potentially broad scope of the opinion may result in all out-of-state companies being subject to the CBT—despite their lack of physical presence in New Jersey. The types of activities that could subject companies to the CBT based on the broad scope of the Lanco decision include:

• Providing financial services to New Jersey customers;

• Licensing franchises or intangibles for use with respect to products sold in New Jersey to unrelated parties;

• Licensing software for use in New Jersey; or

• Selling digital products or providing remote services to consumers located in New Jersey.

Sutherland Observation: Taxpayers may consider entering into a voluntary disclosure agreement with New Jersey to address prior-year exposures. Before the Lanco New Jersey Supreme Court decision, the Tax Division was preparing to release an intangible holding company voluntary disclosure program by the end of October. The specifics of the program are unclear, but the Division had previously entertained taxpayer’s requests for "neutralization" agreements, whereby the taxpayer’s intangible holding company agrees to pay New Jersey tax based on the New Jersey apportionment factors of the related operating company paying the royalties. Impact of Decision: Other States’ Taxes

Several states apply "throwback" provisions that operate to increase a taxpayer’s sales factor by requiring the taxpayer to throwback sales from any jurisdiction in which the taxpayer is not subject to tax. Based on the Lanco decision, taxpayers should consider New Jersey’s economic nexus standard in determining whether to "throwback" New Jersey sourced receipts.

Many states have enacted provisions that require taxpayers to add back to taxable income otherwise deductible interest and intangible expenses paid to a related entity. The addback provisions vary with respect to the types of expenses that must be added back to taxable income, including intangible expense, interest related to intangible income, and all interest. States imposing addback provisions also provide exceptions. For example, a common exception is the "subject to tax" exception that allows taxpayers to avoid the addback of an expense if the recipient of the payment is subject to tax at a pre-determined tax rate. See e.g. Va. Code § 58.1-402.B(8)(a)(1). Based on this decision, holding companies that may now be subject to New Jersey CBT, may reap some "silver lining" benefits by enabling royalty and interest payors to qualify for an exception to New Jersey expense disallowance, as well as, "subject to tax" exceptions to expense disallowance in other states where the payor files a separate return.

Taxpayers should consider the impact of this decision on their financial statements. The adoption of the physical presence nexus standard by the highest court in a state may suggest infirmity in the physical presence requirement for income tax nexus purposes generally. Based on the decision, taxpayers should re-evaluate the sufficiency of the enterprises’ tax reserves.

Based on the recent pronouncement by the Financial Accounting Standards Board in Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes ("FIN 48"), enterprises must perform a complete review of their income tax positions, including a non-filing position, for financial reporting purposes. Upon adoption, FIN 48 requires that the enterprise evaluate whether it is more-likely-than-not that the taxpayer will be able to sustain the benefit of the filing or non-filing position in order for the enterprise to recognize the tax benefit for financial statement purposes. FIN 48 requires that taxpayers assume that the issue will be examined in making the determination of whether it is more-likely-than-not that the taxpayer would be able to sustain the benefit of such position.

As a result of the New Jersey Supreme Court’s decision, enterprises must seriously consider whether to reserve for non-filing under similar circumstances.

© 2007 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.