United States: Maryland Appeal Court Rules Intangible Holding Companies Have Nexus

Maryland Court of Special Appeals Holds Intangible Holding Companies Have Corporate Income Tax Nexus

On January 24, the Maryland Court of Special Appeals held that two out-of-state intangible holding companies had corporate income tax nexus with Maryland because they were in a “unitary business” relationship with their Maryland parent company.1 In reaching this determination, the Court particularly emphasized the fact that the parent company deducted its payments which were treated as income by its intangible holding companies. The Court of Special Appeals reversed a circuit court decision that had cancelled the tax assessments against the taxpayers, and in doing so, endorsed the Maryland Tax Court’s original decision that upheld the Maryland Comptroller’s assessment against the intangible holding companies.

Background

The parent company (P), a manufacturer with a physical presence in Maryland, created two intangible holding companies (IHC1, a royalty company, and IHC2, an investment company) that were incorporated in Delaware and lacked a physical presence in Maryland. IHC1 granted P the exclusive license to make, use and sell any of its patented inventions in exchange for a “reasonable fee” or royalty payments. IHC2 earned interest income by investing in and managing P’s excess cash and capital according to a long-term investment plan. P deducted both its royalty payments to IHC1 and its interest payments to IHC2 from its taxable income.

IHC1 and IHC2 did not file Maryland corporate income tax returns and as Delaware entities, their intangible and interest income derived from their transactions with P fell under Delaware’s exemption of passive income. Moreover, the intangible and interest income were not taxable in separate reporting states (in which P was doing business) that lacked related-party expense addback rules.

In 2006, the Comptroller audited P, IHC1 and IHC2 for tax periods from 1983 to 2003, determining that the subsidiaries were required to apportion income to Maryland. The Comptroller used P’s ratio to apportion its Maryland income and expenses and applied it to IHC1 and IHC2’s federal taxable income derived from P, excluding any income that did not originate from P.2 As a result, based on its position that the two holding companies had substantial connections and nexus with Maryland under unitary business principles, the Comptroller assessed over $26 million against IHC1 and over $2.6 million against IHC2. The Comptroller also made an alternative assessment of tax3 against P based on the denial of the deduction for royalty and interest payments, on the grounds that P 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 holding companies had nexus with Maryland because they lacked real economic substance as business entities separate from their parent company.4 The holding companies subsequently appealed to the Cecil County Circuit Court, which found that P and IHC1 were not in a unitary business and that P and IHC2 conducted transactions at arm’s length, reversing the Tax Court’s decision and cancelling the assessments against both IHC1 and IHC2. The Comptroller appealed the matter to the Court of Special Appeals.

Out-of-State Intangible Holding Companies Subject to Maryland Tax

Unitary Business Analysis

In reversing the circuit court, the Court of Special Appeals noted that Maryland law permits the state to tax multistate corporations doing business in Maryland to the fullest extent permitted by the U.S. Constitution.5 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,6 while the Commerce Clause requires that an entity have substantial nexus before it may be taxed by a state.7 A state may tax an apportioned sum of a corporation’s multistate business if the business is deemed “unitary” and the state is not seeking to tax values derived from unrelated out-of-state business activities of a discrete business enterprise.

The Court then acknowledged that it had previously ruled that there is sufficient nexus to justify a state’s taxation of an out-of-state subsidiary when the economic reality is that the parent’s business in Maryland produced the subsidiary’s income.8 Applying this prior ruling to the present case, the Court determined that P, IHC1 and IHC2 operated as a unified business since P generated income in Maryland and deducted its payments to its subsidiaries, and the subsidiaries recognized the payments as income.

In addition, the “hallmarks” of a unitary business relationship under constitutional law were present: “functional integration, centralized management, and economies of scale.”9 The holding companies were not only dependent upon P for their core business functions, but were also controlled by P. Where the parent’s expense in the taxing state is its subsidiaries’ income, the Court concluded that such control establishes a unitary business. Moreover, the Court rejected the argument that case precedent addressing trademark holding companies does not apply to scenarios involving patent holding companies, stating that a distinction in type of intellectual property “does not affect how or where they are ‘used’ for purposes of state income taxation.”

Furthermore, P’s deduction of its payments to IHC1 and IHC2 in Maryland were treated as “gains to assets on its own balance sheets,” gains to IHC1 and IHC2. Therefore, the expenses were incurred in Maryland and the corresponding gains were also realized in Maryland.

Statute of Limitations and Prior Audits

The Court also disagreed with the holding companies’ contentions that the Comptroller was barred from recovery by the statute of limitations and by its failure to assess the taxes at issue in its prior audits of P. First, with respect to the statute of limitations, Maryland law permits income tax to be assessed at any time if a return is not filed as required. Since both holding companies failed to file returns as required by law, an assessment was permitted “at any time.” Next, the holding companies were responsible for their own deprivation of the opportunity to timely address the issues underlying the assessments. They were the ones who could have sought the Comptroller’s opinion. The Comptroller was not commanded to investigate each and every expense payment made by P when it was “on notice” of them during its audits.

Apportionment Factor

Finally, the Court addressed the holding companies’ position that their income should have been apportioned according to P’s sales alone and not based on P’s apportionment factor, which takes into account P’s property or payroll. The Court found that because P’s apportionment factor reasonably reflected its expenses in Maryland, which were equivalent to the holding companies’ income, the same factor reasonably shows the amount of income attributable to Maryland as part of P’s unitary business. Therefore, the use of P’s apportionment factor to determine the holding companies’ Maryland income was not erroneous, and the Comptroller’s assessments were upheld.

Commentary

This decision is consistent with Maryland’s continuing attempt to thwart businesses from using intangible holding companies that result in a state tax benefit. Accordingly, businesses with a physical presence in Maryland must be prudent when they create an “out-of-state” intangible holding company. The Comptroller may very well take the position that the company falls within the state’s taxing jurisdiction based upon a “unitary business” relationship resulting from substantial intercompany transactions between the in-state parent (which generates deductions in the home state) and the subsidiary (which generates income in tax-free or tax-favored jurisdictions).

However, the Tax Court’s use of a unitary analysis in a separate reporting jurisdiction like Maryland, and the finding that two entities which have no independent economic substance from their parent have to be treated as separate taxpayers subject to tax in Maryland using its parent’s apportionment factor is particularly controversial and untested in other jurisdictions. The unitary theory directly addresses the issue of apportionment, not nexus.10 Without the ability to require statutory combined reporting for unitary businesses in Maryland, passive investment holding companies that solely hold investments and intangible holding companies that hold patents and other intangible items arguably should not be forced to file in Maryland on the basis of economic nexus principles alone.

Even though Maryland requires separate returns,11 this decision indicates that the state is moving toward an acceptance of unitary business principles. Though combined reporting was not specifically endorsed in this decision, the requirement that both out-of-state subsidiaries file as Maryland taxpayers and share the same apportionment factor as their parent effectively caused a result not unlike combined reporting on a unitary basis as required in numerous states. Also, this decision may affect other cases concerning intercompany payments that are pending before the Tax Court.12

Finally, the Comptroller’s assessments extend back to 1983, many years preceding the Geoffrey13 decision in South Carolina. It is interesting that a state would make an assessment based on a theory that had not been judicially adopted for many of the periods under assessment. Considering that this case has been reversed twice, there does not seem to be a consensus among the Maryland courts concerning this issue. Therefore, it is probable that the taxpayers will seek review by the Maryland Court of Appeals, the state’s highest court.

Footnotes

1 Comptroller of the Treasury v. Gore Enterprise Holdings, Inc.; Comptroller of the Treasury v. Future Value, Inc., Maryland Court of Special Appeals, Nos. 1696, 1697, Jan. 24, 2013.

2 IHC1’s tax liability was calculated by multiplying royalties from P by P’s apportionment factor, and IHC2’s tax liability was calculated by multiplying interest from P by P’s apportionment factor.

3 The alternative assessment against P was in the amount of $193,718, including interest and penalties. This amount reflects the fact that P filed tax returns, which triggered the statute of limitations.

4 W.L. Gore & Assoc., Inc. v. Comptroller of the Treasury, Maryland Tax Court, Nos. 07-IN-OO-0084,

07-IN-OO-0085, 07-IN-00-0086, Nov. 9, 2010.

5 MD. CODE ANN., TAX-GEN § 10-402.

6 In Quill Corp. v. North Dakota, 504 U.S. 298 (1992), the U.S. Supreme Court explained that the “Due Process Clause ‘requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax,’ and that the ‘income attributed to the State for tax purposes must be rationally related to values connected with the taxing State.’” (citations omitted)

7 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.

8 The Classics Chicago, Inc. v. Comptroller of the Treasury, 985 A.2d 593 (Md. Ct. Spec. App. 2010).

9 MeadWestvaco v. Ill. Dep’t of Revenue, 553 U.S. 16 (2008).

10 For example, the U.S. Supreme Court has characterized the unitary business principle as the “linchpin of apportionability.” See ASARCO, Inc. v. Idaho State Tax Commission, 458 U.S. 307 (1982). It should be noted that Maryland strictly prohibits combined filings, and so the Comptroller and the Tax Court could not simply decide to combine the three entities on the basis of unity. MD. CODE ANN., TAX-GEN § 10-811.

11 Note that Maryland has been considering a change to combined reporting for years. In an effort to obtain information to assist the state in evaluating the potential impact of combined reporting on state revenue, Maryland required pro forma combined reports to be filed for the 2006 through 2010 tax years. MD. CODE ANN., TAX- GEN § 10-804.1; MD. REGS. CODE § 03.04.14.02. Also, combined reporting legislation has been introduced during prior legislative sessions (for example, H.B. 941 was introduced in February 2012) and the current legislative session (H.B. 1158 was introduced on February 8, 2013).

12 For example, cases involving ConAgra Brands (No. 09-IN-OO-0150) and Staples (Nos. 09-INOO- 0148, 09-IN-OO-0149) are being considered by the Tax Court.

13 Geoffrey, Inc. v. South Carolina Tax Commission, 437 S.E. 2d 13 (S.C. 1993).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions