United States: Maryland High Court Holds Separate Reporting Requirement Did Not Prevent Taxation Of Deferred Gain

On August 18, the Maryland Court of Appeals, the state's highest court, held that the state's requirement that related corporations file separate income tax returns did not prohibit the state from taxing gains deferred by an out-of-state subsidiary under Internal Revenue Code (IRC) Section 311(b).¹ In prior decisions involving the same taxpayer, lower Maryland courts had determined that the out-of-state subsidiary, which had no economic substance apart from its parent company, had substantial nexus with Maryland and was subject to the state's corporation income tax due to its parent company's activities in the state.

Background

The taxpayer (NIHC) was a subsidiary of Nordstrom, a national retailer that operates stores in Maryland. NIHC and a second subsidiary of Nordstrom (N2HC), did not conduct business or own tangible personal property in Maryland. Both subsidiaries were formed to license trademarks to Nordstrom. Specifically, Nordstrom entered into a licensing agreement with NIHC in which Nordstrom authorized NIHC to license the use of Nordstrom's trademarks in exchange for the entire stock of NIHC. Nordstrom later transferred its trademarks to NTN, a wholly-owned subsidiary of Nordstrom that like NIHC and N2HC, did not conduct business or own tangible personal property in Maryland. After Nordstrom transferred the stock it owned in NTN and NIHC to N2HC for cash, NIHC transferred the licensing agreement to N2HC as a dividend before Nordstrom paid any royalties to N2HC.

As a result of the dividend of the licensing agreement, NIHC recognized gain on the distribution of appreciated property under IRC Section 311(b).² Nordstrom reported the value of the distribution as a gain by NIHC, as well as the amortization of N2HC's basis, on Nordstrom's consolidated federal tax return for the fiscal year ending on January 31, 1999. NIHC was required to defer the reporting of the gain over the 15-year period in which N2HC amortized the value of the license agreement and which would generally be eliminated in federal consolidated and most state combined and consolidated filings.

With respect to the Maryland corporation income tax, each member of the Nordstrom federal consolidated group filed separate Maryland returns, whether or not these companies conducted business in Maryland. The Maryland returns for 2002 and 2003 filed for subsidiaries that had no physical presence in Maryland, including NIHC and N2HC, reported the IRC Section 311(b) gain as reflected on the federal consolidated return for each subsidiary, but applied a zero Maryland apportionment factor. In September 2006, the Maryland Comptroller issued notices of assessment against Nordstrom, NIHC and N2HC, based on the position that income-shifting in the form of trademark royalty expenses had resulted in an underpayment of Maryland corporation income tax.

Prior Decisions

Following a series of decisions by various Maryland courts, the Maryland Tax Court held that NIHC had substantial nexus with Maryland, the IRC Section 311(b) gain arising from NIHC's distribution of licensing rights to N2HC produced taxable income and that Maryland's requirement for separate income tax returns did not prohibit taxing that gain.³ In determining that NIHC's gain was subject to Maryland tax, the Tax Court found that the gain was recognized due to Nordstrom's activities and its use of the trademarks in Maryland. According to the Tax Court, there was no way to separate the value of the trademarks, the licensing of the trademarks and the gain recognized by NIHC from Nordstrom's activities in Maryland.

On NIHC's appeal, the Circuit Court for Baltimore County overturned the Tax Court's decision and held that the deferred gain was not subject to the Maryland corporation income tax in the year in which the gain was recognized for federal income tax purposes.⁴ The Circuit Court noted that even though the subsidiary had substantial nexus with Maryland, requiring the subsidiary to file Maryland corporation income tax returns, intercompany gain could not be deferred on such returns, because the state did not follow federal consolidated return principles.

The Comptroller appealed the Circuit Court's decision to the Maryland Court of Special Appeals. In an unreported decision, the Court of Special Appeals reversed the Circuit Court. The Court of Special Appeals noted that the only issue before it was whether Maryland's separate reporting requirement prevented the taxation of the gain reported on NIHC's 2002 and 2003 returns. In reversing the Circuit Court, the Court of Special Appeals found no error in the Tax Court's decision to uphold the assessment against NIHC. The Maryland Court of Appeals granted NIHC's request to consider the case.

Separate Return Requirement Did Not Prohibit Taxing Gains

The Maryland Court of Appeals agreed with the Court of Special Appeals to uphold the Tax Court's determination that the state's separate reporting requirement did not prohibit the Comptroller from taxing NIHC's IRC Section 311(b) gain on a deferred basis. In reaching its decision, the Court of Appeals clarified that Maryland's separate reporting statute provides simply that "[e]ach member of an affiliated group of corporations shall file a separate income tax return."⁵ A regulation elaborates that "each separate corporation shall report its taxable income without regard to any consolidation for federal income tax purposes."⁶ The Court explained that "[n]either the statute nor the corresponding regulations explicitly address the treatment of § 311(b) deferred gain, much less its treatment in the context of a subsidiary corporation that lacks economic substance apart from its parent."

The Comptroller computed the assessment by using the amounts for Maryland taxable income reported on NIHC's Maryland returns, which correlated with the amounts for its federal taxable income reported on NIHC's federal returns. NIHC argued that under Maryland's separate reporting requirement, it should have paid Maryland income tax on the entire gain it recognized as a result of the transactions with Nordstrom and the other subsidiaries in 1999, a tax year that was outside the statute of limitations. According to NIHC, it instead mistakenly reported a portion of that income on the Maryland returns for the 2002 and 2003 tax years. NIHC argued that Nordstrom should have computed a separate pro forma federal return for each of the affiliated companies and based its Maryland return for each year on the income shown on the corresponding pro forma federal return. Under this approach, NIHC would have reported the entire gain on the pro forma federal returns and Maryland return as income in 1999. If this method had been followed, NIHC would have reported no income from that gain for 2002 and 2003. In rejecting this argument, the Court explained that NIHC never actually completed any pro forma federal returns and did not amend its Maryland returns in this manner.

The Court of Appeals agreed with the Court of Special Appeals that whether NIHC should have reported the entire gain as income subject to Maryland income tax in 1999 was a separate question from whether the Comptroller could assess income actually reported by NIHC. In summarizing the case, the Court of Appeals expressed that "NIHC asks that, because it mistakenly neglected to report its entire gain and pay the appropriate tax on its 1999 Maryland return, it should be forgiven any tax liability on that income, even though it reported a portion of that income on its 2002 and 2003 returns." The Court concluded that "the separate reporting requirement does not eliminate the tax liability for the income reported, properly subject to tax, and not previously taxed."

Commentary

The Court of Appeals' decision began with a description of the "four corners offense" used by basketball teams that were ahead in the waning moments of games. This offense was used not to score, but to deny the opposition from having an opportunity to score by keeping the ball away from them.⁷ Astute readers of tax opinions probably did not have to read any further to realize that the Court was going to unfavorably compare the purposes of the taxpayer's corporate structure to the "four corners offense," and ultimately deny the taxpayer the requested relief in this case.

The Court's decision followed a long line of decisions by lower Maryland courts, and was specifically limited to the issue of whether the state's separate reporting requirement prevented the state from taxing the deferred IRC Section 311(b) gain. This decision did not address the underlying issue of whether NIHC, an out-of-state subsidiary, had nexus with Maryland due to the activities of its parent company, and did not question the conclusion that NIHC lacked economic substance.

Interestingly, a high-ranking officer of the taxpayer testified at trial that there was a misunderstanding concerning the application of the Maryland separate return rules. As a result, the IRC Section 311(b) gain was originally reported in the same time periods in Maryland as for federal consolidated reporting purposes. While the lack of economic substance of the overall structure clearly was troubling to the Court, the fact that the taxpayer did not correct its error to file amended returns reflecting the IRC Section 311(b) gain on the 1999 tax return, on the grounds that such tax year was already closed, proved to be too much for the taxpayer to overcome, especially given the assumption by the Court that the taxpayer's structure lacked economic substance.

This case highlights the substantial distinctions between filing separate returns for state tax purposes, and federal consolidated tax returns, as well as the fact that taxpayers often overlook these issues given the relative lack of guidance on the subject, with significant consequences. Based on the outcome of this case, state tax auditors in separate reporting states that do not recognize federal consolidated tax concepts may increase their efforts in this area to ensure that taxpayers are correctly applying separate reporting concepts to report their income. Likewise, taxpayers will need to consider whether the proactive filing of amended corporation income tax returns for open tax years is appropriate.

Footnotes

1. NIHC, Inc. v. Comptroller of the Treasury, Maryland Court of Appeals, No. 63, Aug. 18, 2014.

2. IRC § 311 addresses the federal income tax treatment of corporate distributions of property. In general, a corporation does not recognize gain or loss on distributions of its stock, rights to acquire its stock or property. IRC § 311(a). However, if a corporation distributes appreciated property, it recognizes gain to the extent the fair market value of the property exceeds its adjusted basis. IRC § 311(b).

3. Nordstrom, Inc. v. Comptroller of the Treasury, Maryland Tax Court, Nos. 17-IN-OO-0317 and 07- INOO-0318, Feb. 25, 2010.

4. NIHC, Inc. v. Comptroller of the Treasury, Circuit Court for Baltimore County, Case No. 03-C-10- 9151, Dec. 7, 2011.

5. MD. CODE ANN., TAX-GEN § 10-811.

6. MD. REGS. CODE tit. 03, § 04.03.03B(1).

7. As the Court notes, the advent of the "shot clock" requiring teams to shoot within a certain amount of time largely negated this strategy.

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