United States: Green Light, Red Light or Blue Light? New Mexico Supreme Court Sends Mixed Signals with Kmart Decision

On the eve of the New Year, the New Mexico Supreme Court handed down its long-awaited decision in the Kmart case involving the state’s power to subject an out-of-state intangible holding company to gross receipts and income tax on royalties from licensing trademarks and trade names to a related in-state licensee. Kmart Corp. v. Taxation and Revenue Department, No. 27,269, N.M. Sup. Ct., Dec. 29, 2005. From a taxpayer’s perspective, there is good news and bad news in the decision.

The good news is that the taxpayer prevailed on the gross receipts tax issue, although on narrow statutory grounds. The court held the tax did not apply to receipts from the out-of-state grant of a license to use property in the state, because the statute had been amended to make it clear that the transaction should be treated as a nontaxable out-of-state "sale" of the license to use intangible property, rather than the taxable in-state "lease" of intangible property used by the licensee within the state.

The bad news is that the court did not reach the income tax issues raised by the case, but instead quashed the certiorari it had previously granted on the income tax issue and, more importantly, ordered that the New Mexico Court of Appeals decision sustaining the tax over constitutional objections to "be filed concurrent with the filing of this opinion." In short, for the moment at least, the law in New Mexico, as in South Carolina (Geoffrey), North Carolina (A&F Trademark), and New Jersey (Lanco), is that economic nexus – rather than Quill’s physical-presence standard – is the Commerce Clause jurisdictional standard for income tax purposes.

To appreciate the significance of the Kmart decision and "nondecision," it is important to understand the background of the case and the posture in which it has been languishing for the past five years. The underlying facts of the case should be familiar reading to anyone with even a passing acquaintance with Geoffrey, A&F, Lanco, and other intangible holding company cases. Kmart created a subsidiary (Kmart Properties, Inc. ("KPI")) to own and manage its trademarks, trade names, and service marks, such as "Blue Light Special," "At Home with Martha Stewart," and "Kmart" (collectively the "marks"). After Kmart transferred the marks to KPI, KPI licensed them back to Kmart in return for a royalty of 1.1 % of Kmart's gross sales in the United States. Because Kmart was able to deduct the royalty payments to KPI, it significantly reduced, and in some cases eliminated, Kmart’s income tax liability in New Mexico. KPI, on the other hand, paid state taxes only in Michigan, where all its employees and tangible property were located, and Michigan does not tax income from royalty payments.

In addressing the question of whether New Mexico had sufficient nexus to subject KPI to income tax on the more than $2 million of royalties that it received as a result of Kmart’s New Mexico sales, the New Mexico Court of Appeals had little difficulty concluding that due process strictures were satisfied. Kmart Properties, Inc. v. Taxation and Revenue Dep't, _ NM _, _ P2d _ (Ct. App. 2001), petition for cert. granted, 131 NM 564, 40 P3d 1008 (2002), petition for cert. quashed and opinion ordered to be filed, __ NM ___, ___ P3d ___ (2005) (hereinafter cited as Kmart Properties, Inc., (Court of Appeals)). Because KPI purposefully directed its efforts toward New Mexico and purposefully availed itself of the benefits of the New Mexico market by allowing its marks to be exploited in the state, KPI met the "minimum contacts" standard of the Due Process Clause, which does not require that the taxpayer be physically present in the state.

The more controversial question was whether KPI had the "substantial nexus" with New Mexico that the Commerce Clause demands. The Court recognized that "[t]here has been a split among state courts regarding whether Quill's [physical] presence requirement was intended as a broad, Commerce Clause principle applicable to all state taxes, or whether physical presence was limited to sales and use taxes." Kmart Properties, Inc., (Court of Appeals). Squarely confronting this conflict, the court concluded that Quill’s physical-presence requirement does not apply to income taxes. In reaching this conclusion, the court pointed to the text of the Court’s opinion in Quill, which "repeatedly emphasized a narrow focus upon sales and use taxes" and left the "clear impression that it was not applying the ... physical-presence requirement to any other taxes." Kmart Properties, Inc., (Court of Appeals). The court further observed that sales and use taxes can impose special burdens on interstate commerce (beyond the payment of money) that distinguish them from income taxes:

Unlike an income tax, a sales and use tax can make the taxpayer an agent of the state, obligated to collect the tax from the consumer at the point of sale and then pay it over to the taxing entity. Whereas, a state income tax is usually paid only once a year, to one taxing jurisdiction and at one rate, a sales and use tax can be due periodically to more than one taxing jurisdiction within a state and at varying rates.

Kmart Properties, Inc., (Court of Appeals).

Once having concluded that the Commerce Clause analysis of the New Mexico income tax was "controlled, not by Quill’s physical presence [test], but by the overarching substantial nexus test announced in Complete Auto Transit," the court found that "the use of KPI’s marks within New Mexico’s economic market, for the purpose of generating substantial income for KPI, establishes a sufficient nexus between that income and the legitimate interests of the state and justifies the imposition of a state income tax." Kmart Properties, Inc., (Court of Appeals).

The creation of nexus over intangible holding companies through the operations of their licensees in the state generally arises in the context of income taxation rather than sales and use taxation, because sales and use taxes generally do not apply to the sale or license of intangibles. However, New Mexico – a state with one of the broadest sales taxes in the country - does apply its gross receipts (sales) tax to receipts from the license to use certain intangible property in the state.¹ Consequently, in Kmart, there were gross receipts tax issues as well as income tax issues raised by the intangible holding company arrangement. Although the precise factual context in which the related-party nexus issue arose is atypical from a sales and use tax perspective, the general principles that the court articulated are clearly relevant to cases involving the more typical sales and use tax controversy involving sales of tangible personal property.

In addressing the question of whether New Mexico had sufficient nexus to subject KPI to gross receipts tax on the more than $2 million of royalties that it received as result of Kmart’s New Mexico sales, the court had no difficulty concluding that due process strictures were satisfied for the reasons already described above in connection with our discussion of the income tax issues raised by the case. The more controversial question was whether KPI had the "substantial nexus" with New Mexico that the Commerce Clause demands. Since KPI admittedly had no physical presence of its own in the state, the court recognized that "[i]f the Department is to satisfy the Quill standard, it must demonstrate something special about the nature of trademarks and KPI's relationship with Kmart Corporation within New Mexico that constitutes physical presence or its functional equivalent." Kmart Properties, Inc., (Court of Appeals). The court found that both these factors justified the conclusion that KPI had "physical presence or its functional equivalent" in New Mexico.

After briefly describing the legal nature of a trademark, whose ownership is inseparably connected to the business with which it is associated, the court observed that [w]hen Kmart Corporation created KPI and transferred ownership of the "Kmart" name, it legally separated the trademark and goodwill from the actual business upon which that goodwill depends. As a practical matter, KPI and Kmart Corporation became … corporate ‘Siamese Twins,’ inextricably bound to each other.

Kmart Properties, Inc., (Court of Appeals). In substance, then, Kmart – though not the "agent" of KPI – nevertheless was a "representative" of KPI in New Mexico, acting through its employees "to represent and promote the goodwill of KPI's marks to the New Mexico consuming public." Kmart Properties, Inc., (Court of Appeals). Consequently, Kmart’s physical presence in the state could be attributed to KPI in much the same way as the physical presence of the in-state "independent contractors" was attributed to the out-of-state vendors in Scripto and Tyler Pipe. What mattered was not "the label or technical legal status of the representative within the taxing state," but rather "a physical presence, within the taxing state, of someone acting on the company’s behalf." Kmart Properties, Inc., (Court of Appeals).

Based on the Scripto/Tyler Pipe standard, the court found ample justification for concluding that Quill’s physical presence standard was satisfied. In its view, the record supported the conclusion that Kmart used its stores and employees in New Mexico as "local representatives" of KPI and its goodwill: "An extensive apparatus of Kmart stores, signs, and employees are … physically present in New Mexico to work on behalf of KPI’s goodwill and associated interests." Kmart Properties, Inc., (Court of Appeals). The court therefore held that "the combination of Kmart Corporation’s activities in New Mexico, together with the tangible presence of KPI’s marks, constitutes the functional equivalent of physical presence as afforded by the independent representatives in Scripto and Tyler Pipe." Kmart Properties, Inc., (Court of Appeals).

The Court of Appeals reasoning is needed to assess the effect of the Supreme Court’s decision. From a gross receipts tax standpoint, the New Mexico Supreme Court plainly resolves the issue of the taxability of royalties paid by in-state licensees to out-of-state intangible holding companies in favor of the taxpayer. However, it does so on the narrowest of statutory grounds, namely, that an amendment to a statute excluding from the definition of a lease the "granting of a license to use property" and characterizing it as a sale effectively removes royalty agreements consummated outside of New Mexico from the scope of the gross receipts tax. While this is good news for New Mexico taxpayers (and potential taxpayers), particularly out-of-state licensors of software and other intangibles, it has little impact on taxpayers elsewhere, because most state sales and use taxes do not apply to license royalties. On the income tax side, however, the New Mexico Court of Appeals decision has been removed from the limbo in which it has been resting for the past five years and it is now good law in New Mexico, with arguable implication for the emerging law regarding income tax nexus over intangible holding companies in other states. Although there is still a remote possibility that the New Mexico Court of Appeals could change its mind about quashing the certiorari it had granted on the income tax issue (assuming that Kmart were to seek a reconsideration of that issue), we are not holding our breaths for that eventuality. In summary, Kmart must now be added to Geoffrey, A&F, and Lanco as decisions squarely holding that economic rather than physical presence is the test for substantial nexus under the Commerce Clause for income tax purposes. Finally, there is the question of Kmart implications for sales and use tax nexus. As noted above, the New Mexico Supreme Court’s reversal on the merits of the gross receipts tax issue leaves the status of the Court of Appeals nexus analysis somewhat unclear. At a minimum, however, it stands as a template for state taxing authorities (and their counsel) in arguing for "attributional nexus," even though any citation to that opinion as "authority" must note that it has been "reversed on other grounds."

© 2005 Sutherland Asbill & Brennan LLP. All Rights Reserved.

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