United States: You Can’t Have Your Cake and eat it too — Maryland Holding Company Settlement Program Nets $198.7 Million; Comptroller Bemoans Money Left on the Table

Maryland Comptroller William Donald Schaefer recently reported that the intangible property management company settlement program netted $198.7 million, but the State had to forgo about $306 million that the Comptroller believes he would have collected sooner or later. The culmination of the settlement program largely brings to a close a dispute between taxpayers and the Comptroller that has lasted for more than a decade. The Comptroller commented that "[s]ince it’s the holiday season, I’ll try to consider this mixed bag from Santa to be a little more ‘half full’ than ‘half empty.’" The Comptroller intends to aggressively pursue those taxpayers that did not take advantage of the settlement program.

As we reported in our December 2003 edition, Comptroller Schaefer has been engaged in an outright battle with taxpayers for close to a decade. The struggle started in approximately 1995-1996 when the Comptroller began auditing Delaware-based intangible property management companies. The Comptroller assessed Maryland corporate income taxes against the intangible property management companies based on the royalties and interest income they received from related corporations doing business in Maryland. The Comptroller also issued alternative assessments against the related corporations, disallowing deductions for royalties and interest paid to the intangible property management companies. The Comptroller’s underlying theory for the assessments is that the intangible property management companies are "phantom corporations" under Maryland law and, as a result, are required to determine their Maryland income using the apportionment factor of their "parent" corporation. The intangible property management companies in turn have generally responded that since they have no property and no activities in Maryland, they are not subject to taxation in Maryland under the commerce and due process clauses of the U.S. Constitution.

Following a series of administrative hearings before the Comptroller, the cases began reaching the docket of the Maryland Tax Court in 1998 and 1999. On April 26, 1999, taxpayers prevailed in a major battle when the Maryland Tax Court issued three separate decisions in favor of the taxpayer. See SYL, Inc. v. Comptroller of the Treasury, Docket No. C-96-0154-01 (Md. T.C. April 26, 1999); Crown Cork & Seal (Delaware) Inc. v. Comptroller of the Treasury, Docket No. C-97-0028-01 (Md. T.C. April 26, 1999); MCI Int’l Telecomms. Corp. Inc. v. Comptroller of the Treasury, Docket No. C-96-0028-01 (Md. T.C. April 26, 1999). In all three decisions, the Tax Court held that the activities of the affiliated corporation doing business in Maryland could not be attributed to the intangible property management company because the intangible property management company was not a "phantom" corporation. See SYL, Docket No. C-96-0154-01, slip op. at 5; MCIIT, Docket No. C-96-0028-01, slip op. at 8; Crown Cork & Seal (Delaware), Docket No. C-97-0028-01, slip op. at 2. In all three cases, the Tax Court held that the affiliation between the intangible property management company and the related company with a Maryland presence, standing alone, was "hardly enough to satisfy substantial nexus" as required in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977). See SYL, Docket No. C-96- 0154-01, slip op. at 7; MCIIT, Docket No. C-96- 0028-01, slip op. at 10; Crown Cork & Seal (Delaware), Docket No. C-97-0028-01, slip op. at 2. In two of the cases, the Tax Court also held that licensing intellectual properties for use by an affiliate in Maryland does not establish substantial nexus. See SYL, Docket No. C-96- 0154-01, slip op. at 7; Crown Cork & Seal (Delaware), Docket No. C-97-0028-01, slip op. at 2. Taxpayers earned another victory when, on March 17, 2000, the Maryland Circuit Court in Baltimore (City) affirmed the pro-taxpayer decisions issued by the Tax Court. See SYL, Inc. v. Comptroller of the Treasury, Docket No. 24-C- 99-002389 AA (Md. Cir. Ct. March 17, 2000); Crown Cork & Seal (Delaware) Inc. v. Comptroller of the Treasury, Docket No. 24-C-99-002388 AA (Md. Cir. Ct. March 17, 2000); MCI Int’l Telecomms. Corp. Inc. v. Comptroller of the Treasury, Docket No. 24-C-99-002387 AA (Md. Cir. Ct. March 17, 2000).

Then the taxpayers suffered a major set-back. On June 9, 2003, the Maryland Court of Appeals, the highest court in Maryland, reversed SYL and Crown Cork & Seal (Delaware), holding that the intangible property management companies were phantom corporations, were subject to taxation in Maryland, and were required to compute their Maryland taxable income using the apportionment factor of their parent corporation. See Comptroller of the Treasury v. SYL, Inc., Comptroller of the Treasury v. Crown Cork & Seal (Delaware) Inc., 375 Md. 78, 825 A.2d 399 (June 9, 2003). SYL and Crown Cork & Seal (Delaware) each filed a petition for writ of certiorari asking the United States Supreme Court to intervene, but the Supreme Court declined to hear either case. See SYL, Inc. v. Maryland Comptroller of the Treasury, Docket No. 03-335, cert. denied, 540 U.S. ___ (Nov. 3, 2002); Crown Cork & Seal (Delaware) Inc., Docket No. 03-566, cert. denied 540 U.S. ___ (Dec. 15, 2003).

Taxpayers have also faced temporary minor set backs in the Maryland General Assembly. Early in 2003, a measure was proposed in the Maryland Senate that generally would have required a corporation to add back otherwise deductible royalties and interest paid to a related intangible property management company. See Senate Bill 398, 2003 Leg., 417th Reg. Sess. (Md. 2003). When the measure stalled, similar legislation was proposed and passed by the Maryland House, passed as amended by the Maryland Senate, but ultimately vetoed by the Maryland Governor. See House Bill 753, 2003 Leg., 417th Reg. Sess. (Md. 2003).

In explaining his decision to veto the legislation, Maryland Governor Ehrlich wrote:

Letter from Maryland Governor Ehrlich to the Speaker of the Maryland House of Delegates (May 21, 2003).

Consistent with the Governor’s observation, Comptroller Schaefer has personally been involved in the intangible property management company issue. In June 2003 when the Maryland Court of Appeals ruled in favor of the Comptroller in SYL and Crown Cork & Seal (Delaware), the Comptroller publicly applauded the Court’s decision, stating that the decision "upholds our long-standing position that Delaware holding companies should pay their fair share of tax to Maryland when they demonstrate a clear connection to sales activity in Maryland." Press Release, Maryland Comptroller of the Treasury, Comptroller Schaefer Applauds "Delaware Holding Companies" Decision (June 9, 2003). With respect to the cases following in the wake of SYL and Crown Cork & Seal (Delaware), the Comptroller promised that "[w]e will work closely with the Attorney General’s Office to make sure that these cases move forward as quickly as possible." Id.

Armed with the decisions in SYL and Crown Cork & Seal, in November 2003 the Comptroller extended a settlement offer to the intangible property management companies. Under that offer, the Comptroller would reduce penalties from 25% to 2% provided the taxpayer paid all taxes and all interest. Not surprisingly, few taxpayers accepted the offer.

During the Summer of 2004, the Maryland Legislature dramatically changed the battlefield. Similar to other separate return states, the Legislature passed legislation requiring taxpayers to "add back" deductions for royalties and interest paid to certain related taxpayers. In a truly bizarre turn of events, at the same time the Legislature enacted a "settlement period" in which taxpayers with issues similar to those in SYL could pay all taxes and 1/2 of the interest for tax years beginning on or after January 1, 1995, and receive complete abatement of all similar assessments prior to 1995. The settlement period program began on July 1, 2004 and ended on November 1, 2004. Comptroller Schaefer was charged with administering the program. Under the settlement program, taxpayers could generally elect to have the intangible property management company pay tax on its income, or add back the deductions for royalties and interest.

The settlement period program was a "win" for many taxpayers and a double-edged sword for the State. By the end of the settlement period, the Comptroller’s Office received applications on behalf of 443 corporate entities. The number of combined entities was much smaller since some taxpayers had established a separate legal entity for each location in Maryland. The Comptroller approved $207,784,377 in settlement payments from the 443 applicants and $9,043,292 in refunds, resulting in a net amount of about $198 million for the State. Of the 443 settlement applications, most (259) related to taxpayers with cases either in Maryland Tax Court (76), in administrative appeal (17), or in audit (166). The remaining 184 related to cases new to the system (i.e., were generally not on the Comptroller’s radar screen). Due to losses from unrelated activities, some taxpayers electing the "add back" option were able to take advantage of the settlement program without having to make any payments. Of the 443 applications, 325 elected the "add back" alternative, 106 elected to pay tax at the intangible property management company level, and the remaining 18 claimed refunds.

The "cost" of the settlement program was rather high. Approximately $77 million in pre- 1995 assessments were abated. Since taxpayers could use existing losses to shield income under the "add back" option, approximately $75 million of post-1994 assessments were abated. Penalty and interest abated for post-1994 tax years was approximately $83 million. The Comptroller refunded more than $9 million. The foregoing amounts were either on the Comptroller’s books or reported on the settlement applications. The Comptroller has estimated that an additional $61 million attributable to unaudited pre-1995 liabilities was lost, bringing the cost to more than $306 million. Additional amounts attributable to post-1994 amended returns where no audit had been concluded were also likely lost.

As a result of the settlement program, every intangible property management company case in the Maryland Tax Court, with one exception, and every case in administrative appeals, has been dismissed. The Comptroller reports that all but a few of the cases that were under audit have also accepted the settlement. The Comptroller believes that the single case still pending at the Maryland Tax Court involves facts that are not dissimilar from those of SYL and Crown Cork & Seal, and so the Comptroller is reportedly "a little mystified" as to why the taxpayer did not accept the offer. The Comptroller believes that his claim will ultimately be upheld in that case. Comptroller Schaefer has warned that he will continue pursuing other intangible property management companies suspected of "tax avoidance" through audit, assessment, and appeal.

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