United States: Trademark Holding Companies are Subject to North Carolina Franchise and Income Taxes

In a decision that establishes the economic nexus principle as the basis for the imposition of tax in North Carolina, the North Carolina Court of Appeals affirmed income and franchise tax assessments against several Delaware trademark holding companies for royalty and interest payments they received from retail companies operating in North Carolina. A&F Trademark, Inc. v. Tolson, 605 S.E.2d 187 (N.C. Ct. App. 2004). 2004 N.C. App. (LEXIS 2162)

The Limited, Inc. ("the Limited") engages in the sale of men’s, women’s and children’s clothing and accessories through separate retail operating subsidiaries doing business across the United States. Nine of these retail subsidiaries (the "Retail Companies") operated in North Carolina at over 130 locations. During the 1980s and early 1990s, the Limited incorporated retail trademark holding companies in Delaware (the "Taxpayers"), and each one was assigned certain trademarks.

After the trademarks were assigned, the Taxpayers entered into agreements with the Retail Companies to license them the trademarks. Each licensing agreement required the Retail Company to pay the Taxpayer, as licensor, a royalty payment of five to six percent of its retail operating gross sales. The Taxpayers also entered into agreements loaning any excess operating funds back to the Retail Companies in the form of notes receivable bearing a market rate of interest. Under the licensing and loan agreements, the Retail Companies paid the Taxpayers $301,067,619 in royalties and $122,031,344 in interest in 1994, accounting for 100% of the Taxpayers’ income for that year. The Retail Companies deducted these royalty and interest expenses for tax purposes.

The Taxpayers have no employees in North Carolina and do not own or lease real property or tangible personal property in the State. The Taxpayers, therefore, did not file corporate franchise and income tax returns in North Carolina. As a result, the Secretary of Revenue issued the Taxpayers notices of proposed assessments for corporate franchise and income tax. The Taxpayers protested and, after an administrative hearing, the Secretary issued a final decision sustaining the proposed assessments without penalties. Subsequently, the Tax Review Board affirmed the final assessments. The Taxpayers appealed to the Wake County Superior Court, which upheld the decision of the Tax Review Board. The Taxpayers then appealed to the North Carolina Court of Appeals.

The Secretary of Revenue provided in Rule 5C.0102 that "doing business" in North Carolina means operating a business enterprise or activity in the State for economic gain, such as owning, renting, or operating income-producing property in North Carolina, including trademarks and tradenames.¹ The Taxpayers asserted that they were not "doing business" in North Carolina and that Rule 5C.0102 was an improper expansion of the State’s income tax laws. The Court of Appeals disagreed. According to the court, Rule 5C.0102 was consistent with North Carolina statutory law, not an improper expansion of it. The administrative rule, at all times, "properly reflected the policy of the General Assembly for income taxation of trademark royalty payments."² Accordingly, the Court held Rule 5C.0102 to be "directly applicable for income tax purposes to the taxpayers’ activities in North Carolina."³

North Carolina also imposes a franchise tax upon every corporation doing business in the state.⁴ For franchise tax purposes, doing business in North Carolina is defined as each and every "act, power, or privilege exercised or enjoyed in [North Carolina], as an incident to, or by virtue of the powers and privileges granted by the laws of [North Carolina]."⁵ The Taxpayers asserted that the franchise tax requires a quid pro quo where the business is subjected to the franchise tax in return for the State protecting and fostering the endeavor. The Taxpayers claimed there was no such exchange. The Court again disagreed and noted that the State protected North Carolina’s marketplace making it possible for the Taxpayers to earn income. By providing "an orderly society in which the related retail companies conduct business, North Carolina has made it possible for the taxpayers to earn income pursuant to the licensing agreements."⁶ As a result, the Court held the Taxpayers were subject to the franchise tax.

The Taxpayers made a second argument that the Commerce Clause prevents North Carolina from subjecting them to corporate franchise and income taxes because they lacked a physical presence in North Carolina. The Court, however, ruled that United States Supreme Court precedent does not require that a taxpayer be physically present in the State to be subject to corporate franchise and income taxes. The Court wrote:

The Taxpayers Are "Excluded Corporations" Providing only a brief explanation, the Court of Appeals also held that the Taxpayers were "dealing in" intangible property and were "excluded corporations." An "excluded corporation" was defined in North Carolina to be any corporation that received more than half of its ordinary income from "investments in" or "dealing in" intangible property.⁸ If the Taxpayers were excluded corporations, they were required to apportion their business income using the single-factor sales formula. Citing North Carolina decisional law, the Taxpayers argued that "investments and/or dealing in" trademarks did not include the activity of licensing trademarks. The Court rejected the argument holding that to "deal in" trademarks "encompasses the taxpayers’ activities with respect to the trademarks."⁹

Unfortunately for trademark holding companies, the North Carolina Court of Appeals has adopted an economic nexus principle for purposes of imposing corporate franchise and income taxes. The full consequences of this decision remain to be seen.