|December 18, 2008|
Previously published on November 2008
The Maryland Tax Court put a gloss on the Maryland Supreme Court’s SYL/Crown Cork decision in finding that two subsidiaries of a Maryland taxpayer were subject to Maryland Corporate Income Tax because the subsidiaries lacked economic substance—even though the subsidiaries conducted no business and maintained no tangible property in Maryland.
The Maryland Comptroller issued alternative Corporate Income Tax (“CIT”) assessments against Nordstrom Inc. (“Nordstrom”) and two of Nordstrom’s subsidiaries—NIHC, Inc. (“NIHC”) and N2HC, Inc. (“N2HC”). With respect to Nordstrom, the Comptroller denied Nordstrom’s deductions for royalty expenses it paid to N2HC for the years 2002–2004. The Comptroller also asserted that NIHC and N2HC were subject to CIT for 2002 and 2003 even though they did “no business in Maryland and own[ed] no tangible property in Maryland, but [were] subsidiaries of [Nordstrom] that [did] business in Maryland.”
NIHC and N2HC each filed Maryland CIT returns reflecting zero apportionment for the assessment years. Nordstrom also filed Maryland CIT returns reflecting the Maryland apportionment of its store and warehouse activities. The Comptroller agreed to withdraw its assessment against Nordstrom if the subsidiaries were found to have nexus, which was the case.
Nordstrom is a nationally known retailer that operates 150 stores in 27 states and operated four department stores, two discount stores and one distribution center in Maryland during the audit period. In 1996, Nordstrom formed NIHC and NTN, Inc. (“NTN”) and contributed to NIHC the right to license Nordstrom trademarks (“Marks”) beginning in February 1999, and contributed the Marks to NTN. In March 1997, Nordstrom formed N2HC and capitalized it with cash. At this time, Nordstrom also contributed the Marks to NTN. One month later, Nordstrom contributed NIHC and NTN to N2HC. Upon the advice of Nordstrom’s tax advisers (“so as to minimize potential state ‘Geoffrey’ assessments”),2 in 1999 NIHC dividended its right to license the Marks to N2HC. Pursuant to I.R.C. Section 311(b), this transaction caused: (a) NIHC to recognize a $185 million deferred intercompany gain in 1999 and each of the next succeeding 14 years; and (b) N2HC to recognize a concomitant amortization deduction.
Beginning in February 1999, N2HC licensed the Marks to Nordstrom for an annual royalty stream of approximately $200 million. Nordstrom’s accountants opined such rate was reasonable. N2HC lent approximately two-thirds of such amounts back to Nordstrom. The tax court opinion does not describe the terms of such loan nor does it state whether any third party opined whether such terms were at arm’s length.
Throughout the entire audit period, N2HC maintained an office in Oregon at which a full time intangible specialist paralegal resided. This N2HC employee notified N2HC of potential infringements of the Marks and also interfaced with N2HC’s outside trademark counsel to maintain the Marks and to bring actions to protect and enforce the Marks.
The Parties’ Positions
Nordstrom contended that unlike the taxpayer in Comptroller v. SYL, Inc. and Crown Cork & Seal Co. (Delaware), Inc.,3 N2HC was an economically viable business entity. SYL only employed part time officers from a “nexus-service” company, paid those employees a “miniscule” amount, rented an office that was a “mail drop,” and did nothing to maintain or protect its trademarks. On the other hand, N2HC maintained its own office in Oregon and employed a full time experienced paralegal who actively managed and registered the Marks and “who worked closely with outside trademark counsel to protect and enforce the Nordstrom Marks.” NIHC claimed that it was not subject to Maryland CIT because the I.R.C. Section 311(b) gain the Comptroller sought to tax resulted from the distribution of the license agreement to N2HC and “Nordstrom’s activity in Maryland had nothing to do with [that] gain.”
The Comptroller contended that the approximately $200 million of royalties that Nordstrom paid to N2HC, and the interest expense that was generated by lending a majority of those amounts back to Nordstrom, were not arm’s length market transactions. The Comptroller further asserted that because NIHC and N2HC lacked economic substance, that they should be disregarded.
The Maryland Tax Court’s Holding
In short, the tax court held that the subsidiaries had nexus with Maryland because they lacked substance and engaged in transactions with their parent, which did business in Maryland:
Nexus exists, independent of physical presence because interrelated activities of commonly owned and controlled corporations where a subsidiary corporation lacks economic substance as a separate business entity. [Because] NIHC and N2HC lack[ed] real economic substance as separate business entities[, the] entities of NIHC and N2HC must be considered as the activities of their parent, Nordstrom, and, as such, there are substantial activities in Maryland.
Therefore, the tax court imposed CIT on: (a) NIHC’s Section 311(b) gain; (b) the amount of N2HC’s royalty income (in excess of its amortization expense); and (c) the interest N2HC received from Nordstrom. In other words, the Maryland Tax Court effectively subjected to CIT the entire amount of royalties that Nordstrom paid to N2HC and the intercompany interest expense.
Blank Rome Observations
- It is curious that the Maryland Tax Court found that NIHC and N2HC were subject to CIT and ruled as to the calculation of their tax bases yet never addressed the manner in which these subsidiaries’ Maryland apportionment was to be calculated. The court’s failure to address this issue is all the more curious when one remembers that NIHC and N2HC filed Maryland CIT returns with zero apportionment. If the subsidiaries were to use Nordstrom’s Maryland apportionment factor, the effect would be to deny Nordstrom’s deduction of royalty and interest paid to its related parties. This result, however, does not make sense in light of Maryland adopting “add back” legislation beginning January 1, 2004, but could explain why the Maryland Comptroller limited its assessment of NIHC and N2HC to 2002 and 2003.
- The tax court based its reasoning, in part, on the fact that the royalties and interest Nordstrom paid to N2HC “were not arms length market transactions.” The court did not explain how this conclusion can be squared with the fact that Nordstrom’s accountants “performed an appraisal of the Nordstrom Marks...and estimated a reasonable royalty rate for the use of the Marks.”
- The court found that the ultimate tax result of the assignment of the licensing agreement and its subsequently being dividended had the same effect as the transfer and license back of trademarks in SYL, except that the structure of the transaction in Nordstrom was a “more complicated transaction [that] create[d] an illusion of substance.” This statement may be read to show that the Maryland Tax Court was not about to let anything deter it from recasting a transaction, the result of which it did not like. Further evidence of the results-oriented nature of the decision is that the tax court failed to mention that—in addition to the intellectual property benefits of segregating the Marks—Nordstrom segregated the Marks to achieve the non-income tax benefit of reducing personal property tax.
- This case represents the outer limits of a judicial body’s creativity in striking down what it perceived to be a distasteful tax avoidance strategy. The taxpayer may feel as if it is in the twilight zone of taxation because the court imposed tax liability on entities that it found to lack economic substance and on income generated by a transaction that the court did not dispute bore “no relation to Nordstrom’s use of Marks in its Maryland stores or any other activity conducted in Maryland.” We question whether the Comptroller will find the taxpayers’ seven digit payment as lacking substance.
- The court stated that the “activities of NIHC and N2HC must be considered as the activities of their parent, Nordstrom, and, as such, there are substantial activities in Maryland.” This statement puts the proverbial rabbit in the hat and must do so because it does not follow logically. The tax court attributed the income of NIHC and N2HC to Nordstrom not because those subsidiaries had activities in Maryland but because Nordstrom had activities in Maryland. This statement is all the more curious because the tax court never discussed whether an agency relationship existed between Nordstrom and its subsidiaries and never so much as alluded to unitary business principles or combined reporting. The tax court’s conclusion is reached through mystifying logic.
- In an October 27, 2008 press release, the Comptroller informed taxpayers of the level of financial success his efforts to aggressively pursue perceived tax avoidance strategies have borne. The Comptroller described this case as “the most recent victory for the Comptroller’s office in an aggressive effort to crack down on corporations avoiding taxes using Delaware Holding Company tax schemes and other tax avoidance strategies” and reported that “the Comptroller’s office has collected more than $267 million in taxes through Delaware Holding Company cases, and has an additional $143 million in outstanding assessments against corporations using this tax-avoidance system.” These statements confirm that—particularly in tough economic times—the intensity of the state’s litigation posture is directly proportional to the level of the stakes involved.
- It should be noted that the following description of the intercompany transactions reflects the Maryland Tax Court’s view of the steps the Nordstrom parties took, but differs significantly from the Statement of Facts contained in Petitioners’ Pretrial Memorandum of Law. While the two descriptions may differ significantly, the manner in which NIHC, N2HC, and Nordstrom reflected the result of their transactions on their federal and Maryland returns appears to be the same.
- The Tax Court decision neither mentions nor addresses that Petitioners’ Pretrial Memorandum of Law states that transferring the Marks to a separate legal entity “would [also] insulate the valuable Marks from potential Washington personal property taxation.”
- Comptroller v. SYL, Inc. and Crown Cork & Seal Co. (Delaware), Inc., 375 Maryland 78, cert. denied 504 U.S. 984 and 504 U.S. 1090 (2003).