by Roger Russell

Nexus, the connection between a state and a business that allows the state to impose its tax, is an issue that won’t go away as state legislatures and courts seek ways to prevent the loss of tax revenue.

The Maryland Court of Appeals has ruled that two Delaware corporations that do no business in Maryland and own no tangible property in Maryland, but are subsidiaries of parents that do business in Maryland, are subject to Maryland tax.

The two corporations, SYL Inc. and Crown Cork & Seal (Delaware) are subsidiaries of Syms Inc. and Crown Cork & Seal Co. Inc. Although the companies won at the state Tax Court and Circuit Court level, the Maryland Court of Appeals reversed. The court said that both businesses “had no real economic substance as separate business entities.” It pointed out that the subsidiaries had no full-time employees, provided virtually no services and “used offices in Delaware that were little more than mail drops.”

Since it found that the subsidiaries had no economic substance, the court held that a portion of SYL’s and Crown Delaware’s income, based on their parent corporations’ Maryland business, is subject to Maryland income tax.

A number of corporations have taken advantage of Delaware’s favorable intangible property laws by incorporating Delaware subsidiaries to hold and manage their trademarks, trade names and other intellectual property. The parent typically pays the subsidiary a royalty for use of the trademark, which it deducts from its income in the various states in which it pays income tax.

While states have the authority to impose tax, the commerce clause of the U.S. Constitution prohibits states from unduly burdening interstate commerce, and the due process clause requires a definite nexus, or connection between the taxpayer’s activities and the state, in order for the state to impose its tax.

“This is not an economic substance case,” said Morrison & Foerster attorney Paul Frankel, who tried the SYL case. “If SYL had no economic substance, it obviously could not be taxed. This is a nexus case.”

“There are cases pending all over the country on this issue,” Frankel continued. “It’s the hottest issue in the state tax world - whether you can tax someone without physical presence. We, therefore, intend to appeal the case to the U.S. Supreme Court.”

“The decision is poorly reasoned from several standpoints,” agreed co-counsel Harry Shapiro, of Baltimore-based Saul Ewing LLP.

“The Court of Appeals violated its standard of review. Normally, an appellate court will accept the facts of the lower court. In this case, the Tax Court heard testimony from a number of witnesses, there was a transcript of hundreds of pages and yet the appellate court decided to rewrite the facts as it would have found them,” Shapiro pointed out.

“Second, the court decided the case on a unitary tax principle, but Maryland is a state that requires separate reporting of returns of affiliates. There’s no consolidated reporting, so the only way they could have reached the decision was to have included the Delaware company’s income in calculating the taxable income of the company that did business in Maryland,” he said.

“The court’s finding that the company is a sham is directly contrary to the facts found by the Tax Court. There were significant non-tax reasons for the transactions to be structured this way, and both the Tax Court and the Circuit Court agreed,” said Shapiro.

The need for revenue is an important ingredient in the court’s decision, according to Shapiro. “Maryland and other states are in a budget crisis.”

“The legislature passed a comprehensive tax bill that included a section that would have denied the deduction for payments to the royalty company, but the governor vetoed it. So the Court of Appeals decided they would collect the tax anyway,” he explained.

“It’s not just an issue of trying to raise revenue,” said Harley Duncan, executive director of the Federation of Tax Administrators, a group representing the state tax agencies of 50 states. “This has become a common tax-planning technique that moves income from one state to another. The concern is that, when you allow this shifting of income, you shift the burden of the tax to other taxpayers.”

Maryland Comptroller William Donald Schaefer said that there are 38 similar cases pending in Maryland Tax Court, involving nearly $22.8 million in tax assessments, while hearings have been scheduled for 33 other cases involving holding companies with assessments totaling $11 million.

“These are just the tax liabilities we’re talking about - they don’t include interest and penalties, which could be significant,” he said.

Even though some courts have found a real business purpose in the intangible property holding company other than the shifting of income, said Duncan, “no one case settles the issue for any period of time because they are fact-intensive as to whether there is a business purpose or economic substance.”

George Farrah, director of state services for BNA Tax Management, agreed. “Everyone is looking to the courts to provide some level of certainty and define the principle of law better, but there will always be some level of subjectivity in determining whether or not a transaction is a sham.”

“It will always come down to a facts-and-circumstances test,” he said, “and it’s going to be unclear for both states and taxpayers to understand what factors are necessary in order to prove their case one way or the other.”

The Supreme Court has not taken very many state cases in this area, according to Farrah. “In the cases they took in prior years they have stopped short of providing a bright-line test. Even if they did there’s no indication they would provide a whole lot of clarity,” he said.

“What we’re left with is a decision like the Maryland court - look to the facts, and decide that a transaction does or does not lack economic substance. It’s not much of an aid to help other taxpayers structure a transaction,” Farrah lamented.

“The result of this decision is that the line has been pushed a little toward the state side,” he said. “Even though there may be a few factors that indicate that you’re a real corporation, it wasn’t enough here. You have to do more than just window dressing to not be found a sham.”

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