State Tax Return. Geoffrey Bagged In Oklahoma: Tax Commission Sets Its Scopes on Geoffrey's Income From Intangible Property And Hit The Target

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1 February 2006 Volume 13 Number 2 State Tax Return Geoffrey Bagged In Oklahoma: Tax Commission Sets Its Scopes on Geoffrey's Income From Intangible Property And Hit The Target Matthew J. Cristy Atlanta (404) Geoffrey, Inc. ("Geoffrey"), the Toys 'R' Us affiliate named after Toys 'R' Us's beloved mascot, Geoffrey Giraffe, that owns the Toys 'R' Us trademarks, service marks, and trade names (the Marks ), lost another battle in its ongoing nexus war with the states. Reminiscent of an earlier battle in South Carolina, Geoffrey recently lost a challenge by Oklahoma to tax its income from intangibles. Geoffrey, Inc. v. Tax Comm'n, No. 99,938, CCH (Okla. Civ. App. Dec. 23, 2005). Geoffrey's Marks are licensed to Toys 'R' Us and Kids 'R' Us stores in Oklahoma and other states in exchange for royalty fees. Following South Carolina's lead, 1 the Oklahoma Tax Commission ("Commission") issued an assessment to Geoffrey for corporate income tax and interest based on Geoffrey's royalties from Oklahoma stores. Geoffrey challenged the assessment, claiming (in part) that it did not have the requisite "substantial nexus" to be taxed by Oklahoma. In 1993, Geoffrey lost a similar case before the Supreme Court of South Carolina. South Carolina's highest court found Geoffrey had substantial nexus with South Carolina because it licensed intangibles in the state and derived income from that licensing. Geoffrey recently relived its 13-year-old nightmare. The Oklahoma Court of Civil Appeals ("Court") found Geoffrey had substantial nexus with Oklahoma, despite the fact that "Geoffrey does not own or lease real or tangible personal property, maintain an office or have any employees or officers in the state of Oklahoma." Quoting the Commission's Final Order that was upheld, the Court ruled that "[t]he licensing of [Geoffrey's] Marks for use within Oklahoma's economic market for the purpose of generating substantial income for [Geoffrey], establishes sufficient nexus 1 Geoffrey, Inc. v. South Carolina Tax Comm'n, 313 S.C. 15, 437 S.E.2d 13 (S.C. 1993), cert. denied, 510 U.S. 992, 114 S. Ct. 550, 126 L. Ed. 2d 451 (1993). 1

2 between the royalty income and the legitimate interests of the State of Oklahoma and justifies the imposition of the state income tax." 2 The Court's Ruling On Physical Presence And Substantial Nexus As it had in South Carolina, Geoffrey argued that it did not have substantial nexus with Oklahoma sufficient to permit the state to impose its income tax because Geoffrey did not have physical presence in the state. Geoffrey's only connections with Oklahoma were the use of its intangible property in the state by its parent company, Toys 'R' Us, Inc., and the licensing income flowing from that use. Just as in South Carolina, Geoffrey sought to rely upon the U.S. Supreme Court's Quill 3 decision for the proposition that a taxpayer must have a physical presence in a state to have substantial nexus. The Quill Court, addressing North Dakota's imposition of use tax collection on a mail-order vendor with no physical presence in the state, reaffirmed its earlier holding in Bellas Hess 4 that physical presence is required for a state to impose use tax collection liability. The Oklahoma Court of Civil Appeals refused to apply the Quill Court's holding to income taxes, writing that "[w]e do not agree with Geoffrey's interpretation that Quill expanded the Bellas Hess bright-line, physical presence requirement for use and sales taxes to all types of taxes." 5 The South Carolina case came back to haunt Geoffrey in a couple of ways. First, Geoffrey cited six cases to support its claim that most states that have dealt with the issue have applied Quill's physical presence requirement. Unfortunately, one of those cases from the New Jersey Tax Court was later reversed by the New Jersey Superior Court, which relied upon, among other decisions, the South Carolina Geoffrey case. 6 Second, the Oklahoma Court also relied heavily upon the South Carolina case, quoting liberally from it. The Oklahoma Court examined the analysis of the New Jersey Superior Court Lanco decision and found three alleged reasons not to read Quill as requiring physical presence for income tax purposes. 7 Lanco's analysis, in turn, had relied upon the analysis in A&F Trademark 8 and the Oklahoma Court quoted from A&F Trademark as follows: 2 Geoffrey, Inc. v. Tax Comm'n, No. 99,938, CCH (Okla. Civ. App. Dec. 23, 2005) (quoting the Commission's Final Order, which adopted the administrative law judge's Findings of Fact, Conclusions of Law and Recommendations without modification). 3 Quill Corp. v. North Dakota, 504 U.S. 298 (1992). 4 Nat'l Bellas Hess, Inc. v. Dep't of Revenue, 386 U.S. 753 (1967). 5 Geoffrey, No. 99,938, CCH We assume the Superior Court decision, issued Aug. 24, 2005, was released after the parties in the Oklahoma Geoffrey case submitted their briefs. The Court stated that the other cases cited by Geoffrey also did not apply because they involved a use tax, were decided on grounds other than the Commerce Clause, or were reversed by a higher court. 7 See Lanco, Inc. v. Director, Div. of Taxation, 379 N.J. Super. 562, 869 A.2d 1234 (N.J. Super. Ct. App. Div. 2003). 8 A&F Trademark, Inc. v. Tolson, 605 S.E.2d 187 (N.C. Ct. App. 2004). 2

3 First, the tone in the Quill opinion hardly indicates a sweeping endorsement of the [Bellas Hess] bright-line test it preserved, and the Supreme Court's hesitancy to embrace the test certainly counsels against expansion of it.... Second, retention of the Bellas Hess test was grounded, in no small part, on the principle of stare decisis and the "substantial reliance" on the physical-presence test, which had "become part of the basic framework of a sizable industry." Neither consideration advocates for the position adopted by the taxpayers in the present case.... Third, there are important distinctions between sales and use taxes and income and franchise taxes "that makes the physical presence test of the vendor use tax collection cases inappropriate as a nexus test." "The use tax collection cases were based on the vendor's activities in the state, whereas" the income and franchise taxes in the instant case are based solely on "the use of [the taxpayer's ] property in th[is] state by the licensee[s]" and not on any activity by the taxpayers in this State."... Since the tax at issue in this case is not based on the taxpayer's activity in North Carolina, but rather on the taxpayers' receipt of income from the use of the taxpayers' property in this State by a commonly-owned third party, "it would [be] inappropriate and, indeed, anomalous... [to determine] nexus by [the taxpayers'] activities or [their] physical presence in North Carolina. 9 The A&F Trademark Court, quoted by the Oklahoma Court of Civil Appeals, also tried to suggest that physical presence is not required for a state's imposition of income tax because an income tax is less burdensome than a sales tax collection responsibility since an income tax is only paid once a year to one taxing jurisdiction at a single rate. Having dismissed the physical presence test mandated by the High Court in Quill and other cases, the Oklahoma Court added: [W]e further agree with the [South Carolina] Geoffrey Court's benefits analysis and conclude, in this case, that (1) the real source of Geoffrey's income is not a paper agreement, but the Oklahoma customers of Toys[ 'R' Us], Inc., (2) by providing an orderly society in which Toys[ 'R' Us], Inc. conducts business, Oklahoma has made it possible for Geoffrey to earn income pursuant to its licensing agreement, (3) Geoffrey has received protection, benefits, and opportunities from Oklahoma as manifested by the fact that it earns income in this State, and (4) the tax is rationally related to these protections, benefits, and opportunities 9 Id. at (cites omitted and emphasis added in the original). 3

4 because only that portion of Geoffrey's income generated from the use of its intangibles within Oklahoma is being taxed. 10 Notably, the Oklahoma Court failed to cite a single decision by the U.S. Supreme Court as authority for its holding that the "benefits analysis" is the proper analysis. The Court's Ruling On Allocation Versus Apportionment Geoffrey argued its royalty income should be allocated to Delaware, the state of its commercial domicile, as opposed to being apportioned. Oklahoma statutes generally provide income from intangible personal property will be allocated to the situs of the owner's domicile. However, the statutes also provide that income derived from a unitary business enterprise, including income derived from patents and copyright royalties, must be apportioned to Oklahoma, and the Commission found Geoffrey was engaged in a unitary business. According to the Court, Geoffrey denied it was engaged in a unitary business for the first time in briefs before the Court and did not raise the issue before the administrative law judge, despite the fact that the Commission raised the issue "numerous times below." 11 In its appellate brief, Geoffrey's arguments were limited to two conclusory statements that the Commission's conclusion was "without factual support" and was in error. Geoffrey had the burden to show error in the Commission's assessment. Because Geoffrey failed to affirmatively demonstrate the Commission's error, the Court upheld the Commission's decision to apportion Geoffrey's income. The Commission also applied a "modified one-factor apportionment formula" to Geoffrey instead of the standard statutory three-part apportionment formula based on a taxpayer's property, payroll, and sales. The opinion gives no indication that Geoffrey challenged application of the single-factor apportionment formula. Generally, companies engaged in interstate commerce will benefit from the three-part formula and should argue strenuously, if need be, for the standard formula to be applied. The Court's Ruling On The Due Process Argument The Court rejected Geoffrey's argument that imposing the Oklahoma corporate income tax upon the company violated its right to due process under the U.S. Constitution, reasoning that: [T]he Quill Court determined that, for imposition of a duty to collect use taxes on an out-of-state mail-order vendor, it is sufficient for due process purposes that the vendor 'purposefully directed' its activities at residents of the taxing state.... Geoffrey argues that it did not purposefully direct 10 Geoffrey, No. 99,938, CCH Id. 4

5 Commentary its activities at residents of Oklahoma and that its licensing activities were only directed to Toys[ 'R' Us], Inc.... ["]Geoffrey has not been unwillingly brought into contact with South Carolina through the unilateral activity of an independent party.... By electing to license its trademarks and trade names for use by Toys R Us in many states, Geoffrey contemplated and purposefully sought the benefit of economic contact with those states. Geoffrey has been aware of, consented to, and benefited from Toys R Us's use of Geoffrey's intangibles in South Carolina. Moreover, Geoffrey had the ability to control its contact with South Carolina by prohibiting the use of its intangibles here as it did with other states.["] 12 The Court aligned itself with several other state courts by holding that the physical presence test set forth in Quill applies only to sales and use tax, notwithstanding the U.S. Supreme Court's guidance to the contrary. The Court's holding that the Oklahoma corporate income tax is immune from the requirements of the physical presence test articulated by the Supreme Court in Quill because the tax is not a sales and use tax is questionable at best. The same Commerce Clause governs all state taxes, so the same rule should apply to them all. In Complete Auto, 13 the seminal case on whether a state tax violates the Commerce Clause, the Supreme Court established a four-part test for determining if any state tax violates the Commerce Clause. One of the four parts of the test prevents states from imposing a tax unless "the tax is applied to an activity with a substantial nexus with the taxing State." 14 In Quill, the Supreme Court considered its prior holding in Bellas Hess that state taxes imposed against an out-of-state corporation without any substantial physical presence in the taxing state violated the U.S. Constitution. 15 The Supreme Court affirmed its holding in Bellas Hess and held that a corporation without physical presence in the taxing state lacks substantial nexus to be taxed under the Commerce Clause as interpreted by Complete Auto. 16 Taken together, Complete Auto, 12 Id. (quoting Geoffrey, Inc. v. South Carolina Tax Comm'n, 437 S.E.2d 13, 16 (S.C. 1993)). 13 Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977). 14 Id. at See Bellas Hess, 386 U.S. at 758 ("In order to uphold the power of Illinois to impose use tax burdens on National in this case, we would have to repudiate totally the sharp distinction which these and other decisions have drawn between mail order sellers with retail outlets, solicitors, or property within a State, and those who do no more than communicate with customers in the State by mail or common carrier as part of a general interstate business. But this basic distinction, which until now has been generally recognized by the state taxing authorities, is a valid one, and we decline to obliterate it.") (internal footnotes omitted). 16 See Quill, 504 U.S. at 311 ("While contemporary Commerce Clause jurisprudence might not dictate the same result were the issue to arise for the first time today, Bellas Hess is not inconsistent with Complete Auto and our recent cases. Under Complete Auto's four-part test, we will sustain a tax against a Commerce Clause challenge so long as the 'tax 1. is applied to an activity with a substantial nexus with the taxing State, 2. is fairly apportioned, 3. does not discriminate against interstate commerce, and 4. is 5

6 Bellas Hess, and Quill suggest that any state tax violates the Commerce Clause unless it applies to an activity with a substantial, physical presence in the taxing state. The Oklahoma Court of Civil Appeals failed to recognize the correlation between the holdings in Complete Auto, Bellas Hess, and Quill. Instead, the Court briefly focused its opinion on certain language in Quill relating to other taxes. Then it blindly followed the rationale set forth in Lanco, relying almost exclusively on analysis quoted directly from the Lanco decision, while ignoring the vast precedent that had already been established by the U.S. Supreme Court (Quill, Bellas Hess, Complete Auto, etc.). Unfortunately, the Court's blind reliance on the decision of another state's court appears to be a recent, disappointing trend when addressing the issue of Quill's physical presence requirement. The language that the Court quoted from Lanco, and upon which the Court relied so heavily, had been previously borrowed by the Lanco court from A&F Trademark, Inc., 17 a North Carolina Court of Appeals case. The Lanco case also relied heavily on the Geoffrey decision in South Carolina. The Oklahoma Court gave short shrift to a Texas case, Rylander v. Bandag Licensing Corp., 18 which was cited by Geoffrey. In Bandag, the Texas Court of Appeals, under the Commerce Clause, struck down the Texas franchise tax as applied to a taxpayer who lacked a physical presence in the state. The Oklahoma Court of Civil Appeals stated that the Bandag Court did not address whether physical presence was required. The Bandag Court actually did address whether physical presence was required in the context of taxation of royalty income from the licensing of intangibles. The Bandag Court found that physical presence was required. The income that the Texas Comptroller sought to tax (under the franchise tax) included royalties for the use of a patent in Texas. The Bandag Court limited its consideration to whether the mere possession of a certificate of authority to do business constituted "substantial nexus" because neither the Comptroller nor the Texas Attorney General had the audacity to assert that the Geoffrey decision from South Carolina passed constitutional muster. The Texas Comptroller had in fact rejected the "theories" for asserting nexus with a non-resident taxpayer to which the South Carolina Court in Geoffrey paid lip service. In fact, an official with the Texas Comptroller's Tax Policy section conceded under oath that licensing intangibles to another corporation for use in Texas does not create nexus with Texas. Maybe the Oklahoma Supreme Court will set the record straight. (continued ) fairly related to the services provided by the State.' 430 U.S., at 279. Bellas Hess concerns the first of these tests, and stands for the proposition that a vendor whose only contacts with the taxing State are by mail or common carrier lacks the 'substantial nexus' required by the Commerce Clause.") (emphasis added). 17 A&F Trademark, Inc. v. Tolson, 605 S.E.2d 187 (N.C. App. 2004), cert. denied, 126 S. Ct. 353 (2005). 18 Rylander v. Bandag Licensing Corp., 18 S.W.3d 296 (Tex. App. Austin 2000, pet. denied). 6

7 Lessons To Be Learned Direct targeting of intangible holding companies The states reaching for the income of out-of-state intangible holding companies are not only growing in number, but, at least in Oklahoma, are extending their reach beyond the pockets of affiliates physically present in the state and reaching directly into the pockets of the intangible holding companies themselves, despite the fact that the companies have no physical presence in the state. Comprehensive constitutional arguments A strong argument can be made that these cases are wrongly decided and violate the Commerce Clause. As the number of negative decisions grows, it becomes increasingly important for taxpayers to marshal all the Supreme Court precedent and Commerce Clause arguments, even at the earliest stages of a state assessment. If a case goes to court, a taxpayer should be prepared to attack the decisions in other states because the state courts rely heavily upon each other's decisions rather than upon Supreme Court precedent. Unfavorable apportionment rules In these types of cases, it is generally a good idea to argue the appropriate apportionment formula to use (in addition to arguing the nexus issue). Taxpayer's should be aware that tax department's often assert the most aggressive apportionment method when seeking to improve a controversial tax. Unitary business In these types of cases, if the taxing department raises the unitary business issue, taxpayers should be prepared to put forth any arguments that the intangible holding company and the affiliate operating in the state are not engaged in a unitary business. States have broad discretion in determining rules for apportionment, but they must be fair. This article is reprinted from the State Tax Return, a Jones Day monthly newsletter reporting on recent developments in state and local tax. Requests for a subscription to the State Tax Return or permission to reproduce this publication, in whole or in part, or comments and suggestions should be sent to Susan Ervien (214/ or shervien@jonesday.com) in Jones Day s Dallas Office, 2727 N. Harwood, Dallas, Texas Jones Day All Rights Reserved. No portion of the article may be reproduced or used without express permission. Because of its generality, the information contained herein should not be construed as legal advice on any specific facts and circumstances. The contents are intended for general information purposes only. 7