August 2007 Bulletin New Jersey Tax Court: No Reasonable Cause for IHC to Not File Returns

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1 August 2007 Bulletin New Jersey Tax Court: No Reasonable Cause for IHC to Not File Returns If you have questions or would like additional information on the material covered in this Bulletin, please contact one of the authors: Kyle O. Sollie David J. Gutowski Kenneth R. Levine or the Reed Smith attorney with whom you regularly work. The text of this Bulletin was previously published in substantially the same form in the Aug. 27, 2007 edition of State Tax Notes (reprint permission granted). This bulletin is presented for informational purposes and is not intended to constitute legal advice. Reed Smith LLP All Rights Reserved. Reed Smith refers to Reed Smith LLP, a limited liability partnership formed in the state of Delaware. On June 18, the U.S. Supreme Court denied certiorari in Lanco, Inc. v. Director, Div. of Taxation. 1 As a result, the law in New Jersey is that an intangible holding company ( IHC ) licensing trademarks into New Jersey is subject to corporate income tax regardless of whether it has any physical presence. Now, a recent New Jersey Tax Court decision, Praxair Technology, Inc. v. Director, Div. of Taxation, 2 extends Lanco to a new set of facts and extends the look-back period farther than the look-back under Lanco. More ominously, the Tax Court held that 25 percent failureto-file penalties should be imposed and that the 5 percent amnesty penalty was not unconstitutional. (The Praxair decision is an unpublished letter opinion; it is available at Earning Patent Royalties Creates Nexus Praxair Technology, Inc. ( PTI ) is an intangible holding company that licensed intangibles to an affiliated operating company. Unlike Lanco, which licensed trademarks, PTI licensed patents and trade secrets. PTI s licensed technologies were used by the affiliate to manufacture industrial gases at various facilities, including facilities in New Jersey. Notwithstanding these factual differences, the Praxair court concluded that it both agrees with and is currently bound by the higher New Jersey Court s holding in Lanco. 3 The Division Can Look Back Before 1996 For IHCs with holding companies, 1996 was considered an important year: That was the year in which the Division amended its nexus regulation to add an example providing that a royalty-earning IHC had nexus by earning trademark royalties related to sales of products by an affiliate in New Jersey. 4 Because of that amendment, many practitioners had thought that the Division would go no earlier than 1996 in its assessments. Indeed, the Tax Court in Lanco implied this. In Lanco, the only tax year at issue was Nevertheless, the Tax Court in Lanco said that it would be problematical to apply a no-physical-presence rule to years before In its view, several New Jersey cases that pre-dated the regulatory change had based nexus on physical presence so the regulation reflect[ed] a change in applicable law. 6 Further, the Lanco Tax Court recognized the reliance interests of taxpayers since New Jersey had precedent that suggested that physical presence was required. 7 Based on this dicta in the Tax Court s Lanco opinion, many taxpayers thought that IHCs were taxable only back to The Praxair decision, however, directly dealt with years before (In Praxair, the tax years included 1994 and 1995.) The Praxair court rejected the Tax Court s view in Lanco on the pre years. 8 The Praxair court concluded that the addition of the example in the regulation did not represent a change of policy. NEW YORK LONDON CHICAGO PARIS LOS ANGELES WASHINGTON, D.C. SAN FRANCISCO PHILADELPHIA PITTSBURGH OAKLAND MUNICH ABU DHABI PRINCETON N. VIRGINIA WILMINGTON BIRMINGHAM DUBAI CENTURY CITY RICHMOND GREECE r e e d s m i t h. c o m

2 Rather, the court concluded that the example merely clarifie[d] and explain[ed] the statute, 9 under that statute, which had been enacted in 1973, 10 Praxair was subject to tax. The Praxair Court Sustains 25 Percent Failure-to-File Penalty New Jersey imposes a 25 percent late-filing penalty. 11 The Director has discretion to waive the penalty [i]f the failure to pay any such tax when due is explained to the satisfaction of the director. 12 The standard to waive the penalty is a reasonable cause for delay which clearly indicates an absence of willful neglect. 13 In 1994, there was no regulatory guidance concerning nexus for IHCs. The Division may have asserted a nophysical-presence rule as an audit position, 14 but this policy was not widely publicized. The first decision of a state court of last resort involving an IHC and nexus was Geoffrey, which was decided in Back then, the decision in Geoffrey was considered by many to be ground-breaking. 16 Nonetheless, the court in Praxair determined that PTI had no reasonable cause to not file returns for the years in question. 17 The court stated that it was not reasonable for a sophisticated taxpayer such as PTI to fail to recognize the distinction between the established law regarding sales tax from Quill and before, and established law regarding income tax from the New Jersey statute. 18 The court s conclusion on this point is difficult to understand. Even the New Jersey Supreme Court, which ruled against Lanco, recognized that a split of authority has developed regarding whether the Supreme Court s holding [in Quill] was limited to sales and use taxes. 19 And only one year after the Division issued its assessment of PTI, the New Jersey Tax Court itself (in a decision by Judge Pizzuto) concluded in Lanco that physical presence was required for income tax nexus. 20 Yet, somehow, the court concluded that PTI s non-filing position was not reasonably plausible. 21 The Praxair Court Sustains 5 Percent Amnesty Penalty In addition to the 25 percent failure-to-file penalty, PTI was subject to a 5 percent amnesty penalty. In spring 2002, New Jersey established a tax amnesty under which taxpayers could come forward and pay any tax owed without interest, costs, or penalty. 22 Taxpayers that participated, however, relinquished all administrative and judicial rights of appeal. 23 Taxpayers that did not come forward, such as PTI, were subject to an additional, unwaivable 5 percent penalty for the amnesty period. 24 PTI argued that the amnesty program put it in a situation that was untenable: It must participate in order to avoid the 5 percent penalty, but if it participates, it must relinquish its appeal rights. 25 PTI argued that this Catch-22 violated its due process rights. The Tax Court disagreed with PTI, 26 and also disposed of PTI s manifestly unjust argument without any satisfying analysis. 27 Significance of Decision The Praxair decision is significant to any company that has (or had) an IHC licensing intangibles into New Jersey but that did not file a return. Some taxpayers may have hoped to distinguish Lanco on its facts. Lanco licensed trademarks to an affiliate that sold consumer products through retail stores. PTI, by contrast, licensed patents to an affiliate conducting an industrial-products business. The court s decision in Praxair, however, suggests that Lanco will be applied broadly by the courts. Therefore, taxpayers should not expect to successfully distinguish their IHC from Lanco based on factual differences. Second, taxpayers should expect the Division to assert nexus to the date their IHC was formed. Third, taxpayers should expect little sympathy from the Division or the courts regarding penalty abatement. Although Praxair may not reflect the view of all Tax Court judges, based on the oral arguments in Lanco it seems that most appellate judges view IHCs with suspicion

3 FIN 48, Interest, and the Throwout Rule The court s decision that physical presence is not required for income tax nexus even for periods before the Division s 1996 regulation may cause companies to re-evaluate their nexus exposure for purposes of FIN In general, under FIN 48, if you haven t filed a return, your nexus exposure never goes away. 30 Further, you will need to continue increasing your reserve to account for interest. New Jersey s interest rate is three percentage points above prime and is compounded annually, 31 so interest can quickly add up. (For example, the interest at issue for the period in Praxair is greater than the tax itself.) Meanwhile, IHCs continue to struggle with how to compute their tax for periods after 2001, when New Jersey s throwout rule went into effect. Under the Division s view, if a taxpayer isn t filing a return in a state, any sales sourced to that state are excluded from the sales-fraction denominator. 32 The Division also excludes intercompany sales that are sourced to a unitary-combined state in which those sales are eliminated. 33 IHCs typically have only intercompany sales and do not file separate-company returns in many (if any) states. Therefore, under throwout, an IHC s New Jersey sales fraction can be as great as 100 percent. Even though New Jersey, since 2002, has disallowed a deduction for most intercompany royalty expenses, 34 this has not stopped the Division from asserting nexus over IHCs. In fact, because of throwout, some IHCs have received assessments in the tens of millions of dollars. The throwout rule is being challenged in General Engines and Pfizer. 35 These cases, which will be heard by the Tax Court together, do not involve IHCs. The only issue currently before the court is whether throwout is unconstitutional on its face. Now, a third taxpayer, Whirlpool Properties, Inc., 36 was just ordered to brief this issue and will argue this issue before the same judge and at the same time as General Engines and Pfizer. Unlike those taxpayers, however, Whirlpool Properties is an IHC. Oral argument will not be heard before November and a final decision on throwout could be years away. In the meantime, your IHC is vulnerable to audit. What Are the Options? For now, many taxpayers are taking no action and hoping that the Tax Court agrees that some relief on throwout is required. But regardless of what happens to throwout, most royalty-earning IHCs will have a difficult, if not impossible, time establishing that they do not have nexus. So for many companies, the best case scenario is that they will pay tax based on their three-factor apportionment percentage computed without throwout. The problem is that the affiliated operating company was already required to add back any royalties paid to the IHC. Although there is an exception if the IHC files a return in New Jersey, 37 the statute of limitations is only four years. 38 Therefore, for most calendar-year taxpayers that filed their original return on extension, the deadline for filing an amended return for 2002 (the first year with throwout and addback) is this October 15. If your IHC is assessed after that date, the operating company won t be able to file an amended return claiming an addback exception. In other words, even if the court completely strikes down throwout, your company will pay tax twice on the same royalty stream (once at the IHC level on the income and again at the operating company level because of the expense disallowance). Therefore, a taxpayer with an IHC may want to consider coming forward now, before a decision on throwout and before the statute of limitations begins to expire for the addback years. Under New Jersey s voluntary disclosure program, taxpayers can come forward anonymously and the Division typically agrees to cut-off some back years and abate some penalties. 39 Even more importantly, as part of a voluntary disclosure, an IHC may be able to negotiate an alternative apportionment method (under the Division s so called section 8 authority 40 ) to avoid full throwout. The Division has been willing to negotiate section 8 agreements with IHCs since throwout came into effect. History has shown, however, that these agreements have gotten worse each time the Division prevails in litigation. (For example, IHCs paid much more tax under agreements entered into after the Division prevailed at the Appellate Division in Lanco than before that decision. 41 ) Therefore, if the Division prevails in - 3 -

4 Tax Court on the facial constitutional challenge to throwout, it is likely that the Division will revisit its section 8 standards to penalize IHCs that failed to come forward sooner. In summary, the Praxair decision is bad news for taxpayers with IHCs. If upheld, it would close the door on an IHC taking a no-nexus position based on factual distinctions from Lanco. It also empowers the Division to assess an IHC all the way back to its formation date and may encourage the Division not to abate penalties. IHCs should consider coming forward now under New Jersey s voluntary disclosure program. They can do this anonymously and will have the best chance of cutting off some back years, and avoiding full throwout and penalties. This could significantly reduce your liability and allow you to resolve your FIN 48 exposure. * * * * * * Reed Smith is a top-15 global relationship law firm with more than 1,500 lawyers in 21 offices throughout the United States, the United Kingdom, Europe and the Middle East. Founded in 1877, the firm represents leading international businesses from Fortune 100 corporations to mid-market and emerging enterprises. Its corporate attorneys provide representation to both issuers and investors with respect to all types of equity and debt securities transactions made at all stages of a company s development cycle. Reed Smith is a preeminent advisor to industries including financial services, life sciences, health care, advertising and media, shipping, international trade and commodities, real estate, and education. For more information, visit reedsmith.com N.J. 380 (2006), cert. denied, 127 S.Ct. 2974, 75 USLW 3500, 75 USLW 3676, 75 USLW 3677 (2007). N.J. Tax Court, Docket No (June 18, 2007). PTI has appealed this decision to the Superior Court of New Jersey, Appellate Division (Docket No. A T5). Praxair at N.J. Reg. 4795(a). Lanco, Inc. v. Director, Div. of Taxation, 21 N.J. Tax 200, 217 (Tax 2003). Lanco, 21 N.J. Tax at 218. Lanco, 21 N.J. Tax at 218. Praxair was heard by a different judge than heard Lanco. There are currently six judges that serve on the New Jersey Tax Court Lanco was heard by Judge Pizzuto and Praxair was heard by Judge Hayser. Praxair at 10. See L.1973, c. 95, 1. N.J.S.A. 54:49-4. N.J.S.A. 54:49-11(a). N.J.A.C. 18: See 28 N.J. Reg. 4795(a) (stating that the Division has taken this audit position for some time ). Geoffrey, Inc. v. South Carolina Tax Comm n, 313 S.C. 15 (1993). See, e.g., 3 Journal of Multistate Taxation and Incentives 147 (Sept. / Oct. 1993) ( This opinion extends nexus significantly beyond where most authorities thought it to be. ) Praxair at 12. Praxair at 13. As noted by the Tax Court, the United States Supreme Court has recognized a bright-line physical presence test for sales and use taxes but not for other types of taxes. Praxair at 4 5, citing Quill Corp. v. North Dakota, 504 U.S. 298, 317 (1992). Lanco, 188 N.J. 380, 382 (2006). Lanco, 21 N.J. Tax 200, 214. Praxair at 11, n

5 N.J.S.A. 54:53-18.a. N.J.S.A. 54:53-18.c. N.J.S.A. 54:53-18.b. Praxair at 14. Praxair at Praxair at 14, n.13. For example, at the Lanco New Jersey Supreme Court oral argument, Justice Barry T. Albin referred to IHC arrangements as gimmickry and stated that something s wrong with allowing taxpayers to reduce their New Jersey tax through such structures. A transcript of the oral argument is available at Accounting for Uncertainty in Income Taxes, FASB Interpretation No. 48 (Financial Accounting Standards Board 2006) ( FIN 48 ). FIN 48 at A15. N.J.S.A. 54:49-3. See New Jersey Division of Taxation, Instructions for Corporation Business Tax Return Form CBT-100. N.J.A.C. 18:7-8.7(d). N.J.S.A. 54:10A-4.4(b). General Engines Company, Inc. v. Director, Div. of Taxation, Tax Court Docket No and Pfizer, Inc. v. Director, Div. of Taxation, Tax Court Docket No See Whirlpool Properties, Inc. v. Director, Div. of Taxation, Tax Court Docket No N.J.A.C. 18:7-5.18(b)(3). N.J.S.A. 54:49-14(a). See New Jersey Division of Taxation, Voluntary Disclosure Program, available at See N.J.S.A. 54:10A-8. See Kyle Sollie, David Gutowski, and Kenneth Levine, Lanco, Throwout, and FIN 48 Pose Multiple Headaches For Passive Investment Companies in New Jersey, BNA Tax Management Weekly State Tax Report (Jan. 26, 2007), available at: