NIHC, Inc. v. Comptroller

NIHC, Inc. v. Comptroller of the Treasury
No. 63, September Term 2013
Taxation - Income Tax - Corporations - Tax Assessment of Subsidiary without
Economic Substance Separate from Parent Corporation on Income Shifted from Parent
to Subsidiary. In Comptroller v. SYL, Inc., 375 Md. 78, 825 A.2d 399 (2003), the Court of
Appeals held that a corporate subsidiary that lacked economic substance as a business entity
separate from its parent corporation had a sufficient nexus with Maryland such that its
income was taxable in Maryland to the same extent as the parent corporation’s income. In
the instant case, a parent corporation created several subsidiaries, which then engaged in a
series of transactions among themselves and with the parent corporation concerning licensing
rights to the parent corporation’s trademarks, the net effect of which was to shift part of the
parent’s income to the subsidiaries. The Comptroller assessed the subsidiaries for Maryland
income tax on the shifted income. Applying SYL, the Maryland Tax Court found that the
subsidiaries lacked economic substance separate from their parent corporation, that they had
a nexus with Maryland through the parent’s business activities, and that their income was
taxable in Maryland to the same extent as the parent corporation’s income. One of the
subsidiaries contested the assessment on the ground that it had mistakenly reported income
on its 2002 and 2003 Maryland tax returns – although it had apportioned none of that income
to Maryland – and, under a Maryland statute requiring the filing of separate corporate returns,
should have reported the income on its 1999 return, which was now outside the period of
limitations. The Tax Court rejected that argument. In the circumstances of this case, where
the Tax Court found that the income reported on the 2002 and 2003 returns of the subsidiary
related to activities of the parent corporation in Maryland during those tax years and that the
subsidiary lacked economic substance apart from its parent, and where the subsidiary had not
filed amended returns to reflect its new view of how it should have reported that income, the
Maryland requirement of separate corporate tax returns did not prohibit the Comptroller from
assessing a tax on the income reported on the subsidiary’s 2002 and 2003 Maryland tax
returns.
Circuit Court for Baltimore County
Case No. 03-C-10-9151
Argued: March 7, 2014
IN THE COURT OF APPEALS
OF MARYLAND
No. 63
September Term, 2013
NIHC, INC.
v.
COMPTROLLER OF THE TREASURY
Barbera, C.J.
Harrell
Battaglia
Greene
Adkins
McDonald
Watts,
JJ.
Opinion by McDonald, J.
Filed: August 18, 2014
Once upon a time, before the advent of the shot clock, some basketball teams
employed a maneuver known as the “four corners offense.” This strategy involved a series
of passes among team members that seemingly did not advance the ultimate purpose of
putting the ball in the hoop, but had the separate purpose of depriving the opposing team of
possession of the ball. In a somewhat analogous enterprise, corporate tax consultants devised
a strategy that involved a series of transactions passing licensing rights between related
corporations and that was motivated by a desire, not to directly enhance corporate profits, but
to keep a portion of those profits out of the hands of state tax collectors. Much as the shot
clock led to the demise of the four corners offense, judicial decisions during the past two
decades have limited the utility of this tax avoidance strategy.1
This case illustrates a variation on that theme. Nordstrom, Inc. (“Nordstrom”) created
several subsidiary corporations, including Petitioner NIHC, Inc. (“NIHC”), which then
engaged in a series of transactions with Nordstrom and with each other, involving the
licensing rights to Nordstrom’s trademarks. When the dust settled, the rights to use
Nordstrom’s trademarks ended up where they had begun – with Nordstrom. But Nordstrom’s
Maryland taxable income was significantly reduced. NIHC, although it had engaged in no
value-creating business activity itself, recognized a significant gain – putatively beyond the
reach of Maryland taxation – that was ultimately related to the reduction in Nordstrom’s
Maryland taxable income. From the perspective of the Respondent Comptroller, the
1
See, e.g., Comptroller v. SYL, Inc., 375 Md. 78, 825 A.2d 399, cert. denied, 540 U.S.
984 and 540 U.S. 1090 (2003); Geoffrey, Inc. v. South Carolina Tax Commission, 437 S.E.2d
13 (S.C.), cert. denied, 510 U.S. 992 (1993).
transactions appeared to be an effort to shift income from Nordstrom – where a portion of
it would be taxable by Maryland – to subsidiaries that arguably had no nexus to Maryland –
where the income would escape Maryland taxation. The Comptroller did not accept that
conclusion and issued tax assessments against the subsidiaries’ income. The Tax Court
concluded, and the Circuit Court and the Court of Special Appeals affirmed, that the
subsidiaries, including NIHC, lacked economic substance separate from Nordstrom and,
applying a recent decision of this Court, that their income had a nexus with Maryland through
Nordstrom’s business activities and was therefore taxable by Maryland.
There is an additional feature that makes this case distinctive: NIHC (actually,
Nordstrom, on behalf of NIHC) contends that it misunderstood the differences in the ways
in which corporations must file returns federally and in Maryland and that it made a mistake
in reporting income on its Maryland returns for 2002 and 2003 – a mistake which, it argues,
should absolve it from paying the assessed tax. In particular, federal law provides for the
filing of a consolidated return by related corporations while Maryland law requires the filing
of separate returns by related corporations. NIHC asserts that, under Maryland’s separate
reporting requirement, it should have reported – and thus paid Maryland income tax – on the
entire gain it recognized as a result of the transactions with Nordstrom and the other
subsidiaries in 1999, a tax year now outside the statute of limitations, and that it instead
mistakenly reported a portion of that income on its Maryland returns for the tax years in
question – tax years 2002 and 2003. The Tax Court held that the separate reporting
2
requirement in Maryland did not prohibit Maryland taxation of the income actually reported
on the 2002 and 2003 NIHC returns. The Circuit Court held otherwise, but the Court of
Special Appeals reversed.
We agree with the Court of Special Appeals that the decision of the Tax Court should
be upheld on judicial review. There appears to be no question that income recognized by
NIHC from these transactions has a connection to business activities of Nordstrom in
Maryland during 2002 and 2003, that a portion of that income was reported on NIHC’s
Maryland returns for 2002 and 2003 (which were never amended to reflect its current
theory), and that the income is taxable by Maryland. The fact that NIHC may have made a
series of mistakes in the preparation of its Maryland tax returns, as a result of transactions
apparently devised to avoid state taxation, does not entitle it to escape its tax liability on that
income.
Background
Corporate Family Portrait
The underlying facts are not in dispute. Nordstrom is a nationally known retailer with
its principal place of business in Seattle, Washington. During the time period relevant to this
3
case, it operated stores in 27 states, including Maryland.2 During that time, Nordstrom filed
consolidated federal income tax returns with its domestic subsidiary corporations.3
In the mid-1990s, Nordstrom decided to transfer its trademarks to a subsidiary for tax
purposes, according to a plan labeled the “anti-Geoffrey strategy” by its tax consultant.4 To
2
During that time, Nordstrom operated four department stores, two discount stores,
and one distribution center in Maryland.
3
The Internal Revenue Code permits an affiliated group of corporations, consisting
of a parent corporation and more than 80 percent-owned domestic subsidiaries, to file
consolidated returns. 26 U.S.C. §1504(a).
4
A representative of Nordstrom testified at the Tax Court hearing in this case that the
transfer was motivated by the company’s desire to avoid a personal property tax on
intangibles in Washington state that might be extended to its trademarks. Documents
admitted in evidence in the Tax Court indicated that the corporate structure and transactions
were also part of a strategy devised by Nordstrom’s tax consultant, Deloitte & Touche LLP,
to circumvent state court rulings that permitted states to tax the income of foreign
subsidiaries created with the purpose of holding intangible assets and shifting income beyond
reach of the tax collector. Deloitte & Touche referred to the plan as an “anti-Geoffrey
strategy” – a reference to a South Carolina Supreme Court decision that held that South
Carolina could tax royalties received by an out-of-state subsidiary holding the trademarks of
its parent. Geoffrey Inc. v. South Carolina Tax Commission, 437 S.E.2d 13 (S.C.), cert.
denied, 510 U.S. 992 (1993). In Geoffrey, the retailer Toys R Us created a second-tier
subsidiary (Geoffrey, Inc.), to which it transferred trademarks and trade names; the subsidiary
then licensed them back in return for royalties paid by the parent, which had the net effect
of shifting income from the parent to a subsidiary that arguably did no business in South
Carolina. The South Carolina Supreme Court held that the royalty income of Geoffrey, Inc.
had a nexus with South Carolina through the use of the trademarks in that state by Toys R
Us, and was subject to taxation in South Carolina without offending the Commerce Clause
or Due Process Clause of the federal constitution.
While the Nordstrom representative acknowledged that the company had carried out
the anti-Geoffrey strategy proposed by Deloitte & Touche, she insisted that the holding
company structure was motivated primarily by a desire to avoid the Washington state
personal property tax. In any event, there appears to be no dispute that the creation of the
(continued...)
4
carry out that plan, in late 1996, Nordstrom created subsidiary corporations called NTN, Inc.
(“NTN”) and NIHC, Inc. (“NIHC”) in Colorado; a few months later, in March 1997, it
created a third subsidiary in Colorado called N2HC, Inc. (“N2HC”). Nordstrom owned the
stock of all three subsidiaries.
During the relevant time period, all of the officers of NIHC and N2HC were officers
or employees of Nordstrom. Both corporations occupied rented office space in Portland,
Oregon, staffed by a paralegal employed by N2HC. The operating expenses of the affiliates
were relatively minimal. NIHC and N2HC had little income or expense other than that
related to the trademark transactions described below.
Passing the Trademark Rights around the Corporate Family
Nordstrom transferred its trademarks to NTN in March 1997, and NTN in turn gave
Nordstrom a license to continue to use the trademarks. In April 1997, Nordstrom transferred
its stock in NTN and NIHC to N2HC for cash. Thus, relevant to the discussion below,
N2HC became the sole shareholder of NIHC.
On January 31, 1999, the license agreement between NTN and Nordstrom was
terminated. NTN then entered into a license agreement with NIHC that granted NIHC a non-
exclusive license to use and sublicense the Nordstrom trademarks.5 On the same day, NIHC
4
(...continued)
subsidiaries and the ensuing inter-company transactions originated as an effort to avoid state
taxes, as opposed to an effort to enhance the retailer’s revenue or profits.
5
NTN eventually assigned the trademarks to NIHC in January 2001.
5
distributed to N2HC, its parent corporation, the license agreement with NTN. Thus, as of
the end of January 1999, N2HC had the right to license Nordstrom’s trademarks and the right
to any income generated through the exercise of that right.
The next day – February 1, 1999 – N2HC entered into a license agreement with
Nordstrom under which N2HC granted Nordstrom a license to use the trademarks for an
arms-length royalty.6 Nordstrom paid N2HC royalties during the relevant time period. For
the tax years 2002, and 2003, Nordstrom paid N2HC royalties in the amount of
$197,802,386, and $212,284,273, respectively.7 N2HC in turn made loans back to
Nordstrom in slightly lesser amounts during the same period.8
At the conclusion of these transactions, Nordstrom continued to have the right to use
the trademarks; the trademarks were the property of NIHC; and N2HC had the right to
license the trademarks and receive royalties from Nordstrom. During the relevant period,
trademarks were licensed only to Nordstrom, NIHC conducted no business other than owning
6
NIHC passed the right to license Nordstrom trademarks from NTN to N2HC on the
same day that it received the licensing right from NTN. NIHC did not directly license the
trademarks to Nordstrom or directly receive a royalty from Nordstrom.
7
Deloitte & Touche appraised the value of the trademarks and determined an
appropriate royalty rate to be paid by Nordstrom. As of October 31, 1998, the value of the
trademarks was determined to be approximately $2.8 billion. Deloitte & Touche did not
determine the value of the licensing agreements.
8
N2HC made loans back to Nordstrom of approximately two-thirds of the royalties
in each of those years, which Nordstrom used for operating capital. Nordstrom paid N2HC
interest, but paid back only small percentages of the principal of the loans. According to
testimony at the Tax Court hearing, N2HC did not make loans to other entities.
6
the trademarks, and both NIHC and N2HC had no earnings other than those resulting from
the transactions among the affiliates described above. The net effect was to shift income
from Nordstrom to the subsidiaries which, considered in isolation from their parent, had no
connection to Maryland.9
Accounting of the Trademark Transactions for Federal Tax Purposes
According to the analysis of Nordstrom’s tax consultant, under the federal tax code,
the distribution of the license agreement from NIHC to N2HC was considered the
distribution of appreciated property that would be recognized as a gain to NIHC under
§311(b) of the Internal Revenue Code, 26 U.S.C. §311(b).10 According to that analysis,
9
The Comptroller’s final determination letter later summarized the effect of these
transactions:
... These transactions ensured that licensing expenses were
incurred by Nordstrom and made payable to N2HC, an entity
operating outside of Maryland. By setting up NIHC, Nordstrom
indirectly created licensing expenses attributable to inter-
company intangible property transfers, where previously, none
would have existed. By doing so, a significant portion of
Nordstrom’s income was moved out of Maryland.
10
That statute states an exception to the general rule set forth in 26 U.S.C. §311(a) that
a corporation is not to recognize a gain or loss when it distributes stock or property to
shareholders. It provides in pertinent part:
(b) Distributions of Appreciated Property. –
(1) In General. – If –
(A) a corporation distributes property ... to a
shareholder in a distribution to which subpart A applies, and
(continued...)
7
NIHC was required under federal tax law to recognize a gain to the extent that the market
value of the licensing agreement exceeded the book value of the dividend.11 In addition, the
dividend created a basis in N2HC that was subject to amortization under federal tax law.12
Accordingly, Nordstrom was required to report the value of the distribution as a gain by
NIHC, as well as the amortization of N2HC’s basis, on Nordstrom’s consolidated federal tax
return for the fiscal year that ended on January 31, 1999.
As indicated above, Nordstrom filed a consolidated federal return with its subsidiaries,
including NIHC and N2HC. Under federal regulations relating to consolidated returns, the
gain from the license distributed by NIHC to N2HC was to be deferred over 15 years,13
10
(...continued)
(B) the fair market value of such property exceeds
its adjusted basis (in the hands of the distributing corporation),
then gain shall be recognized to the distributing corporation as
if such property were sold to the distributee at its fair market
value. ....
11
In footnotes to its brief, the Comptroller contends that Nordstrom and NIHC made
“improper use” of §311(b) and suggests that recognition of the gain at that time was not
mandatory under federal law. We need not resolve these questions of federal tax law to
decide this case.
12
See 26 U.S.C. §197.
13
See 26 CFR §1-1502-13. The 15-year period corresponded to N2HC’s amortization
of the value of the right to license the trademarks under 26 U.S.C. §197. This reporting of
income and amortization deduction in the consolidated return for the transaction between two
affiliates resulted in no income from the transaction for federal purposes.
8
because the transaction was between affiliated corporations.14 For example, for tax years
2002 and 2003, Nordstrom’s consolidated federal returns reported income to NIHC in the
amount of $186,133,333, and a deduction for amortization expense for N2HC in an identical
amount.
NIHC’s Maryland Tax Returns
Under Maryland law, a corporation is subject to tax on income derived from or
reasonably attributable to its business activities in Maryland. Maryland Code, Tax-General
Article (“TG”), §10-402. Any corporation with Maryland taxable income during a tax year
must file an income tax return for that year. TG §10-810. Each member of an affiliated
group of corporations is to file a separate income tax return. TG §10-811.
During the relevant years, NIHC and N2HC filed separate income tax returns in
Maryland that showed no income apportioned to Maryland from the transactions involving
the Nordstrom trademarks. In its Maryland returns for 2002 and 2003, NIHC reported the
deferred gain shown on the consolidated federal returns. In particular, NIHC reported
Maryland modified income of $186,240,824 and $186,128,851 for 2002 and 2003
respectively, but, as indicated above, did not apportion any of that income to Maryland.15
14
Under the tax consultant’s “anti-Geoffrey strategy,” see footnote 4 above, the use of
an additional entity (NIHC) was intended to convert the stream of royalty income into a one-
time transfer of appreciated property that made its income-shifting purpose less obvious than
the strategies used in Geoffrey and SYL, which involved royalty payments from a parent to
a subsidiary holding company.
15
N2HC’s Maryland returns reported Maryland modified income of $18,375,611 and
(continued...)
9
Although NIHC subsequently took the position before the Tax Court that it had concluded
in 2005 that its 2002 and 2003 Maryland returns should not have reported the deferred gain
at all, it did not file amended returns for those years.
Assessment by the Comptroller following Audit of the Maryland Returns
In September 2006, the Comptroller issued Notices of Assessment against Nordstrom,
NIHC, and N2HC, based on the position that income-shifting in the form of trademark
royalty expenses had resulted in an underpayment of the companies’ Maryland income tax.
Nordstrom and its subsidiaries appealed the assessments to the Comptroller’s Hearings and
Appeals Section, which upheld the assessments in Final Determination Letters issued in May
2007. The total tax assessment against NIHC for 2002 and 2003, including the unpaid tax,
interest, and a 25 percent penalty, amounted to $1,949,048; the total tax assessment against
N2HC for 2002 and 2003, including unpaid tax, interest, and penalty, amounted to $228,007.
In both instances, the assessment was based on the amount of income shifted from Nordstrom
to the two subsidiaries through the trademark transactions. An alternative assessment was
made against Nordstrom related to the same income; the Comptroller stated that it would not
be enforced if the assessments of the subsidiaries were upheld on appeal.
15
(...continued)
$33,307,237, respectively for those years, but did not apportion any of that income to
Maryland.
10
First Visit to Tax Court and Judicial Review
The companies appealed the assessments to the Maryland Tax Court. The Tax Court
conducted a hearing at which it received testimony and documentary evidence concerning
the trademark transactions. Pertinent to the issue before us, Greta Sedlock, Nordstrom’s
former Vice President of Tax, testified concerning the companies’ returns for 2002 and 2003
that included the income that was subject of the Comptroller’s tax assessment. Ms. Sedlock
testified that she would have completed those returns differently based upon a letter she had
received from tax authorities in New Jersey in 2005, a state that, like Maryland, requires
separate company reporting. She said that she had come to the view that, because NIHC filed
separate returns from its affiliated corporations, it should have reported the entire gain from
the inter-company transactions on its 1999 Maryland return when the §311(b) gain was
recognized. According to Ms. Sedlock, she now believed that deferral of the gain over 15
years was only appropriate for the consolidated returns filed under federal law. She
apparently believed that she had made a mistake in how she had reported the NIHC’s income
on the 1999 and subsequent Maryland returns.
The Tax Court issued its decision in October 2008. It viewed the “dispositive issue”
as whether there was a sufficient nexus between the two subsidiaries and Maryland, such that
imposition of the State income tax on the income of the subsidiaries would not offend the
Commerce Clause or the Due Process Clause of the federal Constitution. It viewed the case
11
primarily as requiring an application of this Court’s decision in Comptroller v. SYL, Inc., 375
Md. 78, 825 A.2d 399, cert. denied, 540 U.S. 984 and 540 U.S. 1090 (2003).
SYL concerned two instances where companies subject to the Maryland corporate
income tax each created a wholly owned subsidiary in another jurisdiction and transferred
intangible assets to that subsidiary. In each case, the parent company then entered into a
licensing agreement with the subsidiary under which the parent company paid royalties to the
subsidiary for the use of the intangible assets. The parent companies each deducted the
royalty payments in computing income subject to the Maryland income tax and, as a result,
were able to reduce their tax liability in Maryland. The respective subsidiaries, which had
no assets or employees in Maryland, did not file corporate income tax returns in Maryland.
375 Md. at 80-99. In each case, the Court of Appeals held that the subsidiary lacked
economic substance as a business entity separate from its parent and also had a substantial
nexus with Maryland. Thus, a portion of each subsidiary’s income was subject to the
Maryland income tax, based on the extent of its parent company’s business in Maryland. Id.
at 106-09.
The “anti-Geoffrey strategy” adopted by Nordstrom had attempted to circumvent the
rationale ultimately adopted in SYL and similar decisions by using several subsidiaries and
a series of transactions between the parent corporation and the various subsidiaries. The Tax
Court concluded that, while the transactions involving the Nordstrom subsidiaries were more
complicated than those in SYL, the results were much the same. “Fundamentally, the
12
subsidiaries did not act independently, although the financial structure creates an illusion of
substance ... NIHC and N2HC lack real economic substance as separate business entities.”
Accordingly, the Tax Court held that the activities of the subsidiaries must be considered the
activities of Nordstrom, which has a nexus with Maryland. It therefore affirmed the
assessments against the two subsidiaries. Because the assessments against the subsidiaries
were affirmed, the Tax Court rescinded the alternative assessment against Nordstrom.
NIHC sought judicial review in the Circuit Court for Baltimore County, which
rendered a decision in August 2009 based on memoranda submitted by the parties.16 The
Circuit Court noted that the sole issue decided by the Tax Court was whether there was a
sufficient nexus between Maryland and NIHC to allow taxation of NIHC’s income by
Maryland under the federal Constitution. The Circuit Court held that the fact that NIHC
lacked economic substance did not by itself resolve the question whether there was a
sufficient constitutional nexus between its income and the State to satisfy the federal
Constitution. It remanded the case to the Tax Court to address whether there was a
16
N2HC did not seek judicial review of the Tax Court’s decision affirming the
assessment against it.
The Comptroller sought judicial review of the Tax Court’s direction to rescind the
alternative assessment against Nordstrom. The Circuit Court later issued an order directing
the Tax Court to determine whether Nordstrom had claimed a deduction for any income
reported by NIHC. On remand, the Tax Court indicated that it had not found any indication
of such a deduction in the record and reiterated its decision to rescind the alternative
assessment against Nordstrom. That issue is not before us, as the Comptroller is no longer
pursuing the alternative assessment against Nordstrom.
13
constitutionally sufficient nexus between the §311(b) gain realized by NIHC and business
activities in Maryland. If that question were answered in the affirmative, the Circuit Court
directed the Tax Court to analyze two additional questions: (1) whether the §311(b) gain
constituted taxable income under Maryland tax law; and (2) whether the Maryland
requirement of separate entity reporting would prevent taxation of the deferred §311(b) gain
in the 2002 and 2003 tax years.
Second Visit to Tax Court and Judicial Review
In July 2010, the Tax Court again upheld the assessment against NIHC and issued an
Amended Memorandum of the grounds for its decision. The Tax Court held that Maryland’s
taxation of the reported income was constitutional as it was not possible to separate the value
of the trademarks, their licensing, and the gain recognized by NIHC from Nordstrom’s
business activities in Maryland. The Tax Court stated that “but for the activities of
Nordstrom and its use of the trademarks in Maryland, the gain of NIHC would not have been
recognized. Nordstrom’s business activities and the use of the intellectual property rights
obtained through its agreement with N2HC produced the gain income reported by NIHC.”
In addition, the Tax Court held that, because Nordstrom’s nexus was attributed to NIHC, the
income was taxable under Maryland law. Finally, the Tax Court concluded that Maryland’s
requirement of separate entity income tax returns did not prohibit the taxing of the §311(b)
gain “when the income is attributed to the activity of the parent Nordstrom and its use of the
14
marks in Maryland for the subject years.” The Tax Court stated: “NIHC reported the
deferred gains as Maryland modified income and the substance of the transaction does not
prevent the taxing of income earned in the assessment years because of separate reporting
requirements.”
NIHC again sought judicial review of the Tax Court decision. In December 2011, the
Circuit Court affirmed in part and reversed in part the Tax Court decision. The court agreed
with the Tax Court that “the §311(b) gain was the result, in part, of the projected use of the
trademarks in Maryland” and that, therefore, there was substantial evidence of a sufficient
nexus of the reported income with Maryland. It also concluded that the gain income was
“reasonably attributable” to activities in Maryland and therefore taxable under the Maryland
income tax law, as that law had been construed to allow taxation “to the bounds permitted
by the Constitution.”17 However, the court concluded that Maryland’s separate reporting
requirement prohibited the Comptroller from assessing the deferred gain reported by NIHC
for 2002 and 2003, which the court believed should have been reported with the rest of the
gain when it was recognized in 1999. The court therefore reversed the assessment against
NIHC.
17
Hercules, Inc. v. Comptroller, 351 Md. 101, 110, 716 A.2d 276 (1998).
15
Court of Special Appeals Decision
The Comptroller appealed the Circuit Court decision to the Court of Special Appeals.
NIHC did not cross-appeal. In an unreported decision, the Court of Special Appeals reversed
the Circuit Court judgment. The intermediate appellate court noted that the only issue before
it was whether Maryland’s separate reporting requirement prevented the taxation of the gain
reported on NIHC’s 2002 and 2003 returns. The Court of Special Appeals stated that the
Circuit Court had incorrectly focused on how the §311(b) gain should have been reported
instead of whether it was taxable in the way it had in fact been reported.18 The court noted
18
The Court of Special Appeals explained:
The Tax Court concluded that Maryland’s separate entity
reporting requirement did not preclude Maryland’s taxing of the
§311(b) deferred gain as reported by NIHC on its 2002 and 2003
Maryland tax returns. The circuit court, however, did not
address this issue in its review of the Tax Court’s decision.
Instead, the circuit court focused on the proper way in which the
§311(b) gain should be reported, given the conflict between the
IRS regulations governing consolidated federal returns (which
require the recognition of the gain on a deferred basis over
fifteen (15) years), and the Maryland requirement of separate
entity returns (which may require the recognition of the gain in
its entirety, in the year that the gain was realized). Thus, in the
instant case, the circuit court held “[i]f the rules relating to
deferral of gain on the federal consolidated return were
disregarded and [if] NIHC reconstructed its federal taxable
income as if it filed a separate federal income tax return, the
§311(b) gain would not have been reported in 2002 and 2003.”
What NIHC should (or should not) have done in the instant case
is not determinative of the issue presented in this appeal. The
(continued...)
16
that it had not been presented with any law or other authority “that precludes Maryland from
taxing income that is constitutionally taxable by Maryland and that is reported by the
corporate taxpayer as Maryland modified income on its Maryland income tax return.” The
Court of Special Appeals found no error in the Tax Court’s decision to uphold the assessment
against NIHC. Accordingly, it reversed the Circuit Court decision.
The Court of Special Appeals stated that it was expressing no opinion on “the broader
issue of whether a corporation’s §311(b) gain, which is constitutionally subject to taxation
by Maryland, is reportable as Maryland modified income on a deferred basis under
Maryland’s requirement of separate entity income tax returns, where such deferred gain is
reported on the corporation’s consolidated federal income tax return.”
Petition for Certiorari
NIHC sought a writ of certiorari, which we granted to review the merits of the Tax
Court’s amended decision in this case.
18
(...continued)
key is what NHIC did, in fact, do. The uncontradicted evidence
before the Tax Court was that NIHC reported the §311(b)
deferred gain as Maryland modified income in its 2002 and 2003
Maryland tax returns. In other words, whether the deferred
§311(b) gain should or should not have been reported for the tax
years of 2002 and 2003 has been rendered moot by the fact that
NIHC reported such gain on its 2002 and 2003 Maryland tax
returns.
17
Discussion
Standard of Review
As the Tax Court is an adjudicative administrative body of the executive branch, its
decisions are subject to the same standards of judicial review as adjudicatory decisions of
other administrative agencies. Gore Enterprise Holdings, Inc. v. Comptroller, 437 Md. 492,
503, 87 A.3d 1263 (2014); see TG §13-532(a)(1). A reviewing court may uphold a Tax
Court decision only on the findings and reasons given by the Tax Court. Gore Enterprise,
437 Md. at 503. Findings of fact are reviewed on a deferential “substantial evidence”
standard – i.e., whether the record contains evidence that reasonably supports the agency’s
conclusion. Id. at 504. A reviewing court also accords great weight to the Tax Court’s
interpretation of the tax laws, but reviews its application of case law without special
deference. Id. at 504-5.
Deciding What Question is Before Us
Before we can venture an answer to the question before us, we must decide what that
question is. As is sometimes the case in appellate litigation, the parties’ briefs debate the
wording, number, and nature of the question(s) presented.19 Regardless of the preferred
19
For example, NIHC contends that the Court of Special Appeals incorrectly rephrased
the question raised by the Comptroller, and exceeded the limits of judicial review by basing
its decision on a ground not addressed by the Tax Court. The Comptroller argues otherwise
and asserts that, even if we address the question preferred by NIHC, the outcome of this
appeal is no different. The Comptroller also notes that, while NIHC presented three
questions in its petition for certiorari, it has included four questions in its brief, two of which
(continued...)
18
wording of the parties, the issues before us are constrained by the facts found and the legal
conclusions drawn in the decision of Tax Court under review, and by the issues preserved
by the parties in seeking review of that decision in the courts below.
The present case involves judicial review of a decision of the Tax Court pursuant to
TG §13-532. In that context, it is often said that we “look through” the decision of the Court
of Special Appeals and the Circuit Court to review directly the agency decision. See Frey
v. Comptroller, 422 Md. 111, 136-37, 29 A.3d 475 (2011). Thus, our review focuses on the
issues addressed by the Tax Court and its reasoning. As indicated above, our review is also
limited in another way. As a general rule, we address only issues that have been preserved
for review.
In its amended decision, the Tax Court determined that the §311(b) gain recognized
by NIHC had a nexus with Maryland through Nordstrom’s business activities in Maryland
during the pertinent years and was subject to Maryland income taxation for those tax years.
The Circuit Court affirmed those holdings. NIHC did not cross appeal as to those issues.20
19
(...continued)
did not appear in its certiorari petition. NIHC responds that the two questions were
subsumed in one of the questions it originally presented. We need not referee this debate to
identify the question before us.
20
If we were to address those issues, we would have little trouble coming to the same
conclusions as the Tax Court and the Circuit Court. As recounted above, the record
demonstrates that the corporate structure and inter-company transactions were designed to
shift income away from states like Maryland through the use of entities that, as the Tax Court
found, had no economic substance as business entities apart from Nordstrom. Indeed, the
consulting firm that designed the transactions for Nordstrom labeled it the “anti-Geoffrey
(continued...)
19
Thus, in the posture of the case before us, there is no question that the income reported on
NIHC’s Maryland returns for 2002 and 2003 related to Nordstrom’s business activities in
Maryland during those years and that a portion of that income was subject to taxation in
Maryland. A third issue addressed by the Tax Court, at the direction of the Circuit Court,
was whether the Maryland statutory requirement that corporate affiliates file separate returns
prohibited the Comptroller from taxing the portion of that gain reported on NIHC’s 2002 and
2003 returns. The Circuit Court reversed the Tax Court decision on that ground, the
Comptroller sought review of only that part of the Circuit Court’s decision in its appeal to
the Court of Special Appeals, and, following reversal of that issue in the intermediate
appellate court, NIHC requested our review of the issue. That is the only portion of the Tax
Court decision that has been preserved for review.
Deciding the Question Before Us
The critical holding of the Tax Court appears near the end of its amended decision.
After recounting its prior findings and conclusions, including that a portion of NIHC’s gain
– equivalent to the deferred gain on the federal tax return – had been reported on the
20
(...continued)
strategy.” See footnote 4 above. This strategy, although more convoluted than the scheme
devised in the Geoffrey case, also relied on transactions with subsidiaries without economic
substance separate from the parent corporation to argue that income lacked a nexus with the
taxing state. See also Gore Enterprise Holdings, Inc. v. Comptroller, 437 Md. 492, 87 A.3d
1263 (2014) (holding that nexus for taxation by Maryland existed when two corporate
subsidiaries created to hold intangible assets of the parent corporation lacked economic
substance as separate entities).
20
pertinent Maryland tax returns, the Tax Court addressed whether the Maryland requirement
that related corporations file separate tax returns would prohibit taxation of that income. It
stated:
...The Court finds that there is no such prohibition when the
income is attributed to the activity of the parent Nordstrom and
its use of the marks in Maryland for the subject years. NIHC
reported the deferred gains as Maryland modified income and
the substance of the transaction does not prevent the taxing of
income earned in the assessment years because of separate
reporting requirements.
The Court of Special Appeals reached the same conclusion on the facts of this case,21
although it explicitly declined to decide the more abstract question of whether a corporation’s
§311(b) gain is required to be reported as Maryland modified income on a deferred basis on
separate Maryland returns when it is reported on a deferred basis on a consolidated federal
return. In limiting its holding in that manner, the intermediate appellate court wisely adhered
to a maxim of judicial decision-making that counsels against addressing questions abstracted
from the facts before the court. Garner v. Archers Glen Partners Inc., 405 Md. 43, 46, 949
A.2d 639 (2008) (“an appellate court should use great caution in exercising its discretion to
comment gratuitously on issues beyond those necessary to be decided”).
21
In arguing that the intermediate appellate court decided a “different question” from
the abstract question it favors, NIHC focuses on the first sentence of the excerpt of the Tax
Court decision quoted above, discounts the second sentence which referred to NIHC’s
reporting of the deferred gain on its 2002 and 2003 returns, and ignores the context of that
paragraph in the rest of the Amended Memorandum of Grounds for Decision.
21
The separate reporting requirement is set forth in TG §10-811, which provides simply
that “[e]ach member of an affiliated group of corporations shall file a separate income tax
return.” A regulation adopted by the Comptroller elaborates that “each separate corporation
shall report its taxable income without regard to any consolidation for federal income tax
purposes.” COMAR 03.04.03.03B(1). The regulations further provide:
Use of Federal Figures. The starting point for the Maryland
return is the taxable income as defined in the Internal Revenue
Code and developed on the federal return. Corporations
included in a consolidated filing for federal purposes shall file
separate Maryland returns and compute separate taxable income.
COMAR 03.04.03.05B. Neither the statute nor the corresponding regulations explicitly
address the treatment of §311(b) deferred gain, much less its treatment in the context of a
subsidiary corporation that lacks economic substance apart from its parent.
We agree with the Court of Special Appeals that the Tax Court’s determination that
Maryland’s separate reporting requirement for corporations did not prohibit the
Comptroller’s assessment taxing NIHC’s §311(b) gain on a deferred basis should be upheld
on judicial review. We start from the premise that the Comptroller’s assessment of a tax is
presumed to be correct. TG §13-411. The burden is on the taxpayer to show that the
assessment is wrong. Fairchild Hiller Corp. v. Supervisor of Assessments, 267 Md. 519, 523,
298 A.2d 148 (1973); TG §13-528(b). In computing the assessment, the Comptroller used
the figures for Maryland taxable income reported on NIHC’s Maryland returns, which
correlated with the figures for its federal taxable income reported on NIHC’s federal returns
22
for those years – the “starting point” for computation of its tax liability. The Tax Court
found that the ongoing activities of Nordstrom in Maryland, including during the 2002 and
2003 tax years, were responsible for the §311(b) gain reported on NIHC’s Maryland tax
returns for those years22 and that NIHC lacked any economic substance apart from
Nordstrom.
During the course of this case, NIHC has suggested that the Comptroller should have
reached that income in other ways,23 its preferred method – an application of the separate
reporting requirement – being conveniently outside the period of limitations. NIHC argues
that Nordstrom should have re-computed a separate federal return for each of the affiliated
companies for each of the years in question – called a “pro forma” federal return – and based
its Maryland return for each year on the income shown on the corresponding pro forma
federal return. NIHC argues that its pro forma federal returns – and thus its Maryland return
as well – would have reported the entire §311(b) gain as income in 1999 and that NIHC
22
It is incontrovertible that the §311(b) gain was derived from the value of the
licensing agreement that NIHC transferred as a dividend to N2HC. The value of the
licensing agreement ultimately depends on Nordstrom’s commercial activities using those
trademarks, part of which occur in Maryland. In sum, there is no question at this juncture
that the §311(b) gain is related to activities in Maryland, and that a properly apportioned
share of it is taxable by Maryland.
23
In addition to arguing the NIHC’s §311(b) gain should have been assessed as to
NIHC’s 1999 return, which would have been in advance of the Nordstrom business activities
that provided the nexus to Maryland, NIHC’s counsel also suggested in the Circuit Court that
the Comptroller should have disregarded the amortization deduction of N2HC rather than tax
the deferred §311(b) gain actually reported by NIHC. As noted above, the annual amount
of the N2HC amortization deduction was identical to the annual amount of the deferred
§311(b) gain of NIHC assessed by the Comptroller.
23
should have reported no income from that gain on its pro forma federal returns and Maryland
returns for 2002 and 2003. But NIHC never completed any pro forma federal returns, did
not amend its Maryland returns in that manner, and, based on the record in this case, did not
embrace this manner of reporting its income until tax was assessed by the Comptroller, even
though the corporate official in charge of its tax returns claimed to have come to a different
conclusion as to how to report its income within the period for amending the returns.
As the Court of Special Appeals held, whether NIHC could have, or should have,
reported the entire gain as income subject to Maryland income tax in 1999 – in advance of
the business activities of Nordstrom in Maryland in 2002 and 2003 that established the nexus
with the income shifted to NIHC– is a separate question from whether the Comptroller could
assess income actually reported by NIHC for those years. NIHC complains that the Court
of Special Appeals in effect held that it was “bound” by the returns it had filed that it now
says were mistaken. It would seem more accurate to say that it is bound by the record in this
case.
The separate reporting requirement does not contradict any of the key facts on which
the Comptroller’s assessment was based:
• the taxpayer lacked economic substance apart from its parent
corporation
• the income recognized by the taxpayer was related to the business
activities of its parent
• the parent corporation conducted business activities in Maryland during
the tax years in question
24
• the taxpayer reported a portion of the income related to its parent’s
activities on its Maryland tax returns
• that income was not otherwise taxed by Maryland
• the taxpayer never filed amended returns nor did it submit pro forma
federal returns adopting a different method of reporting that income,
although it became aware of a different method of filing within the
period of limitations
There is no question at this juncture that the transactions carried out under the “anti-
Geoffrey strategy” shifted income related to Nordstrom’s activities in Maryland to NIHC.
In essence, NIHC argues that requirement of separate reporting in TG §10-811, together with
the statute of limitations, negates the fact that it actually reported part of the income for the
tax years in which Nordstrom had business activity in Maryland and absolves it of that tax
liability altogether. While the failed anti-Geoffrey strategy was an effort to shift income
beyond the geographical reach of a state tax collector, NIHC’s current argument seeks to
shift income to a time period beyond the reach of a state tax collector. It may be that
appellate judges are not well-versed in concepts that bend time and space, but we believe this
argument is without merit on the facts of this case.
Conclusion
There is no question that the income related to Nordstrom’s activities in Maryland
during 2002 and 2003 tax years was shifted in part to NIHC. The Comptroller assessed tax
on that income as NIHC reported it on its tax returns for those years. However, neither
NIHC nor its affiliated corporations has amended their returns to reflect another way of
25
reporting that income. Essentially, NIHC asks that, because it mistakenly neglected to report
its entire gain and pay the appropriate tax on its 1999 Maryland return, it should be forgiven
any tax liability on that income, even though it reported a portion of that income on its 2002
and 2003 returns. On the facts of this case, the separate reporting requirement does not
eliminate the tax liability for the income reported, properly subject to tax, and not previously
taxed. We hold that, on the record before the Tax Court, NIHC did not carry its burden of
showing that the Comptroller’s assessment was wrong.
J UDGMENT OF THE C OURT OF S PECIAL
A PPEALS A FFIRMED. C OSTS TO BE P AID
BY P ETITIONER.
26