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On Oct. 31, 2018, the Maryland Tax Court affirmed the Maryland Comptroller’s use of an alternative apportionment formula for determining a taxpayer’s corporation income tax on income derived from the licensing of intangible property to several of its affiliates.1
In doing so, the Court rejected an argument by the taxpayer that Maryland’s apportionment regime requires the use of a three-factor formula. Instead, the Court found that an alternative formula is appropriate when the statutorily prescribed formula fails to accurately represent a taxpayer’s Maryland-related income-producing activities. This decision adheres to the theme of unsuccessful taxpayer challenges to the Comptroller’s application of an alternative apportionment formula.
Maryland alternative apportionment provisions
For multistate corporate income taxpayers, Maryland historically has applied a three-factor apportionment formula to determine the portion of income derived from activities within the state.2
The formula includes the property factor, the payroll factor and a double-weighted sales factor. For purposes of calculating the sales factor, special rules apply in sourcing certain intangible income, including royalty income. The Maryland Code of Regulations states “[g]ross income from intangible items such as . . . royalties . . . shall be included in the numerator based upon the average of the property and payroll factors.” 3
Accordingly, for out-of-state companies that do not have property or payroll in a state, income derived from licensing intangible property to Maryland operating companies is mechanically excluded from the sales factor numerator.
In order to prevent potential distortions of income, a Maryland statute allows the Maryland Comptroller to employ an alternative formula, “if circumstances warrant,” in order to “reflect clearly the income allocable to Maryland.”4
In practice, the Comptroller’s alternative formula substitutes the out-of-state corporation’s own apportionment factors with those of the affiliated in-state operating entities. The Comptroller has based this substitution on the assumption that the out-of-state corporation cannot function as an enterprise independently of the in-state-operating companies.
Manpower, Inc., the taxpayer at issue in the case, is a human resources staffing service provider that historically received significant royalty payments from its Maryland Operational Entities (MOEs) for the use of Manpower’s intellectual property. In doing so, the taxpayer oversaw the operations of its MOEs through independently-owned franchise offices, and licensing agreements allowed the MOEs the right to use Manpower’s system.
The Comptroller subjected Manpower to audit for the 1996-2003 tax years. Although the MOEs paid Maryland corporate income taxes for the years in question, Manpower itself did not file Maryland returns. As the MOEs had deducted the royalty payments to Manpower on their Maryland returns, when viewed in the aggregate, Manpower and the MOEs realized significant state income tax savings.
Manpower initially argued that Maryland did not have jurisdiction to impose the corporate income tax. However, Manpower eventually filed Maryland corporate income tax returns for the years under audit based on income reports on its federal income tax returns. Instead of using standard Maryland three-factor apportionment, Manpower used an alternative formula which resulted in substantially less taxable income attributable to Maryland than what was reported as royalty income paid by its MOEs. The Comptroller ultimately assessed Manpower in 2010 for more than $1.4 million in combined tax, interest and penalties. In its assessment, the Comptroller utilized the same alternative formula that it had used in Gore Enterprise Holdings, Inc. v. Comptroller of the Treasury5
as a means to capture the income attributable to Manpower’s Maryland activities.
Tax Court’s analysis
In its appeal, Manpower claimed it possessed sufficient economic substance to be treated as a separate business entity from its operating companies. The Court disagreed with this claim, noting that Manpower owned sufficient voting stock to exercise control over its MOEs and its in-state income was derived from the licensing of intangibles to the MOEs. Thus, the reality of the relationship between Manpower and its MOEs justified Manpower’s corporate income tax filing obligation in Maryland.
Having satisfied the constitutional requirements necessary to levy a tax on Manpower’s intangible income, the Court then examined whether the Comptroller fairly apportioned the income. Once again, the Court relied on a precedent established in Gore. The petitioner in the Gore case, Gore Enterprise Holdings, Inc. (“GEH”), was set up as a subsidiary holding company to manage its parent’s patent portfolio. GEH argued that it should not owe taxes in Maryland because it lacked payroll or property in the state. In addition, GEH claimed the Comptroller could not use an alternative apportionment formula because Maryland statutory law required the use of a three-factor formula.6
The Maryland Court of Appeals rejected GEH’s arguments, stating the Comptroller is not limited to the formula set forth in statutory law if the formula “does not fairly represent the extent of a corporation’s activity in [the] State.”.7
Under Maryland’s special rule for sourcing intangible income, the three-factor formula would yield a zero percent apportionment factor which did not reflect the holding company’s income attributable to Maryland. Thus, the application of an alternative formula was appropriate. Further, the alternative formula applied in Gore was specifically designed to apportion to Maryland only GEH’s income connected to its parent’s operations. Since the royalty expenses paid by the parent “simultaneously constituted income” for its affiliated holding companies, the holding companies’ tax liabilities were calculated by multiplying the royalty expenses by the parent’s apportionment formula.
Since Manpower also lacked property or payroll in Maryland, the Commissioner applied the same apportionment formula methodology that was used in Gore
. The rulings in both Gore
and Comptroller of the Treasury v. SYL, Inc
established several critical precedents that assisted the Court in its decision. First, both cases clarified nexus requirements justifying the taxation of an entity’s intangible income from affiliates. Specifically, Maryland nexus is established when an entity receiving intangible income from its affiliates’ activities lacks “real economic substance as a separate entity.” Entities that exist primarily as personal holding companies to manage affiliates’ intellectual property portfolios will fail the economic substance test. If an entity fails to establish its functional and economic independence, Maryland may tax the entity’s apportioned income without violating the Due Process or Commerce Clauses of the U.S. Constitution.
In the case at hand, the royalty expenses paid by the MOEs “simultaneously constituted the income [of Manpower].” Accordingly, Manpower’s tax liability was calculated by multiplying the royalty expenses by the MOEs’ apportionment formulas. In rejecting Manpower’s argument that the Comptroller was required to use Maryland’s three-factor formula, the Court cited the Comptroller’s authority to apply an alternative formula when standard apportionment is distortive.9
The Court further maintained that the alternative apportionment formula preserved external consistency requirements under the Commerce Clause because it reflects “a reasonable sense of how [Manpower’s] income is generated.” 10
Although the Court rejected the taxpayer’s appeal regarding apportionment, the Court determined that Manpower established reasonable cause to waive penalties and interest prior to the assessment date because the economic substance doctrine was not yet clearly established during the years under audit.
The Maryland Tax Court’s decision to uphold the application of an alternative apportionment formula is consistent with procedures established in a series of similar Maryland court cases. The brief five-page ruling relied on references to well-documented arguments from preceding cases with similar fact patterns, so taxpayers can expect Maryland to continue to adhere to its economic substance doctrine and alternative apportionment regime moving forward.
The Commissioner’s alternative provisions seek to prevent companies from structuring operations with little economic substance in order to drastically reduce state income tax liabilities. At the time of the Gore
ruling, however, some practitioners were concerned that the decision would be applied to entities that are not pure intellectual property holding companies. The Court’s recent decisions suggest that this concern is becoming a reality. For example, in the 2017 Michigan Host, Inc. v. Comptroller of the Treasury12
ruling, the Court supported the application of the apportionment formula used in Gore to the interest income of an entity that acted in the capacity of a corporate financier but did not actually hold intellectual property.
In this case, Manpower’s fact pattern deviated from the circumstances of prior petitioners. Although Manpower owns the intellectual property licensed to its operating companies, according to the Court, it also “generates millions of dollars each year from providing direct human resources and staffing services and paid salary and wage expenses.” In addition, as previously noted, the taxpayer does not qualify as a personal holding company under federal law. Nevertheless, the Court was willing to extend its treatment of pure holding companies to Manpower’s circumstances for the purpose of assessing Manpower’s income tax liability. If the more recent rulings are appealed, it will be interesting to see whether the Maryland Court of Appeals continues to affirm the Tax Court’s decisions as it did in Gore
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