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Which Exit?
Most prominent among these cases was the decision in Lanco Inc. v. Director, Division of Taxation, a New Jersey ruling that our survey suggests is already as familiar to most corporate tax directors as 1992's Quill Corp. v. North Dakota. In Quill, the U.S. Supreme Court ruled that "substantial nexus" was defined by a physical presence. Thus, North Dakota could not require Quill—an out-of-state office-supplies catalog vendor—to collect use taxes on sales within North Dakota.
The question in Lanco was whether physical presence was also necessary to levy income or franchise taxes. Quill has served as the basis for a decade of corporate tax planning. Typically, affiliated holding companies in tax-friendly states—usually Delaware—own and license intangibles such as trademarks and patents to the operating companies. Those operating companies can then deduct the payments to their affiliates.
In Lanco, New Jersey's tax director had attempted to levy income tax on the Delaware holding company that licenses intangibles to clothing manufacturer Lane Bryant. And there was good reason for Lane Bryant officials to worry that New Jersey's argument of "economic nexus" might prevail: the facts in the case were identical to those in 1993's infamous Geoffrey Inc. v. South Carolina Tax Commission. In that case, the South Carolina Supreme Court ruled that Geoffrey, a Delaware holding company that licensed intangibles to Toys "R" Us, was subject to income tax even though it had no physical presence in the state.
New Jersey was not so lucky—the court cited South Carolina as an aberration and ruled that without physical nexus, Lanco was not subject to the state's income tax. The case also didn't do much for New Jersey's reputation: it rocketed to number one among the states considered by our survey respondents to be the most aggressive about asserting economic nexus. (South Carolina, which was first in 1998 and fifth in 2000, dropped to eighth on the list.)
Yet New Jersey's failure to tax a Delaware holding company was not an unalloyed win for corporate tax planning. Earlier in 2003, Maryland pierced the corporate veil of two Delaware holding companies by arguing that they had no real business purpose other than to avoid tax. That's a classic anti-tax-shelter argument, and one that may signal a much more aggressive approach by the states.
The Maryland Court of Appeals ruled simultaneously in Comptroller of the Treasury v. SYL Inc. and in Comptroller of the Treasury v. Crown Cork & Seal Co. (Delaware) Inc. that the Delaware holding companies of Syms and Crown Cork & Seal could be taxed—not individually, as New Jersey attempted in Lanco, but as part of their parent companies—because they "had no real economic substance as separate business entities."
The court noted that all of the characteristics of a functioning company—employees, office space, travel expenses, and so on—"were virtually nonexistent on Crown Delaware's balance sheets." Where such expenses did exist, they were provided by Organization Services Inc., a "nexus services" provider.
Although Crown Delaware claimed revenues of about $37 million per year, total annual wages for its nine "employees" averaged $568 for each year between 1989 and 1993. Indeed, Crown Delaware's total operating costs averaged just over $2,000 per year. "Over the five-year period in question," the court noted, "Crown Delaware incurred a total of $20 in meals and entertainment, about $60 in telephone charges, and about $100 in postage. Travel costs for the entire period...amounted to less than $7." And despite the fact that Crown Delaware theoretically existed to manage intellectual property, it never incurred any legal fees associated with patents or trademarks.
Those who defend moving intellectual property to a Delaware holding company as a legitimate tax-planning strategy admit that the Crown case is not the most flattering example. But even more-persuasive fact patterns are no sure thing. In a similar case decided in 2002—Sherwin-Williams v. Commissioner of Revenue—Massachusetts failed to convince a court that the paint company's Delaware subsidiary was a sham, because, the court ruled, it did engage in legitimate business activities. This past June, New York's Tax Appeals Tribunal looked at the same affiliate and found just the opposite to be the case.
SYL, Crown, and New York's version of Sherwin-Williams make Delaware-style holding companies far more likely to be attacked in court these days—much as Enron's abuses resulted in greater scrutiny of all special-purpose entities. "If you are a publicly traded company, you need to be far more cautious today than in the past with regard to aggressive tax planning," says Stuart L. Rosow, an attorney with Proskauer Rose LLP. Although such planning is still possible for many companies, he says, "the level of scrutiny that it will be subjected to is much greater."
Nexus End Run
A far more significant development, however, is the number of states that have grown tired of fighting and have simply changed the law. "There are two ways [for states] to attack" an out-of-state company, says Doug Lindholm, executive director of COST. "The first is to say it has economic presence. If that's not going to work, because Lanco says you need a physical presence, [the state] can try to deny the deduction to the company that does have physical presence in the state."
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