Trademark Holding Companies Challenge Imposition of State Tax

Caciqueco, Inc. was dissolved into another indirectly owned subsidiary of Limited Brands, Inc., Intimate Beauty Corporation, on January 28, 2000, and Structureco, Inc. was merged into Express LLC, another indirectly owned subsidiary of Limited Brands, Inc., on December 12, 2003.

Subsequent to the year at issue, Limited Brands, Inc. divested itself of its indirect ownership interest in several of the other petitioners as follows: A&F Trademark, Inc. on May 18, 1998, Lanco, Inc. on August 16, 2001, Lernco, Inc. on November 27, 2002 and Limtoo, Inc. on August 23, 1999. Limited Brands, Inc. is not aware of whether the petitioners in which it no longer retains an indirect ownership interest remain in existence or, if still in existence, whether they are currently owned by publicly traded companies, but they do not retain any independent legal interest in the tax assessments at issue in this case.

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The relevant portions of the North Carolina statutes and the relevant regulation are set forth at App. G at 205a-208a.

By the decision below, the North Carolina Court of Appeals reverted to a pre-Quill analysis for income and franchise taxes, adopting the Due Process minimum contacts standard and thereby eviscerating this Court's reasoned differentiation between Commerce Clause and Due Process requirements and excising the "substantial" from "substantial nexus." In Quill, this Court explained that the Due Process and Commerce Clause "standards are animated by different constitutional concerns and policies," 504 U.S. at 312, and that the "concerns about the effects of state regulation on the national economy" under the Commerce Clause support a higher "substantial nexus" standard under the Commerce Clause than applies under the Due Process Clause.

Petitioners were each formed to protect and manage trademarks, service marks and trade names (their "marks") and had no physical presence in North Carolina. None of the petitioners had offices, employees, real property or tangible personal property in North Carolina.

Once petitioners were created, they licensed their marks under non-exclusive licenses to the retail operating subsidiaries of Limited Brands on an arm's length basis. The license agreements did not require that the retailers use the marks in any particular jurisdiction. As a direct result of the management of the marks by petitioners, the marks were successfully protected throughout the world. Each of the petitioners, in addition to licensing its marks, also earned income from loaning money to its affiliated retailer.

Numerous business and legal reasons motivated Limited Brands to establish the separate petitioner companies to own and protect the marks, including: (1) provision of a centralized system to deal with the marks on a worldwide basis, which eases the business' entry into international licensing and retailing; (2) protection of the U.S. retail operations, and the officers and directors, from being harassed in litigation, particularly outside the United States; and (3) protection from hostile takeovers. Avoiding taxes was not a motive in deciding to establish the trademark protection companies, although tax considerations were weighed in deciding where to locate the companies.

Petitioners also presented expert testimony from two economists, David Baumer, associate professor in the Department of Business Management at North Carolina State University, and David Wildasin, Professor of Economics at Vanderbilt University, concerning the economic invalidity of the economic nexus concept advocated by the State Department of Revenue and ultimately accepted by the North Carolina Court of Appeals. Professor Baumer testified that assertion of a nexus adequate for State taxation without any requirement of physical presence in the State would lead to considerable interference with interstate commerce. He also testified that requirement of physical presence in the State is unambiguous and consistent with the economic expectations of business-people and academic observers, and avoids the unnecessary expenditure of resources. (App. J at 272a.) Professor Wildasin testified that it is undesirable on economic grounds for states and localities to tax entities that are not physically present in those jurisdictions. A corporation whose only connection is through the licensing of intangible assets does not impose on a State costs for the provision of any public services and, therefore, should not share in those costs by payment of income taxes. Requiring such out-of-state corporations to pay taxes to a State creates adverse economic incentives, and would harm national economic performance. (App. I at 242a-243a.)

Although the Assistant Secretary presiding over the hearing understood that "it is well-settled that the Secretary cannot rule on the constitutionality of a statute," he nonetheless concluded, in dicta, that Quill's physical presence standard should be rejected due to the changing national commercial landscape. The Secretary entered an order abating all penalties asserted against petitioners, but sustained the imposition of the taxes for one of the three years, the fiscal year ended January 31, 1994, in a Final Decision entered on September 19, 2000. (App. D at 77a-199a.)

2. Petitioners filed a Petition with the North Carolina Tax Review Board to review the Secretary of Revenue's Final Decision. The Tax Review Board confirmed the Final Decision, but did not address petitioners' constitutional arguments under Quill because it lacked the authority to do so. (App. C at 75a-76a.)

3. Petitioners appealed the decision of the Tax Review Board to the Wake County Superior Court. The Superior Court affirmed the Tax Review Board's decision and held, without explanation, that the decision was "not in violation of constitutional provisions." (App. B at 23a.)

4. The North Carolina Court of Appeals affirmed. (App. A at 1a-21a.) The court concluded that the physical presence requirement to meet the "substantial nexus" test under the Commerce Clause for a State's imposition of sales and use taxes does not require physical presence in a State of an entity as a prerequisite to the State's authority to impose franchise or income taxes on that entity. The court rejected petitioners' argument that the Commerce Clause standards apply equally to all taxes, stating that petitioners' argument was a "broad reading of Quill." (App. A at 14a.) The Court of Appeals reasoned that (1) this Court has not applied the physical-presence requirement of Quill to taxes other than sales and use taxes; (2) the stare decisis concerns which motivated this Court to retain the physical presence standard in Quill are not present here; and (3) sales and use taxes are different from franchise and income taxes and those distinctions make physical presence an "inappropriate" nexus standard for franchise and income taxes. (App. A at 15a-16a.) The court also rejected various arguments regarding interpretations of State law. (App. A at 17a-20a.)

5. The North Carolina Supreme Court denied petitioners' petition for discretionary review on March 3, 2005; the Order was entered on March 7, 2005. (App. E at 200a-202a.)

A review of the decisions rendered by the various State courts and tax tribunals since this Court's decision in Quill Corp. v. North Dakota, 504 U.S. 298 (1992), confirms that North Carolina is not alone in its erroneously constricted view of the taxes to which Quill's physical presence requirement applies. The volume of case law also establishes that businesses and governmental entities have been embroiled in costly, time-consuming litigation which, given the high financial stakes, will continue unabated until this Court resolves this crucial issue presented here.

In decisions directly contrary to that of the North Carolina Court of Appeals in this case, Michigan, New Jersey, New York, Tennessee, Texas and West Virginia have rejected attempts by their State departments of revenue to impose taxes merely on the basis of receipts derived from in-state sources, and have held that this Court's decision in Quill precludes a State from imposing franchise or income taxes on an entity that does not have a physical presence in the State. See Guardian Indus. Corp. v. Department of Treasury, 198 Mich. App. 363, 499 N.W.2d 349 (1993), appeal denied sub nom. Cargill, Inc. v. Department of Treasury, 444 Mich. 934, 512 N.W.2d 846 (1994); Lanco, Inc. v. Director, Div. of Taxation, 21 N.J. Tax 200 (Tax Ct. 2003) (appeal pending)¹; In re Wascana Energy Mktg. (U.S.), Inc., DTA No. 817866 (N.Y.S. Div. of Tax Appeals, Aug. 8, 2002); J.C. Penney Nat'l Bank v. Johnson, 19 S.W.3d 831, 839 (Tenn. Ct. App. 1999), cert. denied, 531 U.S. 927 (2000); Rylander v. Bandag Licensing Corp., 18 S.W.3d 296 (Tex. App. 2000); MBNA Am. Bank, N.A. v. Steager, Nos. 03-185 RN, 03-186 RFN, 04-074 RFN, 04-075 RN (W. Va. Office of Tax Appeals Oct. 22, 2004).

At the same time, decisions rendered in Illinois, Kentucky, Maryland, Massachusetts, New Mexico, Ohio, South Carolina and Washington have concluded that the physical presence requirement for "substantial nexus" under the Commerce Clause applies only to determine nexus in cases involving sales and use taxes. See Borden Chems. & Plastics, L.P. v. Zehnder, 312 Ill. App. 3d 35, 726 N.E.2d 73, review denied, 189 Ill. 2d 656, 731 N.E.2d 762 (2000); Annox, Inc. v. Revenue Cabinet, No. K-19039 (Ky. Bd. of Tax Appeals Nov. 18, 2003) (dicta), aff'd, No. 03-Cl-1605 (Franklin County Cir. Ct. Feb. 17, 2005) (affirming decision; omitted dicta); SYL, Inc. v. Comptroller, 375 Md. 78, 825 A.2d 399, cert. denied, 540 U.S. 984 (2003); Truck Renting & Leasing Ass'n v. Commissioner of Revenue, 433 Mass. 733, 746 N.E.2d 143 (2001) (dicta); Kmart Props., Inc. v. Taxation & Revenue Dep't of N.M., No. 21,140 (N.M. Ct. App. Nov. 27, 2001), cert. granted and submitted, No. 27,269 (N.M. Oct. 14, 2004) (not precedential); Couchot v. State Lottery Comm'n, 74 Ohio St. 3d 417, 659 N.E.2d 1225 (dicta), cert. denied, 519 U.S. 810 (1996); Geoffrey, Inc. v. South Carolina Tax Comm'n, 313 S.C. 15, 437 S.E.2d 13, cert. denied, 510 U.S. 992 (1993); and General Motors Corp. v. City of Seattle, 107 Wash. App. 42, 25 P.3d 1022 (2001), cert. denied, 535 U.S. 1056 (2002).

The division among States around the country on this issue could not be clearer. Indeed, the courts within some States have even reached conflicting conclusions with one another. Compare Geoffrey, Inc. v. South Carolina Tax Comm'n, 313 S.C. 15, 18, 437 S.E.2d 13, 15 (holding that "any corporation that regularly exploits the markets of a state should be subject to its jurisdiction to impose an income tax although not physically present"), cert. denied, 510 U.S. 992 (1993), with City of Charleston v. Government Employees Ins. Co., No. 93-CP-10-2567 (S.C. Ct. C.P. Sept. 15, 1997) (concluding that physical presence is required in "cases involving taxes other than 'sales' or 'use' taxes"), rev'd on other grounds, 334 S.C. 67, 512 S.E.2d 504 (1999). Compare Dial Bank v. Alabama Dep't of Revenue, Nos. INC. 95-289 & F. 95- 308 (Admin. Law Div. Aug. 10, 1998); Cerro Copper Prods., Inc. v. Alabama Dep't of Revenue, No. F.94-443 (Admin. Law Div. Dec. 11, 1995) and 9.4% Manufactured Housing Contract Pass-Through Certificate Series 1989A v. Alabama Dep't of Revenue, No. CORP. INC. 95-162 (Admin. Law Div. Dec. 11, 1995) with Lanzi v. Alabama Dep't of Revenue, No. INC. 02-721 (Admin. Law Div. Sept. 26, 2003) ("I am no longer convinced that the Supreme Court intended the Quill physical presence test to apply beyond sales and use tax.").

Rarely has such a fiscally significant issue been met with such little unanimity amongst the States. Rarely have so many States been so willing to interpret precedent in such a constrained manner in their zeal to garner revenue. Rarely has the need for this Court's intervention been as urgent.

Tax nexus is too significant an issue to too many for predictability and clarity to be absent. Uncertainty inhibits business planning and investment and is extraordinarily costly from a fiscal and societal vantage point. While many problems of such magnitude are not easily addressed, this Court has the power and ability to ensure that the integrity of the judicial process is not eroded, reliance interests are respected, and the clarity provided by Quill is restored to this country's business community and tax agencies.

II. THE NORTH CAROLINA COURT OF APPEALS' DECISION CANNOT BE RECONCILED WITH THIS COURT'S PRECEDENT

The North Carolina Court of Appeals did not follow this Court's ruling in Quill Corp. v. North Dakota, 504 U.S. 298 (1992), that the Commerce Clause requires the physical presence of an entity in a State as a prerequisite to the State's exercise of its taxing authority. This Court has never found the Commerce Clause substantial nexus test to be met where the taxed entity did not have a physical presence in the State imposing the tax.

In Quill, this Court held that a mail-order business that had only a de minimis physical presence in North Dakota, yet derived substantial revenue from its mail-order sales to customers in that State, could not be required to collect and remit use tax to North Dakota on its sales to its North Dakota customers. The Court arguably left open the application of the rule outside of the sales and use tax arena, but the Court has never stated that there are different standards under the Commerce Clause based on the type of tax at issue. In Quill, this Court made two statements that have led States to argue that there are different "substantial nexus" requirements under the Commerce Clause. The first was: "Although we have not, in our review of other types of taxes, articulated the same physical-presence requirement that National Bellas Hess, Inc. v. Department of Revenue of Illinois, 386 U.S. 753 (1967) established for sales and use taxes, that silence does not imply repudiation of the Bellas Hess rule." 504 U.S. at 314. The second was: "In sum, although in our cases subsequent to Bellas Hess and concerning other types of taxes we have not adopted a similar bright-line, physical presence requirement, our reasoning in those cases does not compel that we now reject the rule that Bellas Hess established in the area of sales and use taxes." 504 U.S. at 317.

Those statements do not compel rejection of the Quill/Bellas Hess standard for other taxes. Indeed, this Court's pre- Quill and post-Quill decisions consistently support the conclusion that the Commerce Clause's physical presence requirement under the "substantial nexus" test set forth in Quill and Bellas Hess applies equally to all manner of taxes. In Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), a sales tax case, the Court relied equally on franchise tax precedent and that case has widely been regarded as setting forth the standard for income tax cases. See, e.g. Mobil Oil Corp. v. Commissioner of Taxes of Vt., 445 U.S. 425 (1980); Amerada Hess Corp. v. Director, Div. of Taxation, 490 U.S. 66 (1989); Trinova Corp. v. Michigan Dep't of Treasury, 498 U.S. 358 (1991); Barclays Bank PLC v. Franchise Tax Bd., 512 U.S. 298 (1994).

In Complete Auto, 430 U.S. at 274, the Court relied on franchise tax precedent i.e., Colonial Pipeline Co. v. Traigle, 421 U.S. 100, 101 (1975), and emphasized that semantic differences between taxes should not result in different analyses or results under the Constitution, concluding that "[a] tailored tax, however accomplished, must receive the careful scrutiny of the courts to determine whether it produces a forbidden effect on interstate commerce." Complete Auto, 430 U.S. at 288 n.15 (Court noted that its four-prong analysis,² which includes the "substantial nexus" requirement, had been applied by the Court to "many types of tax", id. at 279); Goldberg v. Sweet, 488 U.S. 252 (1989) (tax on telephone calls); Container Corp. of Am. v. Franchise Tax Bd., 463 U.S. 159 (1983) (franchise tax). In Commonwealth Edison Co. v. Montana, 453 U.S. 609, 626 (1981), this Court stated that "[u]nder this threshold test, the interstate business must have a substantial nexus with the State before any tax may be levied on it." It is evident that the substantial nexus test applies whether the tax is directly applied against a taxpayer, e.g., franchise or income tax, or if the taxpayer merely has collection responsibilities, e.g., sales or use tax.

In fact, this Court has suggested that, because of the risk of multiple taxation, a higher jurisdictional threshold should exist for the direct imposition of tax, such as income and franchise taxes, than for collection of use taxes. National Geographic Soc'y v. California Bd. of Equalization, 430 U.S. 551, 557 (1977). No decision of this Court, supports application of a lower standard or a more relaxed standard for income and franchise taxes than for sales and use taxes, nor is there anything in the plain language of the Commerce Clause that supports different standards. Application of the single Commerce Clause standard to all taxes, including income and franchise taxes, is not an unwarranted "expansion" (App. A at 14a), as the North Carolina Court of Appeals held, but is an internally consistent, time-honored, logical approach to the constitutional nexus requirement.

The lower court disregarded the impact of Quill on the basis that Quill's retention of Bellas Hess was grounded on the principle of stare decisis and on the substantial reliance on the physical presence test by the mail order industry, and the court below concluded that "[n]either consideration advocates for the [petitioners'] position." (App. A at 15a.) Stare decisis concerns, however, apply equally to corporations that have relied on this Court's holdings in Quill as their basis for not filing income and franchise tax returns in the jurisdictions where they lack physical presence. Indeed, unlike the situation in Quill which was focused upon one industry, the issue here extends to all entities that lack physical presence in a State, yet derive revenue from its residents.

Moreover, because the statute of limitations on a tax assessment does not begin to run until a tax return is filed, North Carolina General Statutes section 105-241(e), if North Carolina's decision is allowed to stand, all individuals and entities that receive income attributable to the use of their intangible property in a State would become subject to tax for each and every past year for which no tax return was filed in that State. Unlike use tax, which is imposed on the user of the intangible property, franchise and income taxes are direct taxes and these individuals and entities would have no recourse to reimbursement from their customers. Thus, stare decisis is even more critical here than it was when this Court decided in Quill to adhere to its 1967 Commerce Clause precedent in Bellas Hess.

III. STATES HAVE BECOME EMBOLDENED BY THIS COURT'S FAILURE TO INTERCEDE IN STATES' REVENUE-DRIVEN DISREGARD FOR THE COMMERCE CLAUSE TO THE DETRIMENT OF OUT-OF-STATE OWNERS OF INTANGIBLE PROPERTY

Quill was decided by this Court in 1992, affirming its Bellas Hess ruling that the Commerce Clause substantial nexus test requires physical presence in a State to support imposition of sales and use taxes. For the first time this Court recognized the distinction between the nexus requirements under the Due Process and Commerce Clauses. Nonetheless, in the following year, the South Carolina Supreme Court issued its decision in Geoffrey, Inc. v. South Carolina Tax Commission, 313 S.C. 15, 437 S.E.2d 13, cert. denied, 510 U.S. 992 (1993), and ignored this distinction by holding that Quill's physical presence test does not apply to income and franchise taxes, relying upon pre-Quill state decisions that never recognized the distinction between the Due Process and Commerce Clauses. Since the South Carolina court's Geoffrey decision, several States have amended their statutes, promulgated regulations and issued other "authority" to limit Quill's holding to sales and use taxes.³ The result is precisely the evil with which the framers of the Constitution were concerned -- the shifting of tax burdens from citizens to non-citizens at the expense of interstate commerce.

When one considers that the petitioners are nonresident intangible holding companies that have no physical presence in the State of North Carolina and that the State provides no benefits (fire or police protection or the like) to such companies, the resulting tax is a constitutional deterrent to interstate commerce. Indeed, in addition to "substantial nexus," one of the four prongs of Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), requires that any taxes imposed must be fairly related to the services provided by the State. North Carolina does not provide services to any of the petitioners. Intangible property in a State does not travel the roads, and does not require police and fire protection. Disputes as to the marks, moreover, would not even involve state courts because intellectual property matters are routinely litigated in federal courts. This further buttresses the correctness of Quill's physical presence requirement in the context of the Commerce Clause. This Court's intervention is needed to ensure that States do not continue to tread on the Constitution in their attempts to shift their tax burdens to out-of-state entities.

The prospect of multiple taxation based on intangible property by various States is very real. The likelihood of litigation testing the contours of the presence of intangible property in any given jurisdiction is great and the continuing requests for this Court to review challenges to those determinations that are likely to ensue undermines the predictable worth of such business assets. Utilization of an economic nexus standard would be "an invitation to chaos." (App. H at 214a.) To avoid just such problems, in the international tax arena, the Organisation for Economic Co-operation and Development (OECD) Model Treaty and treaties with foreign nations require a "permanent establishment" as a prerequisite to the imposition of tax nexus for non-resident corporations; merely deriving income is an insufficient basis for taxation.

Respondent's attempt to justify its imposition of state income and franchise taxes on petitioners based on the use of their intangible property by others is a violation of the nexus requirement of the Commerce Clause.

² Under the four prong test set out by this Court in Complete Auto a tax will be sustained under the Commerce Clause only if 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 fairly related to the services provided by the State.

³ For example, North Carolina's Department of Revenue promulgated Rule 5C.0102(a)(5)(C) of title 17 of the Administrative Code to expand its interpretation of "doing business" to include "the operation of any business enterprise or activity in North Carolina for economic gain, including . . . the owning, renting or operating of business or income-producing property in North Carolina including . . . [t]rademarks, tradenames, franchise rights, computer programs, copyrights, patented processes,[or] licenses." See also Ark. Reg. 1996-3 (licensing of intangibles in an intragroup intangible licensing transaction creates nexus); Fla. Admin. Code r. 12C-1.011 (selling or licensing the use of intangibles for years beginning after January 1, 1994 creates nexus); Iowa Admin. Code r. 701.52.1(422) (citing Geoffrey and providing that licensing intangibles to corporations doing business in Iowa creates nexus); Directive 96-2 (Mass. Dep't of Revenue July 3, 1996) (licensing of intangibles for use in Massachusetts creates nexus); Minn. Stat. § 290.015 (providing that business within Minnesota includes transactions with customers in the State that involve intangible property and results in receipts attributable to Minnesota); N.J. Stat. Ann. § 54:10A-2 (imposing tax on corporations for the privilege of deriving receipts from New Jersey sources); N.J. Admin. Code tit. 18, § 7-1.9(b) (providing -- even before the statutory change referred to previously -- that a foreign corporation that licenses trademarks to New Jersey corporations for use in New Jersey is subject to tax); Okla. Admin. Code § 710:50-17-3(a)(9) (licensing of intangible rights for use in Oklahoma creates nexus); Wis. Admin. Code § 2.82(4)9 (licensing of intangible rights for use in Wisconsin creates nexus).