A Colorado district court held that Target Brands, Inc. (“TBI”), a subsidiary intangible holding company of Target Corporation (“Target”), had economic nexus with Colorado but the Department of Revenue (the “Department”) failed to use a reasonable alternative apportionment method when it assessed nearly $20 million in state corporate income tax for tax years 1999 through 2009 (the “Tax Years at Issue”). The case, Target Brands Inc. v. Department of Revenue, 2015CV33831, decided by the District Court of the City and County of Denver on January 27, 2017, highlights yet another example of aggressive economic nexus and alterative apportionment arguments of state revenue agencies to expand their revenue base by capturing income from out-of-state intangible holding companies.
TBI’s Business Operations and Corporate Structure
TBI was formed by Target as a wholly-owned subsidiary designed to develop and protect Target’s intellectual property (“IP”), including the Bullseye logo and the TARGET trademark, through three broad business objectives: i) brand acquisition and management; ii) brand compliance; and iii) brand protection. During the Tax Years at Issue, TBI and Target entered into a licensing arrangement whereby Target was granted the right to use TBI’s IP in connection with its retail sales in exchange for a monthly arm’s-length royalty rate. TBI had 80% of its assets outside the United States, including primary offices and payroll in Hong Kong and Florence, as well as offices and payroll in Minneapolis; however, no physical office or payroll ever existed in Colorado. As a result, Target deducted royalties it paid to TBI, an “80/20 company,” from its income, thereby reducing both its federal and Colorado state income. Furthermore, as an 80/20 company, TBI was excluded from Target’s combined Colorado state income tax return. Given that TBI had no property or payroll, i.e., no physical presence, in Colorado, TBI did not separately file its own Colorado income tax return during any of the Tax Years at Issue.
Target’s Use of TBI’s IP in Colorado Created “Economic Nexus”
As a threshold matter, TBI asserted that it did not have nexus with Colorado, as it had no physical presence in the State, and thus could not be subject to the State’s corporate income tax. Conversely, the Department, through a Multistate Tax Commission audit, concluded TBI was “doing business in Colorado” through Target’s use of TBI’s IP in exchange for a royalty fee “based on sales that Target […] made within the state.” Colorado does not statutorily or by regulation define “doing business” in the State for purposes of an intangible holding company’s business activities.
Absent such authority, the Court highlighted a Department publication that stated: “Corporations that do not have employees nor stocks of goods in Colorado […] are not doing business in Colorado and are not subject to Colorado income tax.” Nevertheless, the Court found this guidance to be nonbinding on the Department and “could not be fairly interpreted as applying to intangible property.” The Court then concluded “TBI was doing business in Colorado” because: i) TBI chose to license its IP for use by Target in Colorado; ii) directed use of its IP within the State; and iii) received millions of dollars in income related to the use of its IP within the State. After concluding TBI was “doing business in Colorado” through economic presence in the State, the Court further held that Colorado’s taxation of TBI did not violate the Commerce Clause of the U.S. Constitution.
The Department Properly Invoked Its Alternative Apportionment Authority But Failed to Use A Reasonable Alternative Method
After addressing the Parties’ “economic nexus” arguments, the Court analyzed whether the Department properly invoked its alternative apportionment authority. For tax years 1999 through 2008, Colorado required a three-factor apportionment formula for most corporations, consisting of a property factor, a payroll factor, and a sales factor. During those years, a “sale” by a multistate corporation occurred in Colorado only if “a greater proportion of the income-producing activity [was] performed in [Colorado] than in any other State, based on costs of performance.” To the extent the Department found “unusual fact situations” that “produce incongruous results” under the standard apportionment formula, it was authorized by statute to assert that an “alternative apportionment formula” should be used. As the party seeking alterative apportionment, the Department was required to prove–by a preponderance of the evidence–that: i) the default apportionment formula does not fairly reflect the taxpayer’s business activity in Colorado; and ii) the Department’s proposed alternative method is reasonable.
With respect to the first requirement, the Court held that the Department properly demonstrated the standard apportionment formula did not fairly reflect TBI’s business activity in Colorado. Central to the Court’s analysis was the Department’s argument that “the standard three-factor apportionment formula […] would result in TBI owing no income tax to the State of Colorado” despite the company receiving millions in royalties in connection with Target’s sales to Colorado customers. More specifically, TBI had no payroll or property in Colorado and, for purposes of the applicable sales factor, TBI maintained 100% of income producing activity outside Colorado. As a result, the Court held the Department’s use of an alternative apportionment formula was appropriate because the standard formula did not “account for the manner in which TBI’s income is generated and where the income-generating activity occurs.”
The Court’s reasoning echoes the questionable result in Vodafone Americas Holdings, Inc. v. Roberts, 486 S.W.3d 496 (Tenn. 2016), where the Tennessee Supreme Court allowed the State to invoke alternative apportionment after finding the statutory cost of performance method resulted in some income not being apportioned/taxed in any state (i.e., “nowhere income”). As was the case in Vodafone, the primary question in Target Brands should have been whether an appropriate share of TBI’s income should be apportioned to Colorado. The Court in Target Brands, however, offered some encouraging analysis, stating: “The Court is disinclined to permit the Department to accomplish indirectly what neither it nor the General Assembly could have done, but did not do, directly and expressly.” However, the lack of any Colorado statute or regulation to address apportionment of income for out-of-state intangible holding companies was apparently not enough. The Court concluded that this was an “unusual circumstance” and that the Department had satisfied its burden by proving the standard Colorado apportionment formula did not fairly reflect TBI’s Colorado business activity.
With respect to the second requirement, the Court held that application of the Department’s proposed alternative apportionment method was not reasonable. In this case, the Department excluded TBI’s property and payroll entirely from consideration and, instead, utilized a single sales factor based on Target’s Minnesota sales. Flatly rejecting this approach, the Court stated that “[t]he record is replete with evidence of the material contributions made by TBI’s employees and property toward creating, enhancing, and preserving the income the Department seeks to tax.” As such, the Court held that “omitting these factors is neither ‘reasonable’ or ‘equitable.’” The Court then instructed the Department to include TBI’s payroll and property factors in addition to Target’s sales factor for purposes of determining TBI’s Colorado apportioned income.
The Colorado district court found economic nexus to exist for TBI absent any statutory or regulatory guidance. Additionally, while the Court correctly discussed when evoking alternative apportionment should or should not be allowed (i.e., unusual factual situations), it more or less affirmed the use of alternative apportionment in a situation where: i) the standard cost of performance method did not source any of TBI’s receipts to Colorado; and ii) TBI’s fact pattern was a very common structure/not unique. Indeed, whether the use of out-of-state companies like TBI is truly “unusual” is questionable. For example, in Petition of Staples Inc. and Staples the Office Superstore LLC, Case No. C-02-CV-15-0020009 (Cir. Ct. Ann. Arundel, Dec. 30, 2016), a Maryland circuit court upheld a ruling that related out-of-state companies that provided administrative and managerial services to in-state affiliates had created nexus with Maryland. The circuit court then upheld the Maryland Comptroller’s use of alternative apportionment to capture the royalty and interest income received by the out-of-state companies. Thus, the outcome of Target Brands Inc. begs the question: is this really an unusual fact pattern or is this just another example of state revenue agencies employing extreme measures to capture income otherwise statutorily sourced outside the state?