It’s a new year and with a new year comes speculation about things to come. Will Maryland adopt combined reporting? Will Maryland use a "unitary nexus" theory to tax out-of-state companies? Will Maryland reduce its corporate income tax rate? Although we don’t have a crystal ball that provides the answer to these questions, we can highlight a few cases and bills taxpayers will want to keep an eye on this year. Depending on the outcomes, the issues raised could lead to big changes in Maryland’s tax regime.
Tax Cases to Watch
Gore: Will Maryland Establish a New Unitary Nexus Standard?
On December 6, 2013, the Maryland Court of Appeals heard oral arguments in Gore Enterprise Holdings, Inc. v. Comptroller of the Treasury; Future Value, Inc. v. Comptroller of the Treasury.1 In that case, Gore Enterprise Holdings (GEH) licensed patents to Gore Inc. and, in return, Gore Inc. paid a royalty to GEH. Future Value made loans to Gore Inc. and, in return, Gore Inc. paid interest to Future Value on the loans. The Comptroller issued assessments against GEH and Future Value based on these transactions with Gore Inc.The primary issue is whether the Comptroller can establish nexus over GEH and Future Value based solely on the fact that they were unitary with an in-state operating company (Gore Inc.).
At the oral argument, the judges asked about the business operations of the in-state and out-of-state entities, and also inquired as to whether there was a difference between licensing trademarks and patents for tax purposes. However, the judges focused most of their questioning on whether the unitary business principle can be used to establish nexus over an entity. Counsel for Gore explained to the bench that the state must satisfy two separate nexus tests to tax a transaction: (1) it must establish nexus over the entity, and (2) it must establish nexus over the transaction. In the income tax context, this second test determines whether the state can tax an apportioned share of the income from a transaction or must allocate the income from the transaction to a specific state. Counsel for Gore argued that the unitary business principle is only relevant in applying this second test. Counsel for the Comptroller argued that the unitary business principle can be used to establish Due Process Clause nexus over an entity. At least one judge seemed persuaded by the state’s argument, while the remaining judges either were quiet on this issue or asked questions in an attempt to understand the interplay between nexus, apportionment and the unitary business principle.
Based on the oral argument, how the court will rule in this case is still unclear. However, it is clear from the questions at oral argument that for at least some of the judges, the concept of "unitary nexus" is not as far-fetched as some taxpayers believed. We expect a decision will be issued by spring of this year, at the earliest, but more likely by the end of 2014.
For more on the Gore case, including a discussion of the lower courts’ opinions and the case’s impact on pending cases and audits, please see our February 13, 2013 alert.
NIHC: Can Maryland Tax Gain Recognized Under the Federal Consolidated Return Rules?
The Maryland Court of Appeals has scheduled oral argument for March 7, 2014 in Comptroller of the Treasury v. NIHC, Inc.2 The NIHC case is an appeal from a 2008 Maryland Tax Court decision involving the treatment of a transaction between two intangible holding companies affiliated with Nordstrom – NIHC and N2HC.3
NIHC involves a 1999 transaction, whereby NIHC distributed, as a dividend, a license agreement authorizing the right to license the use of Nordstrom trademarks, to its parent, N2HC. As a result of the dividend of the licensing agreement, NIHC recognized gain on the distribution of appreciated property for federal income tax purposes pursuant to Internal Revenue Code ("IRC") § 311(b). Under the federal consolidated return regulations, NIHC was required to defer recognition of the gain from the distribution for federal income tax purposes and, instead, recognize the gain over the 15-year period in which N2HC amortized the value of the license agreement under IRC § 197. Approximately $186 million per year in deferred § 311(b) gain was reported by NIHC in the Nordstrom federal consolidated returns for 2002, 2003 and 2004. NIHC, on its 2002 and 2003 Maryland tax returns, originally included the $186 million per year of deferred IRC § 311(b) gain in Maryland modified income. NIHC then sought refunds, arguing that the deferred gain was reported in error. NIHC argued that because Maryland has not adopted combined filing, Maryland is prohibited from taxing gain deferred under the federal consolidated return regulations.
The Maryland Tax Court decided three issues. First, the Tax Court found a sufficient constitutional nexus between NIHC’s IRC § 311(b) gain and Nordstrom’s business activities in Maryland. Second, the Tax Court determined that NIHC’s IRC § 311(b) gain was subject to Maryland taxation because NIHC reported § 311(b) deferred gain as Maryland modified income on its 2002 and 2003 Maryland income tax return. Third, the Tax Court ruled that, in light of the nexus between NIHC’s IRC § 311(b) gain and Nordstrom’s business activities in Maryland, Maryland’s separate reporting requirement did not preclude the Comptroller from taxing the IRC § 311(b) gain on a deferred basis pursuant to the federal consolidated return regulations, if the gain was reported on a deferred basis on NIHC’s 2002 and 2003 Maryland income tax returns.
On appeal, the Circuit Court affirmed the Tax Court’s decision on the first two issues, but reversed on the third issue, holding that Maryland’s separate filing requirement for corporations prevented Maryland from taxing NIHC’s IRC § 311(b) gain on a deferred basis. The Comptroller appealed to the Maryland Court of Special Appeals. As a result, only the third issue was before the Court of Special Appeals.
The Court of Special Appeals held that because NIHC reported the IRC § 311(b) deferred gain as Maryland modified income on its 2002 and 2003 Maryland tax returns, it was taxable. The court reasoned that nothing precludes Maryland from taxing income that is constitutionally taxable by Maryland and that is reported by the taxpayer as Maryland modified income on its Maryland tax return. The court did not express an opinion on the actual issue of whether, under Maryland’s separate filing regime, NIHC was required to report the IRC § 311(b) gain on a deferred basis for Maryland income tax purposes, reasoning that the facts of the case (namely, NIHC’s reporting of the deferred gain on its Maryland return) did not require the court to address this issue. NIHC appealed the Court of Special Appeals decision to the Maryland Court of Appeals.
Super-Concrete: Can an LLC Be Treated as a Corporation for Purposes of the Transfer Tax Exemption for Transfers Pursuant to an IRC § 368(a) Reorganization?
The appeal in Super-Concrete Corporation v. State Department of Assessments and Taxation is scheduled to be heard by the Maryland Court of Special Appeals in May 2014.4 The Super-Concrete case involves the scope of Maryland’s exemption from state and local recordation and transfer taxes for conveyances made pursuant to a reorganization under IRC § 368(a).
In Super-Concrete, a Maryland limited liability company elected to be treated as a corporation for federal income tax purposes. The LLC merged with and into a District of Columbia corporation (the Taxpayer). As a part of the merger, the Taxpayer filed a Certificate of Conveyance for real property that the LLC owned in Maryland that was included in the merger. The Taxpayer claimed an exemption from recordation and transfer taxes for the conveyance, claiming the conveyance was made pursuant to a reorganization under IRC § 368(a). The State Department of Assessments and Taxation ("SDAT") denied the Taxpayer’s exemption claim and assessed recordation and transfer taxes, stating that IRC § 368(a) does not describe the merger of an LLC into a corporation. The Taxpayer paid the taxes and subsequently filed a request for refund. SDAT denied the request and the Taxpayer appealed to the Maryland Tax Court.
The Tax Court determined that the merger was not exempt from recordation and transfer taxes. The court held that the recordation tax exemption only applies to entities that are considered to be corporations under Maryland law. Although the LLC elected to be treated as a corporation for federal income tax purposes, an LLC did not fall within the definition of a corporation under the Maryland Tax Property Article. The Circuit Court for Baltimore City affirmed the Tax Court’s decision.
This case could have implications in other contexts outside of recordation and transfer taxes. For instance, Maryland’s sales and use and motor vehicle excise taxes each includes exemptions for transfers as a result of a reorganization under IRC § 368(a). As a consequence, the Maryland Court of Special Appeals’ decision could impact the application of these other IRC § 368(a) reorganization exemptions.
Tax Legislation to Monitor
Maryland’s legislative session began last week. Taxpayers will want to monitor legislative developments on the following topics. In some cases, bills on these topics were pre-filed before the legislative session began.
- Combined Reporting. The introduction of a combined reporting bill has become somewhat of an annual tradition in Maryland. Although such a bill has yet to be introduced, we expect this year to be no different. However, the prospects of a combined reporting bill passing this year seem slim.
- Corporate Income Tax Rate Reduction. SB 8 was filed prior to the start of Maryland’s legislative session and proposes to decrease the state’s corporate income tax rate by .45 percent each year for five years, from 8.25 percent to 6 percent by 2018. However, there are doubts that any proposals to reduce the corporate income tax rate will pass this year given the state’s current FY 2014 revenue projection, which was decreased by more than $60 million last fall.
- Section 179 and Bonus Depreciation Deductions in Play? Pre-filed bill SB 47 proposes to remove Maryland’s provisions decoupling from the bonus depreciation deduction allowed for federal purposes under IRC § 168(k), and the federal election to expense the costs of certain otherwise depreciable property under IRC § 179. Under SB 47, Maryland would conform with both Internal Revenue Code provisions for property placed in service on and after January 1, 2014.
- Exemption for Transfer of Property Between Business Entities. At the request of the State Department of Assessments and Taxation, the Chair of the Senate Budget and Taxation Committee pre-filed SB 106, which proposes to exempt from recordation and transfer taxes the transfer of real property between specified business entities (namely, an LLC or corporation) as part of an IRC § 368(a) reorganization. The bill, if enacted, would apply to instruments of writing recorded on or after July 1, 2014. This bill directly addresses an issue that is currently the subject of litigation (see case summary above for Super-Concrete Corporation v. SDAT). Whether the introduction of this bill is an attempt by SDAT to bolster its litigation position (to show that current law had to be amended to provide an exemption for 368(a) reorganizations involving LLCs) or is a good-faith effort by SDAT to provide a taxpayer-favorable solution to this issue, is unclear. This legislative fix covers only the exemption for recordation and transfer taxes, and would not have an impact on any potential issues concerning the sales tax or motor vehicle tax exemptions for IRC § 368(a) reorganizations.
- No Penalty, No Interest. Pre-filed bill SB 39 proposes to prohibit a tax collector from assessing interest on unpaid taxes if the tax collector does not also assess a penalty. Although the bill’s sponsor has indicated that the bill is intended to be pro-taxpayer, it could result in unfavorable results. For example, in settlement, taxpayers rarely receive interest relief, but are often able to negotiate for a waiver of penalties. If enacted, this bill could result in the Comptroller taking the position that it cannot waive penalties for fear of also being required to waive interest. The Maryland Chamber of Commerce’s Tax Policy Committee intends to follow up with the bill’s sponsor regarding its concerns with the bill.
- Recording Calls Made to Taxpayer Assistance. The Comptroller’s office is expected to introduce a bill that would allow it to record calls made to its Taxpayer Assistance customer service numbers for quality and training purposes. The bill is intended improve the accuracy of information relayed via Taxpayer Assistance.