While the intangible holding company cases involving The Classics, Talbots, and others are pending, the Maryland Comptroller has been aggressively expanding the scope of audit targets beyond royalty-earning intangible holding companies. Now the Comptroller is targeting companies with significant numbers of employees, as well as companies earning income from transactions other than licensing arrangements. In keeping with his preference for combined reporting, the Comptroller has now expanded the scope of his targets in a way that could implicate any arrangement between affiliates if the result of the arrangement lowers Maryland tax. In fact, the information reporting that is now required under legislation passed last year may serve as a useful tool for the Comptroller to carry out his apparent new theory to raise revenue—with or without statutory combined reporting authority.

Specifically, the Comptroller’s most recent argument is that regardless of “the appearance of economic substance” and regardless of whether the arrangement is “intentional or not,” if one affiliate acts “at the will of the parent company,” the Comptroller can disallow deductions. R.R. Donnelley Receivables, Inc. v. Comptroller, 07-IN-00-0614 (Aug. 24, 2007). In the R.R. Donnelly case, the Comptroller is attacking a receivables company, going back to 1989, that has 28 employees and that has even solicited third parties to acquire its services.

Another company that the Comptroller has attacked recently is Recot, Inc. That company has 1,000 employees, has more than $400 million of property and equipment, and conducts major manufacturing operations. It also licenses intellectual property, including patents and trademarks, to affiliates and nonaffiliates. It has no physical presence in Maryland. Nonetheless, the Comptroller has asserted that Recot must file a tax return and pay tax based on Recot’s receipt of royalty income. Predicated on the Comptroller’s assertion that, “Recot has purposely availed itself to, and sought the economic benefit from, the state of Maryland through its leasing of trademarks to its affiliate with a substantial presence in Maryland,” the Comptroller has assessed tax, penalty and interest going back to 1989 totaling more than $10 million. Recot, Inc. v. Comptroller, 07- IN-00-0756 (Nov. 14, 2007).

In the Recot case, the taxpayer pointed out the factual differences between its case and Comptroller of Treasury v. SYL, Inc., 375 Md. 78, 825 A. 2d 399 (2003), a 2003 Maryland Court of Appeals decision which involved an intangibles holding company. (The taxpayer in SYL, as many know, had difficulty establishing that it followed the formalities of its separate existence.) The Comptroller concluded that Recot’s case “could been seen as a wolf in sheep’s clothing, whereas the SYL case could be classified as a wolf in wolf’s clothing.” He argued that “[r]egardless of whether the affiliate company which the intellectual property was transferred to was a blatant sham company such as SYL or whether the affiliate company had one thousand employees involved in a manufacturing business,” the taxpayer still has nexus with Maryland. The Comptroller concluded that “the substance of…Recot…should control the tax consequences, not the organizational structure created by tax planners. The Comptroller found it impossible to see how the business income of Recot due to the…leasing of…intellectual property…is not income reasonably…attributable to carrying on business in Maryland.” Recot, Inc. v. Comptroller, 07-IN-00-0756 (Nov. 14, 2007).

The Comptroller has not taken a consistent approach in the pending cases. On the one hand, as the Recot case shows, the Comptroller has argued that licensing activity, itself, creates nexus—regardless of the substance of the entity doing the licensing. On the other hand, the Comptroller has also been unable to resist arguing, as he did in The Classics litigation, that the alleged “minimal nature of operating expenses of” the holding company should be considered by the Tax Court. Because the Comptroller is having difficulty picking a theory, he has hedged his bets in many instances by issuing assessments against both the operating company and the holding company. Comptroller’s Post Trial Memorandum of Law, The Classics Chicago, Inc. and The Talbots, Inc. v. Comptroller, 06- IN-00-0226 (Nov. 27, 2007).

Finally, penalties remain an issue in every assessment. The Comptroller in The Classics litigation pointed to the steps that tax managers within the company took to change the “appearance” of the arrangement by, for example not including the “Talbots” name in the name of the holding company. The Comptroller also pointed to instances in which the companies’ tax managers allegedly acknowledged, at the time the arrangement was established, that “states…will try to tax [Classics] income.” In all, the Comptroller is arguing that the taxpayer “should have been suspicious about the propriety” of the deductions that were claimed and thus the taxpayer should be penalized because “the device used to siphon taxes out of Maryland” was “singularly blatant in its disregard” of reality. Comptroller’s Post Trial Memorandum of Law, The Classics Chicago, Inc. and The Talbots, Inc.,v. Comptroller, 06-IN-00-0226 (Nov. 27, 2007).

On the point of penalties, the Comptroller continues to go too far. For many of the years at issue, there was no guidance on whether a holding company has nexus with a taxing jurisdiction merely by licensing trademarks. The first decision of a state court of last resort on this issue was in 1993. Geoffrey, Inc. v. South Carolina Tax Comm’n, 313 S.C. 15 (1993). But when that decision was issued, it was considered by many to be groundbreaking. See, e.g., 3 J. MultiState Tax’n 147 (“This opinion extends nexus significantly beyond where most authorities thought it to be”). Moreover, even courts that have ruled in favor of taxpayers have recognized that “a split of authority has developed regarding whether [a physical presence standard is] limited to sales and use taxes.” Lanco, Inc. v. Director, Division of Taxation, 188 N.J. 380, 382 (2006). Thus, it is hard to understand why a taxpayer was negligent for not filing a return.

Fortunately, it seems the Tax Court is suspicious of the Comptroller’s arguments in this regard. It is hoped that the upcoming decisions in the pending cases will provide guidance. Meanwhile, for companies with exposure on this issue, the Comptroller continues to invite taxpayers to come forward voluntarily on a basis that is more favorable than they will face if they are caught.