Frequently, companies with significant patent portfolio or other intellectual property assets create a subsidiary or affiliated holding company to manage and enforce those assets. In many instances, these holding companies are formed to achieve some income tax benefit for the parent corporation or other related subsidiaries by providing a state-level deduction for royalty payments made to the holding company in exchange for licenses to use its intellectual property.

Last week, the Maryland Court of Appeals issued a much anticipated tax decision, ruling the state may tax a Delaware patent holding company on royalties received from licenses of its patent portfolio to a related company doing business in Maryland. The decision, Gore Enterprise Holdings, Inc. v. Comptroller of the Treasury; Future Value, Inc. v. Comptroller of the Treasury, No. 36, September Term, 2013 (Md. March 24, 2014), could have a significant impact on any out-of-state patent holding company whose sole business is licensing its intellectual property to a parent or related company doing business in Maryland.

The case arises from a 2006 Maryland state audit of Gore Enterprise Holdings (GEH), a Delaware holding company and wholly-owned subsidiary of the Delaware-based, specialty manufacturing company W.L. Gore & Associates. Gore operates factories in several states, including Maryland, and GEH owns and manages Gore’s entire patent portfolio, which includes licensing the portfolio to Gore at a royalty rate of 7.5% on Gore product sales in the U.S.

In the 2006 audit, the Maryland Comptroller issued an income tax assessment asserting that GEH owed the state $26 million in back taxes. The comptroller reasoned that GEH’s business operations were nearly inseparable from those of its parent corporation such that GEH had nexus with Maryland and on that basis apportioned a part of GEH’s income to Maryland. The assessment was thoroughly litigated, eventually arriving before the Maryland Court of Appeals. There, Maryland’s high court upheld the taxation of GEH, reasoning that GEH had no economic substance as a business entity separate from its parent, Gore. The Court further held that the unitary business principle can be used to tax an apportioned sum of a company’s multistate business so long as the business is unitary. However, the Court held that the principle does not confer nexus to allow a state to tax directly a subsidiary based solely on the fact that the parent company is taxable in the state and that the parent and subsidiary are unitary.

The decision raises some significant tax concerns for patent holding companies whose parent- or related-licensees do business in Maryland. Although the Court of Appeals rejected the use of the unitary business principle to establish nexus in Maryland for tax purposes, a holding company without economic substance as a separate business entity apart from its parent or related company could nevertheless find itself paying Maryland income taxes on a portion of its income.