On May 3, 2017, in Romantix Holdings Inc. v. the Iowa Dept. of Revenue, the Court of Appeals of Iowa affirmed the Iowa Department of Revenue’s (the “Department”) determination that (1) a parent holding corporation was ineligible to join its Iowa subsidiaries’ consolidated Iowa income tax returns because the holding company was not subject to Iowa income tax; and (2) the holding company’s Iowa subsidiaries could not deduct certain expenses incurred and paid directly by the holding corporation but ratably allocated to the subsidiaries based on a percentage of revenue approach. While the Court ruled against the taxpayer on both issues, this case more broadly holds that an in-state operating subsidiary’s use of an out-of-state holding company’s intangible property, including a business trademark, does not necessarily create nexus for the out-of-state holding company with Iowa. The Court’s ruling potentially conflicts with determinations from other state courts under similar facts where intangible holding companies were held to have nexus based on the activities of in-state operating subsidiaries involving the out-of-state entities’ intangible personal property. See our prior coverage, Colorado District Court Holds Economic Nexus Exists for a Minnesota Intangible Holding Company and Agrees to a Modified Alternative Apportionment Method, June 19, 2017.
Romantix Holdings, Inc. (“RM Holdings”), is a holding company that owns and operates several Iowa subsidiaries, along with the Romantix trademark. Several of the RM Holdings Iowa subsidiaries operate nine adult bookstores and use RM Holdings’ intangible property, e.g., its trademark, to promote their Iowa business operations. RM Holdings, and its Iowa subsidiaries, were acquired in 2007 through a stock redemption agreement using debt financing with monthly installments payable over 15 years. In addition, RM Holdings paid the former owner $100,000 per year for 15 years in exchange for executing a covenant not to compete.
RM Holdings was included in the 2009 consolidated Iowa corporate income tax return with its Iowa subsidiaries. Interest and amortization expenses were all allocated to RM Holdings for that year and were used to offset taxable revenue generated by the other members of the consolidated group. The following year, RM Holdings was excluded from the 2010 Iowa consolidated corporate income tax return and instead interest and amortization expenses were allocated to RM Holdings’ Iowa subsidiaries based on a percentage of revenue method.
The Department disallowed the allocation of the expenses to RM Holdings’ Iowa subsidiaries. RM Holdings, and its Iowa Subsidiaries, protested the assessments, and an Iowa administrative law judge ruled in the taxpayer’s favor. The Department appealed, and the Iowa Director of Revenue held RM Holdings “should not be included on the Iowa Subsidiaries’ consolidated Iowa income tax returns and that the Iowa Subsidiaries were not allowed to deduct [RM Holdings’] acquisition debt and covenant not to [compete] expenses because the subsidiaries, did not owe and did not pay the expenses.”
After an Iowa district court upheld the Director’s determinations, RM Holdings, and its Iowa subsidiaries, appealed the district court’s ruling on the basis that (1) RM Holdings should be included in an Iowa consolidated corporate income tax return with its Iowa subsidiaries; and (2) regardless of the first issue, RM Holdings’ Iowa subsidiaries should be able to claim the acquisition debt / expenses on their 2009 and 2010 consolidated Iowa corporate income tax returns.
Including RM Holdings in the Iowa Consolidated Return
On appeal, the taxpayer argued that RM Holdings was not exempt from Iowa taxation, because it “directly owned intangible property that was utilized by its subsidiaries in the subsidiaries’ Iowa business activity,” and thus, was properly includable with its Iowa subsidiaries in a consolidated Iowa corporate income tax return.
The Court rejected RM Holdings’ argument citing to Iowa Code § 422.34A(5), which exempts from taxation “[o]wning or controlling a subsidiary corporation which is incorporated in or which is transacting business within this state where the holding or parent company has no physical presence in the state […].” The Court also heavily relied on a March 24, 2017 Iowa Supreme Court decision, Myria Holdings Inc. v. Iowa Dept. of Revenue, where an out-of-state holding company was held not to have nexus in Iowa through ownership of shares of stock in, and the allocation of money to, in-state operating subsidiaries.
In Romantix, the Court found that, like the taxpayer in Myria Holdings, “[a]ll of [RM Holdings’] activities with its subsidiaries doing business in Iowa […] were activities of owning and controlling a subsidiary corporation within the meaning of Iowa Code section 422.34A(5).” It is important to note that unlike the taxpayer in Myria Holdings, RM Holdings also owned the Romantix trademark which was likely used by the Iowa subsidiaries to promote their business operations, although, interestingly the Court’s decision makes no reference to the payment of royalty expenses by the subsidiaries to RM Holdings for the use of the trademark. Since RM Holdings did not have taxable nexus with Iowa, the Court held that RM Holdings could not join the Iowa consolidated return with its subsidiaries.
Payment of Expenses by the Iowa Subsidiaries
Notwithstanding the consolidated filing issue, the taxpayer also argued that it properly allocated its debt expenses from acquiring the company in 2007 to its Iowa subsidiaries, and thus, the Iowa subsidiaries should be allowed to offset their operating revenue with these expenses on their 2009 and 2010 consolidated Iowa corporate income tax returns. Specifically, RM Holdings argued that its allocation was proper for Iowa tax purposes because (1) the Iowa subsidiaries guaranteed the acquisition debt; and (2) the income to pay the debt expense flowed from the Iowa subsidiaries to RM Holdings who then directly made the payments.
The Court again rejected RM Holdings’ argument and held that, while the Iowa subsidiaries may have supplied money to RM Holdings to pay the acquisition expenses, the subsidiaries did not actually make the payments themselves. As a result, the Court held the Iowa subsidiaries could not deduct from their taxable revenue the debt repayment expenses for the 2009 and 2010 tax years.
The Court heavily relied on Myria Holdings in reaching its conclusion that RM Holdings did not have nexus as an out-of-state holding company. In fact, the Court made no distinction between the holding company in Myria Holdings and the holding company in Romantix. Instead, it appears that the Court simply relied on precedent without exploring further factual distinctions between these two cases, such as the fact that RM Holdings owned the Romantix trademark and that the intangible property at issue in Myria Holdings was stock of the subsidiaries and money.
While the Romantix Court noted RM Holdings’ ownership of the trademark, it did not provide any explicit analysis as to whether use of a trademark by an in-state operating entity creates nexus. The decision also does not contain any discussion of whether the in-state subsidiaries compensated RM Holdings for the use of the trademark. Without this analysis, it is difficult to fully reconcile the holding in Romantix with the Iowa Supreme Court decision in KFC Corp. v. Iowa Dept. of Revenue, where it was held that “Iowa could tax a foreign corporation whose only connections with Iowa were franchise agreements in which it licensed its trademarks and systems to independent franchisees doing business in Iowa.”
The Iowa Supreme Court in Myria Holdings found that its holding was compatible with KFC Corp. because the holding company in Myria Holdings “received no royalty payments, license fees, or other earned fees in connection with an integral aspect of the affiliated group’s business activities.” In contrast, the Romantix Court ultimately concluded that a holding company that owned a trademark that was used by its in-state operating subsidiaries was not subject to Iowa taxation. As a result, Iowa taxpayers are left with uncertainty because the Court did not (1) clarify whether the out-of-state holding company was compensated for the use of its trademark; or (2) discuss or distinguish the precedential decision of KFC Corp.