On June 18, the U.S. Supreme Court denied certiorari in Lanco, Inc. v. Director, Div. of Taxation.1 As a result, the law in New Jersey is that an intangible holding company (“IHC”) licensing trademarks into New Jersey is subject to corporate income tax—regardless of whether it has any physical presence. Now, a recent New Jersey Tax Court decision, Praxair Technology, Inc. v. Director, Div. of Taxation,2 extends Lanco to a new set of facts and extends the look-back period farther than the look-back under Lanco. More ominously, the Tax Court held that 25 percent failureto- file penalties should be imposed and that the 5 percent amnesty penalty was not unconstitutional. (The Praxair decision is an unpublished letter opinion; it is available at www.reedsmith.com/njtax.)
Earning Patent Royalties Creates Nexus
Praxair Technology, Inc. (“PTI”) is an intangible holding company that licensed intangibles to an affiliated operating company. Unlike Lanco, which licensed trademarks, PTI licensed patents and trade secrets. PTI’s licensed technologies were used by the affiliate to manufacture industrial gases at various facilities, including facilities in New Jersey. Notwithstanding these factual differences, the Praxair court concluded that it “both agrees with and is currently bound by the higher New Jersey Court’s holding in Lanco.”3
The Division Can Look Back Before 1996
For IHCs with holding companies, 1996 was considered an important year: That was the year in which the Division amended its nexus regulation to add an example providing that a royalty-earning IHC had nexus by earning trademark royalties related to sales of products by an affiliate in New Jersey.4 Because of that amendment, many practitioners had thought that the Division would go no earlier than 1996 in its assessments. Indeed, the Tax Court in Lanco implied this. In Lanco, the only tax year at issue was 1998. Nevertheless, the Tax Court in Lanco said that it would be “problematical” to apply a no-physical-presence rule to years before 1996.5 In its view, several New Jersey cases that pre-dated the regulatory change had based “nexus on physical presence” so the regulation “reflect[ed] a change in applicable law.”6 Further, the Lanco Tax Court recognized the reliance interests of taxpayers since New Jersey had precedent that suggested that physical presence was required.7 Based on this dicta in the Tax Court’s Lanco opinion, many taxpayers thought that IHCs were taxable only back to 1996.
The Praxair decision, however, directly dealt with years before 1996. (In Praxair, the tax years included 1994 and 1995.) The Praxair court rejected the Tax Court’s view in Lanco on the pre- 1996 years.8 The Praxair court concluded that the addition of the example in the regulation did not represent a change of policy. Rather, the court concluded that the example “merely clarifie[d] and explain[ed] the statute,”9 under that statute, which had been enacted in 1973,10 Praxair was subject to tax.
The Praxair Court Sustains 25 Percent Failure-to-File Penalty
New Jersey imposes a 25 percent late-filing penalty.11 The Director has discretion to waive the penalty “[i]f the failure to pay any such tax when due is explained to the satisfaction of the director….”12 The standard to waive the penalty is “a reasonable cause for delay which clearly indicates an absence of willful neglect….”13
In 1994, there was no regulatory guidance concerning nexus for IHCs. The Division may have asserted a nophysical- presence rule as an audit position,14 but this policy was not widely publicized. The first decision of a state court of last resort involving an IHC and nexus was Geoffrey, which was decided in 1993.15 Back then, the decision in Geoffrey was considered by many to be ground-breaking.16 Nonetheless, the court in Praxair determined that “PTI had no reasonable cause to not file returns for the years in question.”17 The court stated that it was not “reasonable” for a sophisticated taxpayer such as PTI “to fail to recognize the distinction between the established law regarding sales tax from Quill and before, and established law regarding income tax from the New Jersey statute….”18
The court’s conclusion on this point is difficult to understand. Even the New Jersey Supreme Court, which ruled against Lanco, recognized that “a split of authority has developed regarding whether the Supreme Court’s holding [in Quill] was limited to sales and use taxes.”19 And only one year after the Division issued its assessment of PTI, the New Jersey Tax Court itself (in a decision by Judge Pizzuto) concluded in Lanco that physical presence was required for income tax nexus.20 Yet, somehow, the court concluded that PTI’s non-filing position was “not reasonably plausible.”21
The Praxair Court Sustains 5 Percent Amnesty Penalty
In addition to the 25 percent failure-to-file penalty, PTI was subject to a 5 percent amnesty penalty.
In spring 2002, New Jersey established a tax amnesty under which taxpayers could come forward and pay any tax owed without interest, costs, or penalty.22 Taxpayers that participated, however, relinquished “all administrative and judicial rights of appeal.”23 Taxpayers that did not come forward, such as PTI, were subject to an additional, unwaivable 5 percent penalty for the amnesty period.24 PTI argued that the amnesty program put it in a situation that was untenable: It must participate in order to avoid the 5 percent penalty, but if it participates, it must relinquish its appeal rights.25 PTI argued that this Catch-22 violated its due process rights. The Tax Court disagreed with PTI,26 and also disposed of PTI’s “manifestly unjust” argument without any satisfying analysis.27
Significance of Decision
The Praxair decision is significant to any company that has (or had) an IHC licensing intangibles into New Jersey but that did not file a return. Some taxpayers may have hoped to distinguish Lanco on its facts. Lanco licensed trademarks to an affiliate that sold consumer products through retail stores. PTI, by contrast, licensed patents to an affiliate conducting an industrial-products business. The court’s decision in Praxair, however, suggests that Lanco will be applied broadly by the courts. Therefore, taxpayers should not expect to successfully distinguish their IHC from Lanco based on factual differences.
Second, taxpayers should expect the Division to assert nexus to the date their IHC was formed.
Third, taxpayers should expect little sympathy from the Division or the courts regarding penalty abatement. Although Praxair may not reflect the view of all Tax Court judges, based on the oral arguments in Lanco it seems that most appellate judges view IHCs with suspicion.28
FIN 48, Interest, and the Throwout Rule
The court’s decision that physical presence is not required for income tax nexus—even for periods before the Division’s 1996 regulation—may cause companies to re-evaluate their nexus exposure for purposes of FIN 48.29 In general, under FIN 48, if you haven’t filed a return, your nexus exposure never goes away.30
Further, you will need to continue increasing your reserve to account for interest. New Jersey’s interest rate is three percentage points above prime and is compounded annually,31 so interest can quickly add up. (For example, the interest at issue for the 1994–1996 period in Praxair is greater than the tax itself.)
Meanwhile, IHCs continue to struggle with how to compute their tax for periods after 2001, when New Jersey’s throwout rule went into effect. Under the Division’s view, if a taxpayer isn’t filing a return in a state, any sales sourced to that state are excluded from the sales-fraction denominator.32 The Division also excludes intercompany sales that are sourced to a unitary-combined state in which those sales are eliminated.33 IHCs typically have only intercompany sales and do not file separate-company returns in many (if any) states. Therefore, under throwout, an IHC’s New Jersey sales fraction can be as great as 100 percent. Even though New Jersey, since 2002, has disallowed a deduction for most intercompany royalty expenses,34 this has not stopped the Division from asserting nexus over IHCs. In fact, because of throwout, some IHCs have received assessments in the tens of millions of dollars.
The throwout rule is being challenged in General Engines and Pfizer.35 These cases, which will be heard by the Tax Court together, do not involve IHCs. The only issue currently before the court is whether throwout is unconstitutional on its face. Now, a third taxpayer, Whirlpool Properties, Inc.,36 was just ordered to brief this issue and will argue this issue before the same judge and at the same time as General Engines and Pfizer. Unlike those taxpayers, however, Whirlpool Properties is an IHC. Oral argument will not be heard before November and a final decision on throwout could be years away. In the meantime, your IHC is vulnerable to audit.
What Are the Options?
For now, many taxpayers are taking no action and hoping that the Tax Court agrees that some relief on throwout is required. But regardless of what happens to throwout, most royalty-earning IHCs will have a difficult, if not impossible, time establishing that they do not have nexus. So for many companies, the best case scenario is that they will pay tax based on their three-factor apportionment percentage computed without throwout. The problem is that the affiliated operating company was already required to add back any royalties paid to the IHC. Although there is an exception if the IHC files a return in New Jersey,37 the statute of limitations is only four years.38 Therefore, for most calendar-year taxpayers that filed their original return on extension, the deadline for filing an amended return for 2002 (the first year with throwout and addback) is this October 15. If your IHC is assessed after that date, the operating company won’t be able to file an amended return claiming an addback exception. In other words, even if the court completely strikes down throwout, your company will pay tax twice on the same royalty stream (once at the IHC level on the income and again at the operating company level because of the expense disallowance).
Therefore, a taxpayer with an IHC may want to consider coming forward now, before a decision on throwout and before the statute of limitations begins to expire for the addback years. Under New Jersey’s voluntary disclosure program, taxpayers can come forward anonymously and the Division typically agrees to cut-off some back years and abate some penalties.39 Even more importantly, as part of a voluntary disclosure, an IHC may be able to negotiate an alternative apportionment method (under the Division’s so called “section 8” authority40) to avoid full throwout. The Division has been willing to negotiate section 8 agreements with IHCs since throwout came into effect. History has shown, however, that these agreements have gotten worse each time the Division prevails in litigation. (For example, IHCs paid much more tax under agreements entered into after the Division prevailed at the Appellate Division in Lanco than before that decision.41) Therefore, if the Division prevails in Tax Court on the facial constitutional challenge to throwout, it is likely that the Division will revisit its section 8 standards to penalize IHCs that failed to come forward sooner.
In summary, the Praxair decision is bad news for taxpayers with IHCs. If upheld, it would close the door on an IHC taking a no-nexus position based on factual distinctions from Lanco. It also empowers the Division to assess an IHC all the way back to its formation date and may encourage the Division not to abate penalties. IHCs should consider coming forward now under New Jersey’s voluntary disclosure program. They can do this anonymously and will have the best chance of cutting off some back years, and avoiding full throwout and penalties. This could significantly reduce your liability and allow you to resolve your FIN 48 exposure. .