COMPTROLLER OF THE TREASURY
Argued: March 7, 2014
Circuit Court for Baltimore County Case No. 03-C-10-9151
Barbera, C.J., Harrell, Battaglia, Greene, Adkins, McDonald, Watts, JJ.
Once upon a time, before the advent of the shot clock, some basketball teams employed a maneuver known as the "four corners offense." This strategy involved a series of passes among team members that seemingly did not advance the ultimate purpose of putting the ball in the hoop, but had the separate purpose of depriving the opposing team of possession of the ball. In a somewhat analogous enterprise, corporate tax consultants devised a strategy that involved a series of transactions passing licensing rights between related corporations and that was motivated by a desire, not to directly enhance corporate profits, but to keep a portion of those profits out of the hands of state tax collectors. Much as the shot clock led to the demise of the four corners offense, judicial decisions during the past two decades have limited the utility of this tax avoidance strategy.
This case illustrates a variation on that theme. Nordstrom, Inc. ("Nordstrom") created several subsidiary corporations, including Petitioner NIHC, Inc. ("NIHC"), which then engaged in a series of transactions with Nordstrom and with each other, involving the licensing rights to Nordstrom's trademarks. When the dust settled, the rights to use Nordstrom's trademarks ended up where they had begun – with Nordstrom. But Nordstrom's Maryland taxable income was significantly reduced. NIHC, although it had engaged in no value-creating business activity itself, recognized a significant gain – putatively beyond the reach of Maryland taxation – that was ultimately related to the reduction in Nordstrom's Maryland taxable income. From the perspective of the Respondent Comptroller, the transactions appeared to be an effort to shift income from Nordstrom – where a portion of it would be taxable by Maryland – to subsidiaries that arguably had no nexus to Maryland – where the income would escape Maryland taxation. The Comptroller did not accept that conclusion and issued tax assessments against the subsidiaries' income. The Tax Court concluded, and the Circuit Court and the Court of Special Appeals affirmed, that the subsidiaries, including NIHC, lacked economic substance separate from Nordstrom and, applying a recent decision of this Court, that their income had a nexus with Maryland through Nordstrom's business activities and was therefore taxable by Maryland.
There is an additional feature that makes this case distinctive: NIHC (actually, Nordstrom, on behalf of NIHC) contends that it misunderstood the differences in the ways in which corporations must file returns federally and in Maryland and that it made a mistake in reporting income on its Maryland returns for 2002 and 2003 – a mistake which, it argues, should absolve it from paying the assessed tax. In particular, federal law provides for the filing of a consolidated return by related corporations while Maryland law requires the filing of separate returns by related corporations. NIHC asserts that, under Maryland's separate reporting requirement, it should have reported – and thus paid Maryland income tax – on the entire gain it recognized as a result of the transactions with Nordstrom and the other subsidiaries in 1999, a tax year now outside the statute of limitations, and that it instead mistakenly reported a portion of that income on its Maryland returns for the tax years in question – tax years 2002 and 2003. The Tax Court held that the separate reporting requirement in Maryland did not prohibit Maryland taxation of the income actually reported on the 2002 and 2003 NIHC returns. The Circuit Court held otherwise, but the Court of Special Appeals reversed.
We agree with the Court of Special Appeals that the decision of the Tax Court should be upheld on judicial review. There appears to be no question that income recognized by NIHC from these transactions has a connection to business activities of Nordstrom in Maryland during 2002 and 2003, that a portion of that income was reported on NIHC's Maryland returns for 2002 and 2003 (which were never amended to reflect its current theory), and that the income is taxable by Maryland. The fact that NIHC may have made a series of mistakes in the preparation of its Maryland tax returns, as a result of transactions apparently devised to avoid state taxation, does not entitle it to escape its tax liability on that income.
Corporate Family Portrait
The underlying facts are not in dispute. Nordstrom is a nationally known retailer with its principal place of business in Seattle, Washington. During the time period relevant to this case, it operated stores in 27 states, including Maryland. During that time, Nordstrom filed consolidated federal income tax returns with its domestic subsidiary corporations.
In the mid-1990s, Nordstrom decided to transfer its trademarks to a subsidiary for tax purposes, according to a plan labeled the "anti-Geoffrey strategy" by its tax consultant. To carry out that plan, in late 1996, Nordstrom created subsidiary corporations called NTN, Inc. ("NTN") and NIHC, Inc. ("NIHC") in Colorado; a few months later, in March 1997, it created a third subsidiary in Colorado called N2HC, Inc. ("N2HC"). Nordstrom owned the stock of all three subsidiaries.
During the relevant time period, all of the officers of NIHC and N2HC were officers or employees of Nordstrom. Both corporations occupied rented office space in Portland, Oregon, staffed by a paralegal employed by N2HC. The operating expenses of the affiliates were relatively minimal. NIHC and N2HC had little income or expense other than that related to the trademark transactions described below.
Passing the Trademark Rights around the Corporate Family
Nordstrom transferred its trademarks to NTN in March 1997, and NTN in turn gave Nordstrom a license to continue to use the trademarks. In April 1997, Nordstrom transferred its stock in NTN and NIHC to N2HC for cash. Thus, relevant to the discussion below, N2HC became the sole shareholder of NIHC.
On January 31, 1999, the license agreement between NTN and Nordstrom was terminated. NTN then entered into a license agreement with NIHC that granted NIHC a nonexclusive license to use and sublicense the Nordstrom trademarks. On the same day, NIHC distributed to N2HC, its parent corporation, the license agreement with NTN. Thus, as of the end of January 1999, N2HC had the right to license Nordstrom's trademarks and the right to any income generated through the exercise of that right.
The next day – February 1, 1999 – N2HC entered into a license agreement with Nordstrom under which N2HC granted Nordstrom a license to use the trademarks for an arms-length royalty. Nordstrom paid N2HC royalties during the relevant time period. For the tax years 2002, and 2003, Nordstrom paid N2HC royalties in the amount of $197, 802, 386, and $212, 284, 273, respectively. N2HC in turn made loans back to Nordstrom in slightly lesser amounts during the same period.
At the conclusion of these transactions, Nordstrom continued to have the right to use the trademarks; the trademarks were the property of NIHC; and N2HC had the right to license the trademarks and receive royalties from Nordstrom. During the relevant period, trademarks were licensed only to Nordstrom, NIHC conducted no business other than owning the trademarks, and both NIHC and N2HC had no earnings other than those resulting from the transactions among the affiliates described above. The net effect was to shift income from Nordstrom to the subsidiaries which, considered in isolation from their parent, had no connection to Maryland.
Accounting of the Trademark Transactions for Federal Tax Purposes
According to the analysis of Nordstrom's tax consultant, under the federal tax code, the distribution of the license agreement from NIHC to N2HC was considered the distribution of appreciated property that would be recognized as a gain to NIHC under §311(b) of the Internal Revenue Code, 26 U.S.C. §311(b). According to that analysis, NIHC was required under federal tax law to recognize a gain to the extent that the market value of the licensing agreement exceeded the book value of the dividend. In addition, the dividend created a basis in N2HC that was subject to amortization under federal tax law.Accordingly, Nordstrom was required to report the value of the ...