Maryland affirms economic substance requirement for out of state affiliates
Court rejects unitary business nexus argument
TAX ALERT |
On March 24, 2014, the Maryland Court of Appeals, the state's highest court, issued its opinion in Gore Enterprise Holdings, Inc. v. Comptroller of the Treasury1, rejecting a lower court's ruling that two out-of-state subsidiaries had Maryland nexus solely because they had a unitary relationship with a common parent that was taxable in Maryland, but ultimately upholding the Comptroller of Maryland's (Comptroller's) assessment on the grounds that the parent's in-state activities could be attributed to the subsidiaries because the subsidiaries lacked economic substance. However, taxpayers should not breathe a sigh of relief, as the court's analysis shows that the hallmarks of a unitary relationship can be a factor in deciding whether an entity lacks economic substance. Understanding how this case was decided can help Maryland businesses with out-of-state subsidiaries determine the likelihood of an impact on their own tax obligations in the state.
The facts before the Maryland Court of Appeals in this case were fairly straightforward. The parent company, W.L. Gore & Associates, Inc. (Gore), is a specialty manufacturing company that utilizes patented material to produce medical devices and other industrial products in factories in several states, including Maryland. In 1983, Gore created Gore Enterprise Holdings, Inc. (GEH) to manage Gore's patents. Gore contributed its patents to GEH, and GEH entered into an arrangement with Gore under which GEH granted Gore an exclusive license to use all U.S. patents presently owned or thereafter acquired in exchange for an arm's length fee. In 1996, Gore created Future Value, Inc. (FVI), to manage Gore's excess capital. FVI was funded entirely by contributions from Gore and GEH and earned income from making intercompany loans and conducting other investment activities. Both subsidiaries were organized under Delaware law and maintained no connection with Maryland outside of their affiliation with Gore.
In 2006, the Comptroller assessed GEH and FVI nearly $30 million in tax, interest and penalties for not filing Maryland corporate tax returns. The Comptroller asserted that GEH and FVI lacked economic substance and, under the principles established by the Maryland Court of Appeals in Comptroller of the Treasury v. SYL, Inc., 825 A.2d 399 (2003), had Maryland nexus based on the economic reality that Gore's business in Maryland produced the subsidiaries' apportioned income. In support of this assertion, the Comptroller relied upon the following facts:
- GEH and FVI's boards of directors were all Gore employees or board members
- All activities of GEH and FVI were directed by Gore
- Gore performed all administrative activities for GEH and FVI
- Under a consulting agreement, Gore employees performed most of GEH's essential functions regarding the protection of GEH's intellectual property
- GEH had no role in the creation or acquisition of intellectual property and relied upon Gore to invent or acquire new intellectual property and contribute that property to GEH
- GEH made no decisions regarding its intellectual property that were not in the best interests of Gore, even when the best interests of Gore were not in the best interests of GEH, and only entered into licenses with third parties that produced benefits for Gore
- FVI was wholly capitalized by assets built up through royalties paid to GEH and created circular cash flow through intercompany loans to Gore
- Gore, GEH and FVI had globally integrated goals established in Gore's best interests, and GEH and FVI engaged in no activities contrary to those goals
Gore challenged the assessments, arguing that (1) GEH and FVI did not lack economic substance because they had separate corporate status and all transactions between GEH, FVI and Gore were done at arm's length, and (2) taxation of the subsidiaries by Maryland on the grounds that nexus was established by a lack of economic substance violated the Due Process and Commerce Clauses of the U.S. Constitution. At the trial court level, the Maryland Tax Court agreed with the Comptroller, holding that GEH and FVI could be subject to Maryland tax based on the activities of Gore because the subsidiaries lacked economic substance. Gore appealed, and the Circuit Court for Cecil County reversed the Maryland Tax Court's decision. On subsequent appeal by the Comptroller, the Maryland Court of Special Appeals upheld the assessment and found that GEH and FVI had nexus with Maryland because they had a unitary business relationship with Gore, arbitrarily blazing new ground in this area by treating an apportionment principle as a nexus-generating activity. Gore petitioned the Maryland Court of Appeals for certiorari, which was granted.
On review, the Maryland Court of Appeals considered (1) whether the subsidiaries could be found to have Maryland nexus solely because they were engaged in a unitary business with another entity that was doing business in the state, and (2) whether the subsidiaries' lack of economic substance allowed Maryland to assert nexus through their parent corporation's Maryland activities. To start, the court took the concept of unitary business nexus off the table, stating that the unitary business principle:
[…] does not confer nexus to allow a state to directly tax a subsidiary based on the fact that the parent company is taxable and that the parent and subsidiary are unitary. . . . the unitary principle cannot be used to clear the constitutional hurdles of the Due Process and Commerce Clauses.(emphasis in original)
However, citing precedent in Comptroller of the Treasury v. SYL, Inc.2, the court found that Maryland possesses jurisdiction to tax out-of-state affiliates when they lack economic substance as separate entities and a portion of their income is tied to their parent's Maryland business activity. In this case, the court found that both GEH and FVI depended on Gore for their income, there was a circular flow of money between the subsidiaries and Gore, the subsidiaries relied on Gore for core functions and services, and there was a "general absence of substantive activity from either subsidiary in any meaningful way separate from Gore." Based upon these factors, the Maryland Court of Appeals agreed with the Maryland Tax Court that the subsidiaries lacked economic substance and upheld the assessment.
Although the Maryland Court of Appeals made certain to distinguish economic substance analysis and unitary business analysis as "distinct inquires with distinct purposes," it is interesting to note that the factors relied upon by both the Maryland Tax Court and the Maryland Court of Appeals in finding that GEH and FVI lacked economic substance could also have been used to find that the subsidiaries were engaged in a unitary business with Gore. This leaves open the question of what the Comptroller needs to show in order to establish that an entity lacks economic substance beyond the fact that the entity has some of the hallmarks of a unitary relationship with an affiliate with activities in the state. Clearly, the Maryland Court of Appeal's rejection of the unitary business nexus approach advocated by the Maryland Court of Special Appeals means that something more is required, but the nature and extent of that "something more" is uncertain. Maryland businesses that utilize out-of-state subsidiaries, particularly those formed to provide certain functions (e.g., intangible management, investment management, captive insurance, and other management functions), should take note that these subsidiaries may not be shielded from Maryland corporate income tax.
1 Gore Enterprise Holdings Inc. v. Maryland Comp. of the Treas., Md., No. 36 (March 24, 2014)
2 Maryland Comp. of the Treas. v. SYL Inc., 825 A.2d 399 (Md. 2003)
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