Out-of-state operating company, Delaware trademark protection companies not subject to Maryland income taxation

On March 17, 2000, the Maryland Circuit Court for Baltimore City (the "Circuit Court") affirmed the decisions of the Maryland Tax Court (the "Tax Court"), which had reversed Maryland corporate income tax assessments against MCI International Telecommunications, Corp. ("MCIIT"), SYL, Inc. ("SYL") and Crown Cork and Seal (Delaware) Inc. ("CC&S").

MCI International Telecommunications, Corp. v. Comptroller of the Treasury (Md. Circ. Ct., Case No. 24-C-99-002387), involved a wholesaler of international telecommunications services, which is affiliated with a group of corporations having MCI Communications Corp. as the ultimate parent. MCIIT provided international voice service to foreign telephone companies and domestic long distance telephone companies in exchange for service fees. Fees were paid by MCIIT to domestic long distance carriers for the domestic transmission of "inbound" calls and domestic long distance carriers paid fees to MCIIT for the transmission of "outbound" calls. All of MCIIT's activities were conducted outside of Maryland. One of the domestic long distance carriers is MCI Telecommunications ("MCIT"), a corporate "uncle" of MCIIT, which does business in Maryland. The Comptroller attributed MCIT's nexus to MCIIT and applied MCIT's apportionment factor to MCIIT (because MCIIT did not have property, payroll or sales in Maryland) for the purposes of the Maryland income tax assessment.

MCIIT challenged the assessments, claiming that it is a substantial corporation that did not have any presence in Maryland and, therefore, could not be subject to Maryland income tax. Further, MCIIT asserted that the Comptroller violated the Due Process and the Commerce Clauses of the United States Constitution because MCIIT does not have "minimum contacts" or a "substantial nexus" with Maryland. The Comptroller of Maryland sought to attribute the nexus of MCIT, claiming that MCIIT was a phantom corporation.

Distinguishing prior Maryland decisions in Comptroller of the Treasury v. Armco Export Sales Corp., 82 Md. App. 429 (1990) and Comptroller of the Treasury v. Atlantic Supply Co., 294 Md. 213 (1982), the Tax Court found that MCIIT is a substantial operating company, performing activities which generated revenue from non-affiliated entities, in addition to MCIT. Further, the Tax Court found that MCIIT had its own property, officers, operating territory, employees, and expenses, directly and through its parent, MCI International. As such, the Tax Court concluded that MCIIT was not a phantom corporation, so MCIT's nexus could not be attributed to MCIIT. The Tax Court also held that, because all of MCIIT's income producing activity occurs outside of Maryland and it has no offices, employees, agents or property in Maryland, MCIIT did not have a substantial nexus with Maryland under Complete Auto Transit, Inc v. Brady, 430 U.S. 274, 97 S. Ct. 1076 (1977). The Tax Court further held that, even if there was nexus, the Comptroller would be required to develop an apportionment formula using the factors of MCIIT, (rather than those of its "uncle" affiliate, MCIT). Finally, the Comptroller's attempt to tax MCIIT was held to be a change in administrative policy which can only be instituted on a prospective basis through rulemaking procedures.

Based on the MCIIT decision, the Maryland Tax Court also reversed the Maryland income tax assessments in both SYL, Inc. v. Comptroller of the Treasury (Md. Tax Ct., Case No. 97-0028-01) ("SYL") and Crown Cork and Seal (Delaware) Inc. v. Comptroller of the Treasury (Md. Tax Ct., Case No. 96-0154-01) ("CC&S"). These two cases involved similar facts and issues, i.e., both cases involved a Delaware trademark protection company that licensed to its parent corporation certain trademarks and patents, which had been transferred to SYL and CC&S by the parent corporation. The licensing fees paid to SYL and CC&S reduced the Maryland taxable income of the parent corporation, each of which was taxable in Maryland, and prompted the Comptroller's assessment on the basis that SYL and CC&S were "phantom" corporations. The Court focused on the issue of whether nexus exists between the Delaware corporations and Maryland under Maryland case law and under the Due Process Clause and Commerce Clause of the United States Constitution.

As in MCIIT, the Court noted that nexus could not be attributed from an affiliated entity, because the holding companies were not phantom corporations (SYL and CC&S incorporated the MCIIT decision by reference with respect to the issues of nexus). SYL and CC&S maintained Delaware bank accounts, received mail in Delaware and maintained offices which contained furniture and corporate records. The Court also relied on the evidence that SYL and CC&S were established for valid non-tax reasons, including the protection of the transferred intangibles from the claims of the parent's creditors and the management of the assets in a separate corporation. In declining to extend Geoffrey, Inc. v. South Carolina Tax Commission, 313 S.C. 15 (1993), the Court held under Quill Corp. v. North Dakota, 504 U.S. 298 (1992), that the Delaware corporations did not have the requisite nexus to Maryland, so they were not subject to the taxing jurisdiction of Maryland.

The Comptroller appealed all three cases to the Circuit Court. The Circuit Court extensively reviewed the holdings and analysis of the Tax Court in MCIIT under the three-prong test of United Parcel Service, Inc. v. Comptroller, 69 Md. App. 458 (1986). Thus, the Circuit Court recognized that it must determine whether the Tax Court applied the correct principles of law, whether a reasonable mind could have reached the Tax Court's factual findings, and whether a reasoning mind could have reached the Tax Court's conclusions based on the application of the correct law to its factual findings. The Circuit Court noted that it could reverse the Tax Court's decision only if the Tax Court's factual findings were unreasonable or the Tax Court erroneously applied the applicable law. Based on this standard, the Circuit Court affirmed the Tax Court's decision on the issues of nexus, the development of an apportionment factor and the impact of retroactive changes to administrative policies.

On the same day and based on the same reasoning as applied to the MCIIT decision (i.e., the principles set forth in UPS), the Circuit Court affirmed the Tax Court's decisions in both SYL, Inc. v. Comptroller of the Treasury (Md. Circ. Ct., Case No.24-C-99-002389) and Crown Cork and Seal (Delaware) Inc. v. Comptroller of the Treasury (Md. Circ. Ct., Case No. 24-C-99-002388).

The Comptroller has noted appeals to the Court of Special Appeals of Maryland in the three cases.

Herman B. Rosenthal, Esquire, is the head of the Tax Law Group with the firm of Whiteford, Taylor Preston, L.L.P. His noteworthy experience includes providing tax advice in planning situations, advice with respect to structuring of transactions and advice as to compliance. He is currently serving as lead counsel in litigating several important tax issues. Herman was featured as a speaker at the 1999 Multistate Tax Forum, addressing recent Maryland tax litigation.

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