Maryland Appeal Court Rules Intangible Holding Companies Have Nexus

Maryland Court of Special Appeals Holds Intangible Holding Companies Have Corporate Income Tax Nexus

On January 24, the Maryland Court of Special Appeals held that two out-of-state intangible holding companies had corporate income tax nexus with Maryland because they were in a “unitary business” relationship with their Maryland parent company.1 In reaching this determination, the Court particularly emphasized the fact that the parent company deducted its payments which were treated as income by its intangible holding companies. The Court of Special Appeals reversed a circuit court decision that had cancelled the tax assessments against the taxpayers, and in doing so, endorsed the Maryland Tax Court's original decision that upheld the Maryland Comptroller's assessment against the intangible holding companies.

Background

The parent company (P), a manufacturer with a physical presence in Maryland, created two intangible holding companies (IHC1, a royalty company, and IHC2, an investment company) that were incorporated in Delaware and lacked a physical presence in Maryland. IHC1 granted P the exclusive license to make, use and sell any of its patented inventions in exchange for a “reasonable fee” or royalty payments. IHC2 earned interest income by investing in and managing P's excess cash and capital according to a long-term investment plan. P deducted both its royalty payments to IHC1 and its interest payments to IHC2 from its taxable income.

IHC1 and IHC2 did not file Maryland corporate income tax returns and as Delaware entities, their intangible and interest income derived from their transactions with P fell under Delaware's exemption of passive income. Moreover, the intangible and interest income were not taxable in separate reporting states (in which P was doing business) that lacked related-party expense addback rules.

In 2006, the Comptroller audited P, IHC1 and IHC2 for tax periods from 1983 to 2003, determining that the subsidiaries were required to apportion income to Maryland. The Comptroller used P's ratio to apportion its Maryland income and expenses and applied it to IHC1 and IHC2's federal taxable income derived from P, excluding any income that did not originate from P.2 As a result, based on its position that the two holding companies had substantial connections and nexus with Maryland under unitary business principles, the Comptroller assessed over $26 million against IHC1 and over $2.6 million against IHC2. The Comptroller also made an alternative assessment of tax3 against P based on the denial of the deduction for royalty and interest payments, on the grounds that P had not sufficiently established these amounts as ordinary and necessary business expenses.

A hearing officer in the Comptroller's office upheld the assessments and upon appeal, the Maryland Tax Court affirmed the tax assessments based on its conclusion that the two...