Classics Chicago, Inc. v. Comptroller of Treasury

JAMES R. EYLER, J. The Classics Chicago, Inc. (“Classics”) and The Talbots, Inc. (“Talbots”), appellants, appeal from a judgment entered by the Circuit Court for Baltimore City, affirming a Maryland Tax Court decision, which had affirmed income tax assessments against appellants by the Comptroller of the Treasury, appel ⁶⁹⁹ lee. The assessments were for the years 1993-2003 (“the Taxable Period”). The principal issue before us is whether Classics, a wholly owned subsidiary of Talbots, and which has no physical presence in this State, can be constitutionally required to pay State income taxes on its income, when Talbots maintains a physical presence in this State. Resolution of that issue turns on whether there is a substantial nexus between Classics and this State so that imposition of income tax does not violate the Commerce Clause of the United States Constitution or principles of due process.

For the most part, the parties’ arguments address their differing interpretation of the nature and extent of the holding in Comptroller of the Treasury v. SYL, Inc., 375 Md. 78, 825 A.2d 399 , cert. denied, 540 U.S. 984 , 124 S.Ct. 478 , 157 L.Ed.2d 375 and 540 U.S. 1090 , 124 S.Ct. 961 , 157 L.Ed.2d 795 (2003), in which the Court of Appeals concluded that the nonresident subsidiary involved in that case was subject to State income tax. A secondary issue is whether the assessment against Talbots, arising out of the same underlying transactions relevant to the assessment against Classics, is unlawful. The assessment against Talbots was in the alternative and effective only if the assessment against Classics is not upheld on appeal. We shall affirm the circuit court’s judgment, upholding the assessment against Classics; thus, there is no need to address the assessment against Talbots.

Background The underlying facts are not in dispute. Classics, a Delaware corporation, is a wholly owned subsidiary of Talbots, a Delaware corporation. During the Taxable Period, Talbots sold specialty women’s clothing by catalog and in retail stores located in numerous states, including Maryland. In 1973, Talbots, a private company at the time, was acquired by General Mills, Inc. (“General Mills”).

In 1988, General Mills sold its interest in Talbots to Jusco (USA), Inc. (“Jusco USA”), ⁷⁰⁰ a wholly owned subsidiary of Jusco Company Ltd. (“Jusco”), a Japanese corporation. At the time of the 1988 sale, Talbots sold its trademarks, tradenames, and related intellectual property (“Talbots trademarks”) to Jusco (Europe) BV (“Jusco BV”), a Dutch subsidiary of Jusco, for $100,000,000. Jusco BV financed the purchase of the Talbots trademarks primarily through a loan from Jusco, its parent. Appellants presented evidence that the sale of Talbots trademarks to Jusco BV was not motivated by considerations of state income tax consequences; rather, it was motivated by the desire to obtain favorable accounting and tax treatment under Japanese and Dutch law and to facilitate the expected worldwide expansion by Jusco.

By agreement dated June 26, 1988, Jusco BV licensed to Talbots the right to use the Talbots trademarks for a royalty determined by a percentage of Talbots’ net sales. During the time of this license agreement, Talbots deducted its royalty payments to Jusco BV on its federal income tax returns. The Internal Revenue Service audited Talbots’ tax returns and did not disallow those deductions, in whole or in part. In November, 1993, Jusco USA implemented an initial public offering (“IPO”) of a minority interest in Talbots.

On October 20, 1993, prior to and incident to the IPO, Classics was incorporated. Throughout the Taxable Period, Classics rented office space from Talbots and maintained its principal place of business and domicile in Chicago, Illinois. Throughout the Taxable Period, Classics did not own or lease tangible property in this State and did not have any employees or bank accounts in this State. Incident to the IPO, Classics purchased the Talbots trademarks from Jusco BV for 103 million dollars.

Classics financed the purchase through a loan from Talbots, its parent, in the amount of 102 million dollars. By agreement dated November 26, 1993, Classics licensed to Talbots the right to use the Talbots trademarks for a royalty to be paid by Talbots determined by a percentage of Talbots’ net sales. Appellants ⁷⁰¹ presented evidence that the royalty rate was an arm’s length rate under § 482 of the Internal Revenue Code, and appellee did not introduce any evidence to the contrary. Classics maintained and preserved the Talbot trademarks.

Classics paid rent to Talbots for its offices in Chicago. Classics paid an independent contractor to perform accounting and bookkeeping services. During the Taxable Period, Classics paid cash dividends to Talbots in amounts that were entered into evidence and were undisputed. Appellants complied with formalities required by corporate law.

On March 14, 2005, appellee issued a Notice of Assessment to Classics, assessing income tax for the years 1989 through 2003 in the amount of $2,078,928, plus interest and penalties. On the same date, appellee issued a Notice of Assessment to Talbots, assessing income tax for the years 2001 and 2002 in the amount of $306,090, plus interest and penalties. Appellants protested the assessments. On April 24, 2006, appellee issued a Notice of Final Determination, eliminating the assessment against Classics for the years 1989 through 1992, and affirming the assessment for the Taxable Period, in the total amount of $2,102,100.

On the same date, appellee issued a Notice of Final Determination, affirming the assessment against Talbots in the total amount of $515,602 but as an alternative to the assessment of Classics, effective only if the assessment against Classics is not upheld on appeal. The basis of the assessments was that, during the Taxable Period, Talbots filed State income tax returns and deducted royalty payments to Classics, but Classics did not file State income tax returns and did not report the royalty payments as State taxable income. The assessment against Classics was pursuant to Maryland Code (2004 RepLVol.) § 10-402 of the Tax-General Article (TG), which provides that the portion of a nonresident corporation’s income “derived from or reasonably attributable to its trade or business in this State” that is otherwise taxable must be allocated to this State for State ⁷⁰² income tax purposes. 1 The assessment against Talbots was based on appellee’s disallowance of its royalty payments to Classics for the years 2001 and 2002 as ordinary and necessary business expenses under § 162 of the Internal Revenue Code. 2 Appellants timely appealed to the Tax Court. The Tax Court consolidated the two appeals and held hearings on September 19, 2007 and December 13, 2007.

The parties filed a written stipulation which included the above information and an agreement that documents attached as exhibits were authentic. Edward Larsen, Senior Vice President and Chief Financial Officer of Talbots, and Maureen Grady, Talbots’ Managing Director of Corporate Taxes, testified on behalf of appellants. On April 11, 2008, the Tax Court issued a Memorandum of Grounds for Decision and an order. The court affirmed the assessments and interest but reduced the amount of the penalty.

On April 28, 2008, the Tax Court modified its order and provided that the assessment against Talbots “will remain effective and enforceable only in the event that the assessments against Classics are not ultimately upheld in the appeal process.” In its opinion, the Tax Court stated that appellants relied on several differences between the facts in this case and the facts in SYL. The court characterized the decision in SYL by stating “the Court found nexus existed [between the State and] the subsidiary holding corporation based on the existence of the parent within Maryland and the fact that the subsidiary had ⁷⁰³ no economic substance.” The Tax Court then recited the asserted factual differences, taken largely from the stipulation. After reviewing the factual differences, the Tax Court stated, in pertinent part: The primary factual distinction from those presented in Syl, Inc. is that the trademarks first were transferred from the parent to a foreign holding company, Jusco BV, in order to take advantage of favorable accounting treatments in that country, according to the Petitioners. The ownership of the trademarks was then transferred to the domestic subsidiary Classics from Jusco BV and the Petitioners cite numerous business reasons: the transfer maximizes the value of Talbot’s stock at the time of the IPO; a domestic subsidiary holding the trademarks gives Talbots greater growth flexibility in its business; Classics ownership of the Talbots trademarks allows Talbots to sell geographical rights to the trademarks to other business ventures, and Talbots gets a captive revenue stream of royalty payments into the subsidiary that can be used as collateral for loans.

Petitioners argue that this factual distinction from the facts in SYL, Inc. evidences that there was no motivation on behalf of Talbots, at the time of entering into the transaction with Classics, of avoiding the payment of state taxes. On the contrary, Petitioners note that the transfer of the trademarks back to a domestic subsidiary subjected the holding company, Classics, to state tax liability in those states utilizing the unitary combined reporting approach, which liability Jusco BV, as a foreign entity did not have. Since there were no state tax advantages to the structuring of the trademark transactions and no subjective motivation to avoid taxes was apparent, based on the SYL, Inc. decision, Petitioners assert nexus does not exist and the assessments should be reversed. Petitioners are asserting that the federal “sham doctrine” applies based on the holding in SYL, Inc. That doctrine examines the transactions involved and invalidates those designed solely to skirt income taxes.

Petitioners claim the sham doctrine looks to the subjective motivations of the ⁷⁰⁴ transactions and if those motivations are for no other reasons than tax avoidance, than [sic] the transactions are voided. Petitioners point to the evidence in this case indicating the motivating factors behind and at the time of the creation of Classics, such as to protect the trademarks, to assure a protected revenue stream and provide potential collateral for Talbots, as proof that the transactions were not a sham. According to Petitioners, the SYL, Inc. transactions can be distinguished in that in that situation, the tax avoidance motivations were disclosed at the time the transactions were entered and were predominant. While reference to the sham doctrine is made by the Court of Appeals in SYL, Inc. while citing a Massachusetts Supreme Judicial court decision, SYL, Inc. does not establish the sham doctrine as the standard to be applied when determining nexus of affiliated entities.

Without specific direction from the Court of Appeals, this Court will not rely on the sham doctrine. Rather the test applied is whether the out-of-state affiliates had “real economic substance as separate business entities,” [sic] SYL, Inc. supra at 106 , 825 A.2d 399 . Similar to the entities involved in SYL, Inc., Talbots may have had legitimate business purposes, other than tax avoidance, to fund the payment from Classics to Jusco BV for the trademarks (rather than purchase them itself). However we are directed to examine the substance of the resulting subsidiary.

The evidence indicates that Classics had minimal operating expenses during the eleven year period in question. There were little or no expenses for compensation for officers, salary, wages and cost of labor and minimum expenditures for travel, maintenance, professional services, service charges, directors’ fees and rent. The minimal expenses greatly contrasts with the significant amount of royalty income reported. The transactions generating the income and deductions in question were all inter-company.

Classics royalty income resulted from transactions by its parent Talbots and there was no other income generated. Classics relied entirely on ⁷⁰⁵ its parent for performance of ordinary business operations. The transactions at issue were simply the payment of a significant royalty by a parent to its wholly owned subsidiary, followed by a substantial repayment by the subsidiary to the parent in the form of a dividend. As this was essentially the fact scenario as that presented to the Court of Appeals in SYL.

Inc., we find that Classics lacks real economic substance as a separate business entity. Thus, the activities of Classics must be viewed through the activities of its operating parent, Talbots, and, as such, there are substantial activities of the holding company, Classics, within Maryland. Therefore, Classics has constitutional nexus with Maryland and the assessments against both Classics and Talbots must be affirmed. Appellants filed a petition for judicial review in circuit court.

The court held a hearing on October 8, 2008, and by order dated October 10, 2008, affirmed the Tax Court’s decision. This timely appeal followed. Standard of Review “Despite its name, the Tax Court is not a court; instead, it is an adjudicatory administrative agency in the executive branch of state government.” Furnitureland South, Inc. v. Comptroller of the Treasury, 364 Md. 126 , 138 n. 8, 771 A.2d 1061 (2001) (citations omitted); see also State Dep’t of Assessments and Taxation v. Consolidation Coal Sales Co., 382 Md. 439, 453 , 855 A.2d 1197 (2004) (“Because the Maryland Tax Court is an administrative agency, ‘[t]he standard of review for Tax Court decisions is generally the same as that for other administrative agencies.’ ”) (Quoting Supervisor of Assessments v. Hartge Yacht Yard, Inc., 379 Md. 452, 461 , 842 A.2d 732 (2004)). Our inquiry “is not whether the circuit court erred, but rather whether the administrative agency erred.” Comptroller of the Treasury v. Clise Coal, Inc., 173 Md.App. 689, 697 , 920 A.2d 561 (2007) (citation omitted).

We thus undertake our own de novo review of the decision of the Tax Court. Maryland Bd. of Physicians v. Elliott, 170 Md.App. 369, 400 , 907 A.2d ⁷⁰⁶ 321, cert. denied, 396 Md. 12 , 912 A.2d 648 (2006) (quoting Pollard’s Towing, Inc. v. Berman’s Body Frame & Mech., Inc., 137 Md.App. 277, 287 , 768 A.2d 131 (2001)). Our review is narrow, Finucan v. Maryland State Bd. of Physician Quality Assurance, 151 Md.App. 399, 411 , 827 A.2d 176 (2003), aff'd, 380 Md. 577 , 846 A.2d 377 (2004), and is “ ‘limited to determining if there is substantial evidence in the record as a whole to support the agency’s findings and conclusions, and to determine if the administrative decision is premised upon an erroneous conclusion of law.’ ” Bd. of Physician Quality Assurance v. Banks, 354 Md. 59, 67-68 , 729 A.2d 376 (1999) (quoting United Parcel Serv. v. People’s Counsel for Baltimore County, 336 Md. 569, 577 , 650 A.2d 226 (1994)). It is not our job to substitute our judgment for that of the Tax Court.

See Maryland-National Capital Park and Planning Comm’n v. Anderson, 395 Md. 172, 180-81 , 909 A.2d 694 (2006) (The reviewing court “ ‘must not itself make independent findings of fact or substitute its judgment for that of the agency* ”) (quoting Baltimore Lutheran High School Ass’n v. Employment Security Admin., 302 Md. 649, 662 , 490 A.2d 701 (1985)); United Parcel, 336 Md. at 576-77 , 650 A.2d 226 (“The court’s task on review is not to “ ‘substitute its judgment for the expertise of those persons who constitute the administrative agency.” ’ ”) (Quoting Bulluck v. Pelham Wood Apts., 283 Md. 505, 512 , 390 A.2d 1119 (1978)) (quoting Bernstein v. Real Estate Comm’n, 221 Md. 221, 230 , 156 A.2d 657 (1959), appeal dismissed, 363 U.S. 419 , 80 S.Ct. 1257 , 4 L.Ed.2d 1515 (1960)) (emphasis in United Parcel). We are not bound by the Tax Court’s interpretation of the law. Gigeous v. Eastern Corr. Inst., 363 Md. 481, 496 , 769 A.2d 912 (2001).

We review the Tax Court’s conclusions of law de novo for correctness. Schwartz v. Maryland Dep’t of Natural Res., 385 Md. 534, 554 , 870 A.2d 168 (2005). “Determining whether an agency’s ‘conclusions of law5 are correct is always, on judicial review, the court’s prerogative, although we ordinarily respect the agency’s expertise and give weight to its interpretation of a statute that it adminis ⁷⁰⁷ ters.” Christopher v. Montgomery County Dep’t of Health and Human Services, 381 Md. 188, 198 , 849 A.2d 46 (2004) (citations omitted); see also Maryland Aviation Admin. v. Noland, 386 Md. 556, 573 , 873 A.2d 1145 (2005) (‘“Even with regard to some legal issues, a degree of deference should often be accorded the position of the administrative agency. Thus, an administrative agency’s interpretation and application of the statute which the agency administers should ordinarily be given considerable weight by reviewing courts.’ ”) (Quoting Banks, 354 Md. at 67-69 , 729 A.2d 376 ). Moreover, “[a]n administrative agency may be affirmed only on the basis of the grounds on which it decided the case.” Dep’t of Health and Mental Hygiene v. Campbell, 364 Md. 108 , 111 n. 1, 771 A.2d 1051 (2001) (citations omitted); see also Evans v. Burruss, 401 Md. 586, 593 , 933 A.2d 872 (2007) (“ ‘in judicial review of agency action the court may not uphold the agency order unless it is sustainable on the agency’s findings and for the reasons stated by the agency’ ”) (quoting United Steelworkers of America AFL-CIO, Local 2610 v. Bethlehem Steel Corp., 298 Md. 665, 679 , 472 A.2d 62 (1984)), cert. denied, - U.S. -, 128 S.Ct. 1309 , 170 L.Ed.2d 73 (2008); County Council of Prince George’s County Sitting as District Council v. Brandywine Enters., 350 Md. 339, 349 , 711 A.2d 1346 (1998) (‘Ve will review an adjudicatory agency decision solely on the grounds relied upon by the agency”) (citations omitted).

Finally, “recognizing that the agency’s decision is ‘prima facie correct and presumed valid,’ “we must review the agency’s decision in the light most favorable to it.’ ” Comptroller of the Treasury v. Citicorp Int’l Commc’ns, Inc., 389 Md. 156, 163 , 884 A.2d 112 (2005) (quoting Ramsay, Scarlett & Co. v. Comptroller of the Treasury, 302 Md. 825, 835 , 490 A.2d 1296 (1985)); see also T.G. 13-411 (“[a]n assessment of a tax is prima facie