Comptroller of Treasury v. Gore Enterprise Holdings, Inc.

MATRICCIANI, J. On November 9, 2010, the Maryland Tax Court 1 upheld a tax assessment against Gore Enterprise Holdings, Inc., in the amount of $10,013,428 plus interest, but the Tax Court abated penalties of $2,503,360. The Tax Court simultaneously upheld an assessment against Future Value, Inc., of $1,254,321 plus interest, while abating $313,581 in penalties. Both parties appealed to the Circuit Court for Cecil County, where the cases were consolidated. The circuit court reversed the Tax Court’s assessments on September 30, 2011, and the Comptroller timely appealed on October 6, 2011.

Questions Presented The Comptroller presents the following questions for our review, which we have rephrased and consolidated to comport with our discussion: I. Did the Tax Court err when it held that patent royalties and interest income claimed as expenses in Maryland and paid to wholly-owned foreign subsidiaries are taxable as part of a unitary business?

II

Did the Tax Court err when it apportioned the subsidiaries’ income based on the parent corporation’s apportioned expenses? [ 2 ] ⁵²⁹ For the reasons that follow, we answer no to both questions and we reverse the judgments of the Circuit Court for Cecil County cancelling the assessments. Factual and Procedural History W.L. Gore & Associates, Inc. In 1958, Dr. Wilbert L. Gore founded and incorporated W.L. Gore & Associates, Inc. (“Gore” or “Gore, Inc.”) in Newark, Delaware. Gore is known for its patented “ePTFE” material, which it uses to manufacture industrial and electronic products, as well as fabrics and medical devices. Gore attributes income to Maryland based on its local product sales and on its manufacturing facilities, which employ over two-thousand people in this state.

In the same year that Gore was founded, Delaware amended its income taxation statute to exempt “[cjorporations whose activities within Delaware are confined to the maintenance and management of their intangible investments and the collection and distribution of the income from such investments or from tangible property physically located outside of Delaware.” 51 Del. Laws, c. 315, § 3 (available at http://delcode.delaware.gov/ sessionlaws/gall9/chp315.shtml); 30 Del. C. § 1902(b)(8) (2012). Delaware later added the following clarifying language to the end of § 1902(b)(8): ⁵³⁰ For purposes of this paragraph “intangible investments” shall include without limitation investments in stocks, bonds, notes and other debt obligations (including debt obligations of affiliated corporations), patents, patent applications, trademarks, trade names and similar types of intangible, assets. 30 Del.

C. § 1902(b)(8) (2012); 64 Del. Laws, c. 461, § 10 (available at http://delcode.delaware.gov/sessionlaws/gal32/chp 461.shtml). Gore Enterprise Holdings, Inc. Gore formed Gore Enterprise Holdings, Inc. (“GEH”) in 1983, contributing all Gore patents in exchange for all of GEH’s stock. Gore’s November 4, 1983 board meeting notes include the following comment: Item 7.

Gore Enterprise Holdings, Inc. The directors UNANIMOUSLY APPROVED the action of the Executive Committee in establishing the Gore Enterprise Holdings, Inc. corporation and transferring our patents and overseas receipts to this holding company. The holding company should result in substantial savings of Delaware state income tax but will have no effect on our Federal income tax. GEH is governed by a board of directors comprising Gore, Inc.’s patent attorney, a “tech leader” from Gore, the president of GEH, and Dr. Gore, himself. The board has never included an outside director, and all of GEH’s activities are ultimately directed by the board.

GEH operated without any employees or rent expenses until 1995, when it hired one salaried employee and began to pay Gore, Inc. for the use of a one-hundred-twenty square foot room on Gore’s premises. At that time, Gore agreed to provide its subsidiary, GEH, with various administrative services, including accounting, payroll, employee benefits, and “general services,” in return for a $100 monthly fee (later raised to $105). The parties simultaneously entered into a ⁵³¹ “Legal Services Consulting Agreement” that obligates Gore to provide GEH with various services, including: • Prosecution of patent applications, domestic and foreign. • Conduct or manage litigation or defense of patents against infringement. • Provide advice with respect to utilization of outside counsel. • Counsel, conduct or manage applications to foreign patents and applications. • Counsel with respect to patent infringement, domestic and foreign. • Counsel with respect to interferences with pending patents. • Counsel with respect to licensing negotiations and activities. In return, the Agreement obligates GEH to pay Gore at an hourly rate determined either by a survey of the American Intellectual Property Law Association or by good faith negotiations that would “reflect an arm’s-length transaction.” When Gore employees develop a new technology and decide that it is commercially viable, attorneys working under the Legal Services Agreement and on behalf of GEH prepare and file a patent application covering that invention.

At that point, GEH’s lone employee assumes responsibility for all requisite documentation and correspondence. GEH’s operations are controlled by an “intellectual property committee,” which consists of officers from GEH and Gore, Inc. (to the extent that there is some distinction between the two). The committee oversees licensing of GEH’s patents to Gore and to third parties, as well as acquisition of patents from third parties, and enforcement of its patent portfolio. At its inception, GEH granted Gore “an exclusive license to make, use and sell any patented inventions under all U.S. patents presently owned or hereafter acquired by the [GEH] insofar as the United States and all its territories and posses ⁵³² sions are concerned.” 3 In exchange, Gore pays GEH a “reasonable fee” and deducts that expense from its taxable income. 4 GEH, meanwhile, recognizes these royalty payments as taxable income. 5 Between 1996 and 2007, GEH returned dividends of approximately $5.5 million per month to Gore, Inc. Future Value, Inc. In 1996, Gore exchanged its financial assets in return for all outstanding stock of its newly-formed subsidiary, Future Value, Inc. (“FVI”).

Since its inception, FVI has been funded entirely by contributions from Gore and GEH, and by reinvesting its investment income. A portion of that investment income is derived from loans FVI makes to Gore, Inc. Gore deducts its interest payments to FVI from Gore’s taxable income; 6 FVI recognizes those payments as taxable income. Audits by the Comptroller In 2006, the Comptroller audited Gore, GEH, and FVI and determined that GEH and FVI were required to apportion income to Maryland. The Comptroller took the ratio that Gore used to apportion its Maryland income and expenses— including royalties and interest paid to its subsidiaries—and applied it to GEH’s and FVI’s federal taxable income derived from Gore. 7 The Comptroller assessed against GEH $26,436,315, and assessed against FVI $2,608,895, both including interest and penalties.

The Comptroller also conducted an ⁵³³ “alternative audit” of Gore that disallowed royalty and interest expenses paid to its subsidiaries, and assessed against Gore $193,718, including interest and penalties. 8 A hearing officer in the Comptroller’s office upheld the assessments on January 5, 2007, and GEH and FVI appealed to the Maryland Tax Court. The Tax Court conducted an extensive, three-day hearing in October, 2008. The Tax Court explained its ruling in a memorandum that followed: Maryland courts have consistently concluded that the basis of a nexus sufficient to justify taxation is the economic reality of the fact that the parent’s business in Maryland was what produced the income of the subsidiary. The Classics Chicago, Inc., et. al v. Comptroller of the Treasury, 189 Md.App. [695, 985 A.2d] 593 (2010); 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).

Thus, the resolution of this case depends on whether GEH and FVI as out-of-state affiliates had real economic substance as business entities separate from W.L. Gore. This Court’s previous interpretation of the facts support the Comptroller’s position that GEH and FVI were engaged in a unitary business with W.L. Gore and are not separate business entities. GEH and FVI depend on W.L. Gore for their existence. The facts indicate functional integration and control through stock ownership, as well as common employees, directors and officers of W.L. Gore and the Gore family.

The functional source of GEH’s income is derived from the ideas and discoveries generated by W.L. Gore employees. The circular flow of money is traced by and through W.L. Gore when GEH acquires a patent from the ideas and discoveries of W.L. Gore. The income of GEH is ⁵³⁴ derived from a royalty paid by W.L. Gore under a license agreement on the patent. In addition, the facts also indicate GEH’s reliance on W.L. Gore personnel, office space and corporate services.

The tax returns and other financial data reflect the lack of separate substantial activity of GEH or FVI. Moreover, the evidence also demonstrates that FVI is taxable by Maryland on its intercompany loan income. FVI is inextricably connected to the royalty income generated by W.L. Gore and paid to GEH. There is a circular flow of money through royalties, dividends and loans which support the unitary business of W.L. Gore and its wholly owned subsidiaries, GEH and FVI.

The Court finds that substantial nexus exists between GEH and FVI with the State of Maryland, and that the Comptroller has fairly apportioned the tax on income through its apportionment formula. The Tax Court affirmed the assessments of tax and interest against GEH and FVI, but abated all penalties and dismissed the alternative assessment against Gore, Inc. GEH and FVI then appealed to the Circuit Court for Cecil County, which reversed the Tax Court and cancelled the Comptroller’s assessments in both cases. 9 The Comptroller appealed on October 6, 2011, bringing both disputes before this Court. ⁵³⁵ Discussion Standard of Review Judge James Eyler recently summarized the standard of review governing appeals from the Tax Court in Classics Chi, Inc. v. Comptroller of the Treasury: Despite its name, the Tax Court is not a court; instead, it is an adjudicatory administrative agency in the executive branch of state government. Our inquiry is not whether the circuit court erred, but rather whether the administrative agency erred. We thus undertake our own de novo review of the decision of the Tax Court.

Our review is narrow 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. It is not our job to substitute our judgment for that of the Tax Court. We are not bound by the Tax Court’s interpretation of the law. We review the Tax Court’s conclusions of law de novo for correctness.

Determining whether an agency’s “conclusions of law” 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 administers. Moreover, an administrative agency may be affirmed only on the basis of the grounds on which it decided the case. 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. 189 Md.App. 695, 705-07 , 985 A.2d 598 (2010) (citations and quotation marks omitted). ⁵³⁶ Where, as here, the operative facts before the administrative agency are undisputed, the legal conclusion based on those facts has been treated as an issue of law. Comptroller of the Treasury v. SYL, Inc., 375 Md. 78, 105 , 825 A.2d 399 (2003).

I. The statute at the foundation of this case is TG § 10-402, which taxes a corporation’s income 10 “derived from or reasonably attributable to its trade or business in this State[.]” That section has undergone various changes in the two decades spanning this dispute, but its purpose has always been to tax multi-state corporations doing business in this State to the full extent permitted by the United States Constitution. Classics, 189 Md.App. at 713 , 985 A.2d 593 (citing SYL, 375 Md. at 100 , 825 A.2d 399 ; Hercules Inc. v. Comptroller of the Treasury, 351 Md. 101, 110 , 716 A.2d 276 (1998); NCR Corp. v. Comptroller of the Treasury, 313 Md. 118, 146 , 544 A.2d 764 (1988)). There are two constitutional limits upon Maryland’s power to tax under TG § 10-402: The Commerce Clause and the Due Process Clause impose distinct but parallel limitations on a State’s power to tax out-of-state activities. The Due Process Clause demands that there exist some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax, as well as a rational relationship between the tax and the values connected with the taxing State.

The Commerce Clause forbids the States to levy taxes that discriminate against interstate commerce or that burden it by subjecting activities to multiple or unfairly apportioned taxation. The broad inquiry subsumed in both constitutional requirements is whether the taxing power exerted by the state bears fiscal relation to protection, ⁵³⁷ opportunities and benefits given by the state—that is, whether the state has given anything for which it can ask return. MeadWestvaco Corp. v. Ill. Dep’t of Revenue, 553 U.S. 16, 24-25 , 128 S.Ct. 1498 , 170 L.Ed.2d 404 (2008).

A state may tax an apportioned sum of the corporation’s multistate business if the business is “unitary.” MeadWestvaco, 553 U.S. at 25 , 128 S.Ct. 1498 . The test in any case is thus whether intrastate and extrastate activities formed part of a single unitary business, or whether the out-of-state values that the State seeks to tax derive from unrelated business activity which constitutes a discrete business enterprise. Id. (citations omitted).

The “hallmarks” of a unitary relationship are: 1) functional integration, 2) centralized management, and 3) economies of scale. Id. at 30 , 128 S.Ct. 1498 ; SYL, 375 Md. at 100 , 825 A2d 399 . 11 ⁵³⁸ We have recently held that a nexus sufficient to justify taxation arises from the economic reality that a parent’s business in the taxing state produces a subsidiary’s income. Classics Chi, Inc. v. Comptroller of the Treasury, 189 Md. App. 695, 715-16 , 985 A.2d 593 (2010) (citing Geoffrey, Inc. v. S.C. Tax Comm’n, 313 S.C. 15 , 437 S.E.2d 13 (1993); Comptroller of Treasury v. Armco Export Sales Corp., 82 Md.App. 429 , 572 A.2d 562 (1990)). The holding in Classics is a plain and logical application of the unitary business principle, and it fits squarely with this case.

Gore generated income in Maryland and deducted payments to GEH and FVI, which recognized those payments as their income—an accounting identity that reflects their unified business. Appellees have not pointed us to any cases reaching the opposite conclusion, and even if this accounting identity is not sufficient, GEH and FVI demonstrate the “hallmarks” of a unitary business relationship under constitutional law: functional integration, centralized management, and economies of scale. GEH and FVI are dependent upon Gore for their core business functions, either by contractual arrangement or by the simple fact that they have common directors, executives, and employees. More importantly, to the limited extent that the subsidiaries are separated from Gore in theory or by corporate form, they remain under Gore’s complete control and advance the parent’s interests wholesale. 12 To do otherwise would violate the ⁵³⁹ very tenets of corporate law.

See N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del.2007) (even in bankruptcy, directors must “discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners” (citing Guth v. Loft, Inc., 23 Del.Ch. 255, 270-71 , 5 A.2d 503, 510 (Del.1939))). And though control will not establish a unitary business in every case, see MeadWestvaco, 553 U.S. at 30, 128 S.Ct. 1498 it suffices here, where the parent’s expense in Maryland is its subsidiary’s income.

We also reject GEH’s contention that precedent concerning trademark holding companies, e.g., Geoffrey, Inc. v. S.C. Tax Comm’n, 313 S.C. 15 , 437 S.E.2d 13 (1993), should not apply to GEH as a patent holding company. GEH argues that patents have a constitutional origin, while federal trademark jurisdiction is merely regulation of interstate commerce; GEH thus concludes that “states have leeway in their treatment of trademarks that does not exist relative to patents.” But the fact that these two types of intellectual property have different origins in federal law does not affect how or where they are “used” for purposes of state income taxation, and GEH presents no authority to the