NIHC, Inc. v. Comptroller of the Treasury

McDonald, j. Once upon a time, before the advent of the shot clock, some basketball teams employed a maneuver known as the “four corners offense.” This strategy involved a series of passes among team members that seemingly did not advance the ultimate purpose of putting the ball in the hoop, but had the separate purpose of depriving the opposing team of possession of the ball. In a somewhat analogous enterprise, corporate tax consultants devised a strategy that involved a series of ⁶⁷⁰ transactions passing licensing rights between related corporations and that was motivated by a desire, not to directly enhance corporate profits, but to keep a portion of those profits out of the hands of state tax collectors. Much as the shot clock led to the demise of the four corners offense, judicial decisions during the past two decades have limited the utility of this tax avoidance strategy. 1 This case illustrates a variation on that theme.

Nordstrom, Inc. (“Nordstrom”) created several subsidiary corporations, including Petitioner NIHC, Inc. (“NIHC”), which then engaged in a series of transactions with Nordstrom and with each other, involving the licensing rights to Nordstrom’s trademarks. When the dust settled, the rights to use Nordstrom’s trademarks ended up where they had begun — with Nordstrom. But Nordstrom’s Maryland taxable income was significantly reduced. NIHC, although it had engaged in no value-creating business activity itself, recognized a significant gain — putatively beyond the reach of Maryland taxation — that was ultimately related to the reduction in Nordstrom’s Maryland taxable income.

From the perspective of the Respondent Comptroller, the transactions appeared to be an effort to shift income from Nordstrom — where a portion of it would be taxable by Maryland — to subsidiaries that arguably had no nexus to Maryland — where the income would escape Maryland taxation. The Comptroller did not accept that conclusion and issued tax assessments against the subsidiaries’ income. The Tax Court concluded, and the Circuit Court and the Court of Special Appeals affirmed, that the subsidiaries, including NIHC, lacked economic substance separate from Nordstrom and, applying a recent decision of this Court, that their income had a nexus with Maryland through Nordstrom’s business activities and was therefore taxable by Maryland. There is an additional feature that makes this case distinctive: NIHC (actually, Nordstrom, on behalf of NIHC) eon- ⁶⁷¹ tends that it misunderstood the differences in the ways in which corporations must file returns federally and in Maryland and that it made a mistake in reporting income on its Maryland returns for 2002 and 2008 — a mistake which, it argues, should absolve it from paying the assessed tax.

In particular, federal law provides for the filing of a consolidated return by related corporations while Maryland law requires the filing of separate returns by related corporations. NIHC asserts that, under Maryland’s separate reporting requirement, it should have reported — and thus paid Maryland income tax — on the entire gain it recognized as a result of the transactions with Nordstrom and the other subsidiaries in 1999, a tax year now outside the statute of limitations, and that it instead mistakenly reported a portion of that income on its Maryland returns for the tax years in question — tax years 2002 and 2003. The Tax Court held that the separate reporting requirement in Maryland did not prohibit Maryland taxation of the income actually reported on the 2002 and 2003 NIHC returns. The Circuit Court held otherwise, but the Court of Special Appeals reversed.

We agree with the Court of Special Appeals that the decision of the Tax Court should be upheld on judicial review. There appears to be no question that income recognized by NIHC from these transactions has a connection to business activities of Nordstrom in Maryland during 2002 and 2003, that a portion of that income was reported on NIHC’s Maryland returns for 2002 and 2003 (which were never amended to reflect its current theory), and that the income is taxable by Maryland. The fact that NIHC may have made a series of mistakes in the preparation of its Maryland tax returns, as a result of transactions apparently devised to avoid state taxation, does not entitle it to escape its tax liability on that income. Background Corporate Family Portrait The underlying facts are not in dispute.

Nordstrom is a nationally known retailer with its principal place of business in ⁶⁷² Seattle, Washington. During the time period relevant to this case, it operated stores in 27 states, including Maryland. 2 During that time, Nordstrom filed consolidated federal income tax returns with its domestic subsidiary corporations. 3 In the mid-1990s, Nordstrom decided to transfer its trademarks to a subsidiary for tax purposes, according to a plan labeled the “anti-Geoffrey strategy” by its tax consultant. 4 To ⁶⁷³ carry out that plan, in late 1996, Nordstrom created subsidiary corporations called NTN, Inc. (“NTN”) and NIHC, Inc. (“NIHC”) in Colorado; a few months later, in March 1997, it created a third subsidiary in Colorado called N2HC, Inc. (“N2HC”). Nordstrom owned the stock of all three subsidiaries. During the relevant time period, all of the officers of NIHC and N2HC were officers or employees of Nordstrom.

Both corporations occupied rented office space in Portland, Oregon, staffed by a paralegal employed by N2HC. The operating expenses of the affiliates were relatively minimal. NIHC and N2HC had little income or expense other than that related to the trademark transactions described below. Passing the Trademark Rights around the Corporate Family Nordstrom transferred its trademarks to NTN in March 1997, and NTN in turn gave Nordstrom a license to continue to use the trademarks.

In April 1997, Nordstrom transferred its stock in NTN and NIHC to N2HC for cash. Thus, relevant to the discussion below, N2HC became the sole shareholder of NIHC. On January 31, 1999, the license agreement between NTN and Nordstrom was terminated. NTN then entered into a license agreement with NIHC that granted NIHC a nonexclusive license to use and sublicense the Nordstrom trademarks. 5 On the same day, NIHC distributed to N2HC, its parent corporation, the license agreement with NTN.

Thus, as of the end of January 1999, N2HC had the right to license Nordstrom’s trademarks and the right to any income generated through the exercise of that right. The next day — February 1, 1999 — N2HC entered into a license agreement with Nordstrom under which N2HC granted Nordstrom a license to use the trademarks for an arms- ⁶⁷⁴ length royalty. 6 Nordstrom paid N2HC royalties during the relevant time period. For the tax years 2002, and 2003, Nordstrom paid N2HC royalties in the amount of $197,802,386, and $212,284,273, respectively. 7 N2HC in turn made loans back to Nordstrom in slightly lesser amounts during the same period. 8 At the conclusion of these transactions, Nordstrom continued to have the right to use the trademarks; the trademarks were the property of NIHC; and N2HC had the right to license the trademarks and receive royalties from Nordstrom. During the relevant period, trademarks were licensed only to Nordstrom, NIHC conducted no business other than owning the trademarks, and both NIHC and N2HC had no earnings other than those resulting from the transactions among the affiliates described above.

The net effect was to shift income from Nordstrom to the subsidiaries which, considered in isolation from their parent, had no connection to Maryland. 9 ⁶⁷⁵ Accounting of the Trademark Transactions for Federal Tax Purposes According to the analysis of Nordstrom’s tax consultant, under the federal tax code, the distribution of the license agreement from NIHC to N2HC was considered the distribution of appreciated property that would be recognized as a gain to NIHC under § 311(b) of the Internal Revenue Code, 26 U.S.C. § 311 (b). 10 According to that analysis, NIHC was required under federal tax law to recognize a gain to the extent that the market value of the licensing agreement exceeded the book value of the dividend. 11 In addition, the dividend created a basis in N2HC that was subject to amortization under federal tax law. 12 Accordingly, Nordstrom was required to report the value of the distribution as a gain by NIHC, as well as the amortization of N2HC’s basis, on Nordstrom’s consolidated federal tax return for the fiscal year that ended on January 31, 1999. As indicated above, Nordstrom filed a consolidated federal return with its subsidiaries, including NIHC and N2HC. Under federal regulations relating to consolidated returns, the gain from the license distributed by NIHC to N2HC was to be ⁶⁷⁶ deferred over 15 years, 13 because the transaction was between affiliated corporations. 14 For example, for tax years 2002 and 2003, Nordstrom’s consolidated federal returns reported income to NIHC in the amount of $186,133,333, and a deduction for amortization expense for N2HC in an identical amount. NIHC’s Maryland Tax Returns Under Maryland law, a corporation is subject to tax on income derived from or reasonably attributable to its business activities in Maryland.

Maryland Code, Tax-General Article (“TG”), § 10-402. Any corporation with Maryland taxable income during a tax year must file an income tax return for that year. TG § 10-810. Each member of an affiliated group of corporations is to file a separate income tax return.

TG § 10-811. During the relevant years, NIHC and N2HC filed separate income tax returns in Maryland that showed no income apportioned to Maryland from the transactions involving the Nordstrom trademarks. In its Maryland returns for 2002 and 2003, NIHC reported the deferred gain shown on the consolidated federal returns. In particular, NIHC reported Maryland modified income of $186,240,824 and $186,128,851 for 2002 and 2003 respectively, but, as indicated above, did not apportion any of that income to Maryland. 15 Although NIHC subsequently took the position before the Tax Court that it ⁶⁷⁷ had concluded in 2005 that its 2002 and 2003 Maryland returns should not have reported the deferred gain at all, it did not file amended returns for those years.

Assessment by the Comptroller following Audit of the Maryland Returns In September 2006, the Comptroller issued Notices of Assessment against Nordstrom, NIHC, and N2HC, based on the position that income-shifting in the form of trademark royalty expenses had resulted in an underpayment of the companies’ Maryland income tax. Nordstrom and its subsidiaries appealed the assessments to the Comptroller’s Hearings and Appeals Section, which upheld the assessments in Final Determination Letters issued in May 2007. The total tax assessment against NIHC for 2002 and 2003, including the unpaid tax, interest, and a 25 percent penalty, amounted to $1,949,048; the total tax assessment against N2HC for 2002 and 2003, including unpaid tax, interest, and penalty, amounted to $228,007. In both instances, the assessment was based on the amount of income shifted from Nordstrom to the two subsidiaries through the trademark transactions.

An alternative assessment was made against Nordstrom related to the same income; the Comptroller stated that it would not be enforced if the assessments of the subsidiaries were upheld on appeal. First Visit to Tax Court and Judicial Review The companies appealed the assessments to the Maryland Tax Court. The Tax Court conducted a hearing at which it received testimony and documentary evidence concerning the trademark transactions. Pertinent to the issue before us, Greta Sedlock, Nordstrom’s former Vice President of Tax, testified concerning the companies’ returns for 2002 and 2003 that included the income that was subject of the Comptroller’s tax assessment.

Ms. Sedlock testified that she would have completed those returns differently based upon a letter she had received from tax authorities in New Jersey in 2005, a state that, like Maryland, requires separate company reporting. She said that she had come to the view that, because NIHC filed separate returns from its affiliated corporations, it ⁶⁷⁸ should have reported the entire gain from the inter-company transactions on its 1999 Maryland return when the § 311(b) gain was recognized. According to Ms. Sedlock, she now believed that deferral of the gain over 15 years was only appropriate for the consolidated returns filed under federal law. She apparently believed that she had made a mistake in how she had reported the NIHC’s income on the 1999 and subsequent Maryland returns.

The Tax Court issued its decision in October 2008. It viewed the “dispositive issue” as whether there was a sufficient nexus between the two subsidiaries and Maryland, such that imposition of the State income tax on the income of the subsidiaries would not offend the Commerce Clause or the Due Process Clause of the federal Constitution. It viewed the case primarily as requiring an application of this Court’s decision in Comptroller 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). SYL concerned two instances where companies subject to the Maryland corporate income tax each created a wholly owned subsidiary in another jurisdiction and transferred intangible assets to that subsidiary.

In each case, the parent company then entered into a licensing agreement with the subsidiary under which the parent company paid royalties to the subsidiary for the use of the intangible assets. The parent companies each deducted the royalty payments in computing income subject to the Maryland income tax and, as a result, were able to reduce their tax liability in Maryland. The respective subsidiaries, which had no assets or employees in Maryland, did not file corporate income tax returns in Maryland. 375 Md. at 80-99 , 825 A.2d 399 . In each case, the Court of Appeals held that the subsidiary lacked economic substance as a business entity separate from its parent and also had a substantial nexus with Maryland.

Thus, a portion of each subsidiary’s income was subject to the Maryland income tax, based on the extent of its parent company’s business in Maryland. Id. at 106-09 , 825 A.2d 399 . ⁶⁷⁹ The “anti-Geoffrey strategy” adopted by Nordstrom had attempted to circumvent the rationale ultimately adopted in SYL and similar decisions by using several subsidiaries and a series of transactions between the parent corporation and the various subsidiaries. The Tax Court concluded that, while the transactions involving the Nordstrom subsidiaries were more complicated than those in SYL, the results were much the same. “Fundamentally, the subsidiaries did not act independently, although the financial structure creates an illusion of substance ... NIHC and N2HC lack real economic substance as separate business entities.” Accordingly, the Tax Court held that the activities of the subsidiaries must be considered the activities of Nordstrom, which has a nexus with Maryland.

It therefore affirmed the assessments against the two subsidiaries. Because the assessments against the subsidiaries were affirmed, the Tax Court rescinded the alternative assessment against Nordstrom. NIHC sought judicial review in the Circuit Court for Baltimore County, which rendered a decision in August 2009 based on memoranda submitted by the parties. 16 The Circuit Court noted that the sole issue decided by the Tax Court was whether there was a sufficient nexus between Maryland and NIHC to allow taxation of NIHC’s income by Maryland under the federal Constitution. The Circuit Court held that the fact that NIHC lacked economic substance did not by itself resolve the question whether there was a sufficient constitutional nexus between its income and the State to satisfy the federal Constitution.

It remanded the case to the Tax Court to ⁶⁸⁰ address whether there was a constitutionally sufficient nexus between the § 311(b) gain realized by NIHC and business activities in Maryland. If that question were answered in the affirmative, the Circuit Court directed the Tax Court to analyze two additional questions: (1) whether the § 311(b) gain constituted taxable income under Maryland tax law; and (2) whether the Maryland requirement of separate entity reporting would prevent taxation of the deferred § 311(b) gain in the 2002 and 2003 tax years. Second Visit to Tax Court and Judicial Review In July 2010, the Tax Court again upheld the assessment against NIHC and issued an Amended Memorandum of the grounds for its decision. The Tax Court held that Maryland’s taxation of the reported income was constitutional as it was not possible to separate the value of the trademarks, their licensing, and the gain recognized by NIHC from Nordstrom’s business activities in Maryland.

The Tax Court stated that “but for the activities of Nordstrom and its use of the trademarks in Maryland, the gain of NIHC would not have been recognized. Nordstrom’s business activities and the use of the intellectual property rights obtained through its agreement with N2HC produced the gain income reported by NIHC.” In addition, the Tax Court held that, because Nordstrom’s nexus was attributed to NIHC, the income was taxable under Maryland law. Finally, the Tax Court concluded that Maryland’s requirement of separate entity income tax returns did not prohibit the taxing of the § 311(b) gain “when the income is attributed to the activity of the parent Nordstrom and its use of the marks in Maryland for the subject years.” The Tax Court stated: “NIHC reported the deferred gains as Maryland modified income and the substance of the transaction does not prevent the taxing of income earned in the assessment years because of separate reporting requirements.” NIHC again sought judicial review of the Tax Court decision. In December 2011, the Circuit Court affirmed in part and reversed in part the Tax Court decision.

The court agreed with the Tax Court that “the § 311(b) gain was the ⁶⁸¹ result, in part, of the projected use of the trademarks in Maryland” and that, therefore, there was substantial evidence of a sufficient nexus of the reported income with Maryland. It also concluded that the gain income was “reasonably attributable” to activities in Maryland and therefore taxable under the Maryland income tax law, as that law had been construed to allow taxation “to the bounds permitted by the Constitution.” 17 However, the court concluded that Maryland’s separate reporting requirement prohibited the Comptroller from assessing the deferred gain reported by NIHC for 2002 and 2003, which the court believed should have been reported with the rest of the gain when it was recognized in 1999. The court therefore reversed the assessment against NIHC. Court of Special Appeals Decision The Comptroller appealed the Circuit Court decision to the Court of Special Appeals.

NIHC did not cross-appeal. In an unreported decision, the Court of Special Appeals reversed the Circuit Court judgment. The intermediate appellate court noted that the only issue before it was whether Maryland’s separate reporting requirement prevented the taxation of the gain reported on NIHC’s 2002 and 2003 returns. The Court of Special Appeals stated that the Circuit Court had incorrectly focused on how the § 311(b) gain should have been reported instead of whether it was taxable in the way it had in fact been reported. 18 The court noted that it had not been presented ⁶⁸² with any law or other authority “that precludes Maryland from taxing income that is constitutionally taxable by Maryland and that is reported by the corporate taxpayer as Maryland modified income on its Maryland income tax return.” The Court of Special Appeals found no error in the Tax Court’s decision to uphold the assessment against NIHC.

Accordingly, it reversed the Circuit Court decision. The Court of Special Appeals stated that it was expressing no opinion on “the broader issue of whether a corporation’s § 311(b) gain, which is constitutionally subject to taxation by Maryland, is reportable as Maryland modified income on a deferred basis under Maryland’s requirement of separate entity income tax returns, where such deferred gain is reported on the corporation’s consolidated federal income tax return.” Petition for Certiorari NIHC sought a writ of certiorari, which we granted to review the merits of the Tax Court’s amended decision in this case. Discussion Standard of Review As the Tax Court is an adjudicative administrative body of the executive branch, its decisions are subject to the same standards of judicial review as adjudicatory decisions of other administrative agencies. Gore Enterprise Holdings, Inc. v. Comptroller, 437 Md. 492, 503 , 87 A.3d 1263 (2014); see ⁶⁸³ TG § 13-532(a)(l).

A reviewing court may uphold a Tax Court decision only on the findings and reasons given by the Tax Court. Gore Enterprise, 437 Md. at 503 , 87 A.3d 1263 . Findings of fact are reviewed on a deferential “substantial evidence” standard — i.e., whether the record contains evidence that reasonably supports the agency’s conclusion. Id. at 504 , 87 A.3d 1263 .

A reviewing court also accords great weight to the Tax Court’s interpretation of the tax laws, but reviews its application of case law without special deference. Id. at 504-05 , 87 A.3d 1263 . Deciding What Question is Before Us Before we can venture an answer to the question before us, we must decide what that question is. As is sometimes the case in appellate litigation, the parties’ briefs debate the wording, number, and nature of the question(s) presented. 19 Regardless of the preferred wording of the parties, the issues before us are constrained by the facts found and the legal conclusions drawn in the decision of Tax Court under review, and by the issues preserved by the parties in seeking review of that decision in the courts below.

The present case involves judicial review of a decision of the Tax Court pursuant to TG § 13-532. In that context, it is often said that we “look through”