Random House, Inc. v. Comptroller of Treasury

RODOWSKY, Judge. For taxing the income of corporations carrying on a unitary business in this state and elsewhere, Maryland Code (1957, 1980 Repl. Yol., 1986 Cum.Supp.), Art. 81, § 316 requires that net income be apportioned to this state on the basis of a formula using property, payroll, and sales. 1 ⁶⁹⁸ Applying that formula the Comptroller of the Treasury assessed Random House, Inc. The taxpayer argues that the Comptroller should modify the monetary amounts utilized in the formula because the Comptroller has increased the income to be apportioned, over that reported, by including income from a type of intangible property known as subsidiary rights. We shall uphold the assessment as made by the Comptroller.

Random House is a New York corporation whose principal business office is in that state. As a book publisher, it contracts with authors to acquire their works for publication. Random House edits an author’s manuscript, designs the book and cover, subcontracts the printing and binding, has the printed volumes shipped to its warehouse in Westminster, Maryland, sells the book from orders which are solicited by salesmen throughout the United States and which are accepted by Random House in New York, distributes volumes of the book from its Maryland warehouse to ⁶⁹⁹ purchasers, and invoices and collects from Maryland the price of the volumes sold. In general the contract to publish grants to the publisher certain rights, for a specified territory and period of time, in the author’s work.

For purposes of simplicity we shall consider that the primary rights are to print the work in the English language in hardcover book form and to sell it throughout the United States. In addition, the contract to publish ordinarily will specify other rights, subsidiary rights, which are granted to the publisher and not reserved by the author. Among the vast number of recognized subsidiary rights are: first and second serial (magazine rights), newspaper syndication, dramatization, motion picture (exclusive of such visuals as microfilm, microprint, and filmstrip), and broadcasting (radio and television); reprints, special school or library editions, book clubs (including school and mail order), abridgments, condensations, digests, selections, anthologies, translations, and commercial tie-ins; picturized, three-dimensional, and game versions; visuals (such as microfilm, microprint, and filmstrip), lyric, sound-reproducing, and recording rights; the right to sell copies by mail order or coupon advertising direct to purchasers; the right to sell bound copies or sets of sheets to book clubs, or to purchasers abroad; and so forth. [W. Derenberg & A. Latman, Contemporary Problems in Book Publishing, Magazine Publishing and Advertising, at 36 (Practicing Law Institute 1970). 2 ] Although the present assessments concern four accounting periods in calendar years 1979 through 1981, the issue before us originated in an earlier case when Random House omitted subsidiary rights income from its Maryland returns for 1977 and 1978. The taxpayer’s theory was that its income from subsidiary rights in a given work was derived ⁷⁰⁰ from a business separate from publishing the hardback edition of that work and that, since this separate business was not conducted in Maryland, no income earned from those rights should be allocated to Maryland.

In Xerox Corp. v. Comptroller, 290 Md. 126 , 428 A.2d 1208 (1981), we had held that § 316(c) included business income from intangible property of a unitary business to the extent constitutionally permissible. The Maryland Tax Court, ruling in 1984 on the assessments for 1977 and 1978, held that the sale or licensing of subsidiary rights was part of Random House’s unitary business so that subsidiary rights income was apportionable to Maryland. The Tax Court went on to hold that Random House had not shown that a gross distortion has occurred through the Comptroller’s application of the standard apportionment formula. Furthermore, [Random House] has failed to suggest a feasible method for valuation of its subsidiary rights.

Counsel for Petitioner mentioned “present discounted value with the capitalization type approach” at the hearing, but added that that would be “something that would have to be studied to come up with a value.” ... Hence, there is no way to compare the effect of using an apportionment formula which includes a value for underlying subsidiary rights to the formula in fact used by the Comptroller because no value for the rights is readily determinable. Thus there is no proof that the result reached by the Comptroller was grossly distorted. In the instant case Random House undertook to fill the evidentiary vacuum.

After the Comptroller had assessed Random House for 1979 through 1981 in order to include subsidiary rights income in the apportionable basis, Random House appealed and presented twenty-six pages of data and calculations, with explanatory testimony, to the Tax Court. That agency again held that Random House failed to prove that the apportionment made by the Comptroller grossly distorted the taxpayer’s Maryland income. The Circuit Court for Baltimore City affirmed and we granted certiorari ⁷⁰¹ prior to consideration of the taxpayer’s appeal by the Court of Special Appeals. Random House does not take issue here with the Tax Court’s finding that producing income from subsidiary rights is part of a unitary business conducted by Random House in Maryland and elsewhere.

The attack is limited to the way in which the Comptroller applied the three-factor formula. Random House had neither included subsidiary rights income in the apportionable basis reported in its Maryland returns nor included subsidiary rights and the income therefrom in the property and sales factors of the statutory formula. In making its assessment the Comptroller’s office added into the apportionable basis Random House’s subsidiary rights income and then applied to the increased basis the Maryland apportionment percentage developed by Random House for use in its return. Random House contends that the Comptroller thereby substantially distorted its Maryland income.

It submits that if subsidiary rights income is to be included in the apportionable basis, then both the sales factor and, more important, the property factor must be adjusted to reflect subsidiary rights. The formula used by the Comptroller was (Md. tangible Md. pay- Md. ) Md. % of jL ( property + roll + sales) = apportion-3 (All tangible All pay- All ) able basis. ( property roll sales) The fact that Random House stores its inventory and maintains its billing center in Maryland is commensurately reflected in the property factor used in the assessment. In order to add intangible property to that factor a value must be placed on subsidiary rights.

The taxpayer submits that, in corporate acquisitions in the publishing business, subsidiary rights are valued based on the income stream to be produced by works over their useful lives and that the Comptroller was required to undertake the same sort of valuation. ⁷⁰² Maryland Regs. Code tit. 3, § .04.01.03C(3) (1987) in part provides that, in applying the statutory formula, “[property owned by the taxpayer is valued at its original cost.” Random House does not carry subsidiary rights at all on its balance sheet and in its proof before the Tax Court the taxpayer did not present the total cost of subsidiary rights in the approximately 25,000 literary works to which it holds publication rights. It did, however, present as the income to be used for valuing subsidiary rights its internal computation of the pretax profits of each of its five operating divisions. 3 These profits were derived from both “hardback” sales and subsidiary rights sales and licensing. Another difficulty faced by the taxpayer in using the pretax profits of intracorporate divisions to prove the value of subsidiary rights is that the sales life of a work can extend beyond the year in which rights, including subsidiary rights, were acquired by the publisher.

Attempting to clear this hurdle the taxpayer assumes that earnings from subsidiary rights in a work will first be reflected in divisional pretax profits in the year in which the subsidiary rights are acquired, and that the total net profit in a division for one year may be converted into a figure representing the value of that year’s subsidiary rights for works acquired that year, as well as for each year thereafter in which those rights produce income. Random House spreads forward in time a portion of a division’s net profit for a particular year on the basis of the assumed average sales life of all divisional works. For example, Random House’s methodology assumes that 70% of the sales from each adult division work will be produced in the first year of publication and that the remaining 30% of sales will occur the following year. Taxpayer then reduces the future portion of the profit to present value utilizing a prime rate as the rate of return in order to reflect the value of divisional ⁷⁰³ subsidiary rights in the year for which the pretax profits were earned.

The discounted net profits for each division for each year are totaled to produce what Random House presents as the value of corporate subsidiary rights for that year. This methodology may be illustrated using the dollars involved in the adult division example referred to above. The pretax net profit of the adult division for 1979 was $4,456,000. To value subsidiary rights, Random House treats only 70% of that amount as having been earned in 1979, that is, $3,119,000.

It treats 30% of the 1979 pretax profits, $1,337,000, as if there were a one-year delay in receipt and discounts that $1,337,000 to $1,324,000, producing a discounted value of total 1979 pretax, adult division profits of $4,270,000. The taxpayer assumes, in the example, that the discounted value of 30% of the 1979 pretax profits of the adult division represents the assumed 30% tail on sales of adult division works for which subsidiary rights were acquired in 1978. 4 The initial step of the methodology fails to segregate the pretax profits produced by subsidiary rights from the pretax profits produced by all other unitary business sources. Thus Random House has not valued subsidiary rights per se, but has valued all rights which it has acquired in works currently in print. Seemingly, by using unsegregated net profits, the methodology values publication rights which have already been represented in the property factor denominator by the cost of the tangible volumes of literary works published directly by Random House and held by it in inventory at the Maryland warehouse. ⁷⁰⁴ With respect to the sales or revenue factor of the formula, the taxpayer was able to present from its accounting system the gross income received from subsidiary rights in the accounting periods involved here (the “addback royalty income”).

Armed with its “valuation of subsidiary rights” and the addback royalty income, the taxpayer presented four variations on the formula, labeled “A” through “D” respectively, to the Tax Court. In each presentation the payroll factor numbers are those utilized in the returns as filed and in the assessment. In each variation the denominator of the sales factor, representing revenues everywhere, uses Random House sales as reported on the return plus the addback royalty income. In each variation the denominator of the property factor, representing property everywhere, is the amount reported on the return plus the taxpayer’s “valuation of subsidiary rights.” The differences between “A,” “B,” “C,” and “D” lie in the numerators employed in the sales and property factors which reflect different apportionments to Maryland.

In variation “A” Random House adds to Maryland sales as reported on its return that percentage of addback royalty income which is the ratio of reported sales in Maryland to sales everywhere. In “A’s” property factor Random House adds to the value of Maryland tangible property that percentage of its “valuation of subsidiary rights” which is the ratio of Maryland tangible property to tangible property everywhere. In “B” the numerators of the sales and property factors, as reported, are increased by applying Maryland’s percentage of the national population to the addback royalty income and to the “valuation of subsidiary rights.” Variation “C” apportions none of the addback royalty income to Maryland in the sales numerator and “C’s” property numerator utilizes a population ratio allocation. Similarly “D” makes no apportionment to Maryland of addback royalty income and, in addition, apportions nothing to Maryland for intangible property.

In its argument to the Tax Court Random House favored method “D” and in essence ⁷⁰⁵ argued that all of the addback royalty income and all of its “valuation of subsidiary rights” should be allocated to New York because New York is almost always the place of