Xerox Corp. v. Comptroller of Treasury

Murphy, C. J., delivered the opinion of the Court. This case presents the question whether Maryland taxation of an apportioned amount of certain interest and royalty ¹²⁸ income earned by a corporation engaged in both interstate and intrastate commerce was proper under relevant statutory and constitutional standards. More specifically, the issue is whether the Comptroller of the Treasury was correct in levying an assessment of additional corporate income tax upon Xerox Corporation for the tax years 1972, 1973 and 1974, based upon inclusion within Xerox’s taxable income of interest earned on loans made to foreign subsidiaries and on royalty income received from licensing arrangements made with foreign subsidiaries and nonaffiliated domestic and foreign corporations. I It is well established that the entire net income of a corporation, generated by interstate as well as intrastate activities, may, within constitutional limits, be fairly apportioned among the states for tax purposes by formulas utilizing in-state aspects of interstate affairs.

Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425 , 100 S. Ct. 1223 , 63 L. Ed. 2d 510 (1980); Northwestern States Portland Cement Co. v. Minnesota, 358 U.S. 450 , 79 S. Ct. 357 , 3 L. Ed. 2d 421 (1959). In Maryland, a corporation’s net income for state tax purposes is "the taxable income of such taxpayer as defined in the laws of the United States ....” Maryland Code (1957, 1980 Repl. Vol.), Article 81, § 280A (a). Certain additions to and subtractions from federal taxable income are set forth in § 280A (b) and (c).

At the time relevant to this case, § 280A (c) (4) permitted subtraction from taxable income of "dividend income to the extent included in taxable income and any interest income other than interest earned in the conduct of a business, on loans made under the provisions of Article 58A of this Code, and interest earned on business accounts, notes receivable and installment contracts.” 1 ¹²⁹ Section 316 of Art. 81 further prescribes the manner in which the net income of a corporation shall be calculated for purposes of state taxation. Under § 316 (a) and (b), certain adjustments for income from real or tangible personal property and for capital gains and losses are to be made to federal taxable income. Section 316 (c) provides that the remaining net income of a corporation, referred to as "business income,” "shall be allocated to this State if the trade or business of the corporation is carried on wholly within this State, but if the trade or business of the corporation is carried on partly within and partly without this State so much of the business income of the corporation as is derived from or reasonably attributable to the trade or business of the corporation carried on within this State, shall be allocated to this State and any balance of the business income shall be allocated outside this State. ...” Section 316 (c) also provides that the portion of the business income "derived from or reasonably attributable to the trade or business carried on within this State may be determined by separate accounting where practicable, but never in the case of a unitary business . ...” (Emphasis supplied.) Where separate accounting is neither permissible nor practicable, § 316 (c) provides that the portion of the business income of the corporation allowable to this State "shall be determined in accordance with a three-factor formula of property, payroll and sales, in which each factor shall be given equal weight and in which the property factor shall include rented as well as owned property and tangible personal property having a permanent situs within this State and used in the trade or business shall be included as well as real property.” ¹³⁰ It is thus clear that when separate accounting is not permitted under § 316 (c) — as with the business income of a unitary business — a corporation must compute its Maryland tax liability by using a three-factor (sales, property and payroll) apportionment formula, each "factor” being a fraction. The numerator of the sales factor, for example, is the amount of a corporation’s in-state sales; the denominator of the sales factor is the total amount of a corporation’s in-state and out-of-state sales.

The property and payroll factors are computed in the same manner. The three factors are averaged and the resulting fraction, expressed as a percentage, is multiplied by the corporation’s business income. The resulting dollar amount constitutes the business income apportioned to this State. The applicable tax rate is then applied to the corporation’s apportioned income.

II Xerox Corporation is incorporated under the laws of New York and has its principal place of business in Rochester, New York. It is divided into operating divisions, some of which are in turn combined into groups. The copier division is headquartered in New York, and the corporate headquarters and education division are located in Stamford, Connecticut. Xerox conducts business in all fifty states and the District of Columbia, and has branch offices in several territories of the United States (Puerto Rico, Guam, Samoa, and the Virgin Islands).

Xerox’s business consists primarily of the manufacture of copying equipment, which it sells and rents to its customers. Xerox also provides maintenance services to its customers. The activities conducted by Xerox in Maryland are primarily in connection with the sale, rental and maintenance of its copying machines, which are manufactured in New York. Xerox has no research or development facilities in this State.

Control and supervision of Xerox’s copier business activities in Maryland is exercised by personnel in a regional headquarters in Virginia. A branch office, located in the Baltimore metropolitan area, rents and sells Xerox copying ¹³¹ machines and equipment and provides maintenance services, Xerox’s education division maintains a small facility in Cheverly, Maryland, from which it distributes educational materials. Xerox filed timely Maryland corporate income tax returns with the Comptroller for tax years 1972, 1973 and 1974. These returns reflected an apportionment of Xerox’s net income to the State of Maryland from the manufacture, sale, rental and service of its machines.

The apportionment was made under the Maryland apportionment formula on the basis of Xerox’s property, payroll and sales in Maryland as compared to the same factors at all locations within and without Maryland. Before applying the Maryland apportionment formula, Xerox subtracted from its net income certain royalty and interest income that it had received during the tax years in question. The royalty income was comprised of license fees that Xerox charged for use of certain of its intangible assets, i.e., patents, trademarks, copyrights and business know-how. The license fees, which were determined as a percentage of certain sales of the licensees, were received from various corporations.

Approximately 86% of Xerox’s royalty income came from foreign subsidiaries, with the balance coming from foreign (10%) and domestic (4%) nonaffiliated corporations. An average of almost 90% of Xerox’s royalty income in each of the tax years involved was generated by fees charged to foreign subsidiaries for the use of Xerox’s name. None of the licensing agreements was entered into in Maryland, nor were any of the intangible assets that generated the royalty income acquired or developed in this State. The documents evidencing Xerox’s ownership of the intangible assets were kept at its facilities in Connecticut and New York.

Personnel in Xerox’s corporate headquarters in Connecticut and New York administered the terms of the licensing agreements and collected the licensing fees. Xerox’s ownership interest in the foreign subsidiaries that paid the license fees ranged from 15% to 100%. All of these corporations conducted their businesses entirely outside of the United States and its territories. Each was a separate ¹³² corporation under foreign law and each had its own local management.

Xerox received $11,368,714, $19,148,281, and $20,702,118 in license fees in 1972, 1973 and 1974, respectively. The interest income was produced by loans that Xerox made to certain of its foreign subsidiaries. Although the subsidiaries usually borrowed money in the regular commercial market, Xerox made loans to these corporations when, for example, a subsidiary was precluded from borrowing in its own right by restrictions in existing loan agreements. The loans made by Xerox were all evidenced by formal loan documents and carried various interest rates, depending upon market conditions and the prevailing rate of interest when the loans were negotiated.

The formal loan documents pertaining to these loans were executed in jurisdictions outside of the State of Maryland and were administered by personnel at Xerox’s headquarters in Connecticut. For the years 1972, 1973 and 1974, the foreign subsidiaries had long-term debts outstanding in the regular commercial market of $205,617,000, $258,738,000, and $370,384,000, respectively. Indebtedness from Xerox’s foreign subsidiaries to Xerox was $29,085,084, $59,324,565 and $77,669,226 at the end of tax years 1972, 1973 and 1974, respectively. The Comptroller conducted audits of Xerox’s Maryland corporate income tax returns for 1972, 1973 and 1974.

Xerox’s subtraction of the interest and royalty income was disallowed, and a formal assessment of $102,559 was issued in 1977. In computing the amount of tax owed by Xerox, the Comptroller modified the apportionment formula by including net interest and royalty income in the denominator of the sales factor and the net book value of Xerox’s copyrights and patents in the denominator of the property factor. Xerox appealed the assessment to the Maryland Tax Court. The Tax Court affirmed the assessment, finding that there was "no dispute . .. that Xerox is a unitary business.” It rejected Xerox’s argument that the interest income involved was exempt from Maryland taxation under § 280A (c) (4) of Art. 81, concluding that it was "business income” and therefore taxable under the statute.

The Tax Court also ¹³³ ruled that taxation of the interest and royalty income did not, as claimed by Xerox, violate either the Due Process or Commerce Clauses of the United States Constitution. Xerox’s contention that a "nexus” between the specific income to be taxed and the taxing state is constitutionally required was rejected. Referring to the tests announced in Moorman Manufacturing Co. v. Bair, 437 U.S. 267 , 98 S. Ct. 2340 , 57 L. Ed. 2d 197 (1978), the Tax Court said: "There is a 'minimal connection’ — Xerox has outlets here. The income attributed is 'rationally related’ to Xerox’ values connected to Maryland — it reflects the average of the value of Xerox’ property, payroll and sales in Maryland as compared to Xerox total values.

And finally, Petitioner has failed to show any 'gross distortion’ of its tax liability.” The Tax Court concluded that the apportionment formula used by the Comptroller was proper and resulted "in the taxation of no more than this State’s fair share of Petitioner’s income.” Xerox appealed the Tax Court’s decision to the Circuit Court for Baltimore County. That court expressed the belief that Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425 , 100 S. Ct. 1223 , 63 L. Ed. 2d 510 (1980), was controlling and required affirmance of the Tax Court’s decision. Language in § 316 (c) of Art. 81, which according to Xerox required a stronger showing of a connection between the income to be taxed and the taxing state than that constitutionally required under relevant Supreme Court decisions, was interpreted as mandating nothing more than "the application to the total income of a corporation of a reasonable apportionment formula .. ..” Finally, the circuit court held that the apportionment formula used by the Comptroller was fair and reasonable. Xerox appealed to the Court of Special Appeals, and we granted certiorari prior to determination of the case by the lower appellate court to consider the important issues involved. ¹³⁴ As it did below, Xerox advances three major arguments.

First, that Art. 81, §§ 280A (c) (4) and 316 (c), prohibit Maryland taxation of any part of the interest and royalty income. Second, that Maryland’s taxation of the interest and royalty income offends both the federal and state constitutions. Third, that even if Maryland has the constitutional and statutory authority to tax the interest and royalty income, the formula used to determine Xerox’s Maryland tax liability was constitutionally invalid. Xerox concedes that it operates a "unitary” business in the United States and its territories, and that Maryland properly could tax a portion of the income derived from that business.

Xerox contends, however, that the royalty and interest income was derived from sources totally separate and distinct from its copier business and other active business operations in which it was engaged; that the income was thus not a part of the unitary business which it conducted in part in Maryland; and that such income, therefore, was properly allowable outside of the State for tax purposes. Xerox further contends that there was a complete absence of the requisite interdependence among its copier activities and royalty and interest income-generating activities. The absence of an underlying unitary business, Xerox argues, means that separate accounting rather than apportionment is mandated by § 316 (c). The Comptroller suggests that the identity of the payor corporations is irrelevant to the question whether separate accounting is proper under § 316 (c).

The fact that Xerox conducted a unitary copier business, a part of which it conducted in Maryland, is sufficient, he urges, to preclude the use of separate accounting under § 316 (c). Xerox contends that the interest income was nonbusiness income and therefore excludable from Maryland net income under former § 280A (c) (4). In addition, Xerox argues that Maryland taxation was limited, as provided by § 316 (c), to "so much of the business income of the corporation as is derived from or reasonably attributable to the trade or business of the corporation carried on within this State . . ..” ¹³⁵ This legislative standard, Xerox argues, is more restrictive thaw 'the constitutional stand d and was not met with respect to the interest and royalty income. As a consequence, Xerox contends that Maryland has no jurisdiction to tax that income.

The Comptroller submits that the Legislature intended that § 316 (c) be used to tax as much of a corporation’s income as is constitutionally permissible. The interest income should not be excluded under § 280A (c) (4), he maintains, because it was earned in the conduct of Xerox’s business. Even if there is no statutory bar to Maryland taxation of the interest and royalty income, Xerox contends that the due process and commerce clauses prohibit taxation of this income. It argues that the federal constitution requires a direct nexus between the income to be taxed and the taxing ¡ iLate, a nexus that is missing f l this case.

The Comptroller denies that a direct nexus is required, and submits that under traditional notions of due process there is no constitutional impediment to Maryland taxation of the interest and royalty income. In the alternative, the Comptroller argues that Xerox failed to demonstrate that it did not form a unitary business with its foreign subsidiaries, and therefore the interest and royalty income is taxable under the Supreme Court’s decision in Mobil Oil Corp. v. Commissioner of Taxes, supra. The apportionment formula applied by the Comptroller is also attacked by Xerox on the ground that by failing to apportion its income in a rational manner, the Comptroller acted unconstitutionally. The Comptroller characterizes the use of the modified apportionment formula as fair and reasonable, and rejects each of the alternative formulas advanced by Xerox.

Ill A. As previously indicated, net income for Maryland corporate taxpayers is defined in § 280A (a) as "the taxable income of such taxpayer as defined in the laws of the United ¹³⁶ States .. .Section 280A (c) (4) provides for the subtraction from federal net income of "any interest income other than interest earned in the conduct of a business, on loans made under the provisions of Article 58A of this Code, and interest earned on business accounts, notes receivable and installment contracts.” The determination of whether Xerox’s interest income is taxable under § 280A necessitates consideration of whether § 280A (c) (4) is a "definition” of taxable income, and therefore to be construed strictly against the State, or an "exemption” from taxable income, to be construed in favor of the State. In Balto. Foundry v. Comptroller, 211 Md. 316 , 127 A.2d 368 (1956), the taxpayer argued that the purchase of certain goods, which it used in its foundry operations and then sold to its customers, did not constitute a "retail sale” subject to taxation under the then-existing version of the Retail Sales Tax Act. Section 320 of that Act defined, among other relevant terms, "retail sale,” and § 321 described the tax consequences of transactions that fit within the various definitions set out in § 320.

Section 322 was titled "Exemptions” and listed a number of transactions that would be exempt from taxation even though otherwise within the scope of § 320. With this factual and statutory scheme before it, the Court said: "It may be observed that the exclusion of tangible personal property purchased for the purpose of resale in its original form, or for the purpose of incorporation into a finished product, is by force of the definition and not by inclusion in the exemptions set out in sec. 322. Sales in the categories mentioned are simply not within the scope of the taxing statute. Thus the rule of strict construction of an exemption does not apply, but the rule is applicable, that, where there is doubt as to its scope, a tax statute should be construed most strongly in ¹³⁷ favor of the citizen and against the State.” 211 Md. at 319-20 , 127 A.2d at 369 .

Xerox argues that the statutory construction rules of Balto. Foundry, supra, are applicable to the present case, but we cannot agree that § 280A (c) (4) is part of a "definition” of taxable income. The scope of Maryland taxation of corporate income as defined in § 280A (a) encompasses the corporation’s federal taxable income. Under § 280A (c) (4), interest income is to be subtracted from federal income unless it is derived from a certain source, such as notes receivable.

Interest income is therefore within the scope of the taxing statute and is to be taxed unless excluded by operation of § 280A (c) (4). That section, therefore, must be viewed as an exemption. See Swarthmore Co. v. Comptroller, 38 Md. App. 366, 371 , 381 A.2d 27, 29 (1977). As such, the following rules are applicable in determining whether Xerox’s interest income is taxable under § 280A (c) (4): "It is fundamental that statutory tax exemptions are strictly construed in favor of the taxing authority and if any real doubt exists as to the propriety of an exemption that doubt must be resolved in favor of the State.

In other words, 'to doubt an exemption is to deny it.’ . . . [T]he State’s taxing prerogative is never presumed to be relinquished and the abandonment of this power must be proved by the party asserting the exemption.” Perdue v. St. Dep’t of Assess. & T., 264 Md. 228, 232-33 , 286 A.2d 165, 167-68 (1972) (emphasis in original) (citations omitted) (quoting from Suburban, etc. Gas Corp. v. Tawes, 205 Md. 83, 87 , 106 A.2d 119, 121 (1954)). Xerox has attempted to meet the burden of proving the State’s relinquishment of its power to tax interest income by urging us to hold that § 280A (c) (4) only permits taxation of interest income directly attributable to the type of business operations conducted by the taxpayer in this State. Thus, while Xerox concedes that it must pay Maryland income taxes on the receipt of interest related to its copier operations, both within and without the State, it contends ¹³⁸ that § 280A (c) (4) precludes taxation of the interest received on loans to foreign subsidiaries. In Swarthmore Co. v. Comptroller, supra, the Court of Special Appeals considered the taxability of interest income under § 280A (c) (4).

Observing that the language of § 280A (c) (4) was ambiguous, the court sought to ascertain the Legislature’s intent by looking to subsequent legislative revisions of § 280A (c). The court noted that the language of § 280A (c) (4) was eliminated by ch. 637 of the Acts of 1976. The title to that Act stated that its purpose was to include "in the income of corporations subject to State income tax certain nonbusiness interest . . . income to the same extent included under the federal income tax . . . .” Section 280A (c) (4), prior to its revision, was intended, the court concluded, "to assure that 'interest earned in the conduct of a business’ be taxed, with only specified kinds of nonbusiness interest income being exempt.” 38 Md. App. at 372-73 , 381 A.2d at 30 (emphasis in original). It was the holding of the Tax Court that Xerox’s loans to its subsidiaries generated business income.

Because it appears that § 280A (c) (4), as it then stood, was intended to exempt only nonbusiness interest income, and bearing in mind Xerox’s heavy burden of proof, we conclude that the interest income was not exempt from taxation under the provisions of the statute. B. Xerox subtracted the royalty and interest income from its Maryland net taxable income on the theory that the income should be separately accounted for and allocated entirely to a