Jurisdictional Split on Taxes Based on In-State Trademarks
Two recent cases highlight the different analyses courts may employ when determining whether a state has jurisdiction to impose income based taxes on an out-of-state taxpayer. In the first case, New Mexico Tax. & Rev. Dept. v. barnesandnoble.com LLC, No. 31,231 (N.M. Ct. of App., Apr. 18, 2012), the New Mexico Court of Appeal applied a commerce clause analysis. The taxpayer was an Internet retailer that did not have any property, employees, or sales agents in New Mexico, but whose parent corporation owned three physical stores in the state. The Department argued that the taxpayer’s use of trademarks and logos similar to those used by the in-state stores created a market in New Mexico establishing substantial nexus. Although the taxpayer contended that the in-state use was not done on its behalf, the court reasoned that a trademark and its goodwill are inseparable property rights, and that because consumers expect to be able to find a business on the Internet, some of the goodwill generated by the in-state trademarks inevitably accrues to the taxpayer. The court found that consumers saw only one entity – Barnes & Noble – and had no way of knowing that they actually were dealing with two separate entities when transacting with the in-state stores and the on-line retailer.
Although it is settled law that under the Commerce Clause that a tax may not be applied to an activity absent a substantial nexus with the taxing state, the requirement may be met when in-state activities performed on behalf of a taxpayer are significantly associated with the taxpayer’s ability to establish and maintain a market in the taxing state for its sales. See e.g., Tyler Pipe Indus., Inc. v. Washington State Dept. of Rev., 483 U.S. 232 (1987). According to the barnesandnoble.com court, goodwill was developed both directly, by in-state activities promoting the taxpayer’s website, and indirectly, by the consumers’ increased awareness of Barnes & Noble due to the presence of in-state stores. And, both of these factors were significantly associated with the taxpayer’s ability to establish and maintain a market in New Mexico. Thus, the court held that the taxpayer’s in-state use of the Barnes & Noble trademarks was sufficient to meet the constitutional standard and supported the imposition of the state’s gross receipts tax.
In the second case, Scioto Ins. Comp. v. Oklahoma Tax Comm., No. 108943 (Okla. Sup. Ct., May 1, 2012), the Oklahoma Supreme Court applied a due process analysis. The taxpayer was an insurance company established by Wendy’s International, Inc., in the state of Vermont, to insure various risks of Wendy’s restaurants. The intellectual property in question consisted of the trademarks and operating practices of Wendy’s restaurants. When establishing Scioto, Wendy’s International transferred the intellectual property to the taxpayer in order to meet Vermont’s capitalization requirements for an insurance business. Scioto then licensed the trademarks to Wendy’s International, who in turn sub-licensed the marks to the Wendy’s restaurants located in Oklahoma. In return, the restaurants paid 4% of their gross sales to Wendy’s International, and Wendy’s International paid 3% of the gross sales to Scioto. After receipt of the royalty payments, a subsidiary of Scioto loaned the money back to Wendy’s International, which claimed deductions for both the royalty payments and the interest paid on the notes. The practical effect of this arrangement was, essentially, the elimination of Wendy’s International’s state income tax liability on earnings associated with the Oklahoma licensing fees.
Under due process jurisprudence, the relevant inquiry generally is whether a defendant had minimum contacts with the jurisdiction such that the maintenance of the suit does not offend traditional notions of fair play and substantial justice. Quill Corp. v. North Dakota, 504 U.S. 298, 307 (1992). And, the courts have held that if an out-of-state corporation purposefully avails itself of the benefits of an economic market in the forum state, it may subject itself to the state’s in personam jurisdiction even if it has no physical presence in the state. Id. Here, the Scioto court found that Oklahoma had no connection to, or power to, regulate the licensing agreement between Scioto and Wendy’s International – a contract that was neither made in Oklahoma, nor performed there. Although Scioto acknowledged that the company had never paid out an insurance claim, the court found that Scioto was not a shell entity, and the agreement was not a sham obligation. According to the court, “[t]he Oklahoma Tax Commission cannot summarily disregard the licensing agreement simply because it produces a deduction that the Commission does not like.” Further, the court held that “due process is offended by Oklahoma’s attempt to tax an out-of-state corporation that has no contact with Oklahoma other than receiving payments from an Oklahoma taxpayer (Wendy’s International) who has a bona fide obligation to do so under a contract not made in Oklahoma.”
Although the barnesandnoble.com and Scioto courts applied completely different analyses, the cases demonstrate that taxpayers should thoroughly evaluate the various constitutional standards when determining whether a state has jurisdiction to impose tax on an out-of-state entity. In addition to the limitations set forth in the Commerce and Due Process Clauses, taxpayers recently have raised successful challenges based on other provisions in the Federal Constitution, such as the First Amendment, the Tonnage Clause, and the Equal Protection Clause.
If you have any questions regarding the contents of this newsletter, please contact the following attorneys in the firm’s State and Local Tax Practice Group.