On January 30, 2006, the New Jersey Supreme Court granted Lanco, Inc.’s petition for certification.[fn1] The petition seeks reversal of the Appellate Division decision, which had reversed the well-reasoned decision of the New Jersey Tax Court, and had held that physical presence is not a prerequisite to tax imposition under New Jersey’s Corporation Business Tax. While the New Jersey Supreme Court’s agreement to review the decision is naturally a welcome development for Lanco, the ultimate decision on the economic nexus issue is of critical importance to any corporation or person that might be said to derive revenue from use of its intangible property or product in a state in which it has no physical presence – no office, no tangible personal property, no realty, and no personnel.
Although the highest courts of other states have ducked the issue, [fn2] it is not entirely surprising that New Jersey’s highest court has stepped up to the plate. In a somewhat unusual move, the Appellate Division itself urged the court to take the case; in a footnote to its decision the Appellate Division strongly suggested that the constitutional question on which it had ruled was substantial and stayed its remand of its decision "pending decision on a petition for certification." [fn3] Also notable was the stand-up position taken by the New Jersey Director of the Division of Taxation ("Director"), not to oppose Lanco’s bid to seek New Jersey Supreme Court review of the Appellate Division decision. In fact, the Director’s counsel represented to the court that the Director "agrees that the Appellate Division decision addresses a substantial question under the Constitution of the United States on which there is a divergence of precedent and that it is in the [Director’s] interest to have the question resolved by the Court."
The case involves Lanco’s challenge to a subjectivity notice issued by the Director, based upon the Director’s position that Lanco could be subjected to New Jersey’s Corporation Business Tax ("CBT") solely by virtue of Lanco’s economic presence in the State. Unlike the facts, or the spin on the facts given by taxing jurisdictions and certain courts, which arguably might not present a clear "economic nexus" scenario, e.g., finding an agency relationship or the "functional equivalent" to physical presence, the facts in Lanco leave no room for a nexus assertion on an alternative basis. The parties stipulated that Lanco, a trademark protection company incorporated in Delaware, owned certain trademarks, tradenames, and service marks (the "Marks"), which it licensed to a sister company, Lane Bryant, at arm’s-length royalty rates. Also stipulated was that Lane Bryant, a nationwide retailer of women’s clothing and accessories, used Lanco’s Marks in its business throughout the United States, including New Jersey. The parties also agreed that Lanco had no physical presence in New Jersey; it had no New Jersey office, employees, agents, real property, or tangible personal property, and it conducted all of its licensing activities outside of New Jersey.
New Jersey Tax Court Decision
Based on those facts, the New Jersey Tax Court had no problem concluding that Lanco did not have "substantial nexus" with New Jersey and could not therefore be subjected to the CBT. The Tax Court, which has considerable familiarity with and understanding of the tax issues, scrutinized the parties’ positions and critically reviewed their cited authorities; its decision was well reasoned and scholarly, unlike the decisions hailing from administrative agencies and many courts – including New Jersey’s Appellate Division – which ignore the holding of Quill Corp.v.North Dakota, [fn4] relying instead on its dicta and tone.
First, the Tax Court rejected the common ownership of Lanco and Lane Bryant as providing a basis that would impact upon its constitutional analysis, concluding that their relationship was "not material to the constitutional issue." [fn5]
Next, the Tax Court addressed the Director’s contention that the Quill Court only grudgingly followed its earlier pronouncement in Bellas Hess[fn6] of the physical presence requirement and that the requirement is obsolete. In rejecting the Director’s argument, the Tax Court found that "[t]he majority clearly undertook an analysis of the physical presence requirement on its own merits." [fn7]
The Tax Court also rejected the Director’s argument that the Commerce Clause does not require physical presence in the income tax context, concluding that "[i]t is difficult to see distinctions that give virtue to physical presence as a necessary element of nexus in [the use tax] area and not for purposes of income taxation." [fn8] The Tax Court joins the ranks of other courts in understanding that there is but one Commerce Clause and it applies regardless of the type of tax involved. For example, the Texas Court of Appeals said it well:
- While the decisions in Quill Corp. and Bellas Hess involved sales and use taxes, we see no principled distinction when the basic issue remains whether the state can tax the corporation at all under the Commerce Clause. As construed in Quill Corp. and Bellas Hess, when the corporation conducts its activity solely through interstate commerce and lacks any physical presence in the state, no sufficient nexus exists to permit the state to assess tax. [fn9]
More importantly, however, the Tax Court’s determination that the Commerce Clause applied to the CBT also comports with Justice Scalia’s observation in his concurring decision in Quill: "[i]t is difficult to discern any principled basis for distinguishing between jurisdiction to regulate and jurisdiction to tax. As an original matter, it might have been possible to distinguish between jurisdiction to tax and jurisdiction to compel collection of taxes as agent for the State, but we have rejected that." [fn10]
The Appellate Division Decision
The Appellate Division reversed the Tax Court decision and held that the Commerce Clause standard is higher for use tax collection than for income-based taxes. The CBT, as an income-based tax, could therefore be imposed against Lanco or any other corporation if that corporation derives income somehow connected to New Jersey.
To support that conclusion, the Appellate Division relied primarily on Quill’sdicta rather than its holding, and on three cases from other states, A&F Trademark[fn11] from North Carolina, Geoffrey[fn12] from South Carolina, and Gap (Apparel)[fn13] from Louisiana. The Geoffrey decision has been called by renowned experts in state taxation "extremely shoddy" and criticized as having "legal underpinnings . . . [that] may be questioned." [fn14] A&F Trademark relies extensively on that "extremely shoddy" decision, [fn15] and the third case, Gap (Apparel), is not even a Commerce Clause case, but a Due Process case.
By its reliance on Geoffrey and A&F Trademark, the Appellate Division seems to have agreed with the courts’ conclusions in those cases that businesses that have no physical presence still receive benefits for which the State deserves to be compensated. That argument was directly addressed – and rejected – by the U.S. Supreme Court in both Bellas Hess and Quill, and it is troubling that courts have paid no heed to precedent. During the oral argument in Quill, the Attorney General mentioned some of the benefits he believed were provided – and for which North Dakota was deserving of compensation – particularly "the customer base." Justice Rehnquist responded that "[t]hat’s the argument that was rejected in Bellas Hess after being quite eloquently portrayed by the dissent." [fn16] The Bellas Hess majority, however, agreed with Bellas Hess, which in its briefing to the Court characterized Illinois’ argument as: "[s]ince Illinois confers benefits upon persons within its borders, it indirectly confers upon anyone outside its borders who deals with them sufficient benefit to sustain subjecting him to extraterritorial obligations. Upon this theory, Massachusetts could tax Florida hotels because the prosperity it bestows upon Massachusetts residents enables them to visit those resorts. Minnesota could tax Michigan factories because her farmers are a market for Michigan’s tractors and cars. . . . It was to prevent just such mutual aggressions that the States entered into the federal union." [fn17]
It is unclear why the Appellate Division relied so heavily on the cases it did and why it chose not to undertake the type of detailed substantive analysis the Tax Court did. This approach may be attributed to the fact that, while these issues are common fodder for the Tax Court, such issues are not often dealt with by the Appellate Division. Taxpayers across the country are hoping that the New Jersey Supreme Court will give the issue the reasoned consideration it warrants.
New Jersey has long advocated against the physical presence requirement and had filed an amicus brief in Quill requesting that the Court overturn Bellas Hess. As an amicus in Quill, New Jersey set out a laundry list of purported benefits that the State provides to entities that derive revenue from in-State customers: the exploitation of commercial markets, the protection provided by New Jersey’s judiciary, the availability of New Jersey’s highways, the existence of New Jersey’s educated workplace, and police and fire protection. While we all know that the Court in Quill reviewed, considered, and rejected those "benefits" as insufficient to support a finding of "substantial nexus," the Appellate Division and the courts of several other jurisdictions seem to have forgotten or overlooked that precedent.
Bellas Hess’ warning to the Court on the wide-ranging implications of taxation without physical presence has proved prophetic. States have sought to tax companies on the mere receipt of income from all manner of intangibles purportedly used in the state – from trademarks, to computer software, to music. Without a physical presence standard to place reasonable constraints on states’ attempts to collect tax, virtually everyone will be taxable virtually everywhere. Such a tax system would be impossible to fairly administer.
Further, the need for Commerce Clause protection is more compelling for direct imposition of income taxes than for use tax collection. Businesses’ payments of income taxes affect their bottom line, while use taxes are collected from customers and merely remitted to states, which often compensate the collector for its administrative costs. Administrative burden pales in comparison to actual taxation.
It is hoped that the New Jersey Supreme Court will not be swayed by fiscal concerns that may have motivated the courts whose decisions were relied on by the Appellate Division. The potential implications of the decision are significant; all eyes will be turned to that court.
2 See, e.g., Geoffrey, Inc.v.Oklahoma Tax Comm’n, 2006 Okl. Civ. App. 27 (2005); J.C. Penney Nat’l Bankv.Johnson, 19 S.W.3d 831 (Tenn. Ct. App. 1999), cert. denied, 531 U.S. 927 (2000); A&F Trademark, Inc.v.Tolson, 605 S.E.2d 187 (N.C. Ct. App. 2004), cert. denied, 126 U.S. 353 (2005).
This article appeared in State Tax Notes.
Paul H. Frankel, Hollis L. Hyans, and Amy F. Nogid represent Lanco in this matter