Nordstrom’s State Tax Gambit Fails

The courts say that shifting trademark royalty collection to subsidiaries in other states did not release the upscale retailer from its Maryland tax obligation.

One of the most venerable techniques for reducing state and local tax burdens has been to transfer intangible assets — such as trademarks and trade names — to an entity incorporated in a state other than the one in which the transferor conducts business. The transferor then enters into a licensing agreement with the transferee and pays royalties to the transferee.

From the government’s perspective, if the transferee is not subject to tax in the state because it lacks “nexus” in the state the transferor’s business is conducted, the group will realize an overall tax savings. The same would be true if the transferee was subject to low or no taxes in its state of incorporation with respect to the royalty income.

The result would parallel the outcome achieved by many multinational organizations that engage in “transfer pricing” gambits. The idea is to shift income from high to low tax jurisdictions and, if the trademark shifting device works as planned, such a beneficial shift would indeed occur. Unfortunately, this strategy has rarely stood up to scrutiny, and the latest company to find that its tax planning did not bear fruit is the high-end retailer Nordstrom, which had its tax plan struck down in October.

The case concerns the liability for Maryland income taxes for the years 2002 through 2004, specifically regarding two Nordstrom subsidiaries that do not do business in Maryland and own no tangible property in the state. Nordstrom set up the subsidiaries in the following manner:

Nordstrom, a national retailer with 150 stores in 27 states, was operating several stores in Maryland. In 1996, the retailer incorporated NIHC and NTN in Colorado, and contributed to NIHC a license agreement authorizing it to license the use of Nordstrom’s trademarks in exchange for 100 percent of NIHC’s stock. Later, Nordstrom incorporated N2HC, in Nevada, and contributed cash to N2HC in exchange for all of its stock.

Still later, Nordstrom transferred its “marks” to NTN and, shortly thereafter, transferred its stock in both NTN and NIHC to N2HC in exchange for the cash that Nordstrom had used to capitalize N2HC. Next, NIHC distributed as a dividend to N2HC, the license agreement.

Eventually, N2HC entered into a license agreement with Nordstrom under which N2HC granted Nordstrom a license to use the Nordstrom trademarks in exchange for royalty payments. Throughout the period, N2HC maintained an office in Portland, Oregon, which was staffed by a full-time “intangible property specialist.”

After evaluating its structure, Nordstrom contended that N2HC was not subject to Maryland corporate income tax because in the parent company’s estimation, N2HC was actively engaged in managing, maintaining, enhancing, and protecting the “marks” that had been entrusted to it. The tax court disagreed, however, based on its definition of nexus. (See Nordstrom, Inc. v. Maryland Comptroller, Md. T.C. No. 07-IN-00-0317, October 24, 2008.)

Nexus

The court concluded that the test applicable when determining “nexus” with respect to an entity — a finding of which would subject N2HC to Maryland taxation — is whether the out-of-state affiliates have “real economic substance as separate business entities.” Here, Nordstrom paid royalties to N2HC of approximately $200 million for each of the years in question. N2HC, upon receipt of the royalties, loaned back to Nordstrom approximately two-thirds of each year’s royalties.

Therefore, the court concluded that the payment by Nordstrom to N2HC, and the subsequent loans from N2HC to Nordstrom, were not arms-length market transactions. Moreover, the court accorded significance to the fact that the operating expenses of N2HC were “minimal” compared to its royalty income.

Nexus exists, the court observed, independent of physical presence because of interrelated activities of commonly-owned and controlled corporations. Indeed, the judge found that in the Nordstrom case, NIHC and N2HC lacked real economic substance as separate business entities. Accordingly, their activities in Maryland must be considered as the activities of their parent, Nordstrom.

As a result, there were substantial activities in Maryland, and quite clearly Nordstrom had a constitutional nexus with Maryland. To be sure, the tax court often has ruled against parent companies with greater claims of economic substantial than Nordstrom seemed to showed here. For example, even when a parent has a licensing agreement with a subsidiary that has a semblance of real business activity — and actively participates through its employees in the management and operation of the property — the courts will find that such entity lacks real economic substance as a separate business entity.

This recent Nordstrom finding, therefore, subjects the licensor to state taxes because the requisite nexus is found to exist. At this point, it will be nothing short of a miracle if one of these trademark shifting arrangements withstands judicial scrutiny.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.

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