In the wake of South Dakota v. Wayfair Inc.1 and the U.S. Supreme Court’s endorsement of economic nexus, a subject of wide discussion has been whether nexus issues are dead in the context of sales tax and corporate income tax. Two recent developments indicate that, while the framework for analyzing nexus may have changed, a jurisdiction still must address nexus before imposing tax on a person or entity.
Crown Packaging Technology
The first development is a decision in which the New Jersey Tax Court rejected both the taxpayer’s and the New Jersey Division of Taxation’s motions for summary judgment. The Tax Court determined that the taxpayer, Crown Packaging Technology, had raised issues that, if proven, could indicate that the decision should not be governed by Lanco, Inc. v. Director, Division of Taxation.2 In Lanco, the New Jersey Court of Appeals upheld New Jersey’s ability to tax a company when the company’s only connection with New Jersey was its receipt of royalties from a retailer operating within the state.
In this case, Crown Packaging Technology, Inc. v. Director, Division of Taxation, a company that owned both patents and trademarks entered into license agreements with its subsidiary, under which the subsidiary could use those patents and trademarks in its packaging products manufacturing business. The subsidiary did not manufacture any packaging products in New Jersey. The only connection between the parent’s intellectual property and New Jersey was the presence of the intellectual property on certain advertising materials (such as business cards and stationery) given to the subsidiary’s customers; on shipping materials used to ship the subsidiary’s products into New Jersey; and on the subsidiary’s products, although placement on such products was in a manner that was “small and inconspicuous.”
Unlike in Lanco, where the company’s Lane Bryant trademark was used on retail storefronts in New Jersey, the trademarks and patents at issue in Crown Packaging were placed on products sold by the subsidiary to manufacturers and wholesalers that used the cans to store their own products, such as shaving cream, the lubricant WD-40, and food products. Based on this description of the facts, it is difficult to believe that the ultimate customers of the packaged products were influenced to buy shaving cream and other items because they were stored in an aerosol can designed by Crown Packaging Technology, whose trademark appeared in small print on the can. (Crown Packaging Technology alleged that its trademark was placed on the products made by the subsidiary solely for liability purposes so that if an aerosol can failed, the injured party could identify the manufacturer.)
In Crown Packaging, the Tax Court, while not issuing an ultimate determination, acknowledged that not all connections are sufficient to permit a state to impose a tax pursuant to the Due Process Clause and the Commerce Clause of the U.S. Constitution.3 The New Jersey Tax Court decision specifies that some of the facts alleged by the petitioner, “particularly plaintiff’s remoteness from the use of its IP and lack of control by plaintiff or USA over placement of USA’s products in New Jersey, if true, could possibly require this court to analyze whether requiring plaintiff to file CBT returns” violates the Due Process and Commerce Clauses.
It must be noted that in its decision the New Jersey Tax Court cited two 2012 decisions—one from West Virginia and one from Oklahoma—in each of which it was determined that a trademark company’s connection with a jurisdiction was too remote to satisfy Due Process Clause considerations.
Although the California Court of Appeal decision did not address Commerce Clause or Due Process Clause considerations, it is one of an increasing number of cases where state courts have determined that a state cannot tax a person or an entity based on its ownership of a passive, non-managing interest in a pass-through entity.
Oklahoma Supreme Court Case
In Scioto Insurance Co. v. Oklahoma Tax Commission, the Oklahoma Supreme Court held that Oklahoma could not impose its corporate income tax on Scioto Insurance Company as a result of Scioto’s licensing of its intellectual property to a related party.4 Scioto was organized as an insurance company under the laws of Vermont. It licensed intellectual property to an affiliate, Wendy’s International Inc., under an agreement that was executed outside Oklahoma. Wendy’s International then sublicensed the intellectual property to Wendy’s restaurants, including restaurants in Oklahoma. Scioto “ha[d] no say where a Wendy’s restaurant [would] be located, including Oklahoma.” The amount of money Scioto received from Wendy’s International for use of the intellectual property was “based on a percentage of the gross sales of the Wendy’s restaurants in Oklahoma.” Wendy’s International’s obligation to pay Scioto was “not dependent upon the Oklahoma restaurants actually paying Wendy’s International.”
The Oklahoma 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 . . . who has a bona fide obligation to do so under a contract not made in Oklahoma.” The court found no “basis for Oklahoma to tax the value received by Scioto from Wendy’s International under a licensing contract . . . no part of which was to be performed in Oklahoma.”
West Virginia Court Ruling
Similarly, in Griffith v. ConAgra Brands, Inc., the Supreme Court of Appeals of West Virginia held that the Due Process Clause prohibited the imposition of tax on ConAgra Brands Inc.5 ConAgra licensed intellectual property to related and unrelated licensees that manufactured products bearing the intellectual property, some of which products were eventually sold in West Virginia. ConAgra did not itself manufacture or sell products that bore the intellectual property. All those products were manufactured by ConAgra’s licensees in facilities located outside West Virginia.
Some ConAgra licensees sold or distributed products bearing the intellectual property to wholesalers and retailers located in West Virginia, and those licensees provided services in West Virginia to clients and customers. Notably, products that bore the ConAgra intellectual property were “found in many, if not in most, retail grocery stores in” West Virginia. However, ConAgra Brands did not direct or dictate the licensees’ distribution of products bearing the intellectual property and did not provide services to the wholesalers and retailers located in West Virginia. ConAgra centrally managed and provided for uniformity in brand image and brand presentation for its intellectual property. It paid the expenses for defending its intellectual property and national marketing. ConAgra would have brought legal actions to protect its intellectual property rights exclusively in federal courts under federal laws that protect intellectual property even if those actions “ar[ose], entirely or in part, from conduct occurring in West Virginia.”
The West Virginia court found for ConAgra, holding that tax assessments against a foreign licensor “on royalties earned from the nation-wide licensing of food industry trademarks and trade names [did not] satisfy . . . ‘purposeful direction’ under the Due Process Clause.” In making this decision, the court rebuffed the state’s assertions based on a “stream of commerce” approach that the Due Process Clause was not violated.
Scioto and ConAgra Considered Together
Both Scioto and ConAgra illustrate what could be called the “two-step paradigm,” whereby the Due Process Clause prevented nexus because the putative taxpayer was two steps away from in-state activity. Unlike, for example, an intangible holding company that licenses directly to a retailer operating in a state where the retailer used the trademarks on property located in the state (i.e., the licensor was only one step away from the market), the entities at issue in these two cases directed their activities toward a licensee outside the taxing state. The putative taxpayers did not direct their activities at the taxing state. What the licensee entity did with that license or with products bearing licensed marks was outside the licensor’s control (and, perhaps, its scope of knowledge). The New Jersey Tax Court’s reference to Scioto and ConAgra in the wake of Wayfair is important for acknowledging that, while the nexus paradigm may have changed, the issue still needs to be examined before a jurisdiction can impose tax.
Arizona v. California
The second recent development shedding light on the current nexus situation is not the issuance of a decision by a court, but a current (as of this writing) motion filed with the U.S. Supreme Court by the State of Arizona in which Arizona seeks permission to sue California for aggressive assertion and collection of limited liability company fees.6 In its motion, Arizona asserts that California’s imposition of a flat tax of $800 on companies doing business in California violates the Due Process and Commerce Clauses to the extent the tax is imposed on LLC members that have no connection with California other than their passive, non-managing interest in an LLC. To support this position, Arizona cites the recent California Swart decision.
In Swart, the Court of Appeal of California held that an Iowa corporation whose sole connection with California was its minority ownership interest in a manager-managed California investment fund that was formed as an LLC and elected pass-through treatment for tax purposes did not have sufficient nexus with California and thus was not subject to the state’s franchise tax.7 The court held that because the out-of-state corporation had no interest in specific property of the fund, was not personally liable for the fund’s obligations, played no role in the fund’s management and had no right to do so, and could not act as an agent for the fund or bind it in any way, the corporation was not doing business in California and was, therefore, not subject to California tax. The court made clear that “passively holding a 0.2 percent ownership interest, with no right of control over the business affairs of the LLC, does not constitute ‘doing business’ in California.”8
Although the California Court of Appeal decision did not address Commerce Clause or Due Process Clause considerations, it is one of an increasing number of cases where state courts have determined that a state cannot tax a person or an entity based on its ownership of a passive, non-managing interest in a pass-through entity.9
Alysse McLoughlin is a partner at McDermott, Will & Emery. Katie Quinn is an associate at McDermott, Will & Emery.
- South Dakota v. Wayfair Inc., 138 S.Ct. 2080 (2018).
- Lanco, Inc. v. Dir. Div. of Taxation, 21 N.J. Tax 200 (Tax 2003), rev’d, 379 N.J. Super. 562 (App. Div. 2005), aff’d, 188 N.J. 380 (2006), cert. denied, 551 U.S. 1131 (2007).
- Crown Packaging Technology, Inc. v. Director, Division of Taxation, 003249-2012 (Tax 2019).
- Scioto Insurance Co. v. Oklahoma Tax Commission, 279 P.3d 782 (Ok. 2012).
- Griffith v. ConAgra Brands, Inc., 728 S.E.2d 74 (2012).
- Mot. for Leave to File Bill of Complaint, Arizona v. California (US Sup. Ct. 2019).
- Swart Enterprises, Inc. v. FTB, No. 13CECG02171 (Cal. Ct. App., 5th App. Dist., 2017).
- See, for example, Lanzi v. Ala. Dep’t of Rev., 968 So.2d 18 (Ala. Civ. App. 2006); BIS LP, Inc. v. Division of Taxation, 25 N.J. Tax 88 (N.J. Tax Ct. 2009), affd, 26 N.J. Tax 489 (N.J. App. Div. 2011); and UTELCOM, Inc., and UCOM, Inc. v. Bridges, 77 So.3d 39 (La. Ct. App. 2011).