Appendix — Crown Cork & Seal Co. v. Comptroller of the Treasury of Maryland

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APPENDIX A— CORRECTED ORDER OF

THE COURT OFAPPEALS OF MARYLAND

DATED JULY 14, 2003

COURT OF APPEALS OF MARYLAND

No. 80

September Term, 2000

COMPTROLLER OF THE TREASURY

V.

CROWN CORK & SEAL COMPANY (DELAWARE), INC.

CORRECTED

ORDER

The Court having considered the appellee’s motion

for reconsideration filed in the above entitled case, it is this

14” day of July, 2003,

ORDERED, by the Court of Appeals of Maryland,

that the motion be, and it is hereby, DENIED.

(

/s/ ROBERT M. BELL

Chief Judge

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APPENDIX B — OPINION OF THE COURT OF

APPEALS OF MARYLAND

DATED AND FILED JUNE 9, 2003

IN THE COURT OF APPEALS OF MARYLAND

Nos. 76 & 80

September Term, 2000

COMPTROLLER OF THE TREASURY

COMPTROLLER OF THE TREASURY

v.

CROWN CORK & SEAL COMPANY (DELAWARE), INC.

Opinion by Eldridge, J.

Filed: June 9, 2003.

These cases concern the liability for Maryland income

taxes of two corporations that do no business in Maryland,

and own no tangible property in Maryland, but are

subsidiaries of parents that do business in Maryland.

The dispositive issue is whether there is a sufficient nexus

between the State of Maryland and each subsidiary

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Appendix B

corporation so that the imposition of Maryland income tax

does not violate either the Commerce Clause of the United

States Constitution, Art. 1, Section 8, cl. 3, or principles of

due process.

I.

This opinion encompasses two cases; consequently,

we shall set forth the facts of each case separately.

A. No. 76, Comptroller of the Treasury v. SYL

SYL, Inc. is a Delaware corporation and a wholly owned

subsidiary of Syms, Inc. SYL owns intellectual property

assets used by Syms, specifically trademarks, trade names

and advertising slogans.' SYL’s primary function is to manage

and control these intellectual property assets. Syms is a New

Jersey corporation that sells men’s, women’s and children’s

clothing in numerous states, including Maryland.

Syms incorporated SYL in December 1986, and upon

its formation, Syms assigned the above-described intellectual

property assets to SYL. In return, SYL granted to Syms a

license to manufacture, use and sell the products covered by

the trade names and trademarks in its business throughout

the United States. In consideration for these intellectual

property rights, Syms agreed to pay SYL a royalty based on

the parent corporation’s sales. At the same time that Syms

created SYL, it also created another wholly owned subsidiary

named SYI, Inc., the purpose of which was to give SYL

investment advice.

1. Hereafter in this opinion we shall use the term “trademarks”

for all of the intellectual property assets.

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Appendix B

For the tax years 1986 through 1993, SYL did not file

corporate income tax returns in Maryland. Throughout this

period, SYL did not own or lease tangible property in

Maryland, had no employees in Maryland, and maintained

no bank accounts in Maryland. Nor did SYL directly sell or

lease goods or services in Maryland through advertising,

mailings, or in-person solicitations. Syms, however, did have

extensive business contacts in Maryland during this time

period through its ownership and operation of retail stores

in Maryland. Syms regularly filed Maryland corporate income

tax returns.

In 1996, the Comptroller issued a Notice of Assessment

to SYL, indicating that SYL owed for the years 1986 through

1993 an amount of $637,362 in corporate income taxes,

including interest and penalties. SYL timely protested the

Comptroller’s Notice of Assessment. After a hearing, the

Comptroller, by a hearing officer, issued a Notice of Final

Determination that sustained the Notice of Assessment.

The hearing officer, inter alia, found as follows:

“In general, the Comptroller’s Office assessed

SYL, Inc., a tax-haven entity earning substantial

related party income, based on the position that

SYL, Inc. (“SYL’) was a phantom entity that did

not have substantial economic substance. The

Comptroller’s audit section concluded that SYL’s

lack of substantial substance and its dependence

on Syms Corporation (‘Syms’) for its earnings

required SYL to file returns with Maryland based

on the apportionment factor of its parent company

Syms. The Comptroller’s audit section relied upon

;

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Appendix B

Comptroller v. Armco, 572 A.2d 562 (1990)

(cert.denied); Comptroller v. Atlantic Supply Co.,

448 A.2d 955 (1982). The Comptroller’s Office

believes these decisions are consistent with

Tax-General Article, Section 10-402 which

generally requires that the income reasonably and

fairly attributable to carrying on business in

Maryland be taxable by Maryland. In short, the

Comptroller’s section found SYL to be a phantom

or bookkeeping entity and taxed it based on

economic reality and the true source of its

income.”

“In December, 1986, Syms incorporated SYL

in Delaware and putatively assigned to SYL its

ownership in trademarks. As part of an overall

plan, SYL licensed back to Syms the trademarks

and ostensibly assumed (at least on paper) all

obligations for management and administration of

the marks. Just as before the assignment and

simultaneous license back of the marks, Syms

continued to utilize the marks in its retail clothes

stores in Maryland and other states. SYL charged

Syms a 4% royalty pursuant to a license agreement

which was apparently entered into on December

18, 1986 (though dated July 1986). The 4%

royalties were charged from October 1, 1986 even

though the formal assignment of the intangibles

was not effectuated until December 19, 1986.

Moreover, the valuation of the arm’s length royalty

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Appendix B

rate was provided by a company which was

engaged by a consultant (Coventry Financial

Corp.) which apparently was provided a financial

stake in the tax savings obtained.

“At least one significant objective of forming

SYL was to generate state income tax benefits.

See memorandum of Karen Artz Ash dated

July 22, 1986 at p. 6. See also Rosen, ‘Use of a

Delaware Holding Company To Save State Income

Taxes’, 20 Tax Advisor 180 (1989). Significant

state income tax-savings were generated from SYL

in Maryland and other separate return states

because (a) Syms deducted the substantial royalty

payments of roughly $12 million each year to SYL

and (b) SYL did not report its royalty income as

taxable in Maryland or other separate return states

other than Delaware. Since Delaware does not

generally tax income from intangibles, SYL

generated very substantial state income tax

benefits. It appears from one document (finally

obtained after repeated requests) that Syms paid

a third party — Coventry Financial Corp. — a

percentage of the early year state tax savings for

its consulting efforts in setting up SYL. See the

Richard Diamond to Sy Syms memorandum dated

December 12, 1986 entitled ‘State Income Tax

Savings — Coventry Financial Corp.’ ”

*x* * *

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Appendix B

“While by no means exhaustive, I find some

of the salient and controlling facts as follows:

“(1) SYL was a thinly constituted entity with

very little if any true economic or operational

activity in that:

“(a) It paid out very little in wages and

the $1,200 or so of yearly wages paid were to

employees of third party ‘nexus service providers’

which are in the business of providing tax-haven

entities with ‘apparent substance’. SYL contracted

with one such ‘nexus service provider’ which

provides mail forwarding, shared office space and

Shared employees for numerous other taxpayers.

At least some nexus service providers promote

their services to potential clients at tax seminars,

and it is understood that hundreds, if not

thousands, of taxpayers enter into arrangements

with these nexus service providers.

“(b) SYL had no separate office or

employees other than the shared space and

purported employees of nexus service providers

and the officers of Syms who were compensated

solely by Syms.

“(c) SYL had no phone listing, phone

service or office signage.

“(d) SYL apparently did not license its

marks (or attempt to license) to third parties.

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Appendix B

“(e) SYL officers did not have business

cards, job descriptions, job evaluations or other

indicia of a true employment relationship.

“(f) Though requested, SYL could not

produce invoices issued to Syms pursuant to the

royalty agreement (beyond the initial billing

period).

“(g) Though requested, SYL could not

produce travel reports showing business activity

in Delaware.

“(h) Though requested, SYL failed to

produce a person at the informal hearing who

could speak to any activities being conducted by

SYL.”

“From a legal standpoint, it is difficult to find

fault in the Comptroller’s assessment. As in

Armco, the Comptroller’s Office appropriately

determined that the factors and attributes of Syms

should determine how SYL’s income should be

taxed. Since SYL was found to be a phantom,

it was clearly appropriate to look to the true

underlying source of its income. SYL’s booked

income was in reality generated from Syms’ sales,

property and payroll.

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Appendix B

“It was Syms’ use of the marks, its goodwill

and its efforts in Maryland and elsewhere which

gave the marks value and generated the income

‘booked’ in SYL.”

SYL appealed the assessments to the Maryland Tax

Court, with its “Petition of Appeal” headed “SYL, INC. c/o

Syms Corporation[,] Syms Way[,] Secaucus, New Jersey

07094 v. Comptroller of the Treasury.” SYL’s petition alleged,

inter alia, that it was a Delaware corporation “organized in

1986 by its parent, Syrms Corp. . . . to hold certain registered

trademarks and trade names,” that SYL had “as a valid

business purpose the protection, maintenance and

management of valuable intangible assets,” that SYL

maintains an office in Delaware, a separate bank account,

and has its own corporate officers and board of directors who

meet regularly, that SYL “is a bona fide corporation with

substantial corporate substance” and with “a valid business

purpose,” that the taxation of SYL’s income is not authorized

by Maryland Code (1988, 1997 Repl. Vol., 2002 Supp.),

§ 10-402 of the Tax-General Article, or by any other Maryland

statute, and that the Comptrolier’s assessments violate the

Fourteenth Amendment’s Due Process Clause and the

Commerce Clause of the United States Constitution. The

Comptroller’s answer denied SYL’s allegations concerning

its viability, valid business purpose, substance, etc., as well

as SYL’s legal conclusions under the Maryland statutes and

the federal Constitution.

The parties thereafter entered into a stipulation setting

forth the procedural history of the case, the basic facts

conceming Syms’s operations in Maryland, the fact that SYL

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Appendix B

is a wholly-owned subsidiary of Syms, and SYL’s lack of

property, employees, or bank acccunts in Maryland.

The stipulation also agreed upon the introduction into

evidence of twenty-eight exhibits which were attached.

In addition to the numerous exhibits which were introduced,

the Tax Court held a hearing extending over two days during

which several witnesses testified. The administrative record

discloses the following information about the creation and

operation of SYL.

The suggestion to create SYL for tax benefit reasons

originated from Coventry Financial, a consulting firm which

approached Syms Corp. in June of 1986. Upon the creation

of SYL as a trademark holding company, and SYI, Inc., as a

second wholly-owned subsidiary which would act as an

investment advisor to SYL, Syms Corp. was to assign the

trademarks to SYL and SYL was to license the trademarks

back to Syms. Then, Syms was to pay SYL a royaity for the

use of the trademarks, which SYL was to keep temporarily

before the funds were sent back to Syms as a dividend

payment. In the interim, SYL was to invest the funds, with

SYI controlling the investment decisions. Coventry

Financial’s fee was directly tied to the total amount of tax

savings generated from the implementation of its so-called

“program.”

One of Syms’s inter-company documents stated that,

once SYL received the royalty payments, SYL was to hold

the payments in Delaware for “at least a couple of weeks.”

The document went on to explain that the payments would

later be sent back to Syms in the form of a dividend in the

same quarter to “avoid any variances on the financial

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Appendix B

statements which may alert a state auditor to this transaction.”

Furthermore, a memorandum outlining the Syms-SYL

transaction, written by Richard Diamond, Syms’s Secretary-

Treasurer, to Syms’s Chief Executive Officer, Sy Syms,

stated that, while the royalty payment funds were being held

temporarily in Delaware, it was “necessary” for SYI to be

the investment advisor. The memorandum further stated that

“jt is necessary that it do[es]n’t appear that the investment

decisions are being made by Syms Corp.” Notwithstanding

this statement, three of the four officers of SYI were officers

of Syms. On cross-examination, Mr. Diamond acknowledged

that this “was one of Coventry’s ideas to sort of distance

SYL from Syms Corp. in terms of investing the money; to

help in terms of the tax aspects of this transaction.” He further

acknowledged:

“Q. So would you agree that it was an idea that

was designed to keep tax auditors from

realizing what was going on?

“A. From — yes. From the tax part of it, yes.”

Mr. Diamond later reiterated that, “just from a tax point of

view ... I felt it was advantageous to create some distance

between Syms Corp. and SYL.”

SYL used the services of Gunnip & Company to establish

a presence in Delaware. Among other things, Gunnip offered

SYL a “Delaware address” and “mail forwarding.”

Additionally, a letter from Gunnip to Mr. Diamond advises

that the total $2400 per year fee paid to Gunnip “could be

billed to [SYL] as rent monthly $100.00 and .. . as salary

)

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Appendix B

quarterly $300.00.” Actually, SYL’s Delaware “office” lacked

a phone listing, had no office sign, and no business cards.

SYL’s Board of Directors consisted of four people: (1) Sy

Syms who, as previously mentioned, was Syms’s Chief

Executive Officer; (2) Marcy Syms who was Syms’s Chief

Operating Officer; (3) Richard Diamond who was Syms’s

Secretary-Treasurer and Chief Financial Officer; and

(4) Edward Jones who was an accountant with Gunnip. Jones

also was SYL’s only “employee,” and, out of the $2400.00

annual fee paid to Gunnip, $1200 annually was designated

as Jones’s “salary.”

Mr. Diamond testified that SYL hired outside trademark

counsel to handle the protection of the trademarks.

Nonetheless, on SYL’s financial statements, no legal expenses

were listed on any of the unaudited profit and loss statements

submitted. Mr. Diamond explained that they “were probably

paid for by Syms Corp.” and that “[i]t didn’t make a

difference overall.” In fact, nothing substantial appears to

have changed with respect to the management and

administration of the trademarks after the formation of SYL.

During the cross-examination of Karen Ash, Syms’s and

SYL’s outside trademark counsel, the following ensued:

“Q. Was there any difference whatsoever in the

work performed by your law firm prior to and

subsequent to the assignment of these marks

from Syms to SYL?

“A. No.

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Appendix B

“Q. You continued to do the same thing?

“A.~ Yes.

“Q. Ifa mark needed to be registered you took to

registering it? If an infringement was

suspected, your firm would take the

appropriate action, correct?

“A. Correct.”

Although the business purpose alleged for the formation

of SYL was the “maintenance and management of valuable

intangible assets,” the license agreement between Syms and

SYL authorized Syms to take charge of such maintenance

and management. It stated: “Licensor [SYL] shall have the

right (but not the obligation) to take charge of the defense of

any [infringement] claim, action or proceeding. . . . If licensor

declines . . . to defend any such claim, action or proceeding,

licensee may do so.” The license agreement did impose some

affirmative duties upon SYL, as licensor, in the area of quality

control of the trademarks. Nevertheless, there is no indication

in the record that Edward Jones, SYL’s sole “employee,”

performed any of these duties. Nor are the quality control

duties mentioned in the letter memorializing the services that

Mr. Jones was to provide to Syms or SYL. Instead, according

to the testimony, these duties were assumed by Syms’s

officers when they were wearing their SYL “hats.”

Additionally, the license agreement imposed upon Syms the

duty to “deliver to Licensor a statement certified by the

financial officer of Licensee showing a computation of Net

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Appendix B

Sales and the amount of royalty payable hereunder.”

The record discloses that no certified financial statements

were ever provided to SYL.

SYL’s cash receipts and disbursement journals fail to

reveal any evidence of the economic substance of that

corporation. In the relevant time period, SYL paid no costs

associated with the protection of the trademarks, i.e., no costs

to register the trademarks, no legal fees associated with the

trademarks, and no telephone expenses associated with any

discussion of the trademarks, since SYL apparently did not

have a telephone. A study of SYL’s financial statements

reveals that, in some years, the royalties owed were never

received. Finally, although “facilitating the franchising of

the Syms trade name to third parties” was one of the primary

reasons for the formation of SYL, the trademarks were never

licensed to anyone but Syms Corp.

The Maryland Tax Court, which is an administrative

agency,” in April 1999 issued an order reversing the

assessments levied by the Comptroller. In an accompanying

opinion, the Tax Court incorporated by reference and quoted

extensively from its opinion in another case, MCIIT v.

Comptroller, Tax Court No. C-96-0028-01 (1999), stating

that the analysis and applicable law in the two cases were

the same.’ The Tax Court pointed out that the parent

2. See Shell Oil Co. v. Supervisor, 276 Md. 36, 38, 343 A.2d

521, 522-523 (1975).

3. Ajudicial review action in the MCIIT case, presently pending

before this Court, has been stayed under the automatic stay provisions

of federal bankruptcy law. See 11 U.S.C. § 362(a).

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Appendix B

corporation and the subsidiary were operating as a “unitary”

business, that the Comptroller, relying upon Comptroller v.

Atlantic Supply Co., 294 Md. 213, 448 A.2d 955 (1982),

and Comptroller v. Armco, 82 Md. App. 429, 572 A.2d 562,

cert. denied, 320 Md. 634, 579 A.2d 280 (1990), cert. denied,

498 U.S. 1088, 111 S.Ct. 966, 112 L.Ed.2d 1052 (1991),

asserted that the subsidiary lacked “substantial economic

substance,” and that, therefore, the subsidiary had a

“sufficient nexus” with Maryland through the operations of

the parent in Maryland so that Maryland could

constitutionally tax an appropriate portion of the subsidiary’s

income. The Tax Court then stated that the Atlantic Supply

and Armco holdings applied only when the subsidiary had

no economic substance whatsoever, and that “we conclude

that Petitioner [SYL] is an entity of substance and not a

‘phantom.’ The Tax Court continued:

“In the instant case, the evidence clearly

indicates that Petitioner is not just a book entry

corporation. Petitioner maintains an office in

Delaware. That office contains office furniture and

corporate and financial records are kept there.

Mail is received at the Delaware office location.

It has its own bank account and has an employee.

Legal counsel was retained by Petitioner for

purposes of protection its ‘marks’. The requisites

for corporate existence were met; i.e., the drafting

of by-laws, the election of a board of directors

and corporate officers, the holding of regular and

annual meetings, the recording of corporate

minutes, and the ratification of dividends.

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Appendix B

“Respondent claims that Petitioner ‘was little

more than a corporate vehicle designed to reduce

state income taxes’, (Respondent’s Memorandum,

p. 40), and points to the minimal expenses, the

one employee, the mere formality of the corporate

existence of Petitioner, and the timing of inter-

entity transactions as support that petitioner was

creating the ‘illusion of substance’, (Respondent’s

Memorandum, p. 31). In short, Respondent

assessed on the basis that the Petitioner was a

sham entity for the sole purpose to avoid Maryland

taxes.

“Even if that were true, Armco and Atlantic

Supply only apply to entities with no substance

whatsoever. In addition, it is well settled that tax

avoidance (rather than tax evasion) is a legitimate

business purpose. If Petitioner was legally created

with a tax avoidance purpose, absent authority and

in a separate return environment, the Respondent

cannot tax it. However, the evidence presented

leads to the conclusion that Petitioner was

established for non-tax reasons, among them:

¢ To hold and manage intangible assets in a

separate corporation;

¢ To protect the transferred intangibles from

the claims of Syms’ creditors and from

liabilities of Syms;

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;

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Appendix B

¢ To incorporate in a favorable corporate

jurisdiction;

¢ To avert hostile take-overs; and

¢ To protect and enhance the value of Syms’

name and its borrowing and business

acquisition ability.

These facts easily distinguish the Petitioner from

the phantom taxpayers in Armco and Atlantic

Supply. Nexus cannot be attributed to it for

Maryland taxation purposes.”

Later the Tax Court concluded:

“Focusing solely on Petitioner, we find that

its lack of in-state activity precludes the

imposition of the tax. Petitioner is not doing

business in Maryland. Its income producing

activity all occurs outside of Maryland. Petitioner

has no offices, employees, agents or property in

Maryland. Its only Maryland contact is an

affiliation with an entity with a Maryland

presence. This affiliation is hardly enough to

satisfy substantial nexus.

“Respondent relies on Armco and Atlantic

Supply as support for the application of nexus due

to the presence of Syms in Maryland. That reliance

has been shown above to be erroneous. Respon-

dent then points to the decision of Geoffrey, Inc.

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Appendix B

v. South Carolina Tax Commission, 313 S.C. 15

(1993) as precedent in the taxing of a Delaware

holding company licensing trademarks and trade

names to its parent in-state company. The Geoffrey

Court concluded that the use of intangible property

(the ‘marks’) by the in-state affiliate was sufficient

to pass the constitutional nexus requirements in

order to tax the out-of-state entity. * * * [A]s

indicated above, we differ in our conclusions as

o whether the substantial nexus requirement of

the Commerce Clause was met. Geoffrey focused

on the use of the marks by the in-state affiliate of

the unitary group in order to determine the nexus

of\the foreign corporation. We disagree that that

activity constitutes ‘substantial’ nexus.

“In addition, the unitary relationship between

entities does not automatically establish nexus on

all of the corporate entities in the unitary group.”

The Tax Court also addressed an alternative argument

by SYL, although pointing out that the court’s constitutional

holding rendered the issue moot. The court agreed with SYL

that, under CBS v. Comptroller, 319 Md. 687, 575 A.2d 324

(1990), the Comptroller should have promulgated a

regulation before attempting to tax a portion of the income

of subsidiaries like SYL.

The Comptroller filed in the Circuit Court for Baltimore

City an action for judicial review of the Tax Court’s decision,

and the Circuit Court affirmed the decision. The Comptroller

took an appeal to the Court of Special Appeals. Before

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Appendix B

argument in the intermediate appellate court, this Court

issued a writ of certiorari. Comptroller v. SYL, 360 Md. 485,

759 A.2d 230 (2000).

B. No. 80, Crown Cork & Seal Company (Delaware), Inc.

v. Comptroller of the Treasury

Crown Cork & Seal (Delaware) (hereafter referred to as

“Crown Delaware”), is a Delaware corporation and a wholly

owned subsidiary of Crown Cork & Seal Company, Inc.,

(hereafter referred to as “Crown Parent”), also a Delaware

corporation. Crown Delaware is the owner of certain

intellectual property assets, namely thirteen domestic patents

and sixteen trademarks. Crown Delaware’s purported

function is to manage and control these patents and

trademarks. As set forth in a stipulation of facts filed in the

Maryland Tax Court, Crown Parent is a corporation “engaged

in the manufacturing and sale of metal cans, crowns, and

closures for bottles, can-filling machines, and plastic bottles

and containers, world-wide, including in the State of

Maryland.”

For the tax years 1989 through 1993, Crown Delaware

did not file corporate income tax returns in Maryland. Crown

Delaware did not directly own or lease tangible property in

Maryland, had no employees in Maryland, and maintained

no bank accounts in Maryland. It did not sell or lease goods

or services in Maryland, did not advertise in Maryland, and

engaged in no mailings or solicitations to persons or entities

in Maryland. As both parties agreed in the stipulation filed

with the Tax Court, Crown Parent did engage in extensive

business in Maryland during this time period, as it operated

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Appendix B

manufacturing plants in Baltimore City, Harford County and

Wicomico County, and marketed its products in Maryland.

Crown Parent timely filed Maryland corporate tax returns

for this period.

In 1996, the Comptroller of Maryland issued a Notice of

Assessment to Crown Delaware, stating that Crown Delaware

owed for the years 1989 through 1993 Maryland corporate

income taxes, including interest and penalties, in the amount

of $1,421,034. Crown Delaware timely protested the

Comptroller’s Notice of Assessment. On February 25, 1997,

the Comptroller issued a Notice of Final Determination that

sustained the Notice of Assessment. The Notice of Final

Determination was similar to the previously quoted notice

in the SYL case. To summarize, the Comptroller upheld the

assessment on the grounds that Crown Delaware was a

“phantom company,” a mere corporate shell with little

economic substance and no independent source of income.

According to the Comptroller, Crown Delaware was an alter

ego of Crown Parent, designed to help Crown Parent avoid

Maryland corporate income taxes. The Comptroller asserted

that Crown Parent’s royalty payments to Crown Delaware

on intellectual property rights were a means of shifting

income out of Maryland and into Crown Delaware’s home

State of Delaware. The Comptroller stated that, by piercing

the corporate veil of this “bookkeeping entity,” and taxing

Crown Delaware based on the apportionment factor of Crown

Parent, the State of Maryland would recover the income taxes

to which it was entitled.

Crown Delaware took an appeal to the Maryland Tax

Court, challenging the Comptroller’s assessment. As in the

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Appendix B

SYL case, Crown Delaware argued that the Comptroller was

prohibited under the Commerce Clause of the United States

Constitution, Art. 1, Section 8, cl. 3, from taxing it because

Crown Delaware lacked a substantial nexus with the State

of Maryland. Relying on the principle set forth in Complete

Auto Transit, Inc. v. Brady, 430 U.S. 274, 279, 97 S.Ct. 1076,

1079, 51 L.Ed.2d 326, 331 (1977), that under the Commerce

Clause a state tax is permitted when, inter alia, “the tax is

applied to an activity with a substantial nexus with the taxing

State,” Crown Delaware asserted that there was no nexus in

this case because it had no tangible property or business

presence within Maryland. Crown Delaware also contended

that the Comptroller erred in treating it as a “phantom

corporation,” asserting that it had employees, office space,

and other corporate attributes that imbued it with sufficient

economic substance, and that it was formed for the valid

business purpose of protecting its parent’s intellectual

property assets. Finally, like the subsidiary in the SYL case,

Crown Delaware contended that the Comptroller’s attempt

to tax it represented a change in policy which should have

been accomplished by the promulgation of a regulation.

The Comptroller’s arguments were essentially the same

as in the SYL case. The Comptroller contended that there

was a nexus between Crown Delaware and the State of

Maryland, based on Crown Delaware’s licensing of intangible

property rights to its parent for use in products that were

sold in Maryland. The Comptroller argued that Crown

Delaware relied upon its unitary parent for its entire source

of income, as Crown Parent’s marketing to consumers of

products based on Crown Delaware’s licensed patents and

trademarks was Crown Delaware’s exclusive source of

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Appendix B

royalty fees. In addition, the Comptroller analogized Crown

Delaware to the “sham” subsidiaries involved in Armco and

in Comptroller v. Atlantic Supply Co. The Comptroller

pointed out that Crown Delaware lacked a separate office

and employees from Crown Parent, did not exert a direct

involvement in the control of the intellectual property assets

which it was assigned, and did not conduct business activities

on its own but, instead, relied on the business activities of

Crown Parent. The Comptroller also asserted that the

assessments did not represent a change in policy so as to

require promulgation by a regulation.

The evidence before the Tax Court disclosed the follow-

ing. Crown Delaware was incorporated in 1989, and Crown

Parent assigned its intellectual property assets to Crown

Delaware in exchange for all of Crown Delaware’s issued

stock. Crown Delaware then granted to Crown Parent an

exclusive license, to continue from year to year unless

terminated by either party, to manufacture, use and sell the

products covered by these assets. In consideration for Crown

Delaware’s licensing of these intellectual property rights,

Crown Parent agreed to pay Crown Delaware a royalty based

on Crown Parent’s sales.

In attempting to create a Delaware presence, Crown

Delaware employed a third party, Organization Services, Inc.

(“OSI”), “to facilitate the establishment of its business

operations.” OSI’s brochure stated that it provided “complete

services for corporations to minimize state taxes” through

the use of various suggested subsidiaries. George P. Warren,

the founder and president of OSI, described his company’s

function as “providing nexus services to Delaware Investment

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Appendix B

Holding Companies.” Among these “nexus services,” the OSI

brochure listed “discretionary mail forwarding.” Additionally,

the OSI brochure warned prospective customers as follows:

“Caution!

“A Delaware subsidiary must have substance to

satisfy other states as to its situs within Delaware.

This will include, but is not limited to, the follow-

ing evidence of Delaware activity:

Employees

Personal income tax withholding

Unemployment tax reporting

Bank accounts and other assets

Office space

Furniture and equipment

Stationery and business cards

Books and records eet |

Director and stockholder meetings”

OSI provided these “nexus services” for about 400 other

companies like Crown Delaware. Mr. Warren’s duties as an

“employee” of Crown Delaware were described by Crown

Parent’s general counsel as “do[ing] everything necessary

basically in Delaware to comply with the law and regulations

to give substance to this company as a viable and good

company in Delaware.”

Crown Delaware leased its corporate office space from

OSI at the rate of up to $100.00 per month. In return, OSI ~—

provided “desk space” on a “part-time or full-time basis”

24a

Appendix B

as well as conference rooms for meetings. Under the sublease

agreement between OSI and Crown Delaware, OSI was to

list Crown Delaware’s name on one of the telephone numbers

assigned to OSI in the Wilmington, Delaware “white pages”

directory. OSI’s address is listed on Crown Delaware’s

company checks.

Additionally, Crown Delaware hired OSI employees to

manage its daily operations. Each of the nine part-time

employees from OSI had a written employment agreement

with Crown Delaware and was paid directly by Crown

Delaware, which also withheld and remitted withholdings

to the appropriate taxing authorities. A review of the

employees’ W-2 forms, however, reveals that the wages paid

to these employees were insignificant in comparison with

the ordinary labor costs incurred by a corporation earning

revenue of over thirty million dollars per year. For example,

in 1989, the total annual wages paid for the nine employees

were $148.00; in 1990, $668 was the total amount paid in

employee wages for the nine employees; in 1991, $562.64;

for 1992, $623.79; and, finally, in 1993, the total amount of

wages paid for all nine employees of Crown Delaware was

$843.66. These employees were paid only once annually.

These nine employees were clerical employees whose

responsibilities never involved any intellectual property

expertise. ;

George P. Warren, Jr., the president of OSI, is both an

officer and director of Crown Delaware. Unéer the terms of

his employment contract, Mr. Warren’s salary for these

services is $200 per year. Jane Warren, the Vice-President

and Secretary of OSI, is also an employee of Crown

25a

Appendix B

Delaware, as is Lee Lieberman, assistant secretary and

assistant treasurer of OSI. OSI also serves as Crown

Delaware’s registered agent for service of process in the State

of Delaware. The employment agreements define the “place

of employment” as “any suitable location within the greater

Wilmington metropolitan area.”

Crown Delaware’s balance sheets for the years in

question reveal that, although the parent company made

royalty payments to Crown Delaware, Crown Delaware

immediately loaned the total payments back to its parent

company. With regard to four of the five royalty payments in

the relevant time period, the wire transfer records show that

the royalty payments paid by Crown Parent were wired back

to Crown Parent on the same day, creating an immediate

circular flow. From 1989 to 1993, the debt owed by the parent

company to Crown Delaware increased each year by the same

amount as the royalty that the parent owed to Crown

Delaware. As of 1993, there was no evidence in the record

of the debt being paid. Nor does any loan agreement,

stipulating to the terms of repayment or the sanctions in the

event of default, appear in the record. Also notable was the

fact that Crown Parent’s 1991 royalty payment to Crown

Delaware was paid on November 7, 1991, which was

thirty-one days before Crown Delaware billed Crown Parent

for the royalty payment and fifty-four days before the end of

the year.

Moreover, for the years 1990 through 1993, despite

having revenues that averaged around thirty-seven million

doilars annually, Crown Delaware’s actual operating costs

averaged just over two thousand dollars per year. The regular

ee

26a

Appendix B

operating costs that inevitably arise in a normal business

operation, such as meals and entertainment, telephone, and

postage, were virtually non-existent on Crown Delaware’s

balance sheets. Over the five-year period in question, Crown

Delaware incurred a total of twenty dollars in meals and

entertainment, about sixty dollars in telephone charges,

and about one hundred dollars in postage. Travel costs for

the entire period in question amounted to less than seven

dollars. Additionally, Crown Delaware’s financial statements

reported no depreciation for personal property.

Despite the fact that Crown Delaware’s sole raison d’étre

was to manage its parent company’s intellectual property,

the subsidiary managed to avoid any and all legal fees

associated with the patents and trademarks at issue. Following

the creation of Crown Delaware, Crown Parent continued to

use the services of the same two patent law firms that handled

its intellectual property prior to Crown Delaware’s creation.

Additionally, the patent and trademark license

agreements disclose that Crown Delaware, the repository of

this intellectual property, granted an exclusive license to its

parent company. Accordingly, Crown Delaware could not

license these intangibles to any other entity. Crown Parent,

however, was entitled to do so, since the agreements

authorized it to sub-license the intangibles to any third party.

Furthermore, the licensing agreements imposed upon Crown

Parent the responsibility of maintaining and defending the

validity and ownership of these intangibles, as well as the

general administrative duties of complying with all laws and

regulations that may relate to them.

i cecereerreetetiasierreenesnieietnnianeeasiiaatentimaiimaniaaiieial

27a

Appendix B

The administrative record repeatedly shows instances

where the formalities that normally serve to separate a parent

corporation from its subsidiary were blurred. For example,

there are instances where the terms “Crown Cork & Seal

Company, Inc.” and “Crown Cork & Seal Company

(Delaware), Inc.” are used interchangeably. There are also

examples of Crown Parent’s officers or directors signing

documents as Crown Delaware’s officers when in fact they

are not officers; examples of Mr. Warren signing as Secretary

of Crown Delaware when in fact he was not Secretary;

or examples of the address of one entity being listed as the

address of the other entity. In each instance, Crown Parent’s

general counsel explained that these examples were merely

“screw-ups” or “mistakes.”

As in the SYL case, the Tax Court issued an order

reversing the assessments. In a brief opinion accompanying

the order, the Tax Court “incorporated by reference” its

opinion in SYL. While the Tax Court recognized that Crown

Delaware and its parent were a unitary business, it rejected

the attempt of the Comptroller to apply the holdings of

Atlantic Supply and Armco to the taxation of Crown

Delaware. The court expressed the view that the holdings of

these two cases were limited to the taxation of “phantom” or

“sham” subsidiaries with “no genuine economic substance.”

The administrative agency concluded that Crown Delaware

had “economic substance,” and held as follows:

“Thus the factual resolution for the Court is

whether nexus exists between Petitioner and

Maryland. In order to meet Commerce Clause

nexus requirements, there must be a “substantial

28a

Appendix B

nexus’ with the taxing state. Complete Auto

Transit v. Brady, 430 U.S. 274, 97 S.Ct. 1076

(1977). Petitioner does not own or lease property

in Maryland. Petitioner has no employees, agents

or offices in Maryland. Its income producing

activity all occurs outside of Maryland. Crown

Parent is the only contact Petitioner has with

Maryland and that contact is not sufficient to meet

the substantial [nexus] requirement.

“Nexus attributed to an out-of-state entity

was found to be proper by the Maryland Courts

only when the entities were true phantom

corporations. . . . The evidence presented clearly

shows that Petitioner is not a phantom or sham

corporation. Petitioner is a viable entity

established for valid business purposes, including

the protection of valuable intellectual property

rights from hostile takeovers of the parent

corporation. Petitioner maintained an office in

Delaware, met all corporate formalities, had

separate bank accounts and employees performing

services pursuant to written employment

agreements.”

The Comptroller filed in the Circuit Court for Baltimore

City this action for judicial review of the Tax Court’s

decision, and the Circuit Court affirmed. The Comptroller

filed an appeal to the Court of Special Appeals. Again, before

argument in the intermediate appellate court, this Court

——

29a

Appendix B

issued a writ of certiorari. Comptroller v. Crown Cork & Seal —

Company (Delaware), Inc., 360 Md. 488, 759 A.2d 232

(2000).

Il.

The controlling principles of Maryland income tax law

and federal constitutional law, in cases like the instant ones,

were recently summarized by Judge Rodowsky for this Court

in Hercules, Inc. v. Comptroller, 351 Md. 101 »716A.2d 276

(1998). First, with regard to federal constitutional limitations,

the Hercules opinion stated (351 Md. at 109-111, 716 A.2d

at 279-280, some internal quotation marks omitted):

“Under both the Due Process and the

Commerce Clauses of the Constitution, a State

may not, when imposing an income-based tax,

‘tax value earned outside its borders.’ Container

Corp. of America v. Franchise Tax Bd., 463 U.S.

159, 164, 103 S.Ct. 2933, 2939, 77 L.Ed.2d 545,

552 (1983) (quoting ASARCO Inc. v. Idaho State

Tax Comm'n, 458 U.S. 307, 315, 102 S.Ct. 3103,

3108, 73 L.Ed.2d 787, 794 (1982)).

* * *

“In order to levy a tax upon Hercules’s Capital

gain from the sale of . . . stock, there must be some

nexus linking this income to activities within the

State. The necessary nexus usually ‘is satisfied by

demonstrating the existence of unitary business,

part of which is carried on in the taxing state.’

30a

Appendix B

NCR Corp. v. Comptroller of the Treasury,

313 Md. 118, 132, 544 A.2d 764, 771 (1988).

Where the nexus exists, the Maryland tax on a

corporation engaged in a multistate business

is governed by Maryland Code (1957, 1997

Repl. Vol.), § 10-402(c) of the Tax-General Article

(TG), which requires that net income be

apportioned to this state on the basis of a formula

using property, payroll, and sales. See Random

House, Inc. v. Comptroller of the Treasury, 310

Md. 696, 697, 701, 531 A.2d 683, 683, 685

(1987); see also NCR Corp., 313 Md. 118, 141-

42,544 A.2d 764, 775; Xerox Corp. v. Comptroller

of the Treasury, Income Tax Div., 290 Md. 126,

129-30, 428 A.2d 1208, 1211 (1981); accord

Mobil Oil Corp. v. Commissioner of Taxes, 445

U.S. 425, 100 S.Ct. 1223, 63 L.Ed.2d 510 (1980).

* * *

“The Supreme Court has recently reemphasized

its three-part test in determining whether a

subsidiary is a part of the unitary business of the

parent; those three elements are: (1) functional

integration, (2) centralization of management, and

(3) economies of scale. Allied-Signal, Inc. v.

Director, Div. of Taxation, 504 U.S. 768, 783, 112

S.Ct. 2251, 2260, 119 L.Ed.2d 533, 549 (1992).”

Turning to the scope of § 10-402 of the Maryland Tax-General

Article, the Court in Hercules reiterated (351 Md. at 110,

716 A.2d at 280, some internal quotation marks omitted):

3la

Appendix B

“The legislative purpose underlying this

statute is to tax multi-state corporations doing

business in Maryland to the bounds permitted by

the United States Constitution. NCR Corp.,

313 Md. at 146, 544 A.2d at 777. To that end,

the question before us becomes one of federal

constitutional, rather than of Maryland statutory,

law. In resolving that question, the burden is

on the taxpayer to show ‘by clear and cogent

evidence’ that [the state tax] results in extra-

territorial values being taxed. Container Corp.,

463 U.S. at 175, 103 S.Ct. at 2945, 77 L.Ed.2d

at 559-60.”

In NCR Corp. v. Comptroller of the Treasury, 313 Md.

118, 131-132, 544 A.2d 764, 770-771 (1988), Judge Adkins

for the Court explained:

“Apportionment under the unitary business

formula, however, is not without its restrictions.

The due process and commerce clauses do not

allow states to tax a corporation’s interstate

activities unless there exists a ‘ “minimal

connection” or “nexus” between the interstate

activities and the taxing State, and “a rational

relationship between the income attributed to the

State and the intrastate values of the enterprise.” ’

Exxon Corp. v. Wisconsin Dept. of Revenue,

447 U.S. 207, 219-220, 100 S.Ct. 2109, 2118, 65

L.Ed.2d 66, 79 (1980) (quoting Mobil Oil Corp.

v. Comm 'r of Taxes, supra, 445 U.S. at 436-437,

100 S.Ct. at 1231, 63 L.Ed.2d at 520).

a oe

32a

Appendix B

“The nexus p]rong . . . of the test is satisfied

by demonstrating the existence of unitary

business, part of which is carried on in the taxing

state. Hellerstein, ‘State Income Taxation of

Multijurisdictional Corporations, Part II:

Reflections on ASARCO and Woolworth,’ 81

Mich.L.Rev. 157, 168 (1982) (hereinafter ‘State

Income Taxation’). Once the requisite nexus has

been shown, the taxpayer then bears the burden

of demonstrating that the income it seeks to

exclude from taxation was derived from unrelated

business activity that constituted a discrete

business enterprise. See Container Corp. supra,

463 U.S. at 164, 103 S.Ct. at 2939-2940, 77

L.Ed.2d at 552; Exxon Corp., supra, 447 U.S. at

223-224, 100 S.Ct. at 2120, 65 L.Ed.2d at 81;

Mobil Oil, supra, 445 U.S. at 442, 100 S.Ct. at

1234, 63 L.Ed.2d at 524.”

The NCR opinion, 313 Md. at 146, 544 A.2d at 777, went on

to emphasize “that the goal of [the applicable Maryland

statute] is ‘taxation of so much of a corporation’s net income

as is constitutionally permissible,’ “ quoting Xerox Corp. v.

Comptroller, 290 Md. 126, 142, 428 A.2d 1208, 1217 (1981).‘

4. House Bill 753 of the 2003 session of the General Assembly

which passed both houses of the General Assembly but was vetoed

by the Governor on May 21, 2003, concerned several provisions of

the Maryland Code relating to taxation. A portion of the bill would

have added language to § 10-402 of the Tax-General Article,

apparently with the purpose of underscoring the scope of the section.

The Governor’s veto message stated in pertinent part:

(Cont'd)

33a

Appendix B

A case relied upon by the Comptroller, and distinguished

by the Tax Court, SYL, and Crown Delaware, is Comptroller

v. Atlantic Supply Co., supra, 294 Md. 213, 448 A.2d 955.

In that case, Atlantic Supply Co. was a wholly owned

subsidiary of the Macke Company, a vending machine

company, with headquarters in Maryland and with wholly

owned subsidiary vending machine companies in other states.

Atlantic Supply was created as a wholesaler to purchase

Coca-Cola products for the parent and various subsidiary

vending machine companies because Coca-Cola refused to

sell directly to retailers. Atlantic Supply had no separate place

of business, no “office that [was] exclusively its own,” no

employees or payroll, and no bank account, although it

had a post office box. 294 Md. at 217, 448 A.2d at 958.

This Court held that the parent corporation and Atlantic

Supply carried on a unitary business, and that (294 Md.

at 223-224, 448 A.2d at 961)

“Atlantic’s trade or business operates exclusively

within Macke’s unitary business. Even though

Atlantic must file a separate tax return, the

particular nature of its business cannot be ignored.

Atlantic’s business could not function without the

funds supplied by Macke-parent and without the

Macke-branches as captive customers. Within the

(Cont’d)

“The changes to corporate income taxation include

restrictions on Delaware Holding Company transac-

tions. ... Currently, the Comptroller is involved in

litigation regarding this very issue. At this juncture,

I believe it is prudent to wait until the Judiciary rules on

the matter.”

34a

Appendix B

framework of the kind of business it does, Atlantic

enjoys the services of Macke-parent employees

for Atlantic’s clerical and accounting functions

and the services of Macke-branch employees as

Atlantic’s buying and selling agents. Those

employees worked in Macke’s unitary

business. ... Those individuals in the general

employ of Macke-parent and of the Macke-

branches, who conducted the business of Atlantic,

were sufficiently related with Atlantic, through

Macke’s unitary business, to permit Atlantic to

apportion its income.”

This Court held that the portion of Atlantic Supply’s income

that was attributable to Maryland was subject to Maryland

income tax. Nevertheless, no argument had been made in

the Atlantic Supply case that all of that subsidiary’s income

should be exempt from Maryland income taxes.

More pertinent is the opinion of the Court of Special

Appeals in Comptroller v. Armco, supra, 82 Md. App. 429,

572 A.2d 562. That case involved three separate

manufacturers doing business in Maryland (Armco, Inc.,

General Motors, and Thiokol), each of which created a wholly

owned sales subsidiary known as a Domestic International

Sales Corporation or DISC. The creation of such a subsidiary,

as a device to encourage exports, had tax advantages under

the federal Internal Revenue Code. Judge Getty for the Court

of Special Appeals in Armco explained the federal tax

advantages as follows (82 Md. App. at 430-431, 572 A.2d

at 563-564):

. SS

35a

Appendix B

“By definition, a sales DISC (LR.C., § 992(a)(1)(A)),

ears income because it buys goods from its parent

company and then resells the goods to an actual

Overseas Customer; a commission DISC earns its

income by a contractual agreement with its parent

company giving it a percentage of each qualify-

ing export sale made by the parent (I.R.C.,

§ 992(a)(1)(C)). In either case, no activity is

performed by the DISC to earn the income.

“DISC income is taxable income, but if the DISC

transactions meet the tests of I.R.C., §§ 991-997,

a DISC pays no federal taxes. Instead, a percentage

of its income is imputed to the parent company as

a constructive taxable dividend; the balance is

taxable to the parent when it is actually distributed

as a dividend. In short, DISCs are an approved

device designed to defer paying the full amount

of tax due when the income is received. This

artificial accounting between related corporations

is an exception to the general rule, I.R.C. § 482,

requiring transactions between parent and

subsidiary corporations to be arms length

. dealing.”

In the Armco case, the Comptroller had attempted to subject

a portion of each DISC’s income to Maryland income tax,

but the Tax Court and the Circuit Court, as in the present

cases, held that there was an insufficient nexus with Maryland

So as to allow Maryland taxation under the Commerce Clause

of the United States Constitution. As pointed out by the Court

of Special Appeals (82 Md. App. at 435, 572 A.2d at 566),

the DISCs.

36a

Appendix B 4

“herein persuaded the Tax Court that nexus to tax

DISCs must come from Maryland property,

payroll, or sales by the DISC itself. We think that

reasoning is flawed due to the very nature of a

DISC, which has no tangible property or

employees and can only conduct its activity and

do business through branches of its unitary

affiliated parent.”

In language that is equally applicable to the SYL and Crown

Delaware cases, the Court of Special Appeals in Armco

concluded (82 Md. App. at 436, 572 A.2d at 566):

~

“The three key elements necessary for

constitutional nexus were affirmatively established

in each of these three DISC cases. They are:

1. The parent is engaged-in business in Hl

Maryland. gq

2. The parent is unitary with the DISC.

3. The apportionment formula is fair.

“Activity directly connected to the DISCs took

place in Maryland in that the goods produced here

and sold overseas generated the DISC income.

That activity included assembly of vehicles by

GM, production of rocket motors by Thiokol,

and steel fabrication by Armco.”

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37a

Appendix B

The Court of Special Appeals in Armco held that a portion

of each subsidiary’s income, namely that properly attributable

to activity in Maryland, was subject to Maryland income tax.

SYL and Crown Delaware, like the Tax Court and the

Circuit Court, take the position that the holding of the Armco

case applies only where the subsidiary lacks all substance or

is a“phantom” corporation. SYL and Crown Delaware point

to the Tax Court’s conclusions that each of them has economic

substance. Treating these conclusions as findings of fact, SYL

and Crown Delaware argue that the findings are supported

by substantial evidence and that, therefore, they are binding

upon this Court in these judicial review actions.

Preliminarily, the basic facts in these two cases are

undisputed. Moreover, neither case involves the situation

where some factors point to one conclusion, other factors

point to a contrary conclusion, and, therefore, a reviewing

court should accord a degree of deference to the balance

struck by the administrative agency as trier of facts.

Cf. Ramsay, Scarlett & Co. v. Comptroller, 302 Md. 825,

834-839, 490 A.2d 1296, 1300-1303 (1985); Baltimore

Lutheran High School v. Employment Security

Administration, 302 Md. 649, 663-664, 490 A.2d 701, 709

(1985); Comptroller v. Haskin, 298 Md. 681, 692-694, 472

A.2d 70, 76-77 (1984). Under circumstances like those in

the present cases, where the facts before the administrative

agency were undisputed, the legal conclusion based on those

facts has been treated as an issue of law. See, e.g., Comptroller

v. Gannett, 356 Md. 699, 707, 741 A.2d 1130, 1134-1135

(1999); Hercules v. Comptroller, supra, 351 Md. at 110,

716 A.2d at 280; State Department v. Consumer Programs,

38a

Appendix B

331 Md. 68, 72-76, 626 A.2d 360, 362-365 (1993);

Comptroller v. Atlantic Supply Co., supra, 294 Md.

at 218-221, 448 A.2d at 958-960.°

The records in these cases demonstrate that SYL and

Crown Delaware had no real economic substance as separate

business entities. They resembled the subsidiaries involved

in the Armco case, except that SYL and Crown Delaware

had a touch of “window dressing” designed to create an

illusion of substance. Neither subsidiary had a full time

employee, and the ostensible part time “employees” of each

subsidiary were in reality officers or employees of

independent “nexus-service” companies. The annual wages

paid to these “employees” by the subsidiaries were minuscule.

The so-called offices in Delaware were little more than mail

drops. The subsidiary corporations did virtually nothing;

whatever was done was performed by officers, employees,

- orcounsel of the parent corporations. The testimony indicated

that, with respect to the operations of the parents and the

protections of the trademarks, nothing changed after the

creation of the subsidiaries. Although officers of the parent

corporations may have stated that tax avoidance was not the

sole reason for the creation of the subsidiaries, the record

demonstrates that sheltering income from state taxation was

the predominant reason for the creation of SYL and Crown

Delaware. For a discussion of the nature of Delaware

trademark-holding subsidiaries like SYL and Crown

Delaware, see Glenn R. Simpson, Diminishing Returns:

5. Even if the ultimate conclusions were viewed as findings of

fact, we would hold that the Tax Court’s findings, that SYL and Crown

Delaware had real economic substance, were unsupported by

substantial evidence in light of the entire records.

19

39a

Appendix B

A Tax Maneuver in Delaware Puts Squeeze on States, THE

WALL STREET JourRNAL, August 9, 2002, at p. Al. See also,

Craig J. Langstraat and Emily S. Lemmon, Economic Nexus:

Legislative Presumption or Legitimate Proposition?

14 Akron Tax J. 1 (1999),

In reality, SYL and Crown Delaware have no more

substance than the subsidiary DISC corporations involved

in the Armco case. Under the holding of Armco, with which

we fully concur, an appropriate portion of SYL’s and Crown

Delaware’s income was subject to Maryland income tax.

Other courts have also upheld the application of state

income tax laws with respect to a portion of the income of

- out-of-state subsidiaries having the sole function of owning

their parents’ trademarks. In Syms Corp. v. Commissioner of

Revenue, 436 Mass. 505, 506, 765 N.E.2d 758, 760 (2002),

the Supreme Judicial Court of Massachusetts upheld the

Commissioner of Revenue’s “disallowance of deductions

Syms had taken for royalty payments it had made to its wholly

owned subsidiary, SYL, Inc.” The description of the

relationship between Syms and SYL, by the Massachusetts

Supreme Judicial Court, is a perfect fit in one of the cases at

bar (436 Mass. at 509, 765 N.E.2d at 762, footnote omitted):

“SYL’s corporate ‘office’ consisted of an

address rented from Jones’s Delaware accounting

firm, for an annual fee of $1,200. The accounting

firm provided this same service to ‘a couple of

hundred’ other corporations that used Delaware

subsidiary corporations to hold their intangible

assets. Jones was not only a partner of the

40a

Appendix B

accounting firm, he was SYL’s only employee,

serving in a part-time capacity for which he was

paid $1,200 per year.

“The business operations of Syms did not

change after the transfer and license-back of the

marks. All of the work necessary to maintain and

protect the marks continued to be done by the

same New York City trademark law firm that had

- previously performed those services, and Syms

(not SYL) continued to pay all the expenses

attendant thereto. All efforts to maintain the good .

will and thus to preserve the value of the marks

were undertaken by Syms, and all advertising

using the marks was controlled and paid for by

Syms or by a wholly owned Syms subsidiary

formed solely to do advertising. The choice of

which products would be sold under the marks,

as well as the quality control of those products,

remained the responsibility of the same persons

who had done that work before the transfer —

Sy Syms, himself, and the Syms staff of buyers.”

The Massachusetts court continued (436 Mass. at 509-510,

765 N.E.2d at 762-763):

“Syms does not contest the validity of the ‘sham

transaction doctrine’ and the commissioner’s

authority under that doctrine to disregard, for

taxing purposes, transactions that have no

economic substance or business purpose other

than tax avoidance. It is a doctrine long established

———o RR??? Sa"

4la

Appendix B

in State and Federal tax jurisprudence dating back

to the seminal case of Gregory v. Helvering, 293

U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935).”

The court upheld the administrative finding “that the transfer

and license back transaction had no practical economic effect

on Syms other than the creation of tax benefits, and that tax

avoidance was the clear motivating factor and its only

business purpose.” 436 Mass. at 511, 765 N.E.2d at 764.

: The Supreme Court of South Carolina in Geoffrey, Inc.

v. South Carolina Tax Commission, 313 S.C. 15, 19-20, 437

S.E.2d 13, 16 (1993), upheld the imposition of state income

tax on a portion of the income of a Delaware trademark-

holding subsidiary of Toys R Us which had stores in South

Carolina, saying: :

“In our view, Geoffrey has not been

unwillingly brought into contact with South

Carolina through the unilateral activity of an

independent party. Geoffrey’s business is the

ownership, licensing, and management of

trademarks, trade names, and franchises. By

electing to license its trademarks and trade names

for use by Toys R Us in many states, Geoffrey

contemplated and purposefully sought the benefit

of economic contact with those states. Geoffrey

has been aware of, consented to, and benefitted

from Toys R Us’s use of Geoffrey’s intangibles in

South Carolina. Moreover, Geoffrey had the

ability to control its contact with South Carolina

by prohibiting the use of its intangibles here as it

42a

Appendix B

did with other states. We reject Geoffrey’s claim

that it has not purposefully directed its activities

toward South Carolina’s economic forum and hold

that by licensing intangibles for use in South

Carolina and receiving income in exchange for

their use, Geoffrey has the ‘minimum connection’

with this State that is required by due process.

See American Dairy Queen Corp. v. Taxation and

Revenue Dep t, 93 N.M. 743, 605 P.2d 251 (1979);

AAMCO Transmissions, Inc. v. Taxation and

Revenue Dep t, 93 N.M. 389, 600 P.2d 841, cert.

denied, 93 N.M. 205, 598 P.2d 1165 (1979).

“In addition to our finding that Geoffrey

purposefully directed its activities toward South

Carolina, we find that the ‘minimum connection’

required by due process also is satisfied by the

presence of Geoffrey’s intangible property in this

State.”

The South Carolina Supreme Court concluded as follows

(313 S.C. at 23-24, 437 S.E.2d at 18): “We hold that by

licensing intangibles for use in this State and deriving income

from their use here, Geoffrey has a ‘substantial nexus’ with

South Carolina.””®

6. The issue has also arisen in New Mexico, and the Court of

Appeals of New Mexico in Kmart Properties, Inc. v. Taxation and

Revenue Department of the State of New Mexico, N.M. Ct. App.

Nov. 27, 2001, held that the income paid to the out-of-state trademark-

holding subsidiary was subject to state income taxes. The New

Mexico Supreme Court granted a petition for a writ of certiorari in

(Cont’d)

CONT yea RaRSOe aay chee oe eres ‘

ag hk ort PENG SETI GT Ate CORO eS

43a

Appendix B

We hold that a portion of SYL’s and Crown Delaware’s

income, based upon their parent corporations’ Maryland

business, is subject to Maryland income tax.

Ii.

A final issue decided by the Tax Court was whether, under

CBS v. Comptroller, supra, 319 Md. 687, 575 A.2d 324, the

Comptroller was required to promulgate an administrative

regulation as a condition precedent to the imposition of

Maryland income tax upon portions of SYL’s and Crown

Delaware’s income. The Tax Court stated that the

promulgation of a regulation was required, but we disagree.

The CBS case involved a policy matter that had been

delegated to the Comptroller. The Comptroller had adopted

one particular policy regarding the matter, and later the

Comptroller changed to a different policy. We held that,

under such circumstances, the Comptroller’s change should

have been embodied in a new administrative regulation.

The instant cases do not involve a policy matter that has been

delegated to the Comptroller. Instead, under our cases, the

income involved is taxable under the Maryland statutory

(Cont’d)

the case, Kmart Properties v. Taxation and Revenue Department,

131 N.M. 564, 40 P.3d 1008 (2002), but the case has been stayed

pursuant to the automatic stay provisions of the bankruptcy law,

11 U.S.C. § 362(a).

The same issue is now pending in the North Carolina courts,

where the Wake County Superior Court has upheld an administrative

decision against a trademark-holding subsidiary.

44a

Appendix B

provisions to the extent permissible under the Commerce

Clause and principles of due process. The issue is the

sufficiency of a nexus between the income and the State of

Maryland so as to permit the imposition of the tax under the

United States Constitution.

In addition, even if it were pertinent, the case does not

involve a change in the Comptroller’s policy. Prior to the

assessments in these cases, the Comptroller had no policy

regarding the matter. The creation of wholly owned

trademark-holding Delaware subsidiaries has been a fairly

recent development.

There were other issues raised in these cases which the

Tax Court did not reach. Consequently, we shall direct a

remand to that administrative body.

JUDGMENTS OF THE CIRCUIT

COURT FOR BALTIMORE CITY

REVERSED, AND _ CASES

REMANDED TO THAT COURT

WITH DIRECTIONS TO

REVERSE THE ORDERS OF

THE MARYLAND TAX COURT

AND TO REMAND THE CASES

TO THE TAX COURT FOR

FURTHER PROCEEDINGS

CONSISTENT WITH THIS

OPINION. APPELLEES TO

PAY COSTS. —

45a

APPENDIX C — OPINION OF THE COURT OF

APPEALS OF MARYLAND

DECIDED SEPTEMBER 13, 2000

COURT OF APPEALS OF MARYLAND

Comptroller v. Crown Cork

OPINION:

Petition for Writ of Certiorari Granted on the motion of

this court.

46a

APPENDIX D — MEMORANDUM OPINION OF THE

CIRCUIT COURT FOR BALTIMORE CITY

FILED MARCH 17, 2000

IN THE

CIRCUIT COURT FOR

BALTIMORE CITY

Case No. 24-C-99-002388 AA

CROWN CORK & SEAL (DELAWARE) INC.

Respondent

v.

COMPTROLLER OF THE TREASURY

Petitioner.

MEMORANDUM OPINION

STATEMENT OF THE FACTS

Crown Cork & Seal (Delaware) Inc. (hereafter “Crown

Delaware”) is a wholly owned subsidiary of Crown, Cork &

Seal Company, Inc. (hereafter “Crown Parent”), a public

corporation in the business of manufacturing and selling

metal cans, crowns, and closures for bottles (plastic and

glass), can filing machines and containers. Crown Parent

owned and operated manufacturing plants in Maryland and

timely filed Maryland corporate income tax returns for the

years 1989 through 1993.

47a

Appendix D

Crown Delaware was formed in Delaware and Crown

Parent contributed its trademarks and patents to Crown

Delaware. The marks were licensed back to Crown Parent

for an agreed upon royalty fee. As a result of the licensing

arrangement, Crown Parent’s Maryland income was reduced

by the amount of the royalties paid to Crown Delaware.

Crown Delaware does not own or lease property in

Maryland. It has no employees, agents or offices in Maryland.

Its income producing activity ail occurs outside Maryland.

Crown Parent is the only contact Crown Delaware has with

Maryland.

On May 13, 1996, the Petitioner, Comptroller of the

Treasury (hereafter “Comptroller”), entered an assessment

of additional Maryland corporation income tax against the

Respondent Crown Delaware $759,263 (plus penalty and

interest) for the years 1989 through 1993, inclusive. Crown

Delaware filed a timely petition for revision of the

assignment, and the Comptroller held an informal hearing

as required by Tax-General Article § 13-508(c). Following

the informal hearing, the Comptroller issued a notice of final

determination dated February 25, 1997, affirming the

assessment as originally entered. The basis for the

Comptroller affirming the assessment was that Crown

Delaware did business in Maryland through its parent, Crown

Parent and was, therefore, required to pay a reasonably

apportioned income tax on its income. From the notice of

the final determination. Crown Delaware appealed to the

Maryland Tax Court.

48a

Appendix D

Following a two-day evidentiary hearing and extensive

post trial briefing, the Tax Court filed an opinion and order

on April 26, 1999, reversing the assessments, based on its

view that the Commerce Clause of the Constitution prohibited

the Comptroller from imposing a Maryland income tax on

Crown Delaware.

From the order of the Maryland Tax Court, the

Comptroller filed a timely petition for judicial review with

this Court.

STANDARD OF REVIEW

The Tax Court is an administrative agency, and judicial

review of its decisions occurs pursuant to State Government

Article § 10-222 and 10-223. Under the applicable standard

of review, the reviewing court does not sit as an independent

fact-finder and will uphold the Tax Court’s findings if they

are supported by substantial evidence. “ A reviewing court

will reverse the decision of the Tax Court, however, if the

agency erroneously determines or erroneously applies the

law.” State Department of Assessments and Taxation v.

Consumer Programs, Inc. 331 Md. 68, 72 (1993).

In United Parcel Service Inc. v. Comptroller, 69 Md. App.

458 (1986), the Maryland Court of Special Appeals set forth

the following three-step analysis for Circuit Court review of

a Tax Court decision:

1. First, the reviewing court must determine

whether the agency recognized and applied

the correct principles of law governing the case.

1 vet! et pases

49a

Appendix D

The reviewing court is not constrained to affirm

the agency where its order is premised solely upon

an-erroneous conclusion of law.

2. Once it is determined that the agency did not

err in its determination or interpretation of the

applicable law, the reviewing court next examines

the agency’s factual findings to determine if they

are supported by substantial evidence, i.e., by such

relevant evidence as a reasonable mind might

accept as adequate to support a conclusion. It is

the agency’s province to resolve conflicting

evidence, and, where inconsistent inferences can

be drawn from the same evidence, it is for the

agency to draw the inference.

3. Finally, the reviewing court must examine how

the agency applied the law to the facts. This, of

course, is a judgmental process involving a mixed

question of law and fact, and great deference must

be accorded to the agency. The test of appellate

review of this function is “whether . . . a reasoning

mind could reasonably have reached the

conclusion reached by the [agency] consistent

with a proper application of the [controlling legal

principles] United Parcel Service Inc., 69 Md.

App. 458 (1986).

50a

Appendix D

ISSUES PRESENTED

The central issue for this Court to determine is whether

the Maryland Tax Court erred inholding a Maryland Statute

and/or case law does not permit the imposition of State tax

on the income of an out-of-state affiliate of a Maryland parent

corporation.

APPLICABLE LAW AND DISCUSSION

As the reviewing court, this Court will follow thethree

step analysis as set forth by the Court of Special Appeals in

United Parcel Service Inc. v. Comptroller, 69 Md. App. 458

(1986), for Circuit Court review of a Tax Court decision.

Applying the standard of review to the Tax Court

decision in the instant case this Court will determine whether

the agency recognized and applied the correct principles of

law governing the case. In making this determination, this

Court reviewed the legal basis for the Tax Court decision in

the instant case. In making its determination of whether CD

had the legally required nexus to be taxed by the Maryland

Comptroller the Maryland Tax Court looked to the Tax

General Article of the Annotated Code of Maryland, as well

as, controlling case law. This Court will provide pertinent

sections of the Tax Court’s Opinion in the instant case as

part of its review of the Tax Court’s decision.

The Court will begin its review with the Tax Court’s finding

on the issue of nexus.

> 6. ie oi

Sla

Appendix D

I. Nexus.

1. The Tax-General Article of the Annotated Code of

Maryland

The Maryland Tax Court examined the application of

the Tax General Article of the Annotated Code of Maryland

to the issue of nexus in the instant case. On this issue, the

Maryland Tax Court in the MCIIT case stated:

Maryland imposes a tax on the taxable income of

a corporation defined as “its Maryland modified

income as allocated to the State...” § 10-301 of

the Tax-General Article of the Annotated Code of

Maryland. Maryland modified income of a

corporation is its federal taxable income, adjusted

by the Maryland additions and subtractions,

§10-301 through 10-308 of the Tax-General

Article of the Annotated Code of Maryland. The

computation of the tax requires the corporation

to allocate Maryland modified income “derived

from or reasonably attributable to its trade or

business in this State” § 10-402(a) of the

Tax-General Article of the Annotated Code of

Maryland. If the entity earns its income from in

and out of the State, that income derived from

instate business activities must be allocated to

Maryland, 10-402(a)(1)&(2) of the Tax-General

Article of the Annotated Code of Maryland. If the

corporation is unitary, then a 3 factor

apportionment formula is applied to its income

in order to determine Maryland taxable income

52a

Appendix D

of that corporation, 10-402(c) of the Tax-General

Article of the Annotated Code of Maryland. Under

subsection (d) of § 10-402, the Respondent [the

Comptroller] may alter the allocation and

apportionment of a corporation’s income

“to reflect clearly the income allocable to

Maryland”. Each corporate member of an

affiliated group, even if unitary, is required to file

a separate tax return to the Respondent

[the Comptroller], § 10-811...

The parties both agree that Petitioner is a

unitary group of entities. Accordingly, relying on

precedent established in two Maryland Court

decisions, Comptroller of the Treasury v. Armco

Export Sales Corp., 82 Md App. 429 (1990) and

Comptroller of the Treasury v. Atlantic Supply Ce.,

294 Md. 213 (1982), the Respondent [the

Comptroller] asserted nexus over the Petitioner

[MCIIT] based on in-state activity of an affiliate,

MCIT. Respondent [The Comptroller] first

determined that Petitioner [MCIIT] lacked

“substantial economic substance”, labeling

Petitioner [MCIIT] as a “Phantom” corporation.

— As such Respondent [the Comptroller] determined

that the cases cited permit the attribution of “nexus

and apportionment factors of the company or

companies actually engaging in any real activity

to the phantom company.” Notice of Final

Determination (Petitioners’ Exhibit #63).

53a

Appendix D

We disagree with the Respondent’s [the

Comptroller] nexus attribution to Petitioner

[MCIT]. Fundamental in both court decisions is

the determination that the taxpaying entity was a

shell or a phantom corporation with no economic

substance. In Armco, the Court was faced with a

statutorily created business known as a Domestic

International Sales Corporation or DISC.

The Court characterized the DISC as a “phantom

book entry corporation created under federal tax

laws...” In expounding on the phantom nature of

a DISC, the Court of Special Appeals noted that

the DISC performed “no activity ... to earn

income” Armco at 431; that “none of the DISC’s

had any tangible assets or employees anywhere;

and that the DISC “can only conduct its activity

and do business through branches of its unitary

affiliated parent” Armco at 430, 435. In addition,

the Court concluded there was a specific

legislative intent to subject the DISC’s to

Maryland income taxation.

In Atlantic Supply, nexus was not an issue.

The taxpayer was clearly doing business in

Maryland. The Court’s focus was the taxation of

an affiliate created for the specific purpose of

obtaining the favorable wholesale price from a

major supplier, Coca-Cola, which its parent,

Macke Company, as a retailer, could not acquire.

Emphasis was placed on the fact that the

employees of the out-of-state affiliates were

authorized to, and did, act in the name of the

54a

Appendix D

taxpayer outside of the state. In addition, the Court

noted that the taxpayer’s business “could not

function without the funds supplied by

Macke-parent and without the Macke branches as

captive customers.” Atlantic Supply, supra at 223.

The Court concluded then that the taxpayer could

apportion its income among the states in which it

did business.

It is clear to this Court that the above holdings

are limited in their scope. The entities involved

lacked any economic substance, thus earning their

“phantom” status. Respondent’s attempt to impose

that status on corporations with substance is not

justified through Armco and Atlantic Supply.

Indeed, in this technologically advanced era, it is

not practical as well. It is conceivable that, for

legitimate business purposes, a seemingly

insignificant affiliate (i.e. one employee and/or

one computer) can exist which generates

substantial income yet have little or no expense.

To attribute nexus solely on the basis that there is

reliance on Maryland affiliates for some or all of

that income expands the limited holdings of

Armco and Atlantic Supply and ignores the reality

that they are separate non-phantom entities

required to report their income separately.

MCIIT, supra, pages 6-8.

The Maryland Tax Court concluded that the Appellate

Courts’ holdings Armco and Atlantic Supply were limited in

55a

oe

Appendix D

scope. In support of this conclusion the Tax Court stated

“the entities involved lacked any economic substance, thus

earning their ‘phantom’ status.”

In applying the Armco and Atlantic Supply decisions to

the instant case, the Maryland Tax Court held that

“Respondent’s (the Comptroller’s] attempt to impose that

status on corporations with substance is not justified through

Armco and Atlantic Supply. Indeed, in this technologically

advanced era, it is not practical as well.” In support of this

holding the Tax Court stated, “It is conceivable that, for

legitimate business purposes, a seemingly insignificant

affiliate (i.e. one employee or one computer) can exist which

generates substantial income yet has little or no expense.”

The Tax Court also held, “to attribute nexus solely on the

basis that there is reliance on Maryland affiliates for some

or all of that income expands the limited holding of Armco

and Atlantic Supply and ignores the reality that they are

separate non-phantom entities required to report, there

income separately.

The Tax Court also held that the application of Armco

and Atlantic Supply to the instant case is justified only if

Crown Delaware is a “phantom” corporation. The Tax Court

then stated reasons why Crown Delaware is an entity of

substance and not a “phantom” corporation. The first reason

stated by the Tax Court was that in the instant case, the

evidence clearly indicates that Petitioner is a viable entity

established for valid business purposes, including the

protection of valuable intellectual property rights from hostile

takeovers of the parent corporation. As support for this

finding the Tax Court referred to evidence presented to that

56a

Appendix D

Court which indicated that Crown Delaware maintains an

office in Delaware, met all corporate formalities, had separate

bank accounts and employees performing services pursuant

to written employment agreements. The Tax Court stated

additionally, that Crown Delaware received royalty income

from third parties (other than Crown Parent or an affiliate)

during some of the years in controversy.

The Comptroller claimed that Crown Delaware

“was little more than a corporate vehicle designed to reduce

state income taxes”, (Respondent Memorandum), and points

to the minimal expenses, the one employee, the mere

formality of the existence of Petitioner, and the timing of

inter-entity transactions as support that Petitioner was

creating the “illusion of substance”, (Respondent

Memorandum). In short, the Comptroller assessed on the

‘basis that Crown Delaware was a sham entity for the sole

purpose to avoid Maryland taxes.

The Maryland Tax Court stated that even if that were

true, Armco and Atlantic Supply only apply to entities with

no substance whatsoever. In addition, the Court stated that it

is well settled that tax avoidance (rather than tax evasion) is

a legitimate business purpose. They rationalized that if Crown

Delaware was legally created with a tax avoidance purpose,

absent authority and in a separate return environment, the

Comptroller cannot tax it. The Maryland Tax Court

concluded, however, that the evidence presented leads to the

conclusion that Crown Delaware was established for non-tax

reasons such as:

* To hold and manage intangible assets in a

separate corporation;

57a

Appendix D

To protect the transferred intangibles from the

claims of Crown Parents’ creditors and from

liabilities of Crown Parent;

To incorporate in a favorable corporate

jurisdiction;

To avoid hostile take-overs;

and To protect and enhance the value of

Crown Parents’ name and its borrowing and

business acquisition ability.

The Maryland Tax Court stated that these facts easily

distinguish Crown Delaware from the phantom taxpayers in

Armco and Atlantic Supply. Therefore, nexus cannot be

attributed to it for Maryland taxation purposes.

The Maryland Tax Court then looked to Crown

Delaware’s activities to determine whether nexus can be

directly found. The MCIIT is applicable to the present facts

in Crown Delaware:

The limits on the taxing powers of a state are

found in the Due Process and Commerce Clauses

of the Constitution. The Supreme Court reviewed

the requirements of both Clauses in Quill Corp.

v. North Dakota, 504. S. 298 (1992).

In Quill, the Court reiterated that the

“Due Process Clause ‘requires some definite link,

some minimum connection, between a state and

the person, property or transaction it seeks to tax,’

and that the ‘income attributed to the State for

tax purposes must be rationally related to ‘values

connected with the taxing State”’. supra at p. 307,

58a

Appendix D

citations omitted. Overruling prior holdings, the

Court determined that the minimum contacts

necessary to establish the jurisdiction to tax

does not require actual physical presence in

the state, but can be found “if foreign corporation

purposefully avails itself of the benefits of

an economic market in the forum State”,

supra at p. 307.

The Supreme Court’s analysis of the

Commerce Clause begins with the requirements

as set forth in its decision in Complete Auto

Transit. Inc. v. Brady, 430 U.S. 274 (1977).

Complete Auto provides a four-part test which

must be satisfied in order for a tax to pass muster

against a Commerce Clause challenge. A tax is

sustained so long as the tax: “1) is applied to an

activity with a substantial nexus with the taxing

State, 2) is fairly apportioned, 3) does not

discriminate against interstate commerce, and 4)

is fairly related to the services provided by the

State”. Complete Auto at p. 279. In discussing the

first prong of the test, the Supreme Court held

that the “substantial nexus requirement is not, like

due process’ minimum contacts’ requirement, a

proxy for notice, but rather means for limited

in-state burdens on interstate commerce.

Accordingly ... a corporation my have the

“minimum contacts’ with a taxing State as required

by the Due Process Clause, and yet lack the

“substantial nexus’ with that State as required by

the Commerce Clause.” Quill at p. 313. The Court

reafirmed the “bright-line” test it established in

59a

Appendix D

National Bellas Hess, Inc. v. Department of

Revenue, 386 U.S. 753 (1967), that a taxpayer

must have a physical presence in the taxing state

in order to satisfy the substantial nexus

requirement of the Commerce Clause.

In addressing the stricter “substantial nexus”

requirement, Petitioner argues that since it has no

physical presence in Maryland, the attempt to tax

its income is a Commerce Clause violation

pursuant to Quill. Respondent contends that the

Quill Court explicitly noted that the physical

presence requirement applies to sales and use

taxes only.

Reliance is also placed on the Armco and

Atlantic Supply decisions to support the

application of an apportioned income tax to a

corporation without any physical presence in

Maryland.

The Respondent is correct in that the tax,

the Quill Court analyzed, was a sales/use tax.

The Court did note that “concerning other types

of taxes we have not adopted < siinilar bright-line,

physical presence requirement”. 504 U.S. at

p. 316. However, the Supreme Court also refused

to restrict the rule to only sales and use taxes.

“Although we have not, in our review of other

types of taxes, articulated the same physical

presence requirement that Bellas Hess established

for sales and use taxes, that silence does not imply

repudiation of the Bellas Hess rule”, supra at

60a

Appendix D

p. 314. This lack of clarity on the parameters of

the physical presence test has led to differing

interpretations among the States as to what the

Commerce C't2use requires in relation to

income-based t2......

Absent apparent explicit direction, we hesitate

to expand the Quill physical present requirement

to taxes other than sales and use. In so doing,

however, we note that “substantial nexus” with

the taxing state is still required in order to pass

constitutional muster. In the rulings of Armco and

Atlantic Supply, due to the nature of the corporate

phantoms, with no substance and therefore, no

presence anywhere, the normal nexus rules were

ignored and the Courts found that nexus could be

attributed based on the in-state presence and

activity of an affiliate. The Commerce Clause was

satisfied through the substantial nexus (the

production and export of goods ) of the in-state

unitary affiliate.

However, as stated above, the instant case

does not present us with a phantom. Petitioner is

an entity of substance with a presence somewhere

and thus the normal nexus (versus nexus

attribution) rules apply. The focus of the

substantial nexus requirement is on the entity

sought to be taxed, not its in-state affiliate.

MCIIT, supra, p. 9-11.

6la

Appendix D

The Maryland Tax Court found that Crown Delaware’s

lack of in-state activity precludes the imposition of the tax.

The Tax Court reasoned that Crown Delaware is not doing

business in Maryland because its income producing activity

all occurred outside of Maryland. Furthermore, Crown

Delaware had no offices, employees, agents or property in

Maryland. Its only Maryland contact was an affiliation wit’:

an entity with a Maryland presence. This affiliation is hardly

enough to satisfy substantial nexus.

Aithough the Comptroller relies on Armco and Atlantic

Supply as support for the application of nexus due to the

presence of Crown Parent in Maryland, the Tax Cc urt held

that that reliance is erroneous. The Comptroller then relied

on Geoffrey, Inc. v. South Carolina Tax Commission, 313

S.C. 15 (1993) as precedent in the taxing of a Delaware

holding company licensing trademarks and trade names to

its parent in-state company. The Geoffrey Court concluded

that the use of intangible property (the “marks”) by the

in-state affiliate was sufficient to pass the constitutional nexus

requirements in order to tax the out-of-state entity.

The Maryland Tax Court disagreed with this analysis for

two reasons. First, Geoffrey dealt with South Carolina law

and its application and therefore, is not precedent for

Maryland application. Second, as indicated above, the

Tax Court differs in their conclusions as to whether the

substantial nexus requirement of the Commerce Clause was

met. The Tax Court went on to say that Geoffrey focuses on

the use of the marks by the in-state affiliate of the unitary

group in order to determine the nexus of the foreign

corporation. The Tax Court held that the activity does not

constitute a “substantial” nexus.

62a

Appendix D

In addition, the Maryland Tax Court stated that the

unitary relationship between entities does not automatically

establish nexus on all of the corporate entities in the unitary

group. As they stated in MCIIT, supra:

The mere presence of an in-state affiliate of a

unitary group does not confer nexus on a

non-phantom out-of-state affiliate of the same

group. Chesapeake Industries, Inc. v. Comptroller,

59 Md. App. 370 (1984). In the unitary taxation

scheme, the foreign corporation’s income and

factors may be included in determining the tax

liability of the in-state affiliate. However, without

nexus, the foreign corporation does not become

subject to the taxing jurisdiction.

The Respondent [Comptroller] claims that the

corporate structure present here allows for the

diversion of income away from Maryland through

the internal transactions of affiliated entities which

have no overall impact on the income of the

unitary group. While this may be true, all such

transactions are not necessarily abusive and in any

event, these are the consequences of requiring

affiliated corporations to file and report income

separately. The Maryland Courts have addressed

the treatment of such transactions when dealing

with phantom corporations. With non-phantom

corporations, such transactions when dealing with

phantom corporations. With non-phantom

corporations, such as Petitioner [MCIIT], the

63a

Appendix D

nexus rules as reiterated in Quill must still be

applied to each affiliate before the State can tax.

MCIIT, supra, p. 11.

Accordingly, the Maryland Tax Court held that the

Comptroller has failed to satisfy the substantial nexus

requirement of the Commerce Clause and the imposition of

income tax on Crown Delaware’s income is unconstitutional.

This Court agrees with the Maryland Tax Court on the

issue of nexus and reviewed the Crown Delaware Opinion

under the three prong test set forth in United Parcel Service

Inc. v. Comptroller, 69 Md. App. (1986). As to the first prong;

this Court holds that the Maryland Tax Court recognized and

applied the correct principle of law governing the Crown

Delaware case.

Furthermore, as to the second prong, this Court examined

the agency’s factual findings to determine if they were

supported by substantial evidence, i.e., by such relevant

evidence as a reasonable mind might accept as adequate to

support a conclusion. Where any inconsistent inferences that

can be drawn, this Court gave deference to the agency’s

inferences, as required by United Parcel Service Inc. v.

Comptroller, 69 Md. App. 458 (1986). This Court holds that

the Maryland Tax Court’s factual findings were supported

by substantial evidence in the Crown Delaware case in

reference to the nexus issue.

64a

Appendix D .

Finally, the third prong requires this reviewing Court to

examine how the agency applied the law to the facts on the

nexus issue.

This, of course, is a judgmental process

involving a mixed question of law and fact, and

great deference must be accorded to the agency.

The test of appellate review of this function is

‘whether . . . a reasoning mind could reasonably

have reached the conclusion reached by the

[agency] consistent with a proper application of

the [controlling legal principles].

United Parcel Service Inc. 69 Md. App. 458 (1986).

This Court has given the Maryland Tax Court great

deference and holds that a reasoning mind could reasonably

have reach the conclusion reached by the Maryland Tax Court

in the Crown Delaware case in that there was no nexus

between Crown Delaware and the State of Maryland.

II. Regulation Promulgation Due to Change in Policy.

Having agreed with the Maryland Tax Court’s finding

that the requisite nexus to warrant the imposition of income

tax on Crown Delaware does not exist, the issue of whether

a regulation had to be promulgated becomes moot. However,

due to the number of taxpayers involved and the likelihood

of judicial review, the Maryland Tax Court addressed this

issue and this Court shall do so as well and in greater detail.

This Court again will apply the three prong test as required

under United Parcel Service Inc., in its review of the Crown

65a

Appendix D

Delaware Opinion. United Parcel Service Inc. 69 Md. App.

458 (1986).

In short, this Court agrees with the Maryland Tax Court’s

holding that the Comptroller’s attempt to assert tax on Crown

Delaware amounted to a substantially new or change in policy

and therefore, can only be instituted through rulemaking

procedures as required by law, which makes the

Comptroller’s attempt improper. The Maryland Tax Court

concluded that the Comptroller’s attempt to assert tax against

non-nexus, non-phantom trademark protection companies as

a result of their licensing of the use of their trademarks, trade

names and service marks to entities, which have a nexus with

the State, amounts to a substantially new or change in policy,

which can only be instituted through the rulemaking

procedures pursuant to CBS, Inc. v. Comptroller, 319 Md.

687 (1990) and the Maryland Administrative Procedures Act.

Md. Code Ann., State Gov’t §§10-101 through 10-139.

In CBS Inc., the Maryland Court of Appeals held that a change

in an agency’s “policy of general application” which results

in “materially modified or new standards” may be made by

prospective rulemaking only. CBS IJnc., at 699. The

Administrative Procedures Act requires that a change or

implementation of policy by a State agency must be

promulgated by regulation and that regulation may only be

promulgated prospectively.

Furthermore, prior to 1995, companies such as Crown

Delaware were not subject to tax, however, phantom

companies like those found in Armco and Atlantic Supply

were subject to tax. The Comptroller relied on ADR No. 2,

title “Interstate Commerce Tax Act” — Domestic and Foreign

_

66a

Apperdix D

Corporation — Nexus Requirements — Apportionment of

Net Income, published in 1989, to set forth parameters of

taxing foreign corporations. However, the Maryland Tax

Court held that nothing in that release, any regulation or

statute, since 1989, suggest that a foreign corporation with

substance but with no business location, representatives, or

other activities within the State of Maryland could be subject

to income taxes as a result of the licensing of the use of

intangible “marks” to in-state entities.

Beginning in 1995, (subsequent to the issuance of the

Geoffrey decision), the Comptroller began asserting

deficiencies against foreign trademark protection companies

based on the in-state activities of their affiliates. The

Maryland Tax Court held that rather than a reflection of

current policy, these assessments represented a change from

its own stated policy (the 1989 Release) and those that

‘affirmed Armco and Atlantic Supply. The Tax Court further

held that that change “materially modified” existing

jurisdiction to tax standards to the detriment of taxpayers

which had relied on the Comptroller’s past pronouncements.

No regulations were promulgated or legislation enacted to

effect this change in policy and, pursuant to CBS, IJnc., any

retroactive attempt to tax Crown Delaware is improper.

Furthermore, the Tax Court held that the Comptroller

apparently believed that a regulation was necessary to expand

the Armco policy as evidenced by the attempt to promulgate

regulations relating to payments made by a Maryland

taxpayer for “marks” from a contractor to an out-of-state

affiliated entity. That attempt was rejected by the legislature

and a review of their comments demonstrated that the

67a

Appendix D

retroactive application of the Comptroller’s policy was

unacceptable per the Maryland Tax Court and this Court

affirms that decision and reasoning.

In addition to agreeing with the Maryland Tax Court’s

analysis of CBS above, this Court extends the analysis of

this issue by expanding the analysis in more detail. As stated

in CBS,

a number of [cases indicate that this requirement

of rulemaking] adds an aspect of fairness when

an agency intends to make a change in existing

law or rule. That fairness is produced by

prospective operation of a new rule and by the

public notice, public hearing, and public comment

processes that accompany rulemaking, but that are

sometimes absent from administrative

adjudication. Cooperman, 209 N.I. Super. at

201-202, 507 A.2d at 268-269. See also K. Davis,

Administrative Law Treatise, §7:25, at 119 (2d

ed. 1979) (“As a means of making new law,

rulemaking is superior to adjudication in two main

respects: (1) It is normally prospective, ... and

(2) rulemaking procedure may allow participation

of nonparties who may be affected . . .”)’ Bonfield,

supra, at 168-180; Shapiro. The Choice of

Rulemaking or Adjudication in the Development

of Administrative Policy, 28 Harv. L.Rev. 921,

930-972 (1965). The advantage of rulemaking in

certain circumstances reinforce the view that this

procedure may sometimes be required. We do not

attempt to make an all-encompassing statement

68a

Appendix D

of what those circumstances may be. But we do

conclude, as did the Attorney General in 1980,

that when a policy of general application,

embodied in or represented by a rule, is changed

to a different policy of general application,

the change must be accomplished by rulemaking.

See 65 Op. Att’y Gen. 396, 404-406 (1980). That

is the sort of change that occurred here, as the

Tax Court’s fact-finding indicates.”

CBS, Inc., at 695-696.

Applying the Maryland Tax Court’s findings, as well as

reviewing CBS separately, this Court agrees with the

Maryland Tax Court on the issue of whether the Comptroller’s

assessment amounts to a substantially new or change in policy

which can only be instituted through the rulemaking

procedure pursuant to CBS, Inc. and the Maryland

Administrative Procedures Act. This Court reviewed the

Crown Delaware Opinion under the three prong test set forth

in United Parcel Service Inc. v. Comptroller, 69 Md. App.

(1986). As to the first prong, this Court holds that the

Maryland Tax Court recognized and applied the correct

principle of law governing the Crown Delaware case.

Furthermore, as to the second prong, this Court examined

the agency’s factual findings to determine if they were

supported by substantial evidence, i.e., by such relevant

evidence as a reasonable mind might accept as adequate to

support a conclusion. Where any inconsistent inferences that

can be drawn, this Court gave deference to the agency’s

inferences, as required by United Parcel Service Inc. v.

Comptroller, 69 Md. App. 458 (1986). This Court holds that

69a

Appendix D

the Maryland Tax Court’s factual findings were supported

by substantial evidence in the Crown Delaware case in

reference to the Regulation Promulgation issue.

Finally, the third prong requires this reviewing Court to

examine how the agency applied the law to the facts on the

nexus issue.

This, of course, is a judgmental process involving

a mixed question of law and fact, and great

deference must be accorded to the agency. The

test of appellate review of this function is ‘whether

. a reasoning mind could reasonably have

reached the conclusion reached by the [agency]

consistent with a proper application of the

[controlling legal principles].

United Parcel Service Inc., 69 Md. App. 458 (1986).

This Court has given the Maryland Tax Court great

deference and holds that a reasoning mind could reasonably

have reached the conclusion reached by the Maryland Tax

Court in the Crown Delaware case in that there was a

substantially new or change in policy and Comptroller’s

retroactive application of the Comptroller’s policy was

unacceptable and improper.

III. Apportionment.

The Maryland Tax Court relies on MCIIT, Inc., supra,

to provide guidance in regard to the apportionment issue.

Having found that the requisite nexus to warrant

70a

Appendix D

the imposition of income tax on [MCIIT] does

not exist, the issue of which apportionment factor

is appropriate becomes moot. As an entity of

substance with no nexus to Maryland, there is no

Maryland income to calculate.

Even if there were ties to Maryland, with an entity

of substance rather than a phantom, the proper

apportionment formula would utilize the sales,

property and payroll of [MCIIT] itself. Only if

[MCIIT] were a phantom would the principle of

Armco and Atlantic Supply be applicable. In those

cases, the Courts allowed the Respondent to

employ the factor of the taxpayer’s in-state parent

and apply it to the phantom’s income. With the

present facts, i.e. no phantom, there is no authority

for the use of the in-state affiliate’s factors.

MCIIT, Inc., supra, p. 12.

While the Maryland Tax Court agrees with the

Comptroller that the appropriate formula is that of applying

its own factors, the Tax Court was not, as is this Court,

convinced that the traditional apportionment formula results

in a distorted enough income figure for Crown Delaware to

warrant the three-factor formula proposed by its witness.

IV. Penalties and Interest

Similar to the prior issues, having found that Crown

Delaware has no tax liability, the issue of penalties and

interest are moot. However, it is the position of this Court,

Tla

Appendix D

as well as the Maryland Tax Court, that Crown Delaware

acted in good faith, complied with existing (and current) law

and that, if liability for income tax had been found, no penalty

should have been imposed. It is also the consistent position

of the Maryland Tax Court that the ability to waive interest

lies solely with the Comptroller and this Court agrees.

Conclusion.

Applying the standard of review as required, this Court

will affirm the Maryland Tax Couri’s decision and finds that

the assessments imposed on Crown Delaware by the

Comptroller for all of the tax years should be reversed.

DATED: March 17, 2000

JUDGE JOSEPH H. KAPLAN

This Judge’s signature appears

on the original document.

72a

APPENDIX E — MEMORANDUM OF GROUNDS

FOR DECISION IN THE MARYLAND TAX COURT

FILED APRIL 26, 1999

(AND RELATED DECISIONS)

IN THE

MARYLAND TAX COURT

No. C-97-0028-01

CROWN CORK & SEAL (DELAWARE) INC.

V.

COMPTROLLER OF THE TREASURY

MEMORANDUM OF GROUNDS FOR DECISION

Crown Cork & Seal (Delaware) Inc., (hereinafter

“Petitioner”), appeals an assessment issued by the

Comptroller of the Treasury (hereinafter “Respondent” for

Maryland income tax for the tax years 1989 through 1993.

At hearings, testimony was taken, documents presented, and

post-trial memorandum were filed.

Petitioner is a wholly owned subsidiary of Crown, Cork

& Seal Company, Inc. (hereinafter “Crown Parent’), a public

corporation in the business of manufacturing and selling -

metal cans, crowns, and closures for bottles (plastic and

glass), can filling machines and containers. Crown Parent

owned and operated manufacturing plants in Maryland and

timely filed Maryland corporate income tax returns for the

years in question.

A Su N AEE EP aE

73a

Appendix E

Petitioner was formed in Delaware and Crown Parent

contributed its trademarks and patents to Petitioner.

The marks were licensed back to Crown Parent for an agreed-

upon royalty fee. As a result of the licensing arrangement

between the related entities, Crown Parent’s Maryland

income was reduced by the amount of the royalties paid to

Petitioner. Respondent assessed Petitioner on the basis that

it was a “phantom” corporation.

The facts and issues presented by this appeal are virtually

identical to those addressed in SYL, Inc. v. Comptroller,

M.T.C. No. C-96-0154-01 (1999) issued the seme day as the

present case. The decision in SYL, Inc. shall be incorporated

by reference for the resolution of the legal issues presented. '

In SYL, Inc., the Court determined that the assessment of an

out-of- state affiliate of a corporate group for income taxes

is constitutionally proper only if there exists nexus between

the activities of the out-of-state affiliate and Maryland. In

addition, the Court concluded that the attribution of nexus

to a foreign corporation, under Maryland case law, is limited

to phantom entities (i.e. no substance).

Thus, the factual resolution for the Court is whether

nexus exists between Petitioner and Maryland. In order to

meet Commerce Clause nexus requirements, there must be a

“substantial nexus” with the taxing state. Complete Auto

Transit v. Brady, 430 U.S. 274 (1977). Petitioner does not

own or lease property in Maryland. Petitioner has no

employees, agents or offices in Maryland. Its income

producing activity all occurs outside of Maryland. Crown

1. Acopy of SYL, Inc. is attached.

74a

Appendix E

Parent is the only contact Petitioner has with Maryland and

that contact is not sufficient to meet the substantial

requirement.

Nexus attributed to an out-of-state entity was found to

be proper by the Maryland Courts only when the entities were

true phantom corporations.” The evidence presented clearly

shows that Petitioner is not a phantom or sham corporation.

Petitioner is a viable entity established for valid business

purposes, including the protection of valuable intellectual

property rights from hostile takeovers of the parent

corporation. Petitioner maintained an office in Delaware, met

all corporate formalities, had separate bank accounts and

employees performing services pursuant to written

employment agreements. In addition, Petitioner received

royalty income from third parties (other than Crown Parent

or an affiliate) during some of the years in controversy.

As anon-phantom entity with no nexus with Maryland,

Petitioner is not subject to Maryland income tax.

_ The Respondent’s erroneous emphasis on the extent of

corporate substance and on the South Carolina decision,

Geoffrey, Inc. v. South Carolina Tax Commission, 313 S.C.

15 (1993) was addressed in SYL, Jnc., supra, and no further

discussion is necessary.

The resolution of the remaining issues presented are

again fully addressed in SYL, Inc., supra and we adopt the

reasoning therein. The Respondent failed to follow the proper

2. The case law is fully analyzed in SYL, Inc. and MCIIT v.

Comptroller, M.T.C. No. C-96-0028-01 (1999).

75a

Appendix E

rulemaking requirements when it amended its policy towards

taxing foreign entities similar to Petitioner. Even if liability

had been found, the apportionment formula used by

Respondent failed to recognize the corporate substance of

Petitioner. Finally, if Petitioner was subject to the tax, no

penalty should have been imposed.

Conclusion.

For the above reasons, we shall pass an Order reversing

the assessments imposed on the Petitioner, Crown Cork &

Seal (Delaware) Inc. for all of the tax years involved.

76a

Appendix E

IN THE

MARYLAND TAX COURT

NO. C-96-0154-01

SYL, INC.

V.

COMPTROLLER OF THE TREASURY

MEMORANDUM OF GROUNDS FOR DECISION

SYL, Inc. (hereinafter “Petitioner”), appeals an

assessment issued by the Comptroiler of the Treasury

(hereinafter “Respondent”) for Maryland income tax for the

tax years 1986 through 1993. Taxes assessed totaled $326,685

for the eight years, plus penalties and interest, for total

assessments of $637,362. At hearings, testimony was taken,

documents were presented, and subsequently, memorandum

were filed.

Petitioner was formed in December, 1986 as a subsidiary

of Syms, a corporation engaged in the retail of off-price

men’s, women’s, and children’s retail clothing with its

principal place of business in New Jersey. Syms has retail

operations in Maryland. Evidence indicates that Petitioner

was formed to hold and manage intangible asset such as

trademarks, service marks, and trade names of its parent,

Syms. The intangible assets transferred to Petitioner produced .

certain benefits to the corporate family, among them being

the reduction of Maryland income tax liability of its parent,

77a

Appendix E

Syms. Petitioner and Syms executed a licensing agreement

whereby the “marks”, now owned by Petitioner, were licensed

to Syms for a fee. This fee paid to Petitioner reduced the

Maryland taxable income of Syms and increased income to

Petitioner. However, Delaware law does not tax Petitioner’s

licensing income. Since Maryland law requires each entity

of an affiliated group to file their tax returns separately, the

money paid to Petitioner from Syms was never taxed by

Maryland.

An audit by Respondent claimed a basis for finding that

the licensing fees paid to Petitioner were taxable. An

assessment was issued, which was affirmed by the

Respondent’s hearing officer.

Issues Presented

The central issue for this Court involves whether

Maryland statute or case law permits the imposition of tax

on the income of an out-of-state affiliate of a Maryland parent

corporation. The issue is identical to that addressed in MCIIT

v. Comptroller, Maryland Tax Court No. C-96-0028-01 (1999)

and it is to that decision that most of our analysis will refer.

The major difference between this case and MCIIT is that

the entity involved here is a holding company, not an

operating corporation.

Similar to MCIIT, Petitioner asserts that a sufficient

nexus does not exist between itself and Maryland to subject

Petitioner to Maryland income tax. Respondent relies on

Maryland case law for support of its assessment. In addition,

Petitioner claims that the imposition of tax on an out-of-

78a

Appendix E

state holding corporation without the promulgation of a

regulation or the enactment of legislation violates Maryland

case law and the Administrative Procedures Act. Respondent

argues that the assessment reflects current law, is not a change

in policy and therefore, no regulation or legislation was

required in order for the assessment to be issued.

In addition, Petitioner asserts that, even if subject to the

tax, Respondent utilized the incorrect apportionment formula

and that the Respondent should have waived penalty and

interest. ,

I. Nexus.

The nexus arguments were fully addressed in MCIIT,

supra. The parties presented the same statutory and case

law as support of their positions as in the instant appeal.

The MCIIT analysis provided:

Maryland imposes a tax on the taxable income

of a corporation defined as “its Maryland modified

income as allocated to the State...” § 10-301 of

the Tax-General Article of the Annotated Code of

Maryland.' Maryland modified income of a

corporation is its federal taxable income, adjusted

by the Maryland additions and subtractions,

§ 10-304 through 10-308. The computation of the

tax requires the corporation to allocate Maryland

modified income “derived from or reasonably

attributable to its trade or business in this State”,

1. All future statutory references shall be of the Tax-General

Article, unless otherwise noted. FN. 3. MCIIT v. Comptroller, supra.

79a

Appendix E

§ 10-402(a). If the entity earns its income from in

and out of the State, that income derived from

instate business activities must be allocated to

Maryland, § 10-402(a)(1) & (2). If the corporation

is unitary, then a 3-factor apportionment formula

is applied to its income in order to determine

Maryland taxable income of that corporation,

§ 10-402(c). Under subsection (d) of § 10-402,

the Respondent may alter the allocation and

apportionment of a corporation’s income “to

reflect clearly the income allocable to Maryland”.

Each corporate member of an affiliated group,

even if unitary, is required to file a separate tax

return to the Respondent, § 10-811... -

The parties both agree that Petitioner is a part

of a unitary group of entities. Accordingly, relying

on precedent established in two Maryland Court

decisions, Comptroller of the Treasury v. Armco

Export Sales Corp., 82 Md.App. 429 (1990) and

Comptroller of the Treasury v. Atlantic Supply Co.,

294 Md. 213 (1982), the Respondent asserted

nexus over Petitioner based on the in-state activity

of an affiliate, MCIT. Respondent first determined

that Petitioner lacked “substantial economic

substance”, labeling Petitioner as a “phantom”

corporation. As such, Respondent determined that

the cases cited permit the attribution of “nexus

and apportionment factors of the company or

companies actually engaging in any real activity

to the phantom company”, Notice of Final

Determination (Petitioner’s Exhibit # 63).

80a

Appendix E

We disagree with the Respondent’s nexus

attribution to Petitioner based on the Armco and

Atlantic Supply decisions. Fundamental in both

Court decisions is the determination that the

taxpaying entity was a shell or phantom

corporation with no economic substance.

In Armco, the Court was faced with a statutorily

created business organization known as a

Domestic International Sales Corporation or

DISC. The Court characterized the DISC as a

“phantom book entry corporation created under

federal tax laws ...”. In expounding on the

phantom nature of a DISC. the Court noted that

the DISC performed “no activity . . . to earn the

income” Armco, supra, at 431; that “none of the

DISC’s had any tangible assets or employees

anywhere; and that the DISC “can only conduct

its activity and do business through branches of

its unitary affiliated parent”, supra at 430,435.

In addition, the Court concluded there was specific

legisiative intent to subject the DISC’s to

Maryland income taxation.

In Atlantic Supply, nexus was not an issue.

The taxpayer was clearly doing business in

Maryland. The Court’s focus was the taxation of

an affiliate created for the specific purpose of

obtaining the favorable wholesale price from a

major supplier, Coca-Cola, which its parent,

Macke Company, as a retailer, could not acquire.

Emphasis was placed on the fact that the

employees of the out-of-state affiliates were

8la

Appendix E

authorized to, and did, act in the name of the

taxpayer outside of the state. In addition, the Court

noted that the taxpayer’s business “could not

function without the funds supplied by Macke-

parent and without the Macke branches as

captive customers.” Atlantic Supply, supra at 223.

The court concluded then that the taxpayer could

apportion its income among the states in which it

did business.

It is clear to this Court that the above holdings

are limited in their scope. The entities involved

lacked any economic substance,’ thus earning

their “phantom” status. Respondent’s attempt to

impose that status on corporations with substance

is not justified through Armco and Atlantic Supply.

Indeed, in this technologically advanced era,

it is not practical as well. It is conceivable

that, for legitimate business purposes, a seemingly

insignificant affiliate (i.e. one employee and/or

one computer) can exist which generates

substantial income yet have little or no expense.

To attribute nexus solely on the basis that there is

3 reliance on Maryland affiliates for some or all of

2 that income expands the limited holdings of

- Armco and Atlantic Supply and ignores the reality

- that they are separate non-phantom entities

2. It is interesting to note that Respondent’s hearing officer

found that Petitioner had no “substantial” or “significant” economic

substance. We find nothing in either statute or case law that

imposes a “substantial” requirement and wili not infer one here.

FN. 4, MCIIT v. Comptroller, supra.

82a

Appendix E

required to report their income separately.

MCIIT, supra, pages 6-8.

Based on MCIIT, applying Armco and Atlantic Supply

to the Petitioner is justified only if Petitioner is a “phantom”

corporation. For the following reasons, we conclude that

Petitioner is an entity of substance and not a “phantom”.

In the instant case, the evidence clearly indicates that

Petitioner is not just a book entry corporation. Petitioner

maintains an office in Delaware. That office contains office

- furniture and corporate and financial records are kept there.

Mail is received at the Delaware office location. It has its

own bank account and has an employee. Legal counsel was

retained by Petitioner for purposes of protecting its “marks”.

The requisites for corporate existence were met; i.e. the

drafting of by-laws, the election of a board of directors and

corporate officers, the holding of regular and annual

meetings, the recording of corporate minutes, and the

ratification of dividends.

Respondent claims that Petitioner “was little more than

a corporate vehicle designed to reduce state income taxes”,

(Respondent’s Memorandum, p. 40), and points to the

minimal expenses, the one employee, the mere formality of

the corporate existence of Petitioner, and the timing of

inter-entity transactions as support that Petitioner was

creating the “illusion of substance”, (Resp’s Memorandum,

p. 31). In short, Respondent assessed on the basis that the

Petitioner was a sham entity for the sole purpose to avoid

Maryland taxes.

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Appendix E

Even if that were true, Armco and Atlantic Supply only

apply to entities with no substance whatsoever. In addition,

it is well settled that tax avoidance ( rather than tax evasion)

is a legitimate business purpose. If Petitioner was legally

created with a tax avoidance purpose, absent authority and

in a separate return environment, the Respondent cannot tax

it. However, the evidence presented leads to the conclusion

that Petitioner was established for non-tax reasons, among

them:

¢ To hold and manage intangible assets in a

separate corporation;

¢ To protect the transferred intangibles from the

claims of Syms’ creditors and from liabilities

of Syms;

¢ To incorporate in a favorable corporate

jurisdiction;

¢ To avert hostile take-overs; and

¢ To protect and enhance the value of Syms’

name and its borrowing and business

acquisition ability.

These facts easily distinguish the Petitioner from the phantom

taxpayers in Armco and Atlantic Supply. Nexus cannot be

attributed to it for Maryland taxation purposes.

Similar to MCIIT, the issue then turns to whether nexus

can be directiy found in Petitioner’s activities. The Court

84a

Appendix E

finds the analysis provided in that case is applicable to the

present facts:

The limits on the taxing powers of a state are

found in the Due Process and Commerce Clauses

of the Constitution. The Supreme Court reviewed

the requirements of both Clauses in Quill Corp.

v. North Dakota, 504 U.S. 298 (1992).

In Quill, the Court reiterated that the “Due

Process Clause ‘requires some definite link, some

minimum connection, between a state and the

person, property or transaction it seeks to tax,’ and

that the ‘income attributed to the State for tax

purposes must be rationally related to ‘values

connected with the taxing State”’, supra at p.307,

citations omitted. Overruling prior holdings, the

Court determined that the minimum contacts

necessary to establish the jurisdiction to tax does

not require actual physical presence in the state,

but can be found “if a foreign corporation

purposefully avails itself of the benefits of an

economic market in the forum State”, supra

at p. 307. |

The Supreme Court’s analysis of the

Commerce Clause begins with the requirements

as set forth in its decision in Complete Auto

Transit, Inc. v. Brady, 430 U.S. 274 (1977).

Complete Auto provides a four part test which

must be satisfied in order for a tax to pass muster

against a Commerce Clause challenge. A tax is

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85a

Appendix E

‘sustained so long as the tax: “1) is applied to an

activity with a substantial nexus with the taxing

State, 2) is fairly apportioned, 3) does not

discriminate against interstate commerce, and 4)

is fairly related to the services provided by the

State”, Complete Auto at p. 279. In discussing the

first prong of the test, the Supreme Court held

that the “substantial nexus requirement is not, like

due process’ ‘minimum contacts’ requirement, a

proxy for notice, but rather a means for limiting

state burdens on interstate commerce. Accordingly

. a corporation may have the ‘minimum

contacts’ with a taxing State as required by the

Due Process Clause, and yet lack the “substantial

nexus’ with that State as required by the

Commerce Clause”, Quill at p. 313. The Court

reaffirmed the “bright-line” test it established in

National Bellas Hess, Inc. v. Department of

Revenue, 386 U.S. 753 (1967), that a taxpayer

must have a physical presence in the taxing state

in order to satisfy the substantial nexus

requirement of the Commerce Clause.

In addressing the stricter “substantial nexus”

requirement, Petitioner argues that since it has no

physical presence in Maryland, the attempt to tax

its income is a Commerce Clause violation

pursuant to Quill. Respondent contends that the

Quill Court explicitly noted that the physical

presence requirement applies to sales and use

taxes only. Reliance is also placed on the Armco

and Atlantic Supply decisions to support the

86a

Appendix E

application of an apportioned income tax to a

corporation without any physical presence in

Maryland.

The Respondent is correct in that the tax the

Quill Court analyzed was a sales/use tax.

The Court did note that “concerning other types

of taxes we have not adopted a similar bright-line,

physical presence requirement”, 504 U.S.

at p. 316. However, the Supreme Court also

refused to restrict the rule to only sales and use

taxes. “Although we have not, in our review of

other types of taxes, articulated the same physical

presence requirement that Bellas Hess established

for sales and use taxes, that silence does not imply

repudiation of the Bellas Hess rule”, supra at

p. 314. This lack of clarity on the parameters of

the physical presence test has led to differing

interpretations among the States as to what the

Commerce Clause requires in relation to income-

based taxes.

Absent apparent explicit direction, we hesitate

to expand the Quill physical presence requirement

to taxes other than sales and use. In so doing

however, we note that “substantial nexus” with

the taxing state is still required in order to pass

constitutional muster. In the rulings of Armco and

Atlantic Supply, due to the nature of the corporate

phantoms, with no substance and therefore no

presence anywhere, the normal nexus rules were

ignored and the Courts found that nexus could be

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87a

Appendix E

attributed based on the in- state presence and

activity of an affiliate. The Commerce Clause was

satisfied through the substantial nexus (the

production and export of goods) of the in- state

unitary affiliate.?

However, as stated above, the instant case

does not present us with a phantom. Petitioner is

an entity of substance with a presence somewhere

and thus the normal nexus (versus nexus

attribution) rules apply. The focus of the

substantial nexus requirement is on the entity

sought to be taxed, not its in- state affiliate. MCIIT,

supra, p. 9-11.

Focusing solely on Petitioner, we find that its lack of in-

state activity precludes the imposition of the tax. Petitioner

is not doing business in Maryland. Its income producing

activity all occurs outside of Maryland. Petitioner has no

offices, employees, agents or property in Maryland. Its only

Maryland contact is an affiliation with an entity with a

Maryland presence. This affiliation is hardly enough to satisfy

substantial nexus.

Respondent relies on Armco and Atlantic Supply as

support for the application of nexus due to the presence of

Syms in Maryland. That reliance has been shown above to

be erroneous. Respondent then points to the decision of

3. Although the term “substantial nexus” was not used by the

Armco Court, the Complete Auto Commerce Clause requirements

had been established for thirteen years prior to the Armco decision.

FN. 7, MCIIT v. Comptroller, supra.

88a

Appendix E

Geoffrey, Inc. v. South Carolina Tax Commission, 313 S.C.

15 (1993) as precedent in the taxing of a Delaware holding

company licensing trademarks and trade names to its parent

in-state company. The Geoffrey Court concluded that the use

of intangible property (the “marks’’) by the in-state affiliate

was sufficient to pass the constitutional nexus requirements

in order to tax the out-of-state entity.

For two reasons, we disagree with the Respondent’s use

of the Geoffrey decision. First, Geoffrey dealt with South

Carolina law and its application and therefore is not precedent

for Maryland application. Second, as indicated above, we

differ in our conclusions as to whether the substantial nexus

requirement of the Commerce Clause was met. Geoffrey

focused on the use of the marks by the in-state affiliate of

the unitary group in order to determine the nexus of the

foreign corporation. We disagree that that activity constitutes

“substantial” nexus.

In addition, the unitary relationship between entities does

not automatically establish nexus on all of the corporate

entities in the unitary group. As we stated in MCIIT, supra:

The mere presence of an in-state affiliate of a

unitary group does not confer nexus on a

non-phantom out-of-state affiliate of the same

group, Chesapeake Industries, Inc. v. Comptroller,

59 Md.App. 370 (1984). In the unitary taxation

scheme, the foreign corporation’s income and

factors may be included in determining the tax

liability of the in-state affiliate. However, without

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89a

Appendix E

nexus, the foreign corporation does not become

subject to the taxing jurisdiction.

The Respondent claims that the corporate

structure present here allows for the diversion of

income away from Maryland through the internal

transactions of affiliated entities which have no

overall impact on the income of the unitary group.

While this may be true, all such transactions are

not necessarily abusive and in any event,

these are the consequences of requiring affiliated

corporations to file and report income separately.

The Maryland Courts have addressed the

treatment of such transactions when dealing with

phantom corporations. With non-phantom

corporations, such as Petitioner, the nexus

rules as reiterated in Qui// must still be applied to

each affiliate before the State can tax. MCIIT,

supra, p. 11.

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Accordingly, we find that the Respondent has failed to

satisfy the substantial nexus requirement of the Commerce

Clause and the imposition of income tax on Petitioner’s

income is unconstitutional.

II. Regulation Promulgation Due to Change in

Policy.

Having found that the requisite nexus to warrant the

imposition of income tax on Petitioner does not exist, the

issue of whether a regulation had to promulgated becomes

moot. However, due to the number of taxpayers involved

90a

Appendix E

and the likelihood of judicial review, we shall address

the issue.

This Court concludes that the Respondent’s attempt to

assert tax against non- nexus, non-phantom trademark

protection companies as a result of their licensing of the use

of their trademarks, trade names and service marks to entities

which have a nexus with the State amounts to a substantially

new or change in policy which can only be instituted through

the rulemaking procedures pursuant to CBS, Inc. v.

Comptroller, 319 Md. 687 (1990) and the Maryland

Administrative Procedures Act, Md.Code Ann., State Gov’t

§ § 10-101 through 10-139. In CBS, Inc., the Maryland Court

of Appeals held that a change in an agency’s “policy of

general application” which results in “materially modified

or new standards” may be made by prospective rulemaking

only, CBS, p. 699. The Administrative Procedures Act

requires that a change or implementation of policy by a State

agency must be promulgated by regulation and that regulation

may only be promulgated prospectively.

Prior to 1995, companies such as Petitioner were not

subject to the tax. Phantom companies like those found in

Armco and Atlantic Supply were subject to tax. In his latest

statement of policy, ADR No. 2, titled “Interstate Commerce

Tax Act—Domestic and Foreign Corporation—Nexus

Requirements -Apportionment of Net Income;-published in

1989, Respondent set forth the parameters of taxing foreign

corporations. Nothing in that release, any regulation or statute

since 1989 suggests that a foreign corporation with substance,

with no business location, representatives, or other activities

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Appendix E

within the State of Maryland could be subject to income tax

as a result of the licensing of the use of intangible “marks”

to in-state entities.

Beginning in 1995, (subsequent to the issuance of the

Geoffrey decision), Respondent began asserting deficiencies

against foreign trademark protection companies based on the

in-state activities of their affiliates. Rather than a reflection

of current policy, these assessments against substantial

entities represented a change from its own stated policy

(the 1989 Release) and that affirmed in Armco and

Atlantic Supply. That change “materially modified” existing

jurisdiction to tax standards to the detriment of taxpayers

which had relied on the Respondent’s past pronouncements.

No regulations were promulgated or legislation enacted to

effect this change in policy and, pursuant to CBS, Inc., any

retroactive attempt to tax Petitioner is improper. Respondent

apparently believed that a regulation was necessary to expand

the Armco policy as evidenced by the attempt to promulgate

regulations relating to payments made by a Maryland taxpayer

for “marks” from a contractor to an out-of state affiliated

entity.* That attempt was rejected by the legislature and a

review of their comments demonstrated that the retroactive

application of the Respondent’s policy was unacceptable.

4. 24 Md. Reg. 1294 (Aug. 29, 1997) and 24 Md. Reg. 1314

(Aug. 29, 1997). The Respondent also attempted to enact legislation

(HB 682, General Assembly Regular Session, 1998) to specifically

provide for the taxation of foreign holding companies, but the bill

was withdrawn before being bought to a vote.

92a

Appendix E

II. Apportionment.

MCIIT, Inc., supra, provides ei in regards to the

apportionment issue:

Having found that the requisite nexus to

warrant the imposition of income tax on Petitioner

does not exist, the issue of which apportionment

factor is appropriate becomes moot. As an entity

of substance with no nexus to Maryland, there is

no Maryland income to calculate.

Even if there were ties to Maryland, with an

entity of substance rather than a phantom, the

proper apportionment formula would utilize the

sales, property and payroll of Petitioner itself.

Only if Petitioner were a phantom would the

principles of Armco and Atlantic Supply be

applicable. In those cases, the Courts allowed the

Respondent to employ the factor of the taxpayer’s

in- state parent and apply it to the phantom’s

income. With the present facts, i.e. no phantom,

there is no authority for the use of the in-state

affiliate’s factors. MCIIT, Inc., supra, p. 12.

While agreeing with the Petitioner that the appropriate

formula is that applying its own factors, we are not convinced

that the traditional apportionment formula results in a

distorted enough income figure for Petitioner to warrant the

three-factor formula proposed by its witness.

93a

Appendix E

IV. Penalties and Interest.

Similar to the prior issues, having found that the

Petitioner has no tax liability, the issue of penalties and

interest are moot. However, it is the position of this Court

that the Petitioner acted in good faith, complied with existing

(and current) law and that, if liability for income tax had

been found, no penalty should have been imposed. It is also

the consistent position of this Court that the ability to waive

interest lies solely with the Respondent.

Conclusion.

For the above reasons, we shall pass an Order reversing

the assessments imposed on the Petitioner, SYL, Inc., by the

Respondent for all of the tax years involved.

94a

Appendix E

IN THE

MARYLAND TAX COURT

NO. C-96-0028-01

MCI INTERNATIONAL

TELECOMMUNICATIONS CORP.

V.

COMPTROLLER OF THE TREASURY

MEMORANDUM OF GROUNDS FOR DECISION

Petitioner, MCI International Telecommunications, Inc.

(hereinafter “MCIIT” or “Petitioner’”), appeals an assessment

issued by the Comptroller of the Treasury (hereinafter

“Respondent”) for Maryland income tax for the tax years

ended March 31, 1991 through March 31, 1993. Taxes

assessed totaled $2,2765,518 for the three years, plus

penalties and interest, for total assessments of $4,425,859.

At hearings, testimony was taken, documents presented, and

motions and memorandum were filed.

The Parties

Before any recitation of the facts as presented, an

explanation of the parties and affiliations is necessary.'

Petitioner, MCIIT, describes itself as a wholesaler of

international telecommunications services. It is part of an

1. All stated facts pertain to the time period of the assessment,

unless specified otherwise.

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Appendix E

affiliated group of corporations collectively known as MCI.

The. parent of the affiliated group is MCI Communications

Corporation (“MCIC”). MCIC has two subsidiaries,

reflecting the two areas of business in telecommunications.

MCI Telecommunications Corporation (“MCIT”) is the

domestic communications arm of MCIC. MCIT operates

throughout the United States, including Maryland. This

entity is a long distance telephone service provider for U.S.

domestic customers, familiar to many through their

advertising.

MCI International, Inc. (“MCII’) is the international

business arm of MCIC. Its business is the provision of

international telecommunications to its affiliates and other

customers. It is located in New York. MCII is the parent

corporation of both Petitioner, MCIIT, which handles

international voice communication and Western Union

International, Inc., which provides mostly data transmissions.

Thus, in the family scheme, MCIIT, the assessed entity,

can be labeled as the child corporation to MCII, the nephew

corporation to MCIT and the grandchild entity to MCIC.?

The Respondent has assessed both Petitioner and its uncle

corporation, MCIT, for income taxes.

Summary of Pertinent Facts

MCIIT provides international voice service to its

customers. Its existence was mandated by the need to have a

single entity ope. © ing in an environment heavily regulated

2. The corporate structure, in its most simplistic form, is best

provided by Petitioner’s Exhibit 4.

96a

Appendix E

by the federal government through the Federal

Communications Commission (FCC). In addition, the

separate international company was a completely different

type of business than the domestic voice transmission

business. Different expertise, equipment, customers and

regulations applied to international communications.

Initially, before MCIIT could begin any voice service

between countries, operating agreements had to be reached

with each country it wished to provide service. These

agreements were negotiated, reviewed and executed by its ©

parent MCII. The domestic carrier, MCIT, had nothing to do

with the preparation of these agreements. Once signed and

filed, the international entities had access to the respective

countries.

MCIL, the parent, also assisted MCIIT in the gaining of

access to the equipment necessary to complete an

international telephone call; namely, undersea cables,

interconnecting cables, computer systems to track minutes

and calls and satellite facilities. The cable is owned by an

consortium of international telecommunications companies

due to the expense of maintaining such a facility. MCIIT pays

MCII a management fee in exchange for its services.

An international telephone call completed by the

Petitioner starts at a mainland point. If it is an inbound call

(to the United States), the call typically originates with the

customer of a foreign telephone company (referred to in

testimony as a “PTT”). The foreign PTT carries the call over

the afore-mentioned submerged ocean cable. The foreign PTT

bill their customers in their countries and then pay MCIIT a

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service fee. At the midpoint on the ocean cable, MCIIT picks

up the call and transmits it to a cablehead where the ocean

cable reaches the shoreline. MCIIT pays a service fee to its

parent, MCII, for the capacity to carry calls on the cabie.

MCIIT then carries the call to a “gateway switch”. This switch

is owned by one of the domestic long-distance carriers

(“LDC”), i.e. AT & T, Sprint, or MCIT. The gateway switch

is not located in Maryland. MCIIT terminates the call at the

gateway switch, where the LDC picks up the call and

transmits it over its domestic long distance network to the

local exchange carrier (i.e. Bell Atlantic), who transmits it

to their ultimate destination. MCIIT pays the LDC a service

fee for carrying the calls on its network.

An outbound call would operate in the reverse fashion.

The LDC would send the call to its gateway switch, where

MCIIT picks it up and transfers it to the ocean midpoint to

the PTT, who would complete the call on the foreign side of

the transaction. In this instance, the LDC would pay MCIIT

a service fee for its service in completing the international

call. MCIIT would pay the PTT a service fee for taking its

call and completing it.

It is the treatment of the service and management fees

paid and received by MCIIT that has generated this appeal.

Petitioner, in 1991, reported for the first time in its Maryland

income tax returns, no Maryland payroll expenses and

nominal property ownership. When combined with the

substantially increased revenue reported, the Respondent

asserted grounds for an audit. At hearing before this Court,

testimony established that payroll expenses were included

in the management fee paid by MCIIT to MCIL, its parent.

98a

Appendix E

That fee also paid for other services MCII provided; i.e.

negotiations, accounting, procurement, data processing, etc.

The fee was determined through an allocation of expenses

by MCII to its subsidiaries. There was no specific agreement

between the entities in defining the exact amount of the fee.

In 1991, the fee paid by MCIIT to MCII was $56 million

dollars.

As for the property, repeatedly the testimony indicated

that MCIIT owned no property in Maryland. The cables and

satellites were owned by other entities to which MCIIT paid

a rent, then capitalized to determine their value for tax

purposes. The rental expense was a fixed allocated amount,

not based on actual usage. No specific rental agreement

between the entities were introduced. The gateway switch to

which international calls were either picked up or handed

off were owned by the domestic long distance carriers, MCIT

being one of them. They were not rented by Petitioner.

Petitioner paid those owners a fee based on actual usage of

the facility. None of the gateway switches were located in

Maryland.

The filing of the 1991 tax returns triggered an audit and

an assessment by the Respondent against both MCIIT,

the Petitioner, and its uncle MCIT. The Respondent

determined that the Petitioner was not a substantial entity

and its existence was based solely as a means by which the

in-state affiliate, MCIT, could divert taxable income to an

out-of-state entity through the payment of service fees paid

to MCIIT for transmissions it handled. Since that entity has

no property, payroll or sales in Maryland, the income

generated by the service fees from the PTT’s and the LDC’s

could not be apportioned to Maryland.

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Appendix E

Relying primarily on case law, the Respondent used the

income reported on the Petitioner’s tax returns, applied the

apportionment formula as derived from information on the

domestic long distance corporation’s (MCIT) returns and

issued assessments against MCIIT. MCIIT appealed those

assessments and a hearing was held by the Respondent. The

hearing officer who heard the appeal was also, it was later

discovered, actively involved in the audit of the Petitioner.

He subsequently affirmed the assessments and the Petitioner

filed a timely appeal with this Court.

Issues Presented

I. Nexus.

The Respondent can assess a tax on the income of an

out-of-state entity if that entity has nexus with the State of

Maryland. Petitioner presents two challenges to Respondent’s

assumption that nexus exists with Maryland.

First, Petitioner contends that neither Maryland statutes

or case law impose nexus in order for Respondent to subject

it to Maryland Income tax. It claims that it does not conduct

any trade or business in Maryland and therefore, pursuant to

Maryland law, its income cannot be subject to tax.

Petitioner next asserts that the Respondent’s attempt to

tax its income violates the Due Process Clause and the

Commerce Clause of the United States Constitution.

Specifically, Petitioner contends that the “minimum contacts”

necessary for an entity to meet Due Process nexus with a

taxing state does not exist here. As for the Commerce Clause,

100a

Appendix E

Petitioner argues that is involved with no activity having

“substantial nexus” with the taxing state and that since it

has no physical presence with Maryland, Respondent’s

assessment violates the principles stated by the U.S. Supreme

Court in Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

II. Apportionment.

Even if this Court finds that sufficient nexus exists for

the imposition of income tax. Petitioner argues that the law

mandates that the proper apportionment formula to be used

in determining the amount of tax liability should be either

one using the sales, property and payroll of the Petitioner

itself or of its parent, MCII.

Petitioner claims that the application by the Respondent

of the “uncle” corporation factor formula amounts to a change

in policy of general application, the implementation of which

requires either statutory or regulatory action, based on the

decision in CBS, Inc. v. Comptroller, 319 Md. 687 (1990).

Petitioner asserts that the lack of regulatory procedures

violates the Maryland Administrative Procedures Act.

In addition, Petitioner argues that the use of MCIT’s

apportionment factor results in unconstitutional unfair

apportionment, unrelated to Petitioner’s activities in

Maryland.

Ill. Procedural Violations.

Petitioner asserts that the hearing officer’s active

involvement in the original audit violates the Petitioner’s

Fifth Amendment due process rights as well as the principles

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10la

Appendix E

mandated by the Administrative Procedures Act. According

to the Petitioner, the Respondent permitted pervasive

influence by the hearing officer on the auditor of Petitioner’s

records and therefore, any proceeding before that hearing

officer was constitutionally suspect. Petitioner seeks

dismissal of the assessments on those grounds.

Conclusions of Law

I. Nexus.

Maryland imposes a tax on the taxable income of a

corporation defined as “its Maryland modified income as

allocated to the State ...” § 10-301 of the Tax- General

Article of the Annotated Code of Maryland.’ Maryland

modified income of a corporation is its federal taxable

income, adjusted by the Maryland additions and subtractions,

§ 10-304 through 10-308. The computation of the tax

requires the corporation to allocate Maryland modified

income “derived from or reasonably attributable to its trade

or business in this State”, § 10-402(a). If the entity earns its

income from in and out of the State, that income derived

from instate business activities must be allocated to

Maryland, § 10- 402(a)(1) & (2). If the corporation is unitary,

then a 3-factor apportionment formula is applied to its income

in order to determine Maryland taxable income of that

corporation, § 10-402(c). Under subsection (d) of § 10-402,

the Respondent may alter the allocation and apportionment

of a corporation’s income “to reflect clearly the income

allocable to Maryland”. Each corporate member of an

3. All future statutory references shall be of the Tax-General

Article, unless otherwise noted.

102a

Appendix E

affiliated group, even if unitary, is required to file a separate

tax return to the Respondent, § 10-811.

Absent the fact that a unitary relationship exists between

the Petitioner and MCIT, the assessment would not have been

imposed upon Petitioner’s income. If the Petitioner was not

part of a unitary group, the evidence indicates that Petitioner

does not conduct any trade or business in this State. Petitioner

either picks up outbound calls from or drops off foreign

inbound calls to the LDC outside of Maryland at the gateway

switch, It is this transporting of voice transmissions that

generates the Petitioner’s income. Since all of its income

producing activity occurs outside of Maryland, pursuant to

§ 10-402, that income is outside of Maryland’s taxing

jurisdiction. Despite the Respondent’s attempt in his

memorandum to label the entire MCI corporate group as

being the Petitioner in this assessment, the statutes warrant

the consideration of each separate affiliate when determining

a Maryland presence.

The parties both agree that Petitioner is a part of a unitary

group of entities. Accordingly, relying on precedent

established in two Maryland Court decisions. Comptroller

of the Treasury v. Armco Export Sales Corp., 82 Md.App.

429 (1990) and Comptroller of the Treasury v. Atlantic Supply

_Co., 294 Md. 213 (1982), the Respondent asserted nexus over

Petitioner based on the instate activity of an affiliate, MCIT.

Respondent first determined that Petitioner lacked

“substantial economic substance”, labeling Petitioner as a

“phantom” corporation. As such, Respondent determined that

the cases cited permit the attribution of “nexus and

apportionment factors of the company or companies actually

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Appendix E

engaging in any real activity to the phantom company”,

Notice of Final Determination (Petitioner’s Exhibit # 63).

We disagree with the Respondent’s nexus attribution to

Petitioner based on the Armco and Atlantic Supply decisions.

Fundamental in both Court decisions is the determination

that the taxpaying entity was a shell or phantom corporation

with no economic substance. In Armco, the Court was faced

with a statutorily created business organization known as a

Domestic International Sales Corporation or DISC. The Court

characterized the DISC as a “phantom book entry corporation

created under federal tax laws .. .”. In expounding on the

phantom nature of a DISC, the Court noted that the DISC

performed “no activity to earn the income” Armco, supra, at

431; that “none of the DISC’s had any tangible assets or

employees anywhere; and that the DISC “can only conduct

its activity and do business through branches of its unitary

affiliated parent”, supra at 430,435. In addition, the Court

concluded there was specific legislative intent to subject the

DISC’s to Maryland income taxation.

In Atlantic Supply, nexus was not an issue. The taxpayer

was clearly doing business in Maryland. The Court’s focus

was the taxation of an affiliate created for the specific purpose

of obtaining the favorable wholesale price from a major

supplier, Coca-Cola, which its parent, Macke Company, as a

retailer, could not acquire. Emphasis was placed on the fact

that the employees of the out-of-state affiliates were

authorized to, and did, act in the name of the taxpayer outside

of the state. In addition, the Court noted that the taxpayer’s

business “could not function without the funds supplied by

Macke- parent and without the Macke branches as captive

104a

Appendix E

customers.” Atlantic Supply, supra at 223. The court

concluded then that the taxpayer could apportion its income

among the states in which it did business.

It is clear to this Court that the above holdings are limited

in their scope. The entities involved lacked any economic

substance,‘ thus earning their “phantom” status. Respondent’s

attempt to impose that status on corporations with substance

is not justified through Armco and Atlantic Supply. Indeed,

in this technologically advanced era, it is not practical as

well. It is conceivable that, for legitimate business purposes,

a seemingly insignificant affiliate (i.e. one employee and/or

one computer) can exist which generates substantial income

yet have little or no expense. To attribute nexus solely on the

basis that there is reliance on Maryland affiliates for some

or all of that income expands the limited holdings of Armco

and Atlantic Supply and ignores the reality that they are

separate non-phantom entities required to report their income

separately.

In the instant case, Petitioner is not just a book entry

corporation. The evidence clearly indicates that it performed

activity (the transfer of inbound and outbound calls over

international territory) that generated income. The revenues

were earned from non-affiliated entities as well as MCIT.

Petitioner has substantial property on its books and has

incurred personnel expense through the payment of

management fees to its parent, MCII. Unlike in Armco,

4. It is interesting to note that Respondent’s hearing officer

found that Petitioner had no “substantial” or “significant” economic

substance. We find nothing in either statute or case law that imposes

a “substantial” requirement and will not infer one here.

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Appendix E

Petitioner’s corporate officers, operating territory, property,

and employees are different from those of the instate

corporation, MCIT. Unlike Atlantic Supply, there was no

evidence to indicate that MCIT employees were authorized

to act in the name of Petitioner. The evidence indicated that

Petitioner was not solely dependent on MCIT and that it could

function as a stand-alone corporation and do business with

the other LDC’s. MCIT was not a captive customer of

Petitioner. :

Finally, unlike the specific provision enacted by the

legislature regarding DISC’s, the taxation of foreign

corporations based on the transactions between them and their

in-state affiliate has not been adopted by either statute or

regulation. The rejection by a legislative committee of

proposed regulations® and the subsequent introduction of

legislation® to specifically provide for that taxation supports

Petitioner’s argument that legislative intent was lacking.

In short, contrary to the DISC in Armco and the in-state

affiliate in Atlantic Supply. Petitioner is not a phantom

corporation and therefore, nexus cannot be attributed to it

for Maryland taxation purposes.

5. 24 Md. Reg. 1294 (Aug. 29, 1997) and 24 Md. Reg. 1314

(Aug. 29, 1997)

6. House Bill 682, General Assembly Regular Session 1998.

The bill was withdrawn before being brought to a vote. Although

this bill was presented subsequent to the hearing in the instant case,

it is relevant to the issues involved.

106a

Appendix E

Having found no support for attributing nexus, the

question then is whether the United States Constitution

permits the imposition of nexus directly on the foreign

affiliate. The limits on the taxing powers of a state are

found in the Due Process and Commerce Clauses of the

Constitution. The Supreme Court reviewed the requirements

of both Clauses in Quill Corp. v. North Dakota, 504 U.S.

298 (1992).

In Quill, the Court reiterated that the “Due Process

Clause ‘requires some definite link, some minimum

connection, between a state and the person, property or

transaction it seeks to tax,’ and that the ‘income attributed to

the State for tax purposes must be rationally related to ‘values

connected with the taxing State’”, supra at p. 307, citations

omitted. Overruling prior holdings, the Court determined that

the minimum contacts necessary to establish the jurisdiction

to tax does not require actual physical presence in the state,

but can be found “‘if.a foreign corporation purposefully avails

itself of the benefits of an economic market in the forum

State”, supra at p. 307.

The Supreme Court’s analysis of the Commerce Clause

begins with the requirements as set forth in its decision in

Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).

Complete Auto provides a four part test which must be

satisfied in order for a tax to pass muster against a Commerce

Clause challenge. A tax is sustained so long as the tax: “1) is

applied to an activity with a substantial nexus with the taxing

State, 2) is fairly apportioned, 3) does not discriminate against

interstate commerce, and 4) is fairly related to the services

provided by the State”, Complete Auto at p. 279. In discussing

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Appendix E

the first prong of the test, the Supreme Court held that the

“substantial nexus requirement is not, like due process’

‘minimum contacts’ requirement, a proxy for notice, but

rather a means for limiting state burdens on interstate

commerce. Accordingly ... a corporation may have the

‘minimum contacts’ with a taxing State as required by the

Due Process Clause, and yet lack the “substantial nexus’

with that State as required by the Commerce Clause”,

Quill at p. 313. The Court reaffirmed the “bright-line” test it

established in National Bellas Hess, Inc. v. Department of

Revenue, 386 U.S. 753 (1967), that a taxpayer must have a

physical presence in the taxing state in order to satisfy the

substantial nexus requirement of the Commerce Clause.

In addressing the stricter “substantial nexus”

requirement, Petitioner argues that since it has no physical

presence in Maryland, the attempt to tax its income is a

Commerce Clause violation pursuant to Quill. Respondent

contends that the Quill Court explicitly noted that the physical

presence requirement applies to sales and use taxes only.

Reliance is also placed on the Armco and Atlantic Supply

decisions to support the application of an apportioned income

tax to a corporation without any physical presence in

Maryland.

The Respondent ts correct in that the tax the Quil/ Court

analyzed was a sales/use tax. The Court did note that

“concerning other types of taxes we have not adopted a

similar bright-line, physical presence requirement”, 504 U.S.

at p. 316. However, the Supreme Court also refused to restrict

the rule to only sales and use taxes. “Although we have not,

in our review of other types of taxes, articulated the same

108a

Appendix E

physical presence requirement that Bellas Hess established

for sales and use taxes, that silence does not imply repudiation

of the Bellas Hess rule”, supra at p. 314. This lack of clarity

on the parameters of the physical presence test has led to

differing interpretations among the States as to what the

Commerce Clause requires in relation to income-based taxes.

Absent apparent explicit direction, we hesitate to expand

the Quill physical presence requirement to taxes other than

sales and use. In so doing however, we note that “substantial

nexus” with the taxing state is still required in order to pass

constitutional muster. In the rulings of Armco and Atlantic

Supply, due to the nature of the corporate phantoms, with no

substance and therefore no presence anywhere, the normal

nexus rules were ignored and the Courts found that nexus

could be attributed based on the in- state presence and activity

of an affiliate. The Commerce Clause was satisfied through

the substantial nexus (the production and export of goods)

of the instate unitary affiliate.’

However, as stated above, the instant case does not

present us with a phantom. Petitioner is an entity of substance

with a presence somewhere and thus the normal nexus (versus

nexus attribution) rules apply. The focus of the substantial

nexus requirement is on the entity sought to be taxed, not its

in-state affiliate.

Initially, we determined that if Petitioner were a non-

unitary corporation, its lack of in-state activity would

7. Although the term “substantial nexus” was not used by the

Armco Court, the Complete Auto Commerce Clause requirements

had been established for thirteen years prior to the Armco decision.

109a

Appendix E

preclude the imposition of the tax. Its income producing

activity all occurs outside of Maryland. Petitioner has no

offices, employees, agents or property in Maryland. Its only

Maryland contact is an affiliation with an entity with a

Maryland presence. This affiliation is hardly enough to satisfy

substantial nexus.

The fact that Petitioner is part of a unitary group does

not alter the above facts nor magically increase its Maryland

presence in order to meet Commerce Clause criteria for

nexus. The mere presence of an in-state affiliate of a unitary

group does not confer nexus on a non-phantom out-of-state

affiliate of the same group, Chesapeake Industries, Inc. v.

Comptroller, 59 Md.App. 370 (1984). In the unitary taxation

scheme, the foreign corporation’s income and factors may

be-included in determining the tax liability of the in-state

affiliate. However, without nexus, the foreign corporation

does not become subject to the taxing jurisdiction.

The Respondent claims that the corporate structure

present here allows for the diversion of income away from

Maryland through the internal transactions of affiliated

entities which have no overall impact on the income of the

unitary group. While this may be true, all such transactions

are not necessarily abusive and in any event, these are the

consequences of requiring affiliated corporations to file and

report income separately. The Maryland Courts have

addressed the treatment of such transactions when dealing

with phantom corporations. With non-phantom corporations,

such as Petitioner, the nexus rules as reiterated in Quill must

still be applied to each affiliate before the State can tax.

110a

Appendix E

Accordingly, we find that the Respondent has failed to

satisfy the substantial nexus requirement of the Commerce

Clause and the imposition of income tax on Petitioner’s

income is unconstitutional.’

II. Apportionment.

Having found that the requisite nexus to warrant the

imposition of income tax on Petitioner does not exist, the

issue of which apportionment factor is appropriate becomes

moot. As an entity of substance with no nexus to Maryland,

there is no Maryland income to calculate.

Even if there were ties to Maryland, with an entity of

substance rather than a phantom, the proper apportionment

formula would utilize the sales, property and payroll of

Petitioner itself. Only if Petitioner were a phantom would

the principles of Armco and Atlantic Supply be applicable.

In those cases, the Courts allowed the Respondent to employ

the factor of the taxpayer’s in-state parent and apply it to the

phantom’s income. With the present facts, i.e. no phantom,

there is no authority for the use of the in-state affiliate’s

factors.

Finally, in anticipation of judicial review, we agree with

the Petitioner in its argument that the Respondent’s attempt

to deviate from the traditional three-factor formula in the

case of a entity of substance or its use of the factor of an

“uncle” affiliate in the case of a phantom corporation violates

the ruling in CBS, Inc. v. Comptroller, 319 Md. 687 (1990)

8. In light of our Commerce Clause ru

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