United States: New Jersey Superior Court Reverses Pro-Taxpayer Decision in Lanco and Finds Nexus

The Superior Court of New Jersey, Appellate Division has further stacked the odds against intellectual property holding companies in the ongoing nexus battle with the states. In Lanco, Inc. v. Director, Division of Taxation, ¹ the Court found that the licensing of intangibles to a company doing business in the state was sufficient contact to create nexus for corporation business tax purposes, in spite of the lack of physical contact with the state. In so doing, the Court aligned itself with other state courts in concluding that the physical presence test set forth in Quill ² is inapplicable to any tax but sales and use tax, notwithstanding guidance to the contrary from none other than the United States Supreme Court.

Lanco, Inc. ("Lanco") was a Delaware corporation that owned certain intangible property, including trademarks, trade names and service marks, that it licensed to an affiliate, Lane Bryant, Inc. ("Lane Bryant"), for use in Lane Bryant’s retail operations nationwide in exchange for a royalty payment. Lanco had no offices, employees, or any other real or tangible personal property in New Jersey. Its only contact with New Jersey was the licensing agreement with Lane Bryant – a retailer with physical operations in the state. The issue before the court was whether Lanco’s contacts with New Jersey pursuant to its license agreement with Lane Bryant were sufficient to create nexus and subject Lanco to the New Jersey Corporation Business Tax.

In a well-reasoned decision, the New Jersey Tax Court held that the dormant Commerce Clause of the United States Constitution prohibited New Jersey from taxing Lanco since Lanco did not have any physical presence in New Jersey. The Court held that the physical presence test articulated in Quill applied to the New Jersey corporation business tax.

In Quill, the United States Supreme Court held that the dormant Commerce Clause prohibited North Dakota from requiring a foreign corporation without any substantial physical presence in the State to collect North Dakota use taxes on goods shipped to North Dakota customers. The Quill Court explained that since the Constitution expressly allows Congress to regulate interstate commerce, Congress can change the result through legislation if necessary.

The Tax Court pointed to three separate rationales upon which it based its decision that Quill applied in an income tax context. First, the Tax Court noted that the differences between use tax and income tax are not so significant as to justify a different rule for each as it relates to physical presence:

Second, the Tax Court determined that physical presence, as a prerequisite to state income tax, was "fully consistent with and strongly suggested by the Commerce Clause cases decided before Quill" because the circumstances in each case involved taxpayers that were in fact physically present in the state. ⁴ Finally, the Court looked to other state court cases decided since Quill that have applied the physical presence test to taxes other than use taxes. ⁵

The Lanco Court followed the United States Supreme Court’s rationale in Quill by suggesting that the New Jersey legislature can (and, to a certain extent, has) change the result through legislation. ⁶ The Lanco Court acknowledged that it was aware of the alleged tax planning and related political issues underlying the dispute:

In a bold move, the Appellate Division of the Superior Court of New Jersey reversed the decision of the Tax Court, holding that the physical presence substantial nexus test established in Quill does not apply to the New Jersey corporation business tax since the tax is not a sales or use tax. Relying heavily on Geoffrey ⁸ and the North Carolina Court of Appeals decision in A&F Trademark, ⁹ the Superior Court reasoned that the "New Jersey Business Corporation Tax may be constitutionally applied to income derived by plaintiff from licensing fees attributable to New Jersey." ¹⁰

The Superior Court opinion extensively quoted the language in A&F Trademark, in which the North Carolina Court of Appeals analyzed the three rationales set forth by the Lanco Tax Court in detail and rejected each in turn. Perhaps most notably, the North Carolina Court repeatedly interpreted the language in the Quill opinion, which some believe suggests that the Court may not have articulated a physical presence test for any other taxes, to indicate that the physical presence test must therefore be only applicable to use taxes. ¹¹

Moreover, the North Carolina Court concluded that there were sufficient distinctions between the tax at issue and the sales and use taxes in Quill to justify a different finding. In an interesting move, the North Carolina Court decided that it was appropriate not to accord the same import to the United States Supreme Court decisions decided before Quill because it was far more likely that a taxpayer would be required to be physically present in a state to earn income there at that time. Finally, the North Carolina Court responded to the Tax Court’s reliance on other state court cases by citing alternative state court cases that conclude that physical presence is not required for the imposition of income tax. ¹²

Relying heavily on these state court cases, the New Jersey Superior Court held that "[w]e are satisfied that the physical presence requirement applicable to the sales and use tax is not applicable to income tax and that the New Jersey Business Corporation Tax may be constitutionally applied to income derived…from licensing fees attributable to New Jersey." ¹³

The Superior Court’s insinuation that the New Jersey corporation business tax is somehow immune from scrutiny under the physical presence test articulated by the Supreme Court in Quill simply because the tax doesn’t happen to be a use tax is questionable at best. The issue of whether the physical presence test articulated in Quill applies beyond state use taxes is, of course, still hotly debated. The better view is that no state taxes are immune from scrutiny under the Quill decision because the same Commerce Clause governs all state taxes and, therefore, the same rule should be applied to all.

The seminal case on whether a state tax violates the Commerce Clause of the United States Constitution is Complete Auto. ¹⁴ Prior to its decision in Complete Auto, the Court, in part, evaluated whether a given state tax violated the Commerce Clause by examining the label used to describe the tax. For instance, under the prior decisions a tax on interstate commerce denominated as a "privilege of doing business tax" was unconstitutional, while a similar "net income tax" or "going concern value tax" was constitutional. In Complete Auto, the Court held that "[t]here is no economic consequence that follows necessarily from the use of the particular words [used to label or describe a state tax], and a focus on that formalism merely obscures the question [of] whether the tax produces a forbidden effect." ¹⁵ The Court went on to establish a four part test, now known as the Complete Auto four part test, for determining if any state tax violates the Commerce Clause. Among the other factors, a state tax passes muster under the Commerce Clause only "when the tax is applied to an activity with a substantial nexus with the taxing State." ¹⁶

In Quill, the Court was asked to reconsider and overrule its prior decision in National Bellas Hess. ¹⁷ In Bellas Hess, the Court held that state taxes imposed against an out-of-state corporation without any substantial physical presence in the taxing state violated the United States Constitution. ¹⁸ The Bellas Hess decision could thus be viewed as an application of the "substantial nexus" requirement as articulated in Complete Auto. In affirming that the physical presence test established in Bellas Hess remains valid, the Quill Court held that a corporation without any physical presence in the taxing state lacks substantial nexus to be taxed under the Commerce Clause as interpreted by Complete Auto. ¹⁹ Taken together, Complete Auto, Bellas Hess, and Quill suggest that any state tax violates the Commerce Clause unless, inter alia, it applies to an activity with a substantial, physical presence in the taxing state.

The Superior Court in Lanco failed to recognize the correlation between the findings in Complete Auto, Bellas Hess, and Quill, and instead, focused its opinion on certain language in Quill relating to other taxes as well as several state court decisions since Quill. In addition, the Superior Court steered clear of the issue raised by the Tax Court relating to the appropriate venue for a change in the law – the courts or the legislature. The Superior Court seemed to blindly follow the rationale set forth in the decisions of several other state courts with little accord to the vast precedent that had already been set forth by the United States Supreme Court (Quill, Bellas Hess, Complete Auto, etc.).

While it is true that the Court in Quill expressly noted that the case involved North Dakota use taxes, ²⁰ the Court has cited and applied Quill or Bellas Hess, Quill’s predecessor, in a number of cases involving state taxes other than use taxes, such as income taxes ²¹ and severance taxes. ²²

The New Jersey Superior Court failed to mention the United States Supreme Court decision in Barclays applying the Complete Auto test in an income tax context. ²³ In Barclays, the Court, in discussing the substantial nexus prong, applied Quill and determined that physical presence is not required for a corporation to be included in a combined return if a unitary relationship exists with an affiliate that does have a physical presence in the state. ²⁴ If the Court had intended to apply some other standard in an income tax context, the Barclays case lended sufficient opportunity to do so.

The Court has also noted that its goal in reviewing "state taxes" in cases such as Complete Auto is to "establish a consistent and rational method of inquiry focusing on the practical effect of a challenged tax." ²⁵ That "goal" of establishing a consistent inquiry in state tax cases would be thwarted if in fact different state taxes were subjected to different tests for determining "substantial nexus" depending on the label attached to the tax. That formalism was rejected in Complete Auto. There’s only one Commerce Clause and, therefore, should be only one test for determining substantial nexus.

Based on the numerous decisions issued in recent years, it appears that this will be an ongoing, and perhaps uphill, battle for intangible holding companies in the future. For Lanco, the Superior Court remanded the case back to the Tax Court for resolution of any remaining issues, but stayed the remand in the event of a further appeal. Accordingly, Lanco will have to decide whether to seek further appeal to the New Jersey Supreme Court. Other taxpayers will also face numerous decisions in light of this ruling. Because the Superior Court failed to set forth the appropriate nexus standard, apart from stating that physical presence is not the standard, the implications of this ruling will be particularly challenging to those taxpayers that are not traditional intellectual property holding companies.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.