Following the precedents set by South Carolina, New York, New Jersey, New Mexico, North Carolina, and other states, the Massachusetts Supreme Judicial Court (“Court”) has upheld the imposition of income tax on an out-of-state intangible holding company that received royalty income from affiliates in Massachusetts but had no physical presence in the state. Following its holding in the recent Capital One case, the Court held that physical presence is not required for an entity to be subject to a state tax based on income. Instead, a taxpayer must only have established substantial nexus with the state. The Court noted that substantial nexus can be established when a taxpayer domiciled in one state carries on business in another state through the licensing of intangible property that generates income for the taxpayer.
Geoffrey, Inc. (“Geoffrey”) was a company incorporated in Delaware and wholly owned by Toys “R” Us, Inc. (“Toys ‘R’ Us”). Geoffrey held all trademarks, trade names, and service marks associated with Toys “R” Us and its related companies, and licensed the intangible property to various Toys “R” Us affiliates for use in their retail operations throughout the United States. Geoffrey did not own any real or tangible personal property in Massachusetts nor did it have any employees or offices located in the state.
Toys “R” Us-Mass, Inc. (“Toys ‘R’ Us-Mass”) was a related company that owned and operated numerous Toys “R” Us, Kids “R” Us, and Babies “R” Us stores in the State of Massachusetts. Toys “R” Us-Mass made royalty payments to Geoffrey in exchange for the use of the intangible property and deducted these payments for purposes of federal taxes. These royalty payments were not added back when calculating their income attributable to the State of Massachusetts. The arrangement was formalized through a licensing agreement between the two companies.
Following an audit of Toys “R” Us-Mass in 2002, it was discovered that the company had not been filing returns in the state despite its receipt of royalty income from a Massachusetts company. The Department of Revenue (“Department”) notified Geoffrey that it had failed to file corporate excise tax returns for the years at issue. After pro forma returns were provided to the Department, Geoffrey was assessed unpaid corporate taxes, interest, and penalties. Geoffrey protested the assessment, but the Commissioner upheld the Department’s findings.
Geoffrey appealed to the Appellate Tax Board (“Board”), which affirmed the Commissioner’s decision, holding that Geoffrey had purposely reaped economic benefits from the state’s retail markets by licensing its intellectual property in the state. The intellectual property was used by three different store chains throughout the state, which resulted in substantial income for Geoffrey. The company was also afforded access to the state and federal courts in Massachusetts to protect its interests if necessary. The Board ruled that these activities were sufficient to create substantial nexus with the state and concluded that imposition of income-based taxes did not violate the Federal commerce clause. The Board also determined that Geoffrey had willfully failed to file returns or pay income taxes in the state, and therefore did not allow for abatement of underpayment penalties. Geoffrey appealed to the courts of Massachusetts, and the Court reviewed the case.
The Court upheld the decision of the Board, disagreeing with Geoffrey’s argument that physical presence was required for a state to impose an income-based tax on an out-of-state taxpayer. Referring to the Capital One case, the Court concluded that substantial nexus could be established where a taxpayer domiciled in one state carries on business in another state through the licensing of intangible property generating income for the taxpayer. The Court maintained that Geoffrey engaged in business activities having a substantial nexus to Massachusetts, including entering into contractual relationships with Toys “R” Us-Mass, heavily marketing to consumers in Massachusetts and appealing to the desires of consumers through the high-quality reputation of goods associated with its trademarks and other intangible property. These activities generated substantial income for Geoffrey, which contributed to the Court’s conclusion that they established a substantial nexus with the state.
Additionally, the Court upheld the imposition of underpayment penalties, holding that Geoffrey willfully failed to file corporate tax returns and pay taxes because they did not exercise ordinary business care and prudence that would be expected of a corporate taxpayer. The Court referred to Department Directive 96-2, issued in 1996, which set forth the Commissioner’s position as to when the ownership and use of intangible property in the state would subject a foreign corporation to taxation. The directive states that the definition of intangible property includes trademarks, trade names, and service marks, all forms of intellectual property used by Geoffrey in Massachusetts. State regulations note that these directives are designed to inform the public of Department policies and practices, as well as assist taxpayers in compliance with state tax laws. Additionally, there was no evidence that Geoffrey had ever sought a letter ruling or guidance from the Department about its potential tax liability in Massachusetts. The Court held that Geoffrey had sufficient notice of the state tax laws and the Board acted properly within its discretion in assessing penalties on the company.
Ryan will closely monitor any future developments associated with this case as they occur. Geoffrey, Inc. v. Commissioner of Revenue, 435 Mass. 17 (2009).
- Practice Areas
- Abandoned and Unclaimed Property
- Business License Tax
- Communications Transaction Tax
- Credits and Incentives
- Employment Tax
- Fuels and Excise Tax
- Income Tax
- Insurance Tax
- International Tax
- Property Tax
- Ryan Advocacy
- Ryan Software
- Severance Tax
- Tax Compliance
- Tax Technology
- Transaction Tax
- Value-Added Tax