The New Jersey tax court denied an intellectual property (IP) holding company’s summary judgment request regarding income tax nexus because the necessary facts were not properly before it.
IP Holding Company’s Structure
The taxpayer was a Delaware holding company with offices located in Illinois. It owned and developed intellectual property such as patents, know-how, technology, and trademarks.
The company’s affiliate developed, manufactured, marketed, and sold containers, related products and provided associated services. The affiliate had New Jersey-based customers and did business in New Jersey.
The company had two license agreements with the affiliate granting it the right to use certain IP owned by the company. Under the agreements, the affiliate paid royalties of:
- 3% on net sales of the licensed products; and
- 2.8% on the licensed IP.
In addition, the company granted an exclusive license to the affiliate for other IP. The affiliate paid the company 50% of the royalties it received for any sublicenses of that exclusive IP.
New Jersey Audit
New Jersey audited the company and:
- assigned all the royalty payments to the company;
- apportioned all the royalty income to the company using the affiliate’s apportionment factor; and
- assessed over $2 million in tax liability, including interest and penalties.
The company’s Illinois combined return did not include the royalty income in numerator of the company’s Illinois sales fraction. So, New Jersey apportioned 0% of that income to Illinois.
Company Denies Nexus Exists with New Jersey
The company claimed it did not have nexus with New Jersey. It argued that New Jersey’s taxation would violate the Due Process Clause in the U.S. Constitution or the substantial nexus factor under the Commerce Clause.
The company claimed its only connection to New Jersey was the use of its IP by the affiliate in New Jersey. For example, the affiliate’s use of the IP on:
- employees’ business cards, stationary, or other advertising material given to potential customers;
- shipping materials used to ship the affiliate’s products into New Jersey; and
- products, but only in an inconspicuous manner.
The affiliate rented storage space in New Jersey for packaging products during certain periods. But neither the affiliate nor any related member owned, used, or leased any office, retail outlet, warehouse, or other building in New Jersey.
Applying Lanco, Inc. v. Dir. Div. of Taxation, New Jersey argued the company was doing business in New Jersey because the company received New Jersey-sourced royalty income. Under Lanco, a taxpayer’s economic presence in New Jersey satisfies the Commerce Clause nexus standard if the taxpayer has royalty income from the use of its IP by an affiliate in New Jersey.
Facts Introduced at Oral Argument
In the hearing for summary judgment, the company argued it did not have nexus with New Jersey under Lanco. Facts distinguishing the company from the taxpayer in that case included:
- the company was not a standard, passive, shell Delaware holding company that owned and licensed IP to a subsidiary;
- the affiliate was not a retailer;
- the affiliate never manufactured products in New Jersey;
- the affiliate’s customers were not retailers;
- the affiliate manufactured special order packaging products;
- neither the company nor the affiliate had any control over where or how customers sold their products contained in the affiliate’s packages; and
- the company’s IP was used at most in three instances and it was barely visible on the affiliate’s products.
Tax Court Analysis
The tax court did not find for summary judgment. The company introduced many facts for the first time at oral argument. New Jersey needed the opportunity to make a factually based determination. Until New Jersey had that opportunity, the court could not rule that the company did not have nexus.
Despite its ruling, the court did discuss the facts of Lanco and the facts presented by the company at oral argument. It noted questions that those facts raise.
The court noted that like the taxpayer in Lanco:
- the company owned and licensed IP to a New Jersey affiliate for the manufacture and sale of the affiliate’s products;
- it received royalty income based on the net sales amount; and
- its affiliate had New Jersey-based customers and did business in New Jersey.
However, the court agreed that some of the facts could raise questions about New Jersey’s authority to require filings. Among those questions:
- Did the taxpayer’s remoteness from the use of its IP and lack of control over placement of the affiliate’s products in New Jersey raise Due Process or Commerce Clause issues?
- Did the taxpayer purposefully avail itself of New Jersey’s economic market?
- Did the taxpayer purposefully exploit the New Jersey market and have more than a de minimis presence in the state?
- Did the taxpayer’s royalty income from New Jersey sources create either minimum contacts for Due Process Clause purposes or substantial nexus for Commerce Clause purposes?
The court reasoned that even if the company received royalty income from the use of IP in New Jersey it could show that it lacked minimal contacts or derivate nexus. The licensing agreements indicated the company intended the affiliate to use the IP on a world-wide basis, including New Jersey. However, the company’s lack of control over where and how the affiliate’s customers sold their products could weaken the “purposeful availment” factor of the nexus test.
The company could also lack the quality or quantity of contacts necessary to be substantial under the Commerce Clause and Due Process Clause analysis. Lanco did not address this issue.
By Andrew Soubel, J.D.