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You Cant Hide Those Trademarks Anymore

A new ruling exposes property in out-of-state holding companies to corporate taxesBIZ SPOTLIGHT – Tax Planning

When is a company operating in New Jersey exempt from the state’s business tax?

Essentially never, thanks to a New Jersey State Supreme Court ruling that last month closed a loophole in the state’s tax law related to treatment of intellectual property, such as patents and trademarks.

What does the ruling mean for New Jersey? About $190 million for the state’s corporate tax coffers, according to the state department of treasury. In the case, Lanco, Inc. v. Director, Div. of Taxation, the Supreme Court ruled that businesses could not shield intellectual property from the state’s corporate business tax by moving it under the umbrella of a Delaware holding company that then licenses it back to the New Jersey entity. According to the department of treasury, the ruling has implications for about 170 Garden State firms.

“It’s a big victory for the [New Jersey] Division of Taxation,” says Marc S. Friedman, chairman of the intellectual property group at Newark-based law firm Sills Cummis Epstein & Gross. “It’s going to raise substantial additional revenues [for the state]. Until such time as Lanco is reversed, it’s going to result in substantial tax revenue increases for New Jersey. Nearly $200 million is a lot of money.”

The seeds of the Lanco case were planted in 1996 when New Jersey adopted a tax aimed at the millions of dollars that New Jersey businesses—mostly retailers, consumer-product makers and manufacturers with valuable trademarks and patents—were sending to Delaware subsidiaries that technically owned their intellectual property.

Columbus, Ohio-based Lane Bryant, which was dunned because it had 25 stores in the state had formed Lanco and transferred its trademarks to the subsidiary. As a result of this maneuver, Lane Bryant paid Lanco royalties out of its New Jersey revenues, reducing the income that could be captured by the state’s business tax.

After an audit by New Jersey Taxing Authority, the state’s director of taxation decided to recalculate Lane Bryant’s tax bill. In response, Delaware-based Lanco, which holds the trademarks of the plus-size women’s clothes retailer, in 1996 challenged the state’s new rule in court.

A New Jersey judge decided in 2003 that the state’s attempt to collect from Lanco violated the Commerce Clause of the U.S. Constitution because Lanco had no physical presence in New Jersey.

“Lanco likely said, ‘Look, we have no presence in New Jersey; we are a Delaware corporation,’” Friedman says. “‘We have no real estate, no property and no employees in New Jersey, therefore, you can’t tax us.’”

The state appealed, and the New Jersey Supreme Court ultimately took its side. Now any company that conducts business here or whose intellectual property is used or sold here will be subject to New Jersey’s Corporation Business Tax.

“What this case says is that even though this Delaware holding company does not have any physical presence in New Jersey, the fact is that their franchise is being used in New Jersey,” says Brad D. Shalit, senior associate in Taxation and Estate Planning in the Roseland-based Connell Foley.

“If somebody wasn’t paying them for its use, they would be able to come to New Jersey and get protection under New Jersey law,” he says. “So even though there isn’t a physical presence in New Jersey, the company is subject to New Jersey taxation,” Shalit adds.

The court’s ruling will likely have a chilling effect on companies considering launching a Delaware holding company to cut their tax bill.

“Companies that are largely based in New Jersey will no longer go through the process of forming Delaware subsidiaries and transferring the intellectual subsidiaries,” Friedman says.

Some companies, Friedman says, may also consider reacquiring the intellectual property from their Delaware subsidiary and then dissolving the Delaware arm.

“Because if the only reason for doing this is to take advantage of the Delaware state income tax exemption,”Friedman says, “it doesn’t make sense now for some companies to have to maintain a Delaware corporation and the expenses associated with it.”

The state stands to collect a windfall of additional tax revenue with the ruling, but it could find a downside as well.

“New Jersey’s biotech companies, which are largely made up of intellectual property, are going to feel some impact from this decision,” Friedman says. “There are New Jersey biotech companies that have transferred their intellectual properties to Delaware subsidiaries. They, without a doubt, are going to be affected by this.”

New Jersey is not alone is casting a net for these hidden dollars. State taxing authorities around the country have been scrutinizing subsidiaries of local corporations to see whether companies have off-loaded their intellectual property into a state—usually Delaware—where it won’t be taxed. The question as to whether states can tax outside holding companies has been gaining momentum across the country as they search for new revenue streams to narrow budget gaps.

In 1993 South Carolina won a landmark tax case when its Supreme Court gave the state the right to tax the royalties Toys “R” Us stores paid to Geoffrey, a Delaware subsidiary created in 1984 by the Wayne-based chain. Courts in North Carolina, Oklahoma, New Mexico and Maryland have also sided with state governments that wanted to tax these holding companies.

However, the New Jersey and South Carolina rulings are far from universal. Michigan, Texas and Tennessee courts have ruled the other way, saying the Delaware holding company has to have a physical presence in any state that wants to tax its income.

Shalit says the Lanco decision could contribute to New Jersey’s reputation as a high-tax, antibusiness state. “New Jersey is very onerous in its taxation of business,” says Shalit. “There is a general policy underlying tax that you shouldn’t impose a tax on people going into business because you want to foster business, you don’t want to hamper it.”

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