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New Jersey’s corporate tax on businesses that draw revenue from the state but have no employees or tangible property there violates the U.S. Constitution’s Commerce Clause, a state judge ruled on Oct. 23. Tax Court Judge Peter Pizzuto rebuked the state’s efforts to tax a Wilmington, Del., company that owns the trademarks of the Lane Bryant clothing stores and collects royalties for their use. The ruling, Lanco Inc. v. Director, Division of Taxation, is significant because many businesses in the state are organized similarly. The state Treasury Department collects an estimated $25 million to $30 million a year from out-of-state holding companies. State officials say they have not decided whether to appeal. The state’s lawyers had pegged their case to a South Carolina Supreme Court precedent, holding a Toys “R” Us affiliate liable for state income taxes, even though it had no employees or offices in the state, because it charged royalties for trademark use in Geoffrey Inc. v. South Carolina Tax Commission. Geoffrey was an interpretation of the U.S. Supreme Court’s ruling in Quill Corp. v. North Dakota, which bifurcated analysis of long-arm taxing statutes under the Commerce Clause and Due Process Clause. The former clause permits state taxation of interstate commerce when the activity at issue has a substantial nexus to the taxing state. The latter requires an entity to have certain minimum contacts with a taxing jurisdiction to support imposition of a tax. The justices in Quill overturned North Dakota’s tax on an out-of-state office-supply company, finding the state had established the minimum contacts required under the Due Process Clause but not the substantial nexus required for taxation under the Commerce Clause. “The decisive question in this case is whether the physical presence requirement confirmed in Quill under the Commerce Clause applies simply to the use tax collection obligation … or whether it is also a necessary element of substantial nexus for the imposition of a state income or franchise tax,” Pizzuto wrote. Geoffrey‘s interpretation of Quill was central to New Jersey’s argument that Lanco Inc. was subject to corporate tax. Geoffrey said Quill gave a use-tax exemption to vendors without a physical presence in the state where their products were delivered. But Geoffrey also found that when liability for state taxation of income is at issue, Quill allows a finding of liability by virtue of intentional use of the state’s market without a physical presence there, Pizzuto said. “This argument is not persuasive,” he wrote. “It does not appear that the differences between the use tax collection obligation, on the one hand, and liability for income taxation are so significant to justify a different rule for each concerning physical presence as an element of Commerce Clause nexus.” Other Supreme Court cases decided before Quill strongly suggest that physical presence is a necessary element of nexus for income taxation, and state court cases decided since Quill do not follow the Geoffrey rule, Pizzuto wrote. “The state is really saying they can reach out and tax pretty much anybody who licenses an intangible in the state,” says Hollis Hyans, a partner in the New York office of San Francisco’s Morrison & Foerster, who represents Lanco. She says Pizzuto’s ruling “looks at the prior cases in this area and concludes very correctly that there’s only one Commerce Clause and it applies equally to the income tax area and the sales tax area. The case often cited by the opposing point of view, Geoffrey, has been widely criticized,” says Hyans. Lanco also was represented by Morrison & Foerster partner Paul Frankel and Charles Costenbader, of counsel at McCarter & English in Newark. The state was represented by Deputy Attorney General Patrick DeAlmeida. He referred questions to Lee Moore, a spokesman for the attorney general’s office, who says only that the state is weighing its options. The Division of Taxation notified Lanco in 1997 that it was required to file corporate tax returns back to 1983. Lanco reached a settlement under an amnesty program in 2002 for all but one of the years at issue in order to keep its appeal alive. Pizzuto’s analysis appears “very well-researched and quite well-reasoned,” says John Coverdale, a tax professor at Seton Hall University School of Law. But Coverdale says he would have given more weight to Quill‘s bifurcation of the Due Process and Commerce clauses. “I personally have always thought the Court did that because they didn’t want to overrule their earlier precedents but they did want to leave the door open to Congress to say yes, states can force collection of use taxes even if they don’t have a physical presence in the state,” says Coverdale. Companies like Lane Bryant create separate business entities that charge fees for use of trademarks to reduce their corporate tax burdens, because the royalty payments are deductible, says Coverdale.

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