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On Oct. 23, the New Jersey tax court issued a decision that most tax experts expect will change the direction state income taxation has been taking for the past decade. The new direction will re-open an opportunity for franchisors and other licensors of intellectual property such as trademarks and patents to avoid paying state income taxes by using intellectual property holding companies based in tax-haven states like Delaware and Nevada. The case of Lanco Inc. v. Director, Division of Taxation holds that New Jersey may not impose its income tax on a corporation whose only contact with the state is that it receives license fees from a company using the licensed marks to conduct business in New Jersey. Lanco Inc. is the licensor of Lane Bryant retail outlets. The relevant Lane Bryant facts are indistinguishable from those of Toys “R” Us, whose Delaware holding company was the basis for the South Carolina Supreme Court’s decision in Geoffrey Inc. v. South Carolina Tax Commission. Both parent companies used Delaware holding companies to hold their trademarks and other intellectual property. Both Delaware companies licensed their IP to retail stores operating as separate corporations in other states. Both Delaware companies received royalties from the operating retail units, free of Delaware income tax under � 1902(b)(8) of the Delaware Code. The operating retail units of both companies deducted the royalties they paid to their Delaware sister companies. The South Carolina and New Jersey departments of taxation both tried to assess their state income tax on the royalty income received by the Delaware holding companies. In Geoffrey, the Delaware entity was held to have sufficient “economic nexus” in South Carolina to be subjected to its income tax, and many other state tax departments have jumped on the Geoffrey bandwagon. Although many tax experts believe the Geoffrey case over-reaches the limitations of the Commerce Clause of the U.S. Constitution, this had merely been a theory until the Lanco case. In Lanco, the New Jersey tax court directly considered the Geoffrey approach. The New Jersey decision thoroughly and convincingly traces the development of the Commerce Clause and explains why Geoffrey reaches an unconstitutional result. It concludes that a company must have substantial physical presence in a state in order to be subject to income tax liability there, and concludes that Lane Bryant’s IP holding company did not have the necessary physical presence in New Jersey. WHERE DOES THE LAW STAND NOW? The Lanco decision does not overrule Geoffrey, since the decisions are from different state courts. However, the compelling logic of the Lanco decision is sure to be followed whenever the same issue is litigated in the future. Although it will take a few years, the “economic nexus” theory of Geoffrey has been cut off at its roots, and will certainly die on the vine. Recognizing Geoffrey’s flaws, New Jersey and several other states have already changed their tax approach to one that really does work: “expense disallowance.” By virtue of a 2002 amendment to its income tax law, New Jersey has joined eight other separate-return states (Alabama, Arkansas, Connecticut, Massachusetts, Mississippi, New York, North Carolina and Ohio) during the past two years in disallowing deductions for royalties and interest paid to related parties. This tactic closes the loophole for most IP holding companies without raising constitutional questions. The new expense disallowance provisions are slightly different in each state, which will make for some state-by-state inconsistencies for taxpayers that continue to use IP holding companies to reduce their state income taxes. But their general design is similar, in that the in-state operating company or franchisee is prevented from deducting most interest or royalty expense paid to a related party. The disallowance is triggered by the relationship between the payer and the payee, normally the red flag used by state tax departments to distinguish bona fide business arrangements from tax loopholes. MANY FRANCHISORS EXEMPT These expense disallowance rules will not always apply in the franchise industry. Many franchisors are not related by common ownership with their franchisees. They are unrelated businesses whose valuable assets are their IP, which they license to franchisees. The absence of an ownership relationship will make all the difference. Tax experts predict that states will now stop asserting that the in-state use of IP creates income tax nexus. Instead, their efforts will be focused on adopting and harmonizing their various expense disallowance laws. As they retreat from their unconstitutional nexus attacks on related holding companies, they will also clear the way for the unrelated out-of-state holding companies to return to a sensible tax regime. If a franchisor wants to establish itself in Delaware or Nevada, it needs no longer fear being lumped into the category of corporate tax shelters that has recently fallen so low in public opinion. Unfortunately, the news is still bad for company-owned outlets in the nine states with expense disallowance rules. These units will still incur higher state income taxes due to the disallowance of deductions for their franchise fees. Other states can be expected to join this list. PROPER TAX PLANNING Franchisors can once again safely realize substantial tax advantages from holding and managing their IP in Delaware or Nevada, rather than one of the states that charge income tax on royalties and franchise fees. The rules are clear. Many recent court cases have established what a franchisor should do in order to have “economic substance” in Delaware or Nevada, and to avoid being accused of improper tax sheltering. The industry of so-called “nexus service providers” in Wilmington and Reno is sophisticated and provides good value to its customers. There will still be ways for inattentive franchisors to get this wrong. If your franchise fee revenue is currently taxable in a state, it will be just as important to have evidence you effectively removed it from that state, as it will be important to have evidence of economic substance in Delaware or Nevada. And you can still jeopardize the value of your IP by failing to exert quality control over your franchisees. The devil will always be in the details! Craig R. Tractenberg is a partner in the Philadelphia offices of Nixon Peabody (www.nixonpeabody.com). He is a topics and article editor of the Franchise Law Journal of the American Bar Association. Tractenberg can be reached at [email protected]. Kenneth H. Silverberg has been a partner at Nixon Peabody since 1990, following 20 years of practice as a CPA and as a tax partner with Arthur Andersen & Co. He counsels and represents corporate clients and others in tax and business matters. If you are interested in submitting an article to law.com, please click here for our submission guidelines.

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