Indiana Nexus for Intellectual Property

A s various states continue to look for ways to increase and maximize their tax revenues, they frequently focus on nexus. At the same time, businesses with significant intangible assets try to minimize their state tax costs through the use of out-of-state subsidiaries that hold intellectual properties (IPs).

In Letter of Finding No. 95-0401, issued June 1, 2002, Indiana joined the ranks of those states broadening their definition of nexus, when it found that an out-of-state company had nexus with the state and was subject to adjusted gross income (AGI) and gross income taxes on IP royalty income.

The taxpayer was a wholly owned subsidiary of an Indiana parent that manufactured parts and owned patents, trademarks and other IP. The taxpayer was a Delaware holding company and maintained an office in that state. It had no office, employees or tangible personal property in Indiana.

After its incorporation, the parent assigned all its IP to the taxpayer in exchange for all the taxpayer's stock. The decision was made “to insulate and protect [the intellectual property] from the day-to-day operational and financial risks of the [parent's] business.”

The parent paid the taxpayer $500,000 for the exclusive right to use the IP, and agreed to fees of 5% of the annual gross sales of certain products. The taxpayer paid a $500,000 dividend to the parent on the day it received the $500,000 fee from the parent; the taxpayer also routinely loaned to the parent the same amounts as the parent paid it in royalties.

On audit, the Indiana Department of Revenue (DOR) held the taxpayer subject to AGI and gross income taxes. In support of its findings, the DOR cited Geoffrey, Inc. v. South Carolina Tax Comm'n, 313 SC 15 (1993), noting “[i]t is well settled that the taxpayer need not have a tangible, physical presence in a state for income to be taxable there. The presence of intangible property is sufficient alone to establish nexus.” The DOR concluded that Indiana was the business situs of the intangible property and that all of the taxpayer's income was Indiana income, because it was derived from that IP.

In addition, the DOR cited the following facts:

1. The taxpayer's income-producing assets consisted solely of the parent's IP.

2. The taxpayer licensed the property exclusively to the in-state parent.

3. All of the taxpayer's income consisted of royalties from the parent and interest on that royalty income and from loans.

4. A lack of evidence that the loans were ever repaid.

5. The return of the royalty income to the parent via loans.

6. The parent's continued ownership of and control over the IP (including the use of the property as security by the parent to obtain unrelated financing).

“Business situs,” which is necessary for a taxpayer to be subject to taxation in Indiana, is defined as “the place at which intangible personal property is employed as capital; or the place where the property is located if possession and control...is localized in connection with a trade or business.”

The DOR also noted, “[t]he rule that the taxable situs of intangibles is at the technical domicile of the owner is but a mere fiction, and will not be followed when the fact is clear that the intangible property has a situs elsewhere” (Wheeling Steel Corp. v. Fox, 298 US 193 (1936)).

Other states have not been as successful as Indiana, and other taxpayers have been more successful. In 2000, the Baltimore City Circuit Court found for the taxpayers in two separate, similar cases. In one, SYL, Inc., No. 24-C-99-002389 AA (3/17/00), the Maryland Comptroller of the Treasury relied on Geoffrey; the court rejected this, because the decision dealt with South Carolina law and was not a precedent for Maryland. In addition, it found that the taxpayer maintained an office with employees, furniture, a bank account, etc., in Delaware.

With increasing pressure on states to maximize revenue, taxpayers considering formation of a separate, out-of-state corporation for their IP would be wise to be aware of the current approach toward nexus in a parent's state and to structure their activities and details so as to bolster their position.

From Karen Dederyan, Gray, Gray & Gray, LLP, Boston, MA