State Tax Alert: New Jersey Supreme Court Holds Physical Presence Principle Inapplicable for Corporation Business Tax Purposes

Tax Controversy Alert

Businesses have long relied on the principle -- found in the Supreme Court’s jurisprudence and grounded in the Due Process and Commerce Clauses -- that a state may impose its taxes on a business only if that business has some minimal physical presence in the state. But in a recent decision, the New Jersey Supreme Court squarely defied this principle and imposed New Jersey income taxes on an intangible property holding company with no physical presence in New Jersey. This decision might impact many taxpayers, not just those with intangible property holding companies.

Lanco, Inc. v. Director, Division of Taxation

On October 12, 2006, the New Jersey Supreme Court held that, notwithstanding the Due Process and Commerce Clauses, New Jersey could apply its Corporation Business Tax (“CBT”) to Lanco, Inc. despite Lanco’s lack of physical presence in New Jersey.1  Lanco is a Delaware intangible property holding company that holds certain trademarks, trade names, and service marks that it licenses to its corporate affiliate, Lane Bryant, Inc., a clothing retailer with stores in New Jersey and other states. Lanco has no physical connection whatsoever to New Jersey (that is, no employees, real estate, rental property, tangible personal property, etc.). Lanco argued that the U.S. Supreme Court’s holding in Quill Corp. v. North Dakota, 504 U.S. 298 (1992) precludes the imposition of state income taxes when the taxpayer has no physical presence in the taxing state.

New Jersey did not seek to sham the royalty payments, invoke judicial anti-abuse doctrines, or contest payments based upon the affiliated status of the licensor and licensee. Instead, New Jersey argued that merely licensing intangibles to an in-state licensee triggers a taxable presence in New Jersey for CBT purposes. In an astonishingly brief opinion that provides little in the way of analysis, the New Jersey Supreme Court wrote that Lanco’s reliance on the Quill holding was misplaced because the court did not believe that “the Supreme Court intended to create a universal physical presence requirement for state taxation under the Commerce Clause.” See Lanco, 2006 N.J. LEXIS at *4. This limited interpretation of the Supreme Court’s physical presence standard in Quill -- that the physical presence requirement applies only to state sales and use taxes -- has been gaining traction in recent years with some courts and has caused a division of authority among state courts.2  The court sidestepped Lanco’s argument that Quill precludes the imposition of a state income tax without physical presence because income taxes are economically more burdensome than sales and use taxes, an argument that some courts adopt and many practitioners endorse. In essence, state income taxes represent a far heavier economic burden on businesses than state sales and use taxes because income taxes affect a business’s bottom line; sales and use taxes merely require businesses to collect and remit the taxes.

What Lies Ahead?

The Lanco decision should concern many U.S. taxpayers, especially those who license intangible property. Lanco exacerbates the growing divide in state case law regarding the physical presence principle, and Lanco is important because New Jersey is perhaps the most commercially significant state to repudiate the principle in the context of state income taxes. Many states have an insatiable appetite for revenue and will undoubtedly draw strength from the Lanco holding as they have from the South Carolina Supreme Court’s ruling in Geoffrey, Inc. v. S.C. Tax Comm’n, 437 S.E.2d 13 (S.C. 1993) (holding no physical presence required), cert. denied, 510 U.S. 992 (1992) and its progeny. This will especially be true if Lanco files a certiorari petition and the U.S. Supreme Court denies it.

The U.S. Supreme Court has declined to review a number of state tax nexus cases since Quill, but the growing split in authority may prompt the Court to consider Lanco. On the legislative front, Congress considered legislation that would codify a physical presence standard for state income tax purposes but did not act on the legislation during the last session. See Business Activity Tax Simplification Act of 2006, H.R. 1956, 109th Cong. (2nd Sess. 2006); see also H.R. Rep. No. 109-575 (2006). That legislation faces stiff opposition from organizations like the National Governors Association, which believes the legislation constitutes a significant “unfunded mandate.”

In the wake of Lanco, companies need to evaluate their potential state tax exposure related to issues such as licensing arrangements -- especially, but not exclusively, those between affiliates -- given the possibility of open-ended assessments by taxing authorities.3  Companies need to evaluate this potential exposure for SFAS 109 and FIN 48 purposes, and businesses exploring possible mergers or acquisitions need to consider this issue when determining deal consideration and indemnification provisions.

1  See Lanco, Inc. v. Dir., Div. of Taxation, 2006 N.J. LEXIS 1339 (N.J. Oct. 12, 2006), aff’g 379 N.J. Super. 562, 879 A.2d 1234 (N.J. Super. Ct. App. Div. 2005), rev’g 21 N.J. Tax 200 (N.J. Tax Ct. 2003)

Compare Geoffrey, Inc .v. Okla. Tax Comm’n, 132 P.3d 632 (Okla. Civ. App. 2005) (holding physical presence unnecessary to impose income tax in intangible holding company context); A&F Trademark, Inc. v. Tolson, 605 S.E.2d 187 (N.C. Ct. App. 2004) (holding physical presence unnecessary to impose income tax in intangible holding company context), cert. denied, 126 S.Ct. 353 (2005); Kmart Properties, Inc. v. Tax & Rev. Dept.,131 P.3d 27 (N.M. Ct. App. 2001) (holding physical presence unnecessary to impose income tax in intangible holding company context); and Sec’y, Dept. of Rev. v. Gap (Apparel), Inc., 886 So.2d 459 (La. Ct. App. 2004) (holding physical presence unnecessary to impose income tax in intangible holding company context), with Lanco, 21 N.J. Tax 200 (holding physical presence necessary to impose income tax in intangible holding company context); Rylander v. Bandag Licensing Corp., 18 S.W.3d 296 (Tex. App. 2000) (holding physical presence necessary to impose franchise tax on intangible property holding company that possessed a Texas certificate of authority to conduct business); Acme Royalty Co. v. Dir. of Rev., 96 S.W.3d 72 (Mo. 2002) (holding MO income tax inapplicable to intangible property holding company because taxpayer owned no property and had no activities or sales in the state). Cf. J.C. Penney Nat’l Bank v. Johnson, 19 S.W.3d 831, 839 (Tenn. Ct. App. 1999) (holding physical presence required for income taxation in context of DE banking corporation with credit card activity in TN), cert. denied, 531 U.S. 927 (2000)

The New Jersey Tax Court mentioned in a footnote that the original determination of the Division of Taxation required filings for Lanco beginning in 1983. See Lanco, 21 N.J. Tax, at fn. 1.

For additional information, please contact any of the following lawyers:

Alan I. Horowitz,, 202-626-5839

Michael M. Lloyd,, 202-626-1589

Related Files
Related Links

The information contained in this newsletter is not intended as legal advice or as an opinion on specific facts. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. For more information about these issues, please contact the author(s) of this newsletter or your existing Miller & Chevalier lawyer contact. The invitation to contact the firm and its lawyers is not to be construed as a solicitation for legal work. Any new lawyer-client relationship will be confirmed in writing.

This newsletter is protected by copyright laws and treaties. You may make a single copy for personal use. You may make copies for others, but not for commercial purposes. If you give a copy to anyone else, it must be in its original, unmodified form, and must include all attributions of authorship, copyright notices and republication notices. Except as described above, it is unlawful to copy, republish, redistribute, and/or alter this newsletter without prior written consent of the copyright holder.