FIN 48 Forces Companies to Wrestle with Uncertain State Nexus Standards

By Michael S. Schadewald

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Under FIN 48, a corporation may recognize the benefit of an uncertain tax position only if there is a more than 50% likelihood that the tax position will be sustained upon examination. In making this determination, it is assumed that the tax position will be audited and that the taxing authority has full knowledge of all relevant information. Thus, the determination of whether a tax position will be sustained is based solely on the technical merits of the position, including the applicable tax laws and the relevant facts and circumstances. If the past administrative practices and precedents of the taxing authority are widely understood, they should be taken into account as well.

State Nonfiling Positions Pose Unique Challenges

Forty-five states and the District of Columbia impose corporate income taxes. It is clear that a corporation must file an income tax return in a state in which it has a regular physical presence, such as an office or other fixed place of business. It is not always clear, however, whether a corporation must file an income tax return in a state in which it has customers but no physical presence. Nexus is the concept used to describe the threshold level of in-state business activity that gives a state jurisdiction to impose a tax on an out-of-state corporation.

Accountants face two dilemmas when applying FIN 48 to a position that a business is not required to file an income tax return in a particular state. First, there is a substantial controversy over whether a corporation must file returns and pay income tax in a state in which it derives a significant amount of income but has no physical presence. Because nexus is a gray area of the law, it may be difficult to conclude that there is a more than 50% likelihood that a nonfiling position will be sustained in such states. Second, if this more-likely-than-not recognition threshold is not met, FIN 48 requires a corporation to record a liability for the full amount of the potential unpaid state income taxes, including interest and any penalties. Recording this contingent liability is problematic—if a return is not filed in a state, the statute of limitations never closes and the liability may remain on the corporation’s balance sheet indefinitely.

The severity of the problem is highlighted by a January 8, 2007, comment letter to FASB (FASB File Reference 1215-U01) from the Council on State Taxation, a leading trade association devoted to state tax issues. According to the letter, “the problem with FIN 48 and nexus is so great that at least one accounting firm has publicly suggested that businesses should consider filing and paying taxes in jurisdictions where they may not have nexus because the alternative under FIN 48 (indefinite reserves, interest, and penalties) is too large a dollar figure for the financial statement to bear.”

Constitutional Protections Against State Taxation

States generally attempt to impose income taxes on out-of-state corporations to the fullest extent permissible under the U.S. Constitution. Therefore, a corporation generally must file an income tax return in any state in which its in-state business activity creates a “constitutional nexus.” The only other federal restriction on state tax jurisdiction is the limited protection provided by Public Law 86-272 (1959), which prohibits a state from imposing a net income tax on an out-of-state corporation that strictly limits its in-state business activity to representatives soliciting orders for sales of goods.

A corporation has constitutional nexus in any state in which the requirements of both the Due Process Clause and the Commerce Clause are satisfied. The Due Process Clause provides that no state shall “deprive any person of life, liberty or property, without due process of law.” To satisfy this requirement, there must be a “minimum connection” between the state and the corporation it seeks to tax [Miller Bros. Co. v. Maryland, 347 U.S. 340 (1954)]. The Commerce Clause gives Congress the power to regulate interstate commerce, and prohibits states from imposing taxes that unduly burden interstate commerce. Among other things, this means a state may tax a corporation only if its activities have a “substantial nexus” with the state [Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977)].

In 1967, the Supreme Court established the principle that constitutional nexus requires an in-state physical presence [National Bellas Hess, Inc. v. Dept. of Revenue, 386 U.S. 753 (1967)]. Bellas Hess was a mail-order vendor based in Missouri. It solicited orders for merchandise through the mail, and made deliveries by mail or common carrier. The Court ruled that Illinois could not force Bellas Hess to collect sales tax on sales to Illinois residents because Bellas Hess had no offices, outlets, tangible property, salespersons, or any other type of physical presence in Illinois. The Court reasoned that a mail-order vendor “whose only connection with customers in the State is by common carrier or the United States mail” should not be required to collect sales tax because this could entangle the interstate business in a “welter of complicated obligations.”

In 1992, the Supreme Court reaffirmed the Bellas Hess physical-presence test in another mail-order/sales tax case [Quill Corp. v. North Dakota, 504 U.S. 298 (1992)]. Quill was a mail-order vendor of office supplies that had no physical presence in North Dakota. The Court concluded that an in-state physical presence was required to satisfy the “substantial nexus” test under the Commerce Clause, and therefore North Dakota could not force Quill to collect sales tax on sales within the state. Notably, however, the decision did not specifically address the issue of whether the physical-presence test also applied to income tax nexus.

Economic Nexus Issue

Since the Supreme Court’s ruling in Quill, a major controversy has been whether the Bellas Hess physical-presence test for constitutional nexus applies to income taxes. Many states assert that a physical presence is not required for income tax nexus, and that a significant economic presence (i.e., deriving a substantial amount of income from sources within the state) is sufficient to create income tax nexus. This “economic nexus” concept has been the subject of extensive litigation, and state courts have issued conflicting rulings. The highest courts in several states have ruled that the Bellas Hess physical-presence test does not apply to income taxes, whereas appellate courts in several other states have come to the opposite conclusion. This controversy makes it difficult for a corporation to conclude that FIN 48’s more-likely-than-not recognition threshold is met with respect to a nonfiling position in a state where the corporation derives significant income but has no physical presence.

Historically, the theory of economic nexus has been a tool that states have used to combat the use of trademark holding companies (also known as intangible property companies or passive investment subsidiaries). In a nutshell, this tax-avoidance strategy involves the transfer of valuable trademarks to a Delaware holding company, which then licenses the use of the trademarks to related operating companies. The royalty payments are potentially deductible by the operating affiliates, but the royalty income of a trademark holding company is not taxed by Delaware. In an attempt to tax the royalties paid to the out-of-state holding company, many states assert that the licensing of intangibles for use in a state is sufficient to create income tax nexus.

States Ruling that Physical Presence Is Not Required

The first state supreme court to rule that an out-of-state corporation “need not have a tangible, physical presence in a state for income to be taxable there” was South Carolina, in Geoffrey, Inc. v. South Carolina Tax Commission [437 S.E.2d 13 (S.C. 1993)]. Geoffrey, Inc., was the Delaware trademark holding company of the toy retailer, Toys “R” Us. Geoffrey licensed the use of its intangibles to affiliates operating stores in South Carolina, but did not have a physical presence in the state. The South Carolina Supreme Court concluded that “by licensing intangibles for use in this State and deriving income from their use here, Geoffrey has a ‘substantial nexus’ with South Carolina,” as required by the Commerce Clause.

Geoffrey motivated numerous states to enact statutes or promulgate regulations which asserted that the licensing of intangibles for use in the state is sufficient to create income tax nexus. Appellate courts in several states have upheld these laws, ruling that the Bellas Hess physical-presence test does not apply to income taxes [see Kmart Properties, Inc. v. Taxation and Revenue Dept. of New Mexico, 131 P.3d 27 (N.M. Ct. App. 2001), writ quashed, 131 P.3d 22 (N.M. 2005); A&F Trademark, Inc. v. Tolson, 605 S.E.2d 187 (N.C. 2004), cert. denied, 611 S.E.2d 168 (N.C. 2005), cert. denied, 126 S.Ct. 353 (2005); Geoffrey, Inc. v. Oklahoma Tax Commission, 132 P.3d 632 (Okla. Civ. App. 2005; and Bridges v. Geoffrey, Inc, La. Ct. App., No. 2007 CA 1063 (Feb. 8, 2008)]. Each case involved a Delaware trademark holding company licensing the use of its intangibles to affiliates operating retail stores. For example, the A&F Trademark case involved the clothing retailer Abercrombie & Fitch.

The most recent high-profile economic nexus case dealing with trademark holding companies is Lanco, Inc. v. Division of Taxation [908 A.2d 176 (N.J. 2006); cert. denied, U.S. Sup. Ct., 06-1236, June 18, 2007]. The New Jersey Supreme Court ruled that the Delaware trademark holding company of the clothing retailer Lane Bryant had income tax nexus in New Jersey, even though it had no physical presence in the state. The court concluded that “the better interpretation of Quill is the one adopted by those states that limit the Supreme Court’s holding to sales and use taxes.” The court also stated that “we do not believe that the Supreme Court intended to create a universal physical-presence requirement for state taxation under the Commerce Clause.”

A recent decision by the West Virginia Supreme Court of Appeals makes it clear that the economic nexus issue is not limited to licensing intangibles for use in a state. In Tax Commissioner v. MBNA America Bank, N.A. [640 S.E.2d 226 (W. Va. 2006); cert. denied, U.S. Sup. Ct., 06-1228, June 18, 2007], the taxpayer was a Delaware bank that issued credit cards, extended unsecured credit, and serviced the credit card accounts of customers nationwide. Although MBNA did not have a physical presence in West Virginia, during one of the tax years in question, it derived more than $10 million of gross receipts from customers in the state. The West Virginia Supreme Court of Appeals concluded that the Bellas Hess physical-presence test “applies only to state sales and use taxes and not to state business franchise and corporation net income taxes,” and that MBNA had “a significant economic presence sufficient to meet the substantial nexus” test under the Commerce Clause. The court also made the following observation:

[W]e believe that the Bellas Hess physical-presence test, articulated in 1967, makes little sense in today’s world. In the previous almost forty years, business practices have changed dramatically. When Bellas Hess was decided, it was generally necessary that an entity have a physical presence of some sort, such as a warehouse, office, or salesperson, in a state in order to generate substantial business in that state. This is no longer true. The development and proliferation of communication technology exhibited, for example, by the growth of electronic commerce now makes it possible for an entity to have a significant economic presence in a state absent any physical presence there. For this reason, we believe that the mechanical application of a physical-presence standard to franchise and income taxes is a poor measuring stick of an entity’s true nexus with a state.

States Ruling that a Physical Presence Is Required

In J.C. Penney National Bank v. Johnson [19 S.W.3d 831 (Tenn. Ct. App. 1999), aff’d, No. M1998-00497-SC-R11-CV (Tenn. 2000), cert. denied, 531 U.S. 927 (2000)], the Tennessee Court of Appeals ruled that a Delaware bank’s credit card activities did not create income tax nexus because the bank did not have a physical presence in the state. The court reasoned that “[w]hile it is true that the Bellas Hess and Quill decisions focused on [sales and] use taxes, we find no basis for concluding that the analysis should be different in the present case.” Likewise, in Rylander v. Bandag Licensing Corp. [18 S.W.3d 296 (Tex. App. 2000), review denied, No. 00-0646 (Tex. 2001)], the Texas Court of Appeals concluded that: “While the decisions in Quill Corp. and Bellas Hess involved sales and use taxes, we see no principled distinction when the basic issue remains whether the state can tax the corporation at all under the Commerce Clause.” In Guardian Industries Corp. v. Dept. of Treasury [499 N.W.2d 349 (Mich. Ct. App. 1993), appeal denied, 512 N.W.2d 846 (Mich. 1994)], the Michigan Court of Appeals concluded that “after Quill, it is abundantly clear that [a taxpayer] must show a physical presence within a target state to establish a substantial nexus to it.” Finally, in ACME Royalty Co. and Brick Investment Co. v. Department of Revenue [96 S.W.3d 72 (Mo. 2002)], the Missouri Supreme Court ruled that, based on the applicable state statutes, licensing intangibles for use in Missouri was not sufficient to create income tax nexus; the opinion did not, however, discuss the Bellas Hess physical- presence test.

Need for Federal Intervention

The U.S. Supreme Court has the ability to resolve the economic nexus controversy, and the issuance of FIN 48 provides the Court with an additional motivation for doing so. One option would be to clarify that the Bellas Hess physical-presence test applies to income tax nexus. This would make it easier to conclude that FIN 48’s more-likely-than-not recognition threshold is satisfied with respect to a nonfiling position in a state from which the corporation derives significant income but has no physical presence. The Supreme Court’s other option would be to clarify that a significant economic presence is sufficient to create income tax nexus. A key issue under this option would be the types or amounts of in-state income that would justify taxation. The Multistate Tax Commission, an intergovernmental state tax agency based in Washington, D.C., has proposed that an appropriate nexus standard is annual in-state sales of more than $500,000 [“Factor Presence Nexus Standard for Business Activity Taxes,” released October 17, 2002].

In both the Lanco and MBNA America Bank cases, the taxpayer filed petitions for a writ of certiorari with the U.S. Supreme Court. On June 18, 2007, the Court denied both petitions, which suggests that it does not want to address the economic nexus issue at this time. In the near term, then, it may be up to Congress to resolve the issue.

Congress has the authority under the Commerce Clause to enact federal legislation to define the threshold level of business activity that creates income tax nexus. During the 109th Congress, bills were introduced in the House and the Senate to create physical presence standards for income tax nexus [H.B. 1956, introduced April 28, 2005, and S.B. 2721, introduced May 4, 2006]. Neither bill was enacted into law. The Business Activity Tax Simplification Act [H.B. 1956] generally would have prohibited a state from imposing an income tax unless a corporation had a physical presence in the state on more than 21 days during a tax year. Similar legislation has been introduced in the 110th Congress [H.R. 5267, introduced Feb. 7, 2008]. In light of the Supreme Court’s refusal to grant certiorari in Lanco and MBNA America Bank, there may be increased pressure on Congress to enact nexus legislation.

Absent a resolution of the issue at the federal level, state courts will remain split as to whether the Commerce Clause permits a state to impose an income tax on a corporation that has a significant economic presence in a state but no physical presence. This gray area of the law often makes it difficult for a corporation to conclude that FIN 48’s more-likely-than-not recognition threshold is satisfied with respect to a nonfiling position in a state where the corporation derives a significant amount of income but has no physical presence. FIN 48 makes the state tax nexus controversy an important financial reporting issue, with potential consequences for corporate shareholders and the financial markets.

©2008 The New York State Society of CPAs. Legal Notices