The U.S. Bankruptcy Court has held that imposition of the Oregon corporate excise tax upon a parent holding company violated the Due Process and Commerce Clauses of the U.S. Constitution1 as the parent had no property or employees in Oregon and had no sales or other revenue directly attributable to Oregon sources. The parent filed a mandatory unitary Oregon consolidated return on behalf of itself and its subsidiaries for the tax years at issue. The parent was not liable for the tax of its subsidiaries merely because it allowed the subsidiaries to use the parent company's intellectual property without charge.
Background
The taxpayer, a parent holding company ("Parent") located outside Oregon and lacking any operations of its own, owned subsidiaries engaged in banking-related operations throughout the United States, including Oregon. Together with these subsidiaries, Parent filed consolidated tax returns from 1999 through 2005 in its name for both federal and Oregon tax purposes.
After a credit rating downgrade caused a severe bank run in September 2008, the Federal Deposit Insurance Corporation (FDIC) seized and sold substantially all the assets of the taxpayer's subsidiaries. Parent then filed a petition for bankruptcy under Chapter 11 of the Bankruptcy Code. Later that year, the Oregon Department of Revenue conducted an audit of the Oregon consolidated tax returns for the 2002 through 2006 filing periods and assessed additional corporate excise tax plus interest and penalties amounting to over $29 million. The Department then filed a proof of claim in the bankruptcy proceedings, seeking payment from Parent. A liquidating trust ("Trust"), which was subsequently designated as the successor in interest to Parent, filed an objection to the proof of claim in the U.S. Bankruptcy Court.
The issue before the Court was whether the corporate excise tax assessment on Parent violated the Due Process and Commerce Clauses of the U.S. Constitution.
Oregon Consolidated Tax Returns
A corporation that is part of a unitary group that is included in a federal consolidated return must be included in a consolidated Oregon return even of the corporation is not doing business in Oregon.2 Under Oregon law, "generally, the consolidated return shall be filed by and in the name of the common parent corporation."3 However, the applicable statute also provides that in the event the common parent is not a member of the affiliated group, or is not subject to Oregon's taxing jurisdiction, the return must be filed in the name of the member with the "greatest presence" in Oregon.4
The Department took the position that by filing the Oregon consolidated returns in Parent's name, Parent had effectively admitted that it was doing business in Oregon and subject to Oregon's taxing jurisdiction. Moreover, the Department argued that Parent's "tax liability shall be joint and several with any other corporation that is included in a consolidated state return with the corporation."5 However, members of an affiliated group are not treated as a single taxpayer for purposes of determining whether any member is subject to Oregon excise tax.6
The Trust asserted that by naming Parent on the consolidated state returns, it was only acting in compliance with a law, which mandates all members of a federal affiliated group to be consolidated for Oregon tax purposes. Consequently, the Trust maintained that naming Parent in the Oregon tax returns was not an admission of any tax liability.
Declining to reach a decision based on the merits of these arguments, the Court next turned to the constitutional challenges brought by the Trust.
Constitutionality of Tax Assessment
The Trust asserted that a tax on Parent offended the Due Process and Commerce Clauses of the U.S. Constitution.
Due Process Clause
First, the Court addressed the Due Process claim. In Quill, the U.S. Supreme Court specified two requirements that must be met by the taxing state in order to satisfy Due Process: (1) there must be "some minimum connection, between a state and the person, property or transaction it seeks to tax," and (2) the "income attributed to the State for tax purposes must be rationally related to values connected with the taxing State."7
The Department sought to prove that each prong of the two-part test was met by attributing the subsidiaries' activities to Parent. With respect to the minimum connection requirement, Oregon asserted that business was conducted and income was earned by the subsidiaries, in part, on behalf of Parent. The Court rejected this nexus argument because Parent and its subsidiaries were distinct legal entities. Also, the Court determined that Parent itself did not conduct business within Oregon, and did not purposefully direct its activities toward the state.
The Department also argued that the "rationally related" requirement was met because the subsidiaries' utilization of Parent's trademarks constituted a profit-seeking activity in Oregon that produced a benefit to Parent through an increase in the enterprise value of its subsidiaries. The Court dismissed this argument as well, explaining that a corporate parent is required to derive "substantial revenues" from its subsidiaries' use of intellectual property,8 but Parent, in the present case, did not earn any income relating to the use of its intellectual property. Accordingly, the Court concluded that the tax on Parent violated the Due Process Clause.
Commerce Clause
The Court continued its analysis by noting that the Commerce Clause demands that a "tax is applied to an activity with a substantial nexus with the taxing State, is fairly apportioned, does not discriminate against interstate commerce, and is fairly related to the services provided by the state."9 In reaching its decision on whether "substantial nexus" existed in this case, the Court evaluated the facts under three analytical frameworks.
First, the Court considered Quill's physical presence doctrine, which requires the physical presence of a taxpayer within the taxing state in order to establish substantial nexus. The Department argued against the merits of this bright-line test, insisting that it was not only antiquated in today's age of electronic commerce, but also applicable only in the context of sales and use taxes. The Trust, on the other hand, asserted that application of the physical presence test was mandatory. The Court agreed with the Department's view that the physical presence test in Quill was limited to sales and use tax cases.
Next, the Court evaluated the Department's contention that the significant economic presence test should apply. This analysis requires both the purposeful direction of activity toward a state and an "examination of the frequency, quantity and systematic nature of a taxpayer's economic contacts with a state."10 Although there have been recent state court rulings that used the significant economic presence test, the Trust argued that such rulings could not overturn well-settled federal precedent, which controls constitutional issues. Agreeing that federal courts controlled constitutional issues, the Court noted that the U.S. Supreme Court has yet to "endorse" the significant economic presence test. Therefore, the Court declined to apply this test though it conceded that economic presence was a "factor to be considered."
Finally, the Court completed its analysis by applying the Complete Auto Transit "substantial nexus" test to the parties' arguments and presentation of the facts.11 The Department argued that an agency relationship existed as a result of Parent's control over its subsidiaries, a control that could be asserted at any time.12 To support this argument, the Department noted that Parent maintained pension, retirement, and investment plans for the benefit of its employees and its subsidiaries' employees. The Trust disagreed, emphasizing the fact that the subsidiaries operated independently of Parent and without oversight.13 Moreover, Parent's role was limited to holding stock in its subsidiaries and monitoring its investment.
The Department also argued that because Parent's intangible property permitted its subsidiaries to advertise and create goodwill for Parent within Oregon, the intangible property provided a sufficient connection with Oregon to allow the excise tax to be imposed on Parent. However, the case upon which the Department relied, New York ex rel. Whitney v. Graves,14 was deemed to be distinguishable. That case concerned a state's attempt to tax the proceeds of the sale of an intangible, whereas the present case concerned Oregon's attempt to hold an out-of-state parent jointly and severally liable for taxes incurred by its in-state subsidiaries.
In addition, citing International Harvester, the Department asserted its power to tax an outof- state stockholder's dividends from an in-state corporation.15 The Court declined to give weight to International Harvester because it was a case addressing a Due Process challenge, rather than the Commerce Clause, and also addressed facts that were distinguishable (a tax upon dividend income). In the present matter, Parent did not receive any royalty payments, license fees, or any other income from the subsidiaries' use of its intellectual property. In other words, Parent did not gain a "quantifiable benefit from the use of its intellectual property in the State."
The Court responded by noting that the position the Department advanced would deeply burden interstate commerce: "any shareholder who receives thousands (or less) in dividends from a subsidiary would be responsible for potentially millions in taxes incurred by that subsidiary. Such a result would have devastating consequences to shareholders and to the United [States'] economy where investments play a crucial role."
Therefore, the tax on Parent constituted an unconstitutional violation of the Commerce Clause. As such, the Court sustained the Trust's objection to the proof of claim filed by the Department in the bankruptcy proceedings, and disallowed in full the corporate excise tax assessment against Parent.
Commentary
In a relatively rare example of a bankruptcy court decision examining state tax nexus issues, the Court's discussion of the Due Process and Commerce Clauses in this context is wide-ranging and relevant to out-of-state holding companies. Under the Due Process Clause analysis, the Court determined that despite the receipt of dividends from its subsidiaries' operations in Oregon, Parent was not considered to have actually conducted any business activity in Oregon. While Oregon did not attempt to tax the dividends issued by the subsidiaries to Parent, Oregon tried to tax Parent on the operational income earned by the subsidiaries conducting business in the state. Although Parent allowed the subsidiaries to use intellectual property in Oregon, Parent did not earn any income from the use of this property. This case provides valuable support for holding companies arguing that under the Due Process Clause, they do not have the necessary minimum contacts with a taxing state.
In its Commerce Clause analysis, the Court did not rely upon the significant economic presence test that has become popular with some state courts, relegating the test to a factor that should be considered in making a substantial nexus determination. In its analysis, the Court distinguished the line of state court economic presence cases by stressing that Parent did not receive any income or quantifiable benefit from the subsidiaries' use of the intangible property. Out-of-state holding companies could use this case to support a Commerce Clause argument in situations where they do not receive income from the intangible property. It remains to be seen whether this particular case will be appealed, and whether the Oregon Tax Court or higher-level court in the state of Oregon will follow the federal bankruptcy court's nexus analysis in future litigation involving the state's corporation income tax.
Footnotes
1 In re: Washington Mutual, Inc., U.S. Bankruptcy Court, D. Delaware, No. 08-12229 (MFW), Dec. 19, 2012.
2 OR. REV. STAT. § 317.710.
3 OR. ADMIN. R. 150-317.710(5)(a)-(A)(1).
4 Id.
5 OR. REV. STAT. § 317.710(2) (emphasis added).
6 Estee Lauder Serv., Inc. v. Dep't. of Revenue, 16 OTR-MD 279, 284 (Or. T.C. 2000).
7 Quill Corp. v. North Dakota, 504 U.S. 298 (1992).
8 The Court cited Dannippon Screen Mfg. Co., Ltd. v. CFMT, Inc., 142 F.3d 1266, 1271 (Fed. Cir. 1998) and Geoffrey, Inc. v. South Carolina Tax Commission, 437 S.E.2d 13, 17 (S.C. 1993).
9 Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977) (emphasis added).
10 Tax Commissioner v. MBNA America Bank, 640 S.E.2d 226 (W. Va. 2006).
11 As discussed above, the four-prong test requires that for a tax not to violate the Commerce Clause, it must be: (i) applied to an activity with substantial nexus in the state; (ii) be fairly apportioned; (iii) non-discriminatory against interstate commerce; and (iv) fairly related to the services provided by the state. Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).
12 For example, Parent could sell the Oregon assets at any time.
13 Parent played a role in establishing general policies.
14 299 U.S. 366 (1937).
15 International Harvester Co. v. Wisconsin Dept. of Taxation, 322 U.S. 435 (1944).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
