Corporate Close Up: Maryland Nexus Determination Results in a Whopping $14M Tax Bill for Staples
Aug 20, 2018
The Maryland Court of Appeals recently affirmed the state’s multimillion dollar assessment against Staples—the office supply giant—based on the state’s determination that the out-of-state retailer had nexus as a result of “enterprise dependency” with in-state affiliates.
Staples Appeals Audit to the Maryland Tax Court
Back in 2009, Staples appealed two Notices of Final Determination for tax years 1999 through 2004 against Staples Inc. and Staples the Office Superstore Inc. (Superstore) to the Maryland Tax Court. Staples Inc. and Superstore are Delaware corporations, based in Massachusetts with no physical presence in Maryland. During the tax period in question Staples Inc. and Superstore had 40 affiliated retail stores in Maryland, all of which were owned and operated by two of their subsidiaries, Staples East and Staples C&C (Subsidiaries).
Maryland’s theory was that Staples and Superstore had nexus with the state, despite their lack of physical presence, by way of their relationship with the Subsidiaries. Staples Inc. charged a fee to the Subsidiaries for managerial and administrative services and also provided a cash pooling service, under which it received interest payments from the Subsidiaries. Superstore provided the Subsidiaries a franchise system, including licensing certain intellectually property, for a set franchise fee.
On appeal, the Maryland Tax Court relied on Gore Enterprise Holdings in upholding the audit assessment when it determined that Staples and Superstore lacked economic substance as separate business entities. The Tax Court then found the existence of a unitary business enterprise between Staples Inc., Superstore and the Subsidiaries, because the entities relied on each other for advertising, legal, financial, accounting, and purchasing or planning services.
After years of procedural wrangling and a “detour” through the Maryland Circuit Court, the Maryland Tax Court’s decision wound up before the Court of Appeals.
The Maryland Court of Appeals’ Decision
The Court of Appeals upheld the Tax Court’s determination of the Subsidiaries’ general lack of economic substance as separate business entities, and determined the Staples Inc. and Superstore were engaged in a unitary business with its Maryland based Subsidiaries.
The court concluded that the Subsidiaries relied on Staples Inc. and Superstore for all core business functions and that economic reality created an enterprise dependency between the parent and its subsidiaries, so much so that the subsidiaries lacked substantive activity that was in any meaningful way separate from its parent’s activities. As a result, the Court of Appeals determined that nexus existed between Staples Inc., Superstore and Maryland.
The Court of Appeals interpreted Gore to require a secondary determination as to whether Staples Inc. and Superstore were unitary with their in-state affiliates. According to Gore, “the constitutional test ‘is not the potential of unitary control, but rather the actual, in fact unitariness or separateness of the subsidiary enterprises.’” The Court of Appeals, quoting Container Corp. of America, further notes that a “‘flow of value, not [just] a flow of goods’” is a constitutional prerequisite to finding a unitary business.
In the present case, the court held that the services provided by Staples Inc. and Superstore created a flow of money, services, and product between themselves and their subsidiaries that was not in-fact separate from the parent’s unitary control. Thus, not only was there a circular flow of goods between the Subsidiaries, Staples Inc. and Superstore, but there was also reliance for managerial services, and other core business functionalities that created a “flow of value” under on unitary enterprise.
Zero Factors and Alternative Apportionment
Next the Court of Appeals turned to a discussion of the appropriate apportionment formula to calculate Staples Inc. and Superstore’s Maryland corporate income taxes. Staples argued that the state was required to use the default three-factor apportionment formula, but the court quickly dismissed this by indicating the standard apportionment formula would result in a zero apportionment factor and thus zero income attributable to Maryland. Because the court concluded that this was not the economic reality of the Staples’s franchise system or cash pooling system utilized in its retail operations in the state, Maryland affirmed the Tax Court’s use of an alternative apportionment method.
Conclusion
The Maryland Court of Appeals found that the basis of a sufficient nexus determination for the subsidiaries is the “‘economic reality’” of the parent’s business. In effect, the affiliates’ enterprise dependency created nexus and ultimately subjected them to taxation in Maryland.