Department of Revenue Defeated in Multi-State Income Tax Case

Scott E. Vincent
Shughart, Thomson & Kilroy
Kansas City

The Missouri Supreme Court recently held that intellectual property holding companies were not subject to Missouri corporate income tax. In a decision of first impression that may be contrary to the so called Geoffrey cases in other states, the Court ruled that foreign corporations holding intellectual property rights were not subject to Missouri corporate income taxes because they had no substantial physical connection in Missouri. The Court reversed the decisions of the Missouri Administrative Hearing Commission. Acme Royalty Co. v. Director of Revenue and Gore Enterprise Holdings v. Director of Revenue (Mo. S. Ct. Nos. SC84225 and SC84226, November 26, 2002) [subject to possible rehearing].

Background

The cases involved foreign corporations, Acme Royalty, Brick Investment Company and Gore Enterprise Holdings, that licensed the use of trademarks, trade names and patents to a related corporation, Acme Brick Company. Acme Brick conducts business in Missouri and in other states. The Department of Revenue audited Acme Brick, identified significant royalty payments to the licensing entities for Acme Brick sales in Missouri, and then attempted to assess Missouri income tax on this royalty income. The Missouri Administrative Hearing Commission ruled in favor of the Department of Revenue and held that the royalty income was taxable in Missouri. The Supreme Court of Missouri reversed this decision.

Analysis

The Court first identified relevant Missouri law. Section 143.431.1 of the Revised Missouri Statutes provides that "[t]he taxable income of a corporation . . . shall be so much of its federal taxable income . . . derived from sources within Missouri as provided in section 143.451." Section 143.451 further provides that "Missouri taxable income of a corporation shall include all income derived from sources within this state." These provisions do not further define Missouri source income, so the Court looked to its prior decisions. Based on these statutes and prior decisions, the Court provided the following analysis:

The basic requirement for there to be Missouri source income is that there is some activity by the taxpayer in Missouri that justifies imposing the tax. Although corporate activities can be immeasurably diverse, for multi-state income tax purposes they fall into three succinct categories: property, payroll and sales. While Appellants are related to ABC, a Delaware corporation that conducts business and pays taxes in Missouri, they are separate legal entities, and as such each must have its own property, payroll or sales in Missouri to be taxed in Missouri."

The Court found no property, payroll or sales activity in the State of Missouri. It also specifically found that the licensing agreements between the appellants and Acme Brick were "negotiated and executed entirely outside the State of Missouri." Based on this analysis and these factual conclusions, the Court found that the appellants simply had no Missouri source income.

Holding

The Supreme Court reversed the Administrative Hearing Commission in a four to three decision, holding that none of the appellants had any contact or sales in Missouri and, therefore, the licensing income that the Director of Revenue attempted to tax was outside the scope of Missouri taxation.

Dissent

A strongly worded dissenting opinion expressed concerns regarding the economic reality of the corporate relationships in this case, characterizing the license entities that own the intellectual property as "tax-evaders." The dissent, noting that Delaware does not tax income from patents and trademarks, also characterized the overall approach as a "tax avoidance scheme" resulting in "nowhere income" that would not be taxed by any state. The dissenting opinion offers the well known Geoffrey v. South Carolina Tax Commission as support for this position. In Geoffrey, the South Carolina Supreme Court found that a Toys R Us subsidiary was subject to South Carolina tax on licensing income.

Conclusion

Acme Royalty is a significant case, because it arguably rejects the Geoffrey approach to taxing intellectual property holding companies in Missouri. If this decision stands and is supported in future cases, the holding will provide multi-state companies with intellectual property subsidiaries a significant planning opportunity. We can expect the Department of Revenue to continue challenging these circumstances due to the significant revenue involved. For example, the Acme Brick licensing entities received over $34 million in royalty payments over a period of a few years, and the Geoffrey case involved $55 million in only one year.

JOURNAL OF THE MISSOURI BAR
Volume 59 - No. 1 - January-February 2003