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July 23, 2012

"Give someone an inch and they'll take a mile." Although this phrase is usually not associated with state taxation, perhaps it should be. More specifically, in the absence of guidance from the United States Supreme Court, states have sometimes taken the inch they have been given in determining what activities are sufficient to constitute nexus for income tax purposes and stretched this inch into a mile.

One example of how states have arguably stretched the inch they have been given is the concept of economic nexus. Based on the economic nexus principle, several states have held that a taxpayer must simply have an economic presence in the state (and not a physical presence) to be subject to that state's income tax. While the concept of economic nexus is not novel ---- Geoffrey, Inc. v. South Carolina Dep't. of Revenue and Taxation, 510 U.S. 992 (1993) was decided in 1993 ---- a recent court decision out of West Virginia, Griffith, etc. v. ConAgra Brands, Inc., Docket 11-0252, Supreme Court of Appeals of West Virginia (May 4, 2012), is of particular importance because it shows that the economic nexus principle does have its limits.

This Tax Advisor Weekly discusses the holding in ConAgra Brands, Inc., its limitations on the economic nexus principle, and its impact on taxpayers. But first, it is important to briefly discuss the concept of nexus, as well as the economic nexus principle.

Generally speaking, nexus describes the degree of contact necessary between a taxpayer and a state for the state to impose a tax. In determining what degree of contact is necessary to establish nexus, each state can enact its own threshold standards through its constitution or statutes. However, the states are also subject to nexus standards imposed under the Due Process Clause and the Commerce Clause of the U.S. Constitution. From a practical standpoint, a large number of nexus challenges to state taxes are made pursuant to the Commerce Clause. Therefore, in this Tax Advisor Weekly, only the nexus requirement of the Commerce Clause is examined.

Commerce Clause
The Commerce Clause, found in Article 1, Section 8, Clause 3 of the U.S. Constitution, states that Congress shall have the power "to regulate commerce with foreign nations, and among the several states, and with the Indian tribes." In Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the U.S. Supreme Court developed a four-pronged test to determine whether a state's imposition of a tax has violated the Commerce Clause. While all four prongs of this test must be met for a state tax to comply with the Commerce Clause, this Tax Advisor Weekly focuses on only one requirement: the tax must be applied to an activity that has a substantial nexus with the state.

"Substantial Nexus"
In Quill Corp. v. North Dakota, 504 U.S. 298 (1992), the U.S. Supreme Court held that physical presence in a state is required to satisfy the "substantial nexus" requirement of the Commerce Clause as it applies to sales and use taxes.

However, a definition of what activity is sufficient to constitute substantial nexus for the purpose of state income taxation (or any state tax other than sales and use tax) was not provided by the Supreme Court. Therefore, state legislatures and courts have adopted their own criteria for what activity constitutes substantial nexus for income tax purposes. And as mentioned above, states have sometimes taken this inch and stretched it into a mile. One such example of this is the economic nexus principle.

Economic Nexus
Several states have adopted the economic nexus principle, and each of these states may have slightly differing requirements for what activities are sufficient to constitute substantial nexus. However, generally speaking, the economic nexus principle holds that a business with no physical presence in a state may still have nexus with that state if it derived income from the use or licensing of intangible property in the state. One of the most notable, and earliest, economic nexus cases is Geoffrey, Inc. v. South Carolina Dep't. of Revenue and Taxation, 510 U.S. 992 (1993). In this case, Geoffrey, Inc., which was a wholly owned subsidiary of Toys R Us, owned trademarks and trade names that it licensed to Toys R Us. Geoffrey, Inc. had no employees, tangible property or offices in South Carolina. However, based on the fact that Toys R Us made sales into South Carolina, the South Carolina Supreme Court held that Geoffrey, Inc. had licensed intangibles for use in South Carolina, had derived income from this use and, therefore, had substantial nexus for Commerce Clause purposes.

Based on the holding in Geoffrey, Inc., it would seem that states have aggressively defined the boundaries of what activity is sufficient to constitute substantial nexus under the Commerce Clause. However, the natural question that arises is, how far can states stretch the inch they have been given? In other words, in the absence of a U.S. Supreme Court ruling, is there no limit to what activities are sufficient to establish substantial nexus under the economic nexus principle? Based on the holding in Griffith, etc. v. ConAgra Brands, Inc., Docket 11-0252, Supreme Court of Appeals of West Virginia (May 4, 2012), at least one state, West Virginia, has drawn a line in the sand and said that the economic nexus principle can only be stretched so far in establishing substantial nexus for Commerce Clause purposes.

Griffith, etc. v. ConAgra Brands, Inc.

ConAgra Foods, Inc. and its affiliates (CA Foods) owned a large number of trademarks and trade names in the food products industry. CA Foods subsequently transferred these trademarks and trade names to ConAgra Brands, Inc. (ConAgra Brands), which was formed as a wholly owned subsidiary of ConAgra Foods, Inc. in 1997. This transfer to ConAgra Brands was done to centralize the management and protection of these trademarks and trade names. CA Foods agreed to pay royalties to ConAgra Brands for the use of the trademarks and trade names. Additionally, ConAgra Brands acquired trademarks and trade names from unrelated entities.

As a result of the licensing agreements, ConAgra Brands collected royalty payments for the use of its trademarks and trade names by both CA Foods licensees and various unrelated, third-party licensees. These royalties resulted from the sale by the licensees of food products bearing the trademarks and trade names to wholesalers and retailers throughout the United States, including West Virginia. In fact, items bearing ConAgra Brands were found in most retail grocery stores in West Virginia. The licensees provided services in West Virginia to these clients and customers. However, ConAgra Brands provided no services in that regard and did not direct or dictate how the licensees distributed the products.

Further, ConAgra Brands did not manufacture or sell the products that were sold; rather, all products were manufactured by the licensees in facilities outside West Virginia, and then sold to clients and customers in West Virginia (and elsewhere in the United States). Finally, ConAgra Brands did not have any employees in the state, did not own or rent offices or other facilities, and did not maintain any inventory or sell or distribute merchandise in West Virginia.

Initially, the Office of Tax Appeals held that ConAgra Brands was subject to corporation net income tax and business franchise tax in West Virginia, and that neither assessment issued for these taxes violated the Commerce Clause. In its decision, the Office of Tax Appeals stated, "That the Petitioner has a 'substantial economic presence' in the State of West Virginia is beyond question." However, the Circuit Court of Berkeley County, where ConAgra Brands brought its appeal, begged to differ. The Circuit Court set aside the decision of the Office of Tax Appeals. It held:

As to the products, bearing labels imprinted with the trademarks and trade names licensed by ConAgra Brands to its licensees, when in West Virginia, either in the hands of those licensees, or the licensees' retailer customers, neither the third-party suppliers of ingredients to the licensees for the products, nor the third-party suppliers of those labels, nor ConAgra Brands, Inc., have, purely by virtue of supplying those ingredients or labels, or licensing the use of those trademarks and trade names, the minimum, much less the substantial connection, with West Virginia to satisfy either the Due Process or Commerce Clauses or, thus, to allow West Virginia to impose its [corporation net income tax and/or business franchise tax] on them. (Emphasis added.)

The Circuit Court further noted that all manufacturing processes used by the licensees occurred at the licensees' facilities located outside West Virginia, and the licensees did not operate retail stores in West Virginia.

On appeal, the Supreme Court of Appeals of West Virginia affirmed the decision of the Circuit Court and invalidated the assessments for corporation net income tax and business franchise tax against ConAgra Brands. The Supreme Court of Appeals did note that Tax. Commr. v. MBNA American Bank, N.A., 220 W.Va. 163 (2006), cert. denied, 551 U.S. 1141 (2007), held that physical presence in West Virginia was not a requirement for Commerce Clause purposes. However, the Supreme Court distinguished this case from MBNA. The Supreme Court of Appeals pointed out that in MBNA the taxpayer continuously and systematically engaged in direct mail and telephone solicitation and promotion in West Virginia. Conversely, ConAgra Brands did not engage in any such solicitation. Further, besides the fact that ConAgra Brands did not have a physical presence in West Virginia, the Supreme Court of Appeals emphasized that ConAgra Brands did not direct or dictate how the licensees distributed the products bearing the trademarks and trade names. Finally, based on the facts, the Supreme Court of Appeals held that ConAgra Brands was not a shell corporation.

The Supreme Court of Appeals even took the time to address two of the more well-known economic nexus cases: the Geoffrey, Inc. case mentioned earlier and KFC Corp. v. Iowa Dep’t of Revenue, 79 N.W.2d 308 (Iowa 2010). The Supreme Court of Appeals first noted that case decisions from other jurisdictions are not dispositive. However, it then went on to distinguish the current case from these cases. It noted that the Geoffrey case did not address the licensing of a trade name by a foreign licensor to a foreign manufacturer that assembles and packages the product out of state for sale to wholesalers and retailers in the forum state. Further, the Geoffrey case did not address the situation where the wholly owned subsidiary, as licensor, entered into licensing agreements with both its affiliates and also with separate corporations or entities. Finally, it noted that in the KFC Corporation case, the in-state Iowa franchisees, which KFC licensed its trademark to, were required to purchase equipment, supplies, paper goods and other products from only KFC-approved manufacturers. Therefore, these facts are unlike those in ConAgra Brand’s case.
Finally, the Supreme Court of Appeals summarized its holding as follows:

Upon all of the above, this Court holds that assessments against a foreign licensor for West Virginia corporation net income and business franchise tax, on royalties earned from the nation-wide licensing of food industry trademarks and trade names, satisfied neither "purposeful direction" under the Due Process Clause nor "significant economic presence" under the Commerce Clause, where the foreign licensor, with no physical presence in this State, did not sell or distribute food-related products or provide services in West Virginia and where: (1) all products bearing the trademarks and trade names were manufactured solely by unrelated or affiliated licensees of the foreign licensor outside of West Virginia, (2) the foreign licensor did not direct or dictate how its licensees distributed the products and (3) the licensees, operating no retail stores in West Virginia, sold the products only to wholesalers and retailers in this State.

Alvarez & Marsal Taxand Says:
While the U.S. Supreme Court has addressed the issue of what constitutes substantial nexus for sales and use taxes, it has not done so in the context of other state taxes. Therefore, states have created their own definitions of what activities constitute substantial nexus. This has led to some states stretching the inch of freedom they have been given into a mile. Notably, some states have adopted the economic nexus principle, which holds that an entity may have nexus with a state even if it does not have a physical presence. However, taxpayers should keep in mind that just because they do business in a state that adopts the economic nexus principle, this does not mean they automatically have nexus with the state. The ConAgra Brands case demonstrates that taxpayers should analyze their specific facts to determine if nexus exists.

Further, while this Tax Advisor Weekly focused on economic nexus in the context of a royalty/licensing company, taxpayers should be aware that some states are attempting to stretch that inch in determining substantial nexus even further. For example, several states have enacted economic nexus standards based solely on the level of sales sourced to the state, with as little as $500,000 in sales being sufficient to establish nexus in some cases. Again, until the U.S. Supreme Court rules on this issue, states appear to be willing to stretch the outer bounds of what constitutes substantial nexus.

As a final point, taxpayers should be cautious when taking the position that they do not have nexus with a state. Pursuant to Accounting Standards Codification 740-10 (FIN 48), taxpayers may be required to book a reserve for an uncertain tax position based on the belief that they do not have nexus with a state. This determination is fact specific, but it is something that should be considered. Further, since any statute of limitations will not begin to run until the taxpayer files a tax return, this reserve may continue to grow over a number of years.  


  • For a discussion of nexus under the Due Process Clause, please refer to Mobil Oil Corp. v. Comm'r of Taxes of Vermont, 445 U.S. 425 (1980), which states that there must be a minimal connection between the interstate activities and the taxing state, and that the income attributed to the state for tax purposes must be rationally related to values connected with the taxing state.  
  • This requirement is often referred to as the bright-line physical presence test.
  • See also, Tax. Comm'r. v. MBNA American Bank, N.A., 220 W.Va. 163 (2006), cert. denied, 551 U.S. 1141 (2007).
  • It should be noted that West Virginia adopted the "unitary business" principle for corporation net income tax and business franchise tax purposes starting in 2009. However, the audit period in the ConAgra Brands, Inc. case was June 1, 2000, through May 31, 2003

As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.   The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

About Alvarez & Marsal Taxand
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