Challenge of Alabama Factor-Nexus Statute May Proceed
Zach McPherson
State & Local Tax
The Alabama Tax Tribunal recently ruled that a taxpayer's challenge to the state's application of its factor-nexus standard may proceed. The taxpayer is Reynolds Brands, which is involved in the management and licensing of intellectual property for R.J. Reynolds Tobacco Co., the cigarette company and subsidiary of Reynolds American.
As purely an intellectual property holding company, Reynolds Brands did not have any property or payroll in Alabama and did not perform any business activities in the state. As such, Reynolds Brands did not file an Alabama corporate income tax or franchise tax return based on its assumption that it did not establish substantial nexus with the state. However, intellectual property owned by Reynolds Brands, including the brand logo and product design, were affixed on cigarettes and other products produced, sold, and distributed by R.J. Reynolds Tobacco to wholesalers in states around the country, including Alabama.
The Alabama Department of Revenue asserted that the taxpayer was subject to state corporate income tax due to sales of products into Alabama in excess of $500,000 that bore its intellectual property under the factor presence statute in Alabama Code Section 40-18-31.2(b)(3). The taxpayer challenged the state's claim under the argument that the factor presence test is unconstitutional as applied to the facts of the company. Specifically, Reynolds Brands claims that as an intellectual property holding company, it has not licensed property to licensees located in Alabama. As such, Reynolds Brands has not established income tax nexus in Alabama.
In the language of U.S. Supreme Court Justice Anthony Kennedy in the 2018 decision in Wayfair v. South Dakota, Reynolds Brands argues that it "has not availed themselves of the Alabama marketplace." The taxpayer is not directly challenging the statute's constitutionality, only its application to the use of licensed intellectual property between related entities and its application to sales in Alabama. After review, the Tribunal agreed that the taxpayer's challenge may proceed as the challenge is not to the statute "on its face" but is a challenge to the way it is being applied. The clearance to proceed gives Reynolds Brands the opportunity to proceed in litigation against the state to avoid being held subject to income tax for several years.
Income tax nexus for intellectual property holding companies has been an evolving issue since the early 1990s. Court rulings on the issue have been mixed, with conflicting decisions coming from separate states. In Griffith v. ConAgra Brands, the West Virginia Supreme Court ruled that an unrelated party licensing intangible property in the state did not have nexus. However, in KFC Corp. v. Iowa Department of Revenue, the Iowa Supreme Court ruled the opposite—that an unrelated owner of intangible property did have income tax nexus. The fact that in the case of Reynolds Brands, the licensee of its intellectual property is a related party could be a sign that the income will ultimately be held to be taxable, but we will have to wait for litigation to proceed to be sure.
An additional consideration regarding this issue is the due process clause of the U.S. Constitution and how courts have applied it to states' ability to tax commercial transactions in the past. In Scioto Insurance Company v. Oklahoma Tax Commission, the Supreme Court of Oklahoma held that an insurance company (Scioto Insurance) organized under the laws of Vermont could not be taxed on licensing income received from a contract with Wendy's International, an entity affiliated with Wendy's Restaurants that became the sub-licensor of the intellectual property from Scioto Insurance. The court ruled that "due process is offended by Oklahoma's attempt to tax an out of state corporation that has no contact with Oklahoma other than receiving payments from an Oklahoma taxpayer … who has a bona fide obligation to do so under a contract not made in Oklahoma." In this and other cases, courts have shown a willingness to consider the due process clause to be a barrier to states' taxing authority, if a taxpayer can show the lack of a connection between itself and the taxing state.
As commerce grows more virtual, state departments of revenue alongside lawmakers will need to become more sophisticated in designing policy to clearly lay out which sales are taxable and which are not. Taxpayers with a legal structure that includes an entity whose main purpose is to hold and license intangible property should examine where the property is used and what income tax nexus liabilities could be triggered as a result.
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