Comptroller of Treasury v. Gore Enter. Holdings, Inc.

• Decision Date: 24 January 2013
• Docket Number: 1697,Nos. 1696,Sept. Term, 2011.,s. 1696
• Citation: 60 A.3d 107,209 Md.App. 524
• Parties: COMPTROLLER OF the TREASURY v. GORE ENTERPRISE HOLDINGS, INC. Comptroller of the Treasury v. Future Value, Inc.
• Court: Court of Special Appeals of Maryland

209 Md.App. 524

60 A.3d 107

COMPTROLLER OF the TREASURY

v.GORE ENTERPRISE HOLDINGS, INC.

Comptroller of the Treasury

v.Future Value, Inc.

Nos. 1696, 1697, Sept. Term, 2011.

Court of Special Appeals of Maryland.

Jan. 24, 2013.

Michael J. Salem (Douglas F. Gansler, Atty. Gen., on the brief) Annapolis, MD, for appellant.

Jeffrey A. Friedman (Michele Borens, G. Brendan Ballard, Sutherland, Asbill & Brennan, Robert F. Reklaitis, Cynthia F. Crawford, LeClair Ryan, on the brief) Washington, DC, for appellee.

Panel: MATRICCIANI, BERGER and JAMES A. KENNEY, III (Retired, Specially Assigned), JJ.

MATRICCIANI, J.

On November 9, 2010, the Maryland Tax Court ¹ upheld a tax assessment against Gore Enterprise Holdings, Inc., in the amount of $10,013,428 plus interest, but the Tax Court abated penalties of $2,503,360. The Tax Court simultaneously upheld an assessment against Future Value,Inc., of $1,254,321 plus interest, while abating $313,581 in penalties. Both parties appealed to the Circuit Court for Cecil County, where the cases were consolidated. The circuit court reversed the Tax Court's assessments on September 30, 2011, and the Comptroller timely appealed on October 6, 2011.

Questions Presented

The Comptroller presents the following questions for our review, which we have rephrased and consolidated to comport with our discussion:

I. Did the Tax Court err when it held that patent royalties and interest income claimed as expenses in Maryland and paid to wholly-owned foreign subsidiaries are taxable as part of a unitary business?

II. Did the Tax Court err when it apportioned the subsidiaries' income based on the parent corporation's apportioned expenses? ²

For the reasons that follow, we answer no to both questions and we reverse the judgments of the Circuit Court for Cecil County cancelling the assessments.

Factual and Procedural History

W.L. Gore & Associates, Inc.

In 1958, Dr. Wilbert L. Gore founded and incorporated W.L. Gore & Associates, Inc. (“Gore” or “Gore, Inc.”) in Newark, Delaware. Gore is known for its patented “ePTFE” material, which it uses to manufacture industrial and electronic products, as well as fabrics and medical devices. Gore attributes income to Maryland based on its local product sales and on its manufacturing facilities, which employ over two-thousand people in this state.

In the same year that Gore was founded, Delaware amended its income taxation statute to exempt “[c]orporations whose activities within Delaware are confined to the maintenance and management of their intangible investments and the collection and distribution of the income from such investments or from tangible property physically located outside of Delaware.” 51 Del. Laws, c. 315, § 3 (available at http:// delcode. delaware. gov/ sessionlaws/ ga 119/ chp 315. shtml); 30 Del. C. § 1902(b)(8) (2012). Delaware later added the following clarifying language to the end of § 1902(b)(8):

For purposes of this paragraph “intangible investments” shall include without limitation investments in stocks, bonds, notes and other debt obligations (including debt obligations of affiliated corporations), patents, patent applications, trademarks, trade names and similar types of intangible assets.

30 Del. C. § 1902(b)(8) (2012); 64 Del. Laws, c. 461, § 10 (available at http:// delcode. delaware. gov/ sessionlaws/ ga 132/ chp 461. shtml).

Gore Enterprise Holdings, Inc.

Gore formed Gore Enterprise Holdings, Inc. (“GEH”) in 1983, contributing all Gore patents in exchange for all of GEH's stock. Gore's November 4, 1983 board meeting notes include the following comment:

Item 7. Gore Enterprise Holdings, Inc.

The directors UNANIMOUSLY APPROVED the action of the Executive Committee in establishing the Gore Enterprise Holdings, Inc. corporation and transferring our patents and overseas receipts to this holding company. The holding company should result in substantial savings of Delaware state income tax but will have no effect on our Federal income tax.

GEH is governed by a board of directors comprising Gore, Inc.'s patent attorney, a “tech leader” from Gore, the president of GEH, and Dr. Gore, himself. The board has never included an outside director, and all of GEH's activities are ultimately directed by the board.

GEH operated without any employees or rent expenses until 1995, when it hired one salaried employee and began to pay Gore, Inc. for the use of a one-hundred-twenty square foot room on Gore's premises. At that time, Gore agreed to provide its subsidiary, GEH, with various administrative services, including accounting, payroll, employee benefits, and “general services,” in return for a $100 monthly fee (later raised to $105). The parties simultaneously entered into a “Legal Services Consulting Agreement” that obligates Gore to provide GEH with various services, including:

• Prosecution of patent applications, domestic and foreign.

• Conduct or manage litigation or defense of patents against infringement.

• Provide advice with respect to utilization of outside counsel.

• Counsel, conduct or manage applications to foreign patents and applications.

• Counsel with respect to patent infringement, domestic and foreign.

• Counsel with respect to interferences with pending patents.

• Counsel with respect to licensing negotiations and activities.

In return, the Agreement obligates GEH to pay Gore at an hourly rate determined either by a survey of the American Intellectual Property Law Association or by good faith negotiations that would “reflect an arm's-length transaction.”

When Gore employees develop a new technology and decide that it is commercially viable, attorneys working under the Legal Services Agreement and on behalf of GEH prepare and file a patent application covering that invention. At that point, GEH's lone employee assumes responsibility for all requisite documentation and correspondence.

GEH's operations are controlled by an “intellectual property committee,” which consists of officers from GEH and Gore, Inc. (to the extent that there is some distinction between the two). The committee oversees licensing of GEH's patents to Gore and to third parties, as well as acquisition of patents from third parties, and enforcement of its patent portfolio.

At its inception, GEH granted Gore “an exclusive license to make, use and sell any patented inventions under all U.S. patents presently owned or hereafter acquired by the [GEH] insofar as the United States and all its territories and possessionsare concerned.” ³ In exchange, Gore pays GEH a “reasonable fee” and deducts that expense from its taxable income. ⁴ GEH, meanwhile, recognizes these royalty payments as taxable income. ⁵ Between 1996 and 2007, GEH returned dividends of approximately $5.5 million per month to Gore, Inc.

Future Value, Inc.

In 1996, Gore exchanged its financial assets in return for all outstanding stock of its newly-formed subsidiary, Future Value, Inc. (“FVI”). Since its inception, FVI has been funded entirely by contributions from Gore and GEH, and by reinvesting its investment income. A portion of that investment income is derived from loans FVI makes to Gore, Inc. Gore deducts its interest payments to FVI from Gore's taxable income; ⁶ FVI recognizes those payments as taxable income.

Audits by the Comptroller

In 2006, the Comptroller audited Gore, GEH, and FVI and determined that GEH and FVI were required to apportion income to Maryland. The Comptroller took the ratio that Gore used to apportion its Maryland income and expenses—including royalties and interest paid to its subsidiaries—and applied it to GEH's and FVI's federal taxable income derived from Gore.⁷ The Comptroller assessed against GEH $26,436,315, and assessed against FVI $2,608,895, both including interest and penalties. The Comptroller also conducted an “alternative audit” of Gore that disallowed royalty and interest expenses paid to its subsidiaries, and assessed against Gore $193,718, including interest and penalties.⁸

A hearing officer in the Comptroller's office upheld the assessments on January 5, 2007, and GEH and FVI appealed to the Maryland Tax Court.

The Tax Court conducted an extensive, three-day hearing in October, 2008. The Tax Court explained its ruling in a memorandum that followed:

Maryland courts have consistently concluded that the basis of a nexus sufficient to justify taxation is the economic reality of the fact that the parent's business in Maryland was what produced the income of the subsidiary. The Classics Chicago, Inc., et. al v. Comptroller of the Treasury, 189 Md.App. [695, 985 A.2d] 593 (2010); Comptroller of the Treasury v. SYL, Inc., 375 Md. 78 , cert. denied, 540 U.S. 984 [124 S.Ct. 478, 157 L.Ed.2d 375] and 540 U.S. 1090 [124 S.Ct. 961, 157 L.Ed.2d 795] (2003). Thus, the resolution of this case depends on whether GEH and FVI as out-of-state affiliates had real economic substance as business entities separate from W.L. Gore.

This Court's previous interpretation of the facts support the Comptroller's position that GEH and FVI were engaged in a unitary business with W.L. Gore and are not separate business entities. GEH and FVI depend on W.L. Gore for their existence. The facts indicate functional integration and control through stock ownership, as well as common employees, directors and officers of W.L. Gore and the Gore family. The functional source of GEH's income is derived from the ideas and discoveries generated by W.L. Gore employees. The circular flow of money is traced by and through W.L. Gore when GEH acquires a patent from the ideas and discoveries of W.L. Gore. The income of GEH is derived from a royalty paid by W.L. Gore under a license agreement on the patent.

In addition, the facts also indicate GEH's reliance on W.L. Gore personnel, office space and corporate services. The tax returns and other financial data reflect the lack of separate substantial activity of GEH or FVI. Moreover, the evidence also demonstrates that FVI is taxable by Maryland on its...