Kpi v. N.M. Taxation & Revenue Dept.

• Decision Date: 27 November 2001
• Docket Number: No. 21140.,21140.
• Citation: 2006 NMCA 026,131 P.3d 27
• Court: Court of Appeals of New Mexico
• Parties: KMART PROPERTIES, INC., a Michigan Corporation, Protestant-Appellant, v. TAXATION AND REVENUE DEPARTMENT OF THE STATE OF NEW MEXICO, Respondent-Appellee.

131 P.3d 27

2006 NMCA 026

KMART PROPERTIES, INC., a Michigan Corporation, Protestant-Appellant, v. TAXATION AND REVENUE DEPARTMENT OF THE STATE OF NEW MEXICO, Respondent-Appellee.

No. 21140.

Court of Appeals of New Mexico.

November 27, 2001.

Certiorari Granted, No. 27,269, January 9, 2002.

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Curtis W. Schwartz, Timothy R. Van Valen, Modrall, Sperling, Roehl, Harris & Sisk, P.A., Santa Fe, for Appellant.

Patricia A. Madrid, Attorney General, Bruce J. Fort, Special Assistant Attorney General, Don Harris, Special Assistant Attorney General, Taxation and Revenue Department, Santa Fe, for Appellee.

James S. Rubin, Rubin, Katz, Salazar, Alley & Rouse, Santa Fe, Paul H. Frankel, Hollis L. Hyans, Irwin M. Slomka, Meredith L. Friedman, Morrison & Foerster L.L.P., New York, NY, Amicus Curiae Lanco, Inc.

Mel E. Yost, Donald A. Walcott, Scheuer, Yost & Patterson, P.C., Santa Fe, Diann L. Smith, General Counsel, Stephen P.B. Kranz, Tax Counsel, William D. Peltz, Bobby L. Burgner, J. Hugh McKinnon, Chair, Vice Chair, and Counsel Lawyers' Coordinating Subcommittee, Washington, DC, Amicus Curiae Committee on State Taxation.

Paull Mines, General Counsel, Greenwood Village, CO, Frank D. Katz, Deputy General Counsel, Santa Fe, Amicus Curiae Multistate Tax Commission.

OPINION

BOSSON, Chief Judge.

{1} Kmart Properties, Incorporated (KPI), a wholly owned Michigan subsidiary of Kmart Corporation, owns and manages trademarks previously developed by Kmart Corporation. KPI challenges New Mexico's assessment of state income taxes and gross receipts taxes upon royalties paid by Kmart Corporation to KPI. KPI bases its challenge upon the following grounds: (1) New Mexico's assertion of jurisdiction to tax KPI violates the Due Process Clause of the United States Constitution; (2) New Mexico's assessment of each tax against KPI is prohibited by the Commerce Clause of the United States Constitution; (3) New Mexico's tax on KPI's gross receipts is not authorized by state law; (4) the method for apportioning KPI's income for income tax purposes violates state law; and (5) the hearing officer was not independent and impartial, and his decision was not timely as required by state law. In affirming both taxes, we address matters of first impression regarding the constitutional limits imposed on New Mexico in its efforts to tax income and gross receipts in light of the physical-presence standard of Quill Corp. v. North Dakota, 504 U.S. 298, 112 S.Ct. 1904, 119 L.Ed.2d 91 (1992) (Quill).

BACKGROUND

{2} In the fall of 1991 Kmart Corporation created KPI for the purpose of holding title to and managing the trademarks, trade names, and service marks (collectively referred to as the "marks") that Kmart Corporation had developed and used in the United States over the years. Those marks include such well known trade names as "Blue Light Special," and "At Home with Martha Stewart," among many others, as well as the trade name "Kmart" that appears on Kmart stores, signs, products, and employee apparel throughout the United States. When creating KPI, Kmart Corporation followed a plan, developed by Price Waterhouse, entitled "Utilization of an Investment Holding Company to Minimize State and Local Income Taxes." Under this plan, Kmart Corporation infused KPI with assets by transferring ownership of all its domestic marks and their associated goodwill to KPI, in exchange for all of KPI's stock. An independent appraiser estimated that the marks were worth between $2,734,100,000 and $4,101,200,000. Both companies were incorporated in Michigan, as were their headquarters and principal places of business. KPI rented an office suite located one block from Kmart Corporation's corporate headquarters, where KPI housed a total of five employees who were transferred from Kmart Corporation, including two intellectual property lawyers and support staff.

{3} On October 30, 1991, Kmart Corporation transferred ownership of the marks to KPI, and the two corporations entered into a licensing agreement whereby KPI granted Kmart Corporation the exclusive right to use the marks in the United States and its territories, thereby allowing Kmart Corporation the continued use of the "Kmart" name. In exchange for Kmart Corporation's exclusive right to use the marks, the licensing agreement required Kmart Corporation to make royalty payments to KPI, based on 1.1 percent of Kmart Corporation's gross sales throughout the United States. The licensing agreement was negotiated, drafted, and signed by the parties in Michigan.

{4} The creation of KPI dramatically affected Kmart Corporations's tax liability within New Mexico. New Mexico income tax laws allow Kmart Corporation to take a business deduction for royalty payments made to KPI. With this deduction, Kmart Corporation was able to reduce significantly and, in some years, eliminate altogether its New Mexico income tax liability. Meanwhile, KPI paid state taxes only in Michigan, which does not tax income from royalty payments. Thus, income formerly attributed to Kmart Corporation's operations in New Mexico and taxed in New Mexico was shifted to KPI, a corporation with no formal operations in the state, which paid no state income taxes on that income.

{5} In 1997 an auditor for the New Mexico Taxation and Revenue Department (the Department) inquired about Kmart Corporation's royalty deduction, and requested from Kmart a copy of the licensing agreement. By applying the 1.1 percent royalty rate to the relevant New Mexico sales revenues, the Department determined that, during the tax assessment period, KPI earned royalty income in excess of $2,000,000 per year from conducting business within New Mexico. Using that information, the Department then audited KPI, which resulted in the assessment of income taxes and gross receipts taxes upon KPI. Assessment No. 2134646 assessed corporate income tax in the amount of $758,392, apportioned to reflect the royalty income from February 1991 through January 1996 that KPI derived from Kmart Corporation's operations in New Mexico. Assessment No. 2134647 assessed gross receipts taxes in the amount of $478,099.55 for royalty payments during this same period. Additionally, each assessment included penalties and interest for the failure to pay these taxes in a timely manner. KPI timely filed a written protest of all assessments. See NMSA 1978, § 7-1-24(B) (2000).

{6} KPI's protest was heard by a Department hearing officer who affirmed the assessment of income and gross receipts taxes plus interest, but reversed the assessment of a penalty. KPI appealed the hearing officer's decision to this Court. See NMSA 1978, § 7-1-25(A) (1989); Rule 12-601 NMRA 2001. The Department did not appeal the hearing officer's decision to eliminate the penalty.

DISCUSSION

{7} This appeal requires us to examine whether the federal constitution prohibits New Mexico taxation of a non-domiciliary company under these circumstances.¹ A state's ability to tax a non-domiciliary company may be limited by the Due Process Clause or the Commerce Clause. See U.S. Const. art. I, § 8, cl. 3 & amend. XIV, § 1. In the past, courts analyzed these clauses with little differentiation between the two, in part because they both address a non-domiciliary company's nexus with the taxing state. See Burger King Corp. v. Rudzewicz, 471 U.S. 462, 475, 105 S.Ct. 2174, 85 L.Ed.2d 528 (1985) ("Jurisdiction is proper, however, where the contacts proximately result from actions by the defendant himself that create a `substantial connection' with the forum State."); cf. Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279, 97 S.Ct. 1076, 51 L.Ed.2d 326 (1977) (Complete Auto Transit) (holding that a state must demonstrate that the "tax is applied to an activity with a substantial nexus with the taxing State"); Nat'l Geographic Soc'y v. Cal. Bd. of Equalization, 430 U.S. 551, 558, 97 S.Ct. 1386, 51 L.Ed.2d 631 (1977) (same). Historically, courts treated the nexus requirement of Commerce Clause jurisprudence as though it were similar, if not identical, to that found in the Due Process Clause. See Quill, 504 U.S. at 325-27, 112 S.Ct. 1904 (White, J., concurring in part and dissenting in part); Nat'l Bellas Hess, Inc. v. Dep't of Revenue, 386 U.S. 753, 756, 87 S.Ct. 1389, 18 L.Ed.2d 505 (1967) (Bellas Hess) (stating that the "same principles" of minimum contacts guide the state's power to tax under each, after observing that the two clauses share a "similar" test), overruled on other grounds by Quill, 504 U.S. at 301-02, 112 S.Ct. 1904; Trinova Corp. v. Mich. Dep't of Treasury, 498 U.S. 358, 373, 111 S.Ct. 818, 112 L.Ed.2d 884 (1991); Memphis Natural Gas Co. v. Stone, 335 U.S. 80, 96-97, 68 S.Ct. 1475, 92 L.Ed. 1832 (1948) (Rutledge, J., concurring).

{8} However, in 1992 while reviewing a state's ability to impose a use tax on an out-of-state mail order company, which had no stores or sales staff in the taxing state, the United States Supreme Court held that the nexus requirements of the two constitutional clauses were distinct. Quill, 504 U.S. at 313-14, 112 S.Ct. 1904. After stating that "a corporation may have the `minimum contacts' with a taxing State as required by the Due Process Clause, and yet lack the `substantial nexus' with that State as required by the Commerce Clause," id. at 313, 112 S.Ct. 1904 the Court fashioned a bright-line test to determine the constitutional validity of sales and use taxes under the Commerce Clause, id. at 314, 112 S.Ct. 1904. To justify a sales and use tax, this bright-line test required a taxpayer's physical presence in the taxing state. Id. at 315-17, 112 S.Ct. 1904.

{9} There has been a split among state courts regarding whether Quill's presence requirement was intended as a broad, Commerce Clause principle, applicable to all state taxes, or whether physical presence was limited to sales and use taxes. See J.C. Penney Nat'l Bank v. Johnson, 19 S.W.3d...