Physical Presence Not Required for Nexus According to Massachusetts Decisions

The Bloomberg BNA Tax Management Weekly State Tax Report filters through current state developments and analyzes those critical to multistate tax planning.

By Steven Roll

An out-of-state corporation that lacks a physical presence in Massachusetts has achieved substantial nexus with the state by virtue of its licensing activities with an in-state entity, the Supreme Judicial Court of Massachusetts held. [Geoffrey Inc. v. Massachusetts Comr. of Rev., Mass., No. 10106, 1/8/09]

In reaching its decision, the court followed a case it decided the same day, Capital One Bank v. Massachusetts Comr. of Rev., No. 10105 (Mass. Jan. 8, 2009). In Capital One the court found that the “physical presence test” articulated in Quill Corp. v. North Dakota, 504 U.S. 298 (1992) is not applicable for determining the constitutional imposition of income-based taxes on an out-of-state entity.

Instead, the court found that the correct standard to gauge the constitutionality of the imposition of an income-based tax is the four-prong test under Complete Auto Transit Inc. v. Brady, 430 U.S. 274 (1977). The “prong” on which the court focused asks whether the taxpayer had achieved “substantial nexus with the state.”

“The Massachusetts decisions in Geoffrey and Capital One follow a number of recent state court decisions on these issues, Jamie Yesnowitz with Grant Thornton in Washington, D.C. told BNA Jan. 13. “I would hope that if the taxpayers in Geoffrey and Capital One both appeal the decision to the U.S. Supreme Court, such appeals be taken by the Court in order to provide fuller clarity on how the Quill case should be applied in the corporate income tax context,” he added.

The case arose after Geoffrey Inc., a Delaware corporation, entered into licensing agreements that allowed Toys ‘R' Us Inc. to use trademarks held by Geoffrey in their retail operations. In the transactions at issue, Geoffrey received over $33 million in royalties from an affiliate based in Massachusetts, TRUMI. In exchange for paying the royalty to Geoffrey, TRUMI was permitted to use for its retail business activities in Geoffrey's trademarks, trade names, and service marks.

Upon audit, the Massachusetts Department of Revenue determined that the royalties Geoffrey received should be sourced to Massachusetts. The department assessed nearly $1.7 million in corporate excise tax against Geoffrey.

No Property or Employees in State.

Protesting the assessment, Geoffrey argued that the assessment was unconstitutional because it lacked a physical presence in Massachusetts. Specifically, Geoffrey noted that it neither owned nor leased property in the state, and did not have any employees situated in the state.

The department's assessment was upheld by the Massachusetts Appellate Tax Board.
On review, the court affirmed the tax board's decision. “[R]esolution of the physical presence issue under commerce clause analysis is governed by our decision in Capital One,” the court said. “We now conclude that substantial nexus can be established where a taxpayer domiciled in one State carries on business in another State through the licensing of its intangible property that generates income for the taxpayer.” The court noted that its rationale is similar to the one adopted by other jurisdictions that have considered the physical presence issue in the context of intangible property and have upheld the imposition of income-based tax assessments.

Key Factors in Decision.

In finding that Geoffrey engaged in business activities with a substantial nexus to Massachusetts, the court said the corporation:

• entered into contractual relationships, in the form of licensing agreements, with TRUMI and Baby Superstore and permitted those entities to use the trademarks exclusively in Massachusetts;
• encouraged Massachusetts consumers to shop at Toys ‘R' Us, Kids ‘R' Us, and Babies ‘R' Us through an implicit promise, manifested by the trademarks, that the products at those stores would be of good quality and value;
• relied on employees at TRUMI to maintain a positive retail environment, including store cleanliness and proper merchandise display; and
• reviewed licensed products and materials that would be sold in the state to ensure high standards and to maintain its positive reputation with Massachusetts consumers, thereby generating continued business and substantial profits.

In addition, Geoffrey received substantial royalty income from retail stores in Massachusetts. It's annual income from the licensing agreements ranged between almost $6 million and $7.5 million during the tax years at issue.

Geoffrey argued that the board erred in failing to abate the penalties it assessed. The physical presence standard set forth by the U.S. Supreme Court in Quill gave it reasonable cause to believe that it lacked nexus with Massachusetts, the company argued.

Court Upholds Penalties.

Rejecting Geoffrey's argument, the court said the physical presence standard in Quill is limited to sales and use taxes. The court found that Geoffrey's belief that it lacked nexus was undermined by the South Carolina Supreme Court's ruling in Geoffrey Inc. v. South Carolina Tax Dept., 437 S.E.2d 13 (S.C. 1993), cert. denied, 510 U.S. 992 (1993), and a department directive on the issue. The court noted that if Geoffrey was uncertain about its filing obligation it could have sought a letter ruling or sought other guidance from the department. There is no evidence that Geoffrey made such an effort, the court said. Grant Thornton's Yesnowitz said he “found it particularly disappointing that the court upheld the imposition of penalties on the taxpayer in Geoffrey, considering the amount of controversy that this issue has engendered across the country over the past decade.”

The full text of the opinion is available on the Internet at