Maryland Tax Court Adopts Economic Substance Doctrine

By Jamie C. Yesnowitz, J.D., LL.M.; Chuck Jones, J.D., CPA; Duane Dobson, CPA, CMI; Lori Magee, J.D., LL.M.; Tom Morgan, J.D.; Giles Sutton, J.D., LL.M.

Editor: Greg A. Fairbanks, J.D., LL.M.

Two recent decisions highlight the Maryland Tax Court's creation and use of the economic substance doctrine in cases involving the use of intangible holding companies (IHCs). The Tax Court ruled in The Classics Chicago, Inc. v. Comptroller and The Talbots, Inc. v. Comptroller, Nos. 06-IN-OO-0226 and 06-IN-OO-0227 (Md. Tax Ct. 4/11/08), that deductions relating to transactions between a parent company with Maryland nexus and a subsidiary can be revoked if the subsidiary does not have sufficient "economic substance."

Further, the court held that the subsidiary, which had not previously filed corporation income taxes in Maryland, had constitutional nexus with Maryland and was subject to a Maryland filing requirement. The Tax Court reached a similar result in Nordstrom, Inc. v. Comptroller, Nos. 07-IN-OO-0317, 07-IN-OO-0318, and 07-IN-OO-0319 (Md. Tax Ct. 10/24/08), where two IHCs belonging to a parent company that did business in Maryland both had nexus with the state because they lacked real economic substance as separate business entities.


In Talbots, the Maryland comptroller's assessments stemmed from the effect of several intercompany transactions. In 1988, Talbots, Inc. (Talbots), a national retailer with locations in Maryland, transferred its intellectual property (including the Talbots trademarks) to Jusco BV, a related foreign holding company. Talbots and Jusco BV then entered into a licensing arrangement whereby in exchange for the right to use the Talbots trademarks, Talbots paid Jusco BV a royalty fee based on a percentage of Talbots' net sales. In 1993, Jusco BV sold the intangible assets to The Classics Chicago (Classics), a new Talbots subsidiary. Classics and Talbots entered into a new licensing agreement under which Classics held the Talbots trademarks and licensed them to Talbots in exchange for royalty payments representing a percentage of Talbots' sales.

Talbots filed Maryland corporation income tax returns and deducted the royalty payments from its Maryland taxable income. Classics did not file Maryland corporation income tax returns because it had no property, bank accounts, or employees in Maryland. Maryland imposed an assessment on Talbots for tax years 2001 and 2002 and on Classics for tax years 1993–2003. The assessments resulted from the comptroller's disallowance of Talbots' royalty and interest deductions because such payments were not considered "ordinary and necessary" business expenses and because the comptroller claimed that Classics had nexus with Maryland and was subject to tax on the receipt of royalty income from the Talbots agreement.

The Sham Doctrine

Talbots relied on Comptroller v. SYL, Inc., 825 A.2d 399 (Md. 2003), to argue that the related-party transactions with Classics should be reviewed under the "sham doctrine," which analyzes the challenged transactions under the framework of whether they were designed solely to avoid taxation. Talbots argued that the deductions arose from a legitimate business expense because the company did not enter into the royalty agreement to avoid state tax liability. The company claimed that there were reasons to engage in such transactions that were not related to state taxation, such as maximizing the value of Talbots stock for an initial public offering, creating a valuable income stream to collateralize, and other legitimate business purposes. Talbots claimed that the facts of SYL differed from its own situation because SYL involved a scheme that was clearly used to avoid the reach of Maryland taxation. In fact, the company asserted that there were some negative implications, from a state tax perspective, resulting from its transactions with Classics, in that Classics became subject to state tax liability in unitary reporting jurisdictions.

The Tax Court found that SYL did not establish the sham doctrine as the standard to be applied when determining the nexus of affiliated entities. The court instead used the economic substance test, which states that an out-of-state affiliate must have real economic substance as a separate business entity. The Talbots and Classics facts did not meet this test. Classics had no other income except for the royalty income from Talbots, had minimal operating expenses, and had only about $2,000 of expenses for office space and bookkeeping services. Talbots loaned Classics nearly all the funds needed to purchase all the intangible assets from Jusco BV. The Tax Court held that these facts showed that Classics completely "relied on the parent for performance of ordinary business operations," proving that Classics lacked economic substance. The court thus elected to view Classics through the lens of Talbots, its parent, which had nexus with Maryland.

As a result, the Tax Court held that Classics had constitutional nexus with Maryland, subjecting Classics to assessment for tax based on the receipt of royalty income from 1993 to 2003. In addition, the court disallowed Talbots' royalty and interest payment deductions for 2001 and 2002 for the related-party transaction. While the Tax Court upheld the assessments that related to Maryland corporation income tax and interest, it reduced the comptroller's penalty assessment from 25% to 10% of the taxes owed.


In Nordstrom, the taxpayers consisted of a national retailer that operated stores in Maryland and two of its subsidiaries (NIHC and N2HC) that did not conduct business or own tangible personal property in the state. Nordstrom entered into a licensing agreement with NIHC in which Nordstrom authorized NIHC to license the use of Nordstrom's trademarks in exchange for the entire stock of NIHC. Nordstrom later transferred its trademarks to NTN, a wholly owned subsidiary of Nordstrom that like NIHC and N2HC did not conduct business or own tangible personal property in Maryland. Nordstrom then transferred the stock it owned in NTN and NIHC to N2HC for cash. NIHC then transferred the licensing agreement to N2HC as a dividend. N2HC then entered into an agreement with Nordstrom to license Nordstrom's trademarks in exchange for royalty payments. Nordstrom paid royalties to N2HC of approximately $200 million during tax years 2002–2004.

Nordstrom, NIHC, and N2HC contended that NIHC and N2HC were not subject to Maryland tax because they had sufficient economic substance to differentiate themselves from the IHCs in prior Maryland cases in this area, such as SYL . In addition, NIHC and N2HC had offices that were staffed by a full-time employee who would bring actions to enforce and protect the trademarks, which in Nordstrom's view was enough substance to pass the sham entity test.

The comptroller argued that the deductions for the royalty payments were not proper because Nordstrom, NIHC, and N2HC should be treated as one company for nexus purposes. The comptroller claimed that NIHC and N2HC had no economic substance because the activities of the subsidiaries were the activities of the parent.

As in Talbots, the Tax Court found that the sham doctrine was not the standard to be applied when determining nexus of affiliated entities. The court applied the economic substance test created in Talbots that required it to examine the economic substance of NIHC and N2HC as well as the legitimate business activities of NIHC, N2HC, and Nordstrom. The application of this test required a transparent consideration of the business activity of Nordstrom, NIHC, and N2HC and a review of the royalties paid by Nordstrom and the financial statements of NIHC and N2HC.

The Tax Court found that the transactions between Nordstrom and its subsidiaries were not at arm's length, considering that one of the subsidiaries loaned most of the royalty payments back to Nordstrom. Note that the Tax Court's conclusion that the transactions were not at arm's length does not appear to follow the analytical construct of examining the business activities and the financial statements of the IHCs. According to the Tax Court, the subsidiaries were similar to those in previous Maryland cases (SYL, Inc. ; Ward Europa, Inc. v. Comptroller, 503 A.2d 1371 (Md. Ct. Spec. App. 1986); and Comptroller v. Armco Export Corp., 572 A.2d 562 (Md. Ct. Spec. App. 1990)) that lacked economic substance. The Tax Court found that "the subsidiaries did not act independently, although the financial structure creates an illusion of substance."

However, there appears to be an inconsistency in this analysis because the requirement of acting independently differs from the requirement of adhering to corporate formalities, substance, purposeful activity, and a profit motive characteristic of economic substance. The Tax Court treated NIHC and N2HC as part of the parent, Nordstrom, which had nexus in Maryland. Because NIHC and N2HC had nexus with Maryland, the Tax Court affirmed assessments against NIHC and N2HC.

The Tax Court rescinded an alternative assessment that the comptroller imposed on Nordstrom itself on the premise that if NIHC and N2HC did not have nexus with Maryland, then Nordstrom should not be able to deduct the payments it received from these entities. The comptroller had proceeded on this alternative basis by arguing that the expenses incurred by Nordstrom were not ordinary and necessary expenses deductible under Sec. 162 and as such could not be deducted for Maryland corporation income tax purposes.


The Talbots and Nordstrom decisions make clear that the economic substance doctrine is now a part of Maryland tax jurisprudence, at least in the area of related- party transactions, and potentially in other areas of Maryland tax law. These cases provide the comptroller flexibility to challenge either the deduction taken by the entity incurring the related-party expense or the nexus status of the entity earning income on the transaction, to the extent such entity claims it is not subject to the state's corporation income tax.

The Maryland Tax Court has placed an additional burden on the taxpayer to prove not only that the transaction is not a sham but that the entities involved in the transaction also have economic substance as standalone entities. Thus, a subsidiary must have some independence and operate as a separate business entity. Unfortunately, to date neither the Tax Court nor the comptroller has offered specific guidance on what facts and circumstances would satisfy the economic substance standard.

Items that a taxpayer will need to consider are whether one entity receives revenue from sources other than royalty payments from the related party, whether the entities in the transaction have officers and/or employees, whether the entities have ordinary and considerable business expenses, and whether the entities were created for purposes other than to avoid state tax liability. The taxpayer will need to show that one entity is not excessively relying on a related-party entity in order for their separate existence to be respected. The taxpayer must ensure that its IHCs have a significant level of substance and that the transactions between the taxpayer and its related IHCs, such as loans and royalty payments, are at arm's length. It remains to be seen whether upper-level Maryland courts will agree with the Tax Court's conception of the economic substance test and, if so, whether the Tax Court or the comptroller will provide guidance on what specific type of fact pattern will satisfy the economic substance standard.


Greg A. Fairbanks, J.D., LL.M., is a tax manager with Grant Thornton LLP in Washington, DC.

For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.

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