New Mexico Supreme Court Rules on Part of Kmart New Mexico State Tax Case

January 04, 2006

Summary
On December 29, 2005, the New Mexico Supreme Court ruled on part of the long awaited Kmart Corp. v. Taxation and Revenue Department New Mexico gross receipts and income tax case. N.M. Sup. Ct. Docket No. 27,269. The court held unanimously that the New Mexico gross receipts tax does not apply to receipts from granting a license to use intangible personal property when the grant of the license occurs outside of New Mexico. The court, however, declined to rule on constitutional state tax jurisdiction issues and statutory corporate income tax issues, letting stand a New Mexico Court of Appeals’ decision adverse to the taxpayer. Kmart Corporation was represented by Curtis Schwartz and Tim Van Valen of Modrall Sperling.

On December 29, 2005, the New Mexico Supreme Court ruled on part of the long awaited Kmart Corp. v. Taxation and Revenue Department New Mexico gross receipts and income tax case. N.M. Sup. Ct. Docket No. 27,269. The court held unanimously that the New Mexico gross receipts tax does not apply to receipts from granting a license to use intangible personal property when the grant of the license occurs outside of New Mexico. The court, however, declined to rule on constitutional state tax jurisdiction issues and statutory corporate income tax issues, letting stand a New Mexico Court of Appeals’ decision adverse to the taxpayer. Kmart Corporation was represented by Curtis Schwartz and Tim Van Valen of Modrall Sperling.

The Kmart case involved a trademark holding company, Kmart Properties, Inc. (“KPI”), which licensed trade names and trademarks to Kmart Corporation (“Kmart”). Kmart was a separate entity filer for New Mexico corporate income tax. Kmart paid KPI a royalty for use of the marks and claimed a corporate income tax deduction on its New Mexico corporate income tax return for payment of the royalty. KPI had no physical presence in New Mexico.

The New Mexico Taxation and Revenue Department (“Department”) assessed KPI for New Mexico gross receipts tax and corporate income tax on money received from Kmart, but expressly allowed Kmart a deduction for the amounts paid. KPI filed an administrative protest to the assessments on several grounds. KPI contested New Mexico’s jurisdiction to tax it under the Commerce and Due Process Clauses of the federal constitution. KPI challenged the imposition of the gross receipts tax on receipts from granting a license when the grant of the license occurred outside of New Mexico. KPI also challenged imposition of the corporate income tax on the ground that, even if there was jurisdiction to tax, application of New Mexico’s Uniform Division of Income for Tax Purposes Act (“UDITPA”) apportioned no income to New Mexico. Finally, KPI challenged some procedural aspects of the hearing process and imposition of penalty. In 1999, the Department’s internal hearing officer ruled against KPI on all grounds, except imposition of penalty. KPI appealed to the New Mexico Court of Appeals which affirmed the hearing officer.

KPI appealed to the New Mexico Supreme Court, though Kmart was later substituted as the party because KPI merged into Kmart. The Supreme Court granted a writ of certiorari on all issues, but requested briefing on only the gross receipts tax statutory and constitutional issues, reserving the income tax issues. Kmart contended, as it had below, that the gross receipts tax did not apply because KPI did not have the statutorily required receipts from “selling property in New Mexico,” when all activities relating to grant of the license occurred outside of New Mexico. Supporting this position, the statute also provided clearly that receipts from the grant of a license were receipts from “selling property.” The Department argued, in essence, that “selling property in New Mexico,” at least in the context of intangible property, referred to the location of the property when used by the licensee/buyer, which was in New Mexico (and all other states). This was contrary to existing precedent in the context of tangible personal property that looked to the location of the sales activity, not the use the property itself.

The Supreme Court agreed with Kmart on the statutory gross receipts tax issue. The court, not needing to rule on constitutional limitations on New Mexico’s jurisdiction to tax KPI to reach a decision on KPI’s liability, declined to do so. The court also quashed its writ of certiorari to the New Mexico Court of Appeals on the corporate income tax jurisdiction and statutory issues, ordering that the Court of Appeals’ decision be published, making its income tax statutory and jurisdiction holdings the law of New Mexico for the time being. That case held that “the combination of Kmart Corporation’s activities in New Mexico, together with the tangible physical presence of KPI’s marks, constitutes the functional equivalent of physical presence.” Prior United States Supreme Court cases held that the physical presence of the alleged taxpayer was necessary for a state to assert taxing jurisdiction, but that actual physical presence was not necessary for a state to impose taxes if the taxpayer was represented by independent sales representatives physically present within the state. KPI, however, was not engaged in selling its trademarks in New Mexico, only licensing them to Kmart in a transaction that occurred outside of New Mexico.

The Court of Appeals also held that §18 of UDITPA allowed the Department to apportion KPI income to New Mexico, eliminating two factors from the standard three factor formula and creating a new sales factor. Kmart had contended that the standard three factor formula applied and it apportioned all KPI income outside of New Mexico.

Kmart will consider whether to apply for a writ of certiorari to the United States Supreme Court on the income tax nexus issue now that the Court of Appeals’ decision is the final decision in New Mexico and/or to move the New Mexico Supreme Court to take the case again on the remaining issues.

The New Mexico Supreme Court’s decision resolves a thicket issues that have been raised by the Department over the years regarding its ability to impose the gross receipts tax on licensors of patents, trademarks, copyrights and perhaps also franchises. There is a case raising similar statutory issues relating gross receipts taxation of fees from granting a franchise still pending before the New Mexico Supreme Court, Sonic Industries v. State, which may have been overruled by the Kmart decision, though it remains to be seen if the court makes any distinctions. Unfortunately, for now, the income tax UDITPA and jurisdictional issues stand adverse to taxpayers. There are, however, other similar cases in the pipeline that will probably ultimately come before the New Mexico Supreme Court, especially relating to proper apportionment.