In Romantix Holdings, Inc.,¹ the Iowa Court of Appeal (CoA) upheld the Iowa Department of Revenue's (Department) determination excluding an out-of-state holding company from an Iowa consolidated filing because it was not found to be doing business in Iowa even though it held intangible property used in Iowa by its subsidiaries. The CoA also upheld the Department's denial of certain expenses allocated to the subsidiaries but paid by the holding company.

Romantix Holdings, Inc. (Holding Company) owned stock of subsidiaries and intangible property, specifically the Romantix trademark. The subsidiaries included a corporation that owned and operated several adult-themed retail stores (Retail Company), a corporation that operated as a management company (Management Company) and a corporation that owned an airplane and hangar (Aircraft Company) used by the employees of the affiliates. All of Retail Company's revenues were transferred to Management Company on a daily basis to pay the Retail Company's expenses and to pay Aircraft Company for use of its airplane by Retail Company employees for business travel. Holding Company had no operations of its own in Iowa.

In 2007, Holding Company and subsidiaries were purchased by a new owner and the prior owner's stock was redeemed. This redemption was financed by debt incurred by Holding Company. The subsidiaries were guarantors of the debt. The debt was paid by Holding Company through funds received from the subsidiaries. The expenses related to the debt payments were allocated to the subsidiaries by the Holding Company based on relative revenues. In 2009, the Holding Company and its affiliates filed a consolidated Iowa return that included the Holding Company. In 2010, the group still filed a consolidated return but did not include the Holding Company as part of the group, although its subsidiaries continued to take the benefit of the deduction for the debt expenses allocated to them.

Iowa Code Section 422.33 provides that a consolidated return may only include corporations having nexus with Iowa and Iowa taxable income. A safe harbor, under Iowa Code Section 422.34A(5), further provides that a corporation is not doing business in Iowa if it does not have a physical presence in Iowa and its only activity is owning or controlling a subsidiary corporation that is doing business in Iowa. In auditing its 2009-10 returns, the Department excluded Holding Company from the consolidated return on the grounds that it did not have nexus with Iowa under Iowa Code Section 422.34A(5). The Department also disallowed the expenses allocated to the subsidiaries on the grounds that the expenses were not paid by, nor were obligations of, the subsidiaries. Holding Company and its subsidiaries (collectively, the Taxpayer), challenged the assessment.

Inclusion in consolidated return

The Taxpayer argued that Holding Company was not exempt under Iowa Code Section 422.34A(5) because it directly owned intangible property (i.e., the Romantix trademark) that was used by the subsidiaries in its Iowa business activities. The Taxpayer cited KFC Corp.² in which the Iowa Supreme Court (IASC) held that a franchisee with no physical presence³ in Iowa had nexus by virtue of the franchisor's use in Iowa of the franchisee's intangible property. The CoA instead applied a more recent IASC decision in Myria Holdings Inc.⁴ in which the IASC excluded a holding company from an Iowa consolidated return because it was exempt under Iowa Code Section 422.34A(5).

In Myria Holdings, a holding company with no physical presence in Iowa, owned two types of intangible property: 1) stock in its subsidiaries; and 2) money that was used by its subsidiaries under a tax allocation agreement. The IASC concluded that the holding company's activities were all related to owning and controlling a subsidiary corporation. The IASC distinguished KFC Corp. on the theory that the holding company in Myria Holdings did not receive any interest or fees from its subsidiaries related to its intangible property, unlike the franchisor in KFC Corp., which received payment for use of its intangibles from franchisees.

The CoA did not address the Romantix subsidiaries' use of Holding Company's intangible property nor distinguish the facts before it from KFC Corp. The CoA also did not suggest there was any distinction between the intangibles in Myria Holdings (namely subsidiary stock and money), from the trademarks used by the subsidiaries of Holding Company. Further, the CoA decision was silent on whether Holding Company received a fee from the subsidiaries for the use of its trademarks. Rather, the CoA simply relied on Myria Holdings in upholding the Department's exclusion of Holding Company from the consolidated return.

Disallowance of expenses allocated to subsidiaries

The CoA also upheld the Department's disallowance of the allocated expenses. In doing so, the CoA agreed with the Department's rationale that: (a) the subsidiaries now owed the debt as guarantors; (b) the subsidiaries did not pay the expenses, although the funds for paying the expenses flowed from the subsidiaries to Holding Company; and (c) the internal allocation of the debt amortization to the subsidiaries were not reasonable and necessary expenses of the subsidiaries.

Implications

It is unknown at this time whether the taxpayer will appeal this decision to the IASC. The KFC Corp. decision seemed to indicate that the use of intangible property, such as trademarks, in Iowa was sufficient to create constitutional nexus for an out-of-state corporation. The Romantix Holdings decision raises the question whether use of intangible property owned by a holding company versus a franchisee, could be an activity protected against nexus-creation by virtue of the application of Iowa Code Section 422.34A(5) or whether there are other facts, such as payment for use of the intangible property not discussed in Romantix Holdings, that would be distinguishable from Myria Holdings, the case upon which it primarily relied.

———————————————

———————————————
ENDNOTES

¹ Romantix Holdings, Inc. et al v. Iowa Dep't. of Rev., No. 16-0416 (May 3, 2017).

² KFC Corp. v. Iowa Dep't. of Rev., 792 N.W.2nd 308 (Iowa 2010).

³ In KFC Corp., the Iowa Supreme Court concluded that the intangibles licensed to the franchisors amounted to the functional equivalent of physical presence, and that physical presence was not required to create income tax nexus under the Commerce Clause of the United States Constitution.

⁴ Myria Holdings Inc. v. Iowa Dep't. of Rev., ___ N.W.2d ___, 2017 WL 1103175 (Iowa 2017).