BEFORE THE HEARING OFFICER

BEFORE THE HEARING OFFICER

OF THE TAXATION AND REVENUE DEPARTMENT

OF THE STATE OF NEW MEXICO

IN THE MATTER OF

KMART PROPERTIES, INC., NO. 00-04

NM ID. NO. 01-287446-00 6,

PROTEST TO ASSESSMENT

NOS. 2134646 AND 2134647

DECISION AND ORDER

This matter came on for formal hearing on November 17, 18, 19 and 20, 1998 before Gerald B. Richardson, Hearing Officer. Kmart Properties, Inc., hereinafter, "KPI", was represented by Curtis W. Schwartz, Esq., Timothy Van Valen, Esq. and Christopher P. Muirhead, Esq., of Modrall, Sperling, Roehl, Harris & Sisk, P.A. The Taxation and Revenue Department, hereinafter, "Department", was represented by Bruce J. Fort, Esq. After the hearing was adjourned, the parties were granted leave to file briefs. The final briefs were filed on February 15, 1999, and the matter was considered submitted for decision at that time. Since that time, supplemental authority has been filed by the parties, with the last submission being on December 21, 1999. Based upon the evidence and the arguments presented, IT IS DECIDED AND ORDERED AS FOLLOWS:

FINDINGS OF FACT

KPI’s headquarters, principal place of business and commercial domicile are located in Michigan.
KPI is a wholly-owned subsidiary of Kmart Corporation, hereinafter, "Kmart".
Kmart is engaged in the general retail business.
At the end of 1991, Kmart operated 2,249 general merchandise stores in the United States and 126 stores in Canada. Kmart owned an additional 2,022 specialty retail subsidiaries throughout the United States and Canada, including but not limited to, Borders Books, Builders Square, Office Max, Pace, Pay Less Drugs, Sports Authority and Walden Books.
During the audit periods, February 1991 through January 1996 for the Corporate Income Tax Assessment and November 1991 through January 1996 for the Gross Receipts Tax Assessment, Kmart owned and operated approximately 22 general merchandise stores in New Mexico.
In 1991, Kmart’s total sales from its general merchandise stores in the United States was $24.448 billion, with an operating income of $1.367 billion.
In 1991, Kmart’s specialty retail subsidiaries had total sales of $9.032 billion and operating income of $0.345 billion.
James Misplon joined Kmart in 1983. In 1987, he became director of corporate tax and comptroller, effectively placing Mr. Misplon in charge of Kmart’s tax department. In 1993, he became Divisional Vice-President for Corporate Taxes. In 1998, he became Kmart’s Vice-President-Tax.
Sometime in late 1990, Mr. Misplon met with a longtime friend of his, Jim VanDeVelde, who held a similar position to his at Hillenbrand Industries.
During Mr. Misplon’s conversation with Mr. VanDeVelde in late 1990, Mr. VanDeVelde informed Mr. Misplon of a tax planning opportunity involving a subsidiary corporation which would own and license intellectual property transferred from Kmart.
Mr. Misplon himself, and others in Kmart’s tax department under his supervision, direction and control, investigated the tax planning opportunity involving a subsidiary corporation which would own and license intellectual property transferred from Kmart.
Kmart’s Tax Department, under Mr. Misplon’s supervision and control, is responsible for Kmart’s tax planning and compliance. Kmart’s Tax Department prepared KPI’s state and federal income tax returns.
After a tax planning opportunity is identified and researched within Kmart’s Tax Department, it is presented to the persons within Kmart with responsibility for the area of business to which the tax planning opportunity relates.
After Kmart’s Tax Department had completed its analysis with regard to the tax planning opportunities which an intellectual property management and protection corporation provided, Mr. Misplon took the idea to Nancie LaDuke, Vice President and Secretary of Kmart for her consideration from a non-tax business perspective.
Ms. La Duke supervised the commercial law, trade regulation, international law and intellectual property sections within Kmart’s Legal Department. Ms. LaDuke was consulted because her responsibilities as Vice President of Kmart’s Legal Department include oversight of Kmart’s intellectual property.
Ms. LaDuke concluded that the creation of an intellectual property management company would make sense from a non-tax business perspective in that it would provide greater focus, responsibility and accountability for management of Kmart’s intellectual property and would reduce the expense of outside legal fees which Kmart historically incurred in relation to the management of its intellectual property. On that basis, Ms. LaDuke recommended the establishment of an intellectual property management and protection corporation to her superiors, Mr. Anthony Palizzi, General Counsel and former acting Chief Executive Officer of Kmart, and Mr. Thomas Murasky, then Chief Financial Officer of Kmart.
Ms. LaDuke was unable to explain how the non-tax business advantages of creating a separate intellectual property management company could not have been accomplished just as well by creating a separate division within Kmart to manage its intellectual property.
The transfer of Kmart’s trademarks to KPI for use by third parties actually created a greater risk of abandonment of Kmart’s intellectual property than would have existed if Kmart had held and managed the trademarks itself. The transfer required not only the execution of the License Agreement, but also the implementation of procedures to ensure that the terms of the License Agreement were met with respect to policing the use of the intellectual property and ensuring the quality of the products and services with which the intellectual property was associated.
Sometime before April 3, 1991, Kmart approached Price Waterhouse, LLP with respect to the tax implications of the creation of a separate corporation to which Kmart’s domestic trademarks would be transferred. A meeting was held on April 17, 1991 with a representative of Price Waterhouse, several employees of Kmart’s Tax department and Michael Lisi and Lisabeth Coakley, Kmart’s in house intellectual property attorneys.
At some time in 1991, Kmart prepared or received a summary of its estimated savings in state income taxes in 33 states which allowed separate entity filing, including New Mexico. The summary estimated state income tax savings of approximately $12 million for the fiscal year ending 1/30/90 and assumed a royalty deduction of $250,000,000.
The Detroit office of Price Waterhouse prepared a memorandum dated July 10, 1991, entitled Utilization of an Investment Holding Company to Minimize State and Local Income Taxes. It concluded that if structured properly, a company formed to hold and license Kmart’s intellectual property could generate significant state and local income tax savings for Kmart in states which allow separate entity filing for corporate income taxes as well as other non-tax benefits. The memorandum outlined that Kmart’s tax savings could be achieved by transferring the intellectual property owned by Kmart’s operating companies to a properly structured holding/investment company and charging a royalty for use of the intellectual property. Kmart would then reduce its taxable income by the royalty expense. The memorandum further advised that the royalty income generated by the investment/holding company could be transferred to Kmart or the operating companies through properly structured cash advances, loans or dividends. If the royalty income is loaned to Kmart, the interest on such loans would provide additional tax reduction benefits to Kmart by the amount of interest paid on such loans. The memorandum further recommended that the holding/investment company be organized as a Michigan Realty and Investment Company located in Michigan. Michigan’s Single Business Tax, which is imposed on Michigan domestic corporations, excludes from taxable income interest and royalty income, thus shielding the interest and royalty income of the holding/investment company from taxation. The memorandum also recommended that the holding/investment company refrain from performing any activity which may result in establishing a taxable connection outside the state in which it is located.
Subsequent to the receipt of the Price Waterhouse memorandum, Mr. Palizzi and Mr. Murasky authorized the formation of a subsidiary of Kmart Corporation which became known as KPI.
The idea of creating a separate corporate entity to hold and license the intellectual property of Kmart originated in the Kmart Tax Department, not its Legal Department.
Before the idea of creating a separate corporate entity to hold and license the intellectual property of Kmart was raised by the head of the Kmart Tax Department, Ms. LaDuke had never considered establishing separate office space for the purpose of allowing Kmart’s intellectual property lawyers to better focus on their intellectual property work, nor had Ms. LaDuke considered creating separate software and data bases for Kmart’s intellectual property legal staff.
Kmart had never considered the creation of a separate corporate entity to hold and license its intellectual property prior to the issue being raised by Mr. Misplon of Kmart’s Tax Department.
None of the other seven practice sections in Kmart’s legal department have been split out or assigned to separate corporate subsidiaries.
In spite of the non-tax business reasons cited by Ms. LaDuke for creating a wholly owned intellectual property management company to more efficiently hold and manage Kmart’s intellectual property, Kmart never transferred its foreign trademarks and tradenames to KPI to be managed or were the trademarks and tradenames of its specialty retail subsidiaries, such as Borders Books, Builders Square, Office Max, Pace, Pay Less Drugs, Sports Authority and Walden Books transferred to KPI for management.
The non-tax business purposes cited by Ms. LaDuke for Kmart to create KPI to own and manage Kmart’s intellectual property could have been met by creating a separate division within Kmart focused solely upon the management of its intellectual property. The real reason for the formation of KPI was to reduce Kmart’s state corporate income taxes in states which allow separate entity filing, including New Mexico.
At some time before July 9, 1991, Kmart solicited proposals from third parties for the purpose of establishing a valuation of the trade names and trademarks which were to be transferred to a separate corporate entity and to establish an arm’s length royalty rate. Arthur Consulting Group submitted a proposal on July 9, 1991. Price Waterhouse was subsequently selected to prepare the valuation report. On August 1, 1991, Price Waterhouse provided Kmart with a written Estimation of a Range of Royalty Rates and Fair Market Values for the Kmart Trade Name.
Price Waterhouse estimated that the range of fair market values of the Kmart trade names owned by Kmart and used in the United States as of August 1, 1991 was between $2,734,100,000 and $4,101,200,000. It further estimated that the range of royalty rates for the use of such tradenames to be between 1% and 1.5% of net sales. Net sales were defined as the gross sales of the Hardlines, Fashions and Reader’s Market divisions of the General Merchandise Group of Kmart, less returns and allowances.
Robert Reilly, a trademark, intellectual property and intangible property valuation expert, independently determined that Price Waterhouse’s study arrived at a reasonable arm’s length royalty rate for licensing the various trademarks and service marks licensed by KPI to Kmart.
Prior to the formation of KPI, Kmart’s trademarks were registered, monitored, policed and defended against infringement by Kmart’s legal department. At the time Kmart’s trademarks were assigned to KPI, KPI had incurred none of the costs and had performed no activities which, in any manner created, enhanced or protected any of the value of those trademarks.
Prior to the formation of KPI, Kmart employed two attorneys specializing in intellectual property law: Lisabeth H. Coakley and Michael Lisi. Lisabeth H. Coakley was given the responsibility for establishing the new office of KPI, including selection of a location, negotiating a lease, buying furniture and fixtures, setting up payroll and accounting systems. Michael Lisi was responsible for selecting computer systems and other tasks.
Prior to the formation of KPI, Michael Lisi and Lisabeth H. Coakley reported to Ms. LaDuke as their supervisor. Ms. LaDuke’s duties included setting salaries for Ms. Coakley and Mr. Lisi.
After KPI was formed, the two attorneys who did the intellectual property work at Kmart became the attorney staff for KPI.
In deciding to physically segregate KPI from Kmart’s offices, Ms. LaDuke was aware that the physical segregation of the intellectual property management subsidiary from the offices of its parent company was an important aspect of the tax planning benefits which accompany the formation of a separate intellectual property subsidiary and Ms. LaDuke took that into consideration when making her decision to locate KPI apart from the offices of Kmart.
In creating KPI in Michigan, Kmart closely followed the recommendations of the Price Waterhouse memorandum dated July 10, 1991, entitled Utilization of an Investment Holding Company to Minimize State and Local Income Taxes.
In creating KPI, the recommendations of the Price Waterhouse memorandum dated July 10, 1991 to establish an independent and substantial separate corporate entity to hold and manage Kmart’s intellectual property were followed. A separate physical location for KPI was established, stationery and business cards were procured with KPI’s own address, a separate telephone listing was created, bookkeeping and banking functions were confined to Michigan and storage was arranged for within Michigan for the physical storage of KPI’s investment securities.
On September 27, 1991, Articles of Incorporation were filed with the Michigan Department of Commerce incorporating KPI.
On October 15, 1991, an oral presentation was made to the Board of Directors of Kmart recommending the formation of KPI. No written reports were submitted for consideration by the Board. That same day, the Board of Directors of Kmart authorized the formation of KPI.
On October 17, 1991, KPI was duly organized. An Action in Writing by Sole Incorporator of KPI was executed adopting and approving KPI’s Bylaws. A Consent in Writing in Lieu of a Meeting of the Board of Directors of KPI was executed, taking appropriate action to organize KPI.
On October 28, 1991, a Consent in Writing in Lieu of a Meeting of the Board of Directors was executed by the KPI Directors further implementing the organization of KPI.
In its creation, and in operation, KPI observed all corporate formalities required by Michigan law.
KPI had its own duly elected Board of Directors, which consisted of three persons, the composition of which changed from time to time during the audit periods.
KPI’s Board of Directors either held special board meetings, or in the alternative and lieu thereof, executed written consents adopting from time to time resolutions relating to the operations and management of KPI, as required and permitted by Michigan law and KPI’s Bylaws.
Annually, KPI’s Board of Directors adopted appropriate resolutions including the election of officers.
At all times during the audit periods, KPI had its own duly elected officers, which consisted of a President, two Vice Presidents, a Treasurer, two Assistant Treasurers and a Secretary and an Assistant Secretary.
At all times during the relevant audit periods, James Misplon was a KPI Assistant Treasurer. At all times during the relevant audit periods, James Misplon was an Assistant Treasurer of most, if not all, Kmart subsidiaries. At all times during the relevant audit periods, Frank McClure was a KPI Assistant Treasurer. At all times during the relevant audit periods Frank McClure was an Assistant Treasurer of most, if not all, Kmart subsidiaries. At all times during the relevant audit periods, Nancie LaDuke was KPI’s Assistant Secretary.
The Corporation Company was KPI’s registered agent in Michigan for 1992. For 1993 and 1994, Michael A Lisi was the registered agent. For 1995 forward, Gerald T. Tschura ws the registered agent.
On October 30, 1991, KPI and Kmart entered an Agreement Regarding Capital Contribution.
The Capital Contribution Agreement memorialized a tax-free exchange of assets for stock between parent and subsidiary corporation in accordance with the United States Internal Revenue Code § 351, which is a common method of capitalizing corporate subsidiaries.
On October 30, 1991, KPI issued to Kmart 100 shares of KPI common stock thereby making Kmart the sole shareholder of KPI, in exchange for Kmart’s capital contribution of certain of its intellectual property to KPI.
On October 30, 1991 by a written Assignment entered into by and between Kmart and KPI, Kmart transferred to KPI all of its domestic service marks, trademarks and tradenames, together with goodwill symbolized by those service marks, trademarks and tradenames, making KPI the owner of all of Kmart’s domestic intellectual property.
Kmart and KPI expressly agreed that the value of the stock transferred to Kmart had the same value as the intellectual property transferred to KPI.
Included in the intellectual property Kmart assigned to KPI was the Kmart logo, which is a significant intellectual property represented by a number of trademarks.
Kmart’s initial plan was to transfer all of its international marks to KPI, but the international marks were not transferred because of costs and shifting priorities within Kmart.
Most of the intellectual property transferred to KPI by Kmart, including the domestic service marks, the trademarks and the trade names, were registered with or registration was pending with the United States Patents and Trademarks Office. KPI and Kmart filed registration statements with the U.S. Patents and Trademarks Office indicating the change of ownership from Kmart to KPI.
KPI generally did not register trade names and trademarks with state offices, relying instead on registrations with the U.S. Trademark and Patent Office. At no time during the audit periods or otherwise was any of the intellectual property transferred by Kmart to KPI ever registered by KPI with the State of New Mexico.
The Boards of Directors of both KPI and Kmart adopted resolutions allowing KPI employees to participate in Kmart-sponsored retirement plans, insurance benefits and other employee benefits. Certain of the Specialty Retail Subsidiaries participated in Kmart-sponsored retirement plans, insurance coverage and other employee benefits while others, such as Borders Books, Pay Less Drugs and Office Max did not.
Any 51% or more owned subsidiary of Kmart could participate in Kmart-sponsored employee benefits plans upon the adoption of a resolution authorizing such by the Boards of Directors of both Kmart and its subsidiary.
At no time during the audit periods or otherwise was KPI ever a party to any litigation in the State of New Mexico with respect to its intellectual property.
At no time did Kmart’s annual reports disclose the formation of KPI and the transfer of assets valued at between $2.7 Billion and $4.1 Billion between the two entities.
KPI initially employed two attorneys, a legal secretary and an office manager to conduct its business affairs. Later, a legal secretary and paralegal were added to the staff. During the audit periods, KPI’s staffing remained substantially the same. All of KPI’s initial employees were transferred from Kmart. All received the same initial salary they had been earning at Kmart.
Although Kmart and KPI have corporate officers in common, KPI does not have any joint or shared employees with Kmart or others. All KPI employees are employed exclusively by KPI. KPI employees often perform work for Kmart and its subsidiaries, but they do so as employees of KPI.
KPI management, e.g., Lisabeth Coakley and/or Gerald Tschura, made the decisions whether to hire additional employees and who would be hired.
KPI management supervised KPI’s staff, evaluated their performance and determined pay increases.
Ms. Coakley served as Vice President, Treasurer and legal counsel for KPI.
On October 31, 1991, KPI leased office space in Troy, Michigan by entering into a lease with Sheffield Office Park. KPI’s office is approximately one block away from Kmart’s headquarters, also located in Troy Michigan. Ms. Coakley selected the Sheffield Office Park location because of its close proximity with Kmart, for whom KPI performed legal services.
Sheffield Office Park is not in any way related to Kmart or KPI except for its lease agreement with KPI. KPI’s name appeared on the office directory at Sheffield Office Park.
KPI purchased all office furniture, supplies, stationery, business cards and office equipment necessary for its operation, such as file cabinets, computers, a photocopier, a fax machine and calculators. KPI paid for the office furniture, supplies, stationery, business cards and equipment with its own funds drawn from its own bank accounts.
KPI’s office space includes four offices, a conference room, lunchroom, file room and reception area.
When it commenced business operations and throughout the audit periods, KPI has had an identifiable place of business with supporting business records, including its own stationery and business cards.
KPI does its own bookkeeping and maintains its own books of account.
KPI’s bookkeeping and accounting software is not compatible with Kmart’s. To incorporate KPI’s books of account into that of Kmart, Kmart’s financial reporting employees download the accounting information and convert the information so that it is compatible with Kmart’s software.
KPI employed the services of independent payroll companies, Automated Data Processing and Payroll One, to perform its payroll functions, including but not limited to, preparation of payroll checks for KPI’s employees and preparation of state and federal employment and unemployment tax reports and returns. The independent payroll companies are also unrelated to and independent of Kmart and Kmart does not utilize their services itself.
KPI incurred and paid its own operating expenses such as salaries and wages, equipment rental, maintenance and repair, rent, state and federal payroll taxes, property taxes, utilities, office supplies, dues and subscriptions, insurance, postage, telephone, meals and travel, data processing and printing.
KPI maintained bank accounts in its own name.
KPI has a payroll checking account at National Bank of Detroit which is separate and apart from its operating business account. All KPI payroll checks are written on KPI’s payroll account.
KPI did not incur any operating or other expenses in New Mexico.
Before formation of KPI, Kmart’s tax department researched whether any states could assert the ability to tax a subsidiary corporation which holds Kmart’s intellectual property based only upon the subsidiary’s use of the intellectual property within such state and it was determined that such a subsidiary would lack taxable nexus.
KPI, in accordance with federal law, filed all required IRS forms 941, Employer’s Quarterly Federal Tax Return, remitting income and FICA taxes withheld from its employees and its employment taxes.
KPI, in accordance with federal law, filed all required IRS forms 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, remitting its federal unemployment taxes.
KPI, in accordance with Michigan law, filed all required Michigan forms C-3200, Combined Returns for Michigan Taxes, remitting Michigan income taxes withheld from its employees.
KPI, in accordance with Michigan law, filed all required Michigan forms MESC 1020, Employer’s quarterly Tax Report, remitting its Michigan unemployement taxes. KPI, in accordance with Michigan law, filed all required Personal Property Statement, forms STC 632, with the City of Troy, rendering its personal property for personal property tax purposes.
KPI, in accordance with Michigan law, filed its Single Business Tax Annual Return, Forms C-8000, and supporting schedules with the Michigan Department of Treasury.
KPI, in accordance with Michigan law, filed all required Michigan Annual Report Domestic Profit Corporations, form C&S 2500, with the Michigan Department of Consumer and Industry Services Corporation, Securities and Land Development Bureau.
From 1991 to 1995, KPI paid Michigan single business tax of $100 per year. KPI paid no other state income taxes as a separate corporate entity. On its proforma Federal Corporation Income Tax Form 1120 for 1994, KPI reported a state income tax expense of $5,337,546.00, representing KPI’s portion of taxes paid on a combined filing basis in states where KPI’s income was combined with Kmart’s income.
KPI relied on Kmart’s tax department to prepare its various tax documents because KPI did not have the requisite expertise in that area and KPI believed that Kmart’s tax department was competent to handle KPI’s tax matters.
The Kmart tax department is available to provide assistance to any of Kmart’s subsidiaries.
On the same day, October 30, 1991, on which Kmart assigned its domestic service marks, trademarks and tradenames and related goodwill to KPI, KPI and Kmart entered into a license agreement whereby KPI granted an exclusive license to use all of the service marks, trademarks and trade names which it owned to Kmart, for Kmart’s use in the United States and its territories. If KPI had not been created as a separate subsidiary to hold Kmart’s service marks, trademarks, tradenames and related goodwill, a licensing agreement would not have been necessary for protection of Kmart’s intellectual properties.
Under the License Agreement, KPI receives consideration from Kmart, in the form of royalties, for the grant of the license. The royalty rate which KPI receives from Kmart equals 1.1% of Kmart’s net sales.
The License Agreement was negotiated and executed in Michigan and by its terms, the agreement is governed by Michigan law and all disputes are to be resolved in Michigan courts.
KPI, as owner of the service marks, trademarks and tradenames, had the power to determine where it would license Kmart to use those properties. In granting a license to Kmart to use those properties in the United States, KPI knowingly granted Kmart a license to use those properties in connection with its retail store operations in New Mexico and elsewhere in the United States.
Under the terms of the License Agreement, Kmart warrants that all products and services bearing the trademarks, and service marks, ("the Marks") will be consistent with the high standards of quality and excellence established over the years by Kmart with respect to the Marks. Kmart further agreed to comply with any quality standards set by KPI with regard to the products or services bearing the Marks. It was further agreed that the initial quality standards would be those currently maintained by Kmart, but should Kmart wish to add a new product or service or change the quality of an existing product or service, Kmart must so advise KPI and advise it of the description of the new product or service, or the revised quality standard. Unless KPI provides written notice of objection to the new product, service or revised quality standard within thirty days, KPI is deemed to have approved the new product, service, or revised quality standard.
Under the terms of the License Agreement, Kmart must furnish or make available to KPI representative samples of the products and services bearing KPI’s Marks to permit KPI to determine if they meet quality standards. KPI is also given the right to inspect Kmart’s places of business. If notified in writing by KPI, Kmart must not offer or provide services or products whose nature or quality does not comply with the quality standards established by KPI.
Under the terms of Paragraph 6 of the License Agreement, Kmart acknowledges the great value of the goodwill associated with the Marks, acknowledges that the goodwill belongs to KPI and acknowledges that actions taken by Kmart may affect the value of the goodwill associated with those marks. Kmart agrees not to take or continue any action which it would have reason to know could cause injury to the Marks or to KPI.
The terms of Paragraph 9 of the License Agreement require that Kmart distribute or sell the products or services bearing KPI’s marks only from establishments maintaining a good business reputation and that are not associated with illegal, vulgar, obscene, immoral, unsavory or offensive activities in order to maintain and enhance the goodwill and image of quality associated by the public with KPI’s Marks.
Under the terms of Paragraph 10 of the License Agreement, KPI acknowledges that Kmart obtains products from manufacturers of its own choice and contracts with contractors of Kmart’s own choice to perform services and that such products and services associated with KPI’s marks may be sold or used only in Kmart’s stores. In addition, Kmart agrees to be fully responsible to KPI for the conduct of those with whom it contracts to ensure compliance with the License Agreement.
Paragraph 11 of the License Agreement requires that Kmart periodically inform persons from whom it obtains products or services bearing KPI’s Marks of the appropriate trademark and copyright notices to be used in connection with the advertising, promotion, display and sale of the products and services.
Paragraph 7 of the License Agreement provides that the parties (Kmart and KPI) are independent contractors and are not agents, employees, partners, joint venturers or in a franchisor/franchisee relationship.
Paragraph 7 of the License Agreement requires that Kmart cooperate with and assist KPI in protecting and defending the Marks and requires that Kmart inform KPI of any infringements upon the Marks.
KPI’s primary objective in entering into the License Agreement which allowed Kmart the use of KPI’s trademarks and service marks was the further protection and enhancement of its valuable trademarks and service marks.
KPI relied on Kmart and its employees to comply with the terms of the License Agreement, which protect and enhance the value of its intellectual property.
KPI’s business operations involved management of the trademarks, service marks and trade names that it owned, as well as providing legal services for its clients, Kmart and its specialty retail Kmart subsidiaries.
KPI did not provide legal services to any persons or entities other than Kmart and its specialty retail subsidiaries.
About half of the time of the attorneys employed by KPI was devoted to providing legal services to Kmart and its specialty retail subsidiaries.
KPI monitored the use of KPI’s intellectual property by Kmart, actively protecting its intellectual property from infringement by others, continually updating filings and registrations to assure that its rights in and to the intellectual property was preserved, and conducting trademark and trade name searches.
To the extent it deemed necessary and appropriate, KPI employed and compensated outside, independent intellectual property counsel to represent it.
KPI monitored the use of its trademarks and service marks by Kmart by reviewing advertising Kmart submitted for review and by examining samples of products Kmart submitted for review. At times, KPI denied Kmart the use of its trademarks and service marks for specific applications and recalled products which did not meet its quality standards.
In reviewing the advertising submitted by Kmart, KPI looked to ensure that its trademarks were used in a consistent manner and to ensure that the use did not infringe on other trademarks or tradenames. If Kmart’s advertising was not in compliance with proper use of its intellectual property, KPI would stop the advertisement and require that it be revised so that it was in compliance with KPI’s guidelines and standards.
If KPI did not take measures to monitor the use of its intellectual property, it risked abandonment of the intellectual property, thereby permitting third parties to use the trademarks or tradenames in whatever manner they desired.
KPI required of Kmart that its vendors of products and services bearing the Marks sign a purchase agreement document attached to the License Agreement.
KPI interviewed and corresponded with product testing laboratories to determine that they had adequate testing procedures to ensure that the quality standards required under the Licensing Agreement would be met with respect to merchandise sold by Kmart.
KPI’s paralegal also went to Kmart stores to obtain samples of merchandise.
KPI regularly monitored five or six stores located in Michigan to inspect how its intellectual property was being used.
KPI did not physically inspect any stores in New Mexico and rarely, if ever, visited any stores outside of Michigan.
KPI maintained a calendaring or docketing schedule to ensure that the intellectual property did not lapse.
It is common for owners of intellectual property to exploit it through licensing agreements.
It is also common for companies owning intellectual property to set up separate subsidiaries for the purpose of licensing intellectual property.
One expert, Ruurd Leegstra of the Price Waterhouse firm, has been associated with between 50 and 100 companies similar to KPI which were created to hold the intellectual property of its parent corporation and license that property to its parent as part of a state tax planning strategy marketed by Mr. Leegstra’s employer to its state tax clients.
Intellectual property licensing is common and there is a substantial industry of professionals and a number of professional organizations involved in some aspect of licensing intellectual property.
It is common for licensees of intellectual property to pay for advertising the products and services associated with the trademarks and tradenames associated with those services, together with the associated trademarks and tradenames.
KPI receives a royalty from Kmart on a quarterly basis, in consideration for KPI’s grant of the license to use KPI’s intellectual property to Kmart. The royalty rate equals 1.1% of Kmart’s net sales.
During the audit periods, KPI received royalty payments from Kmart totalling $1,274,327,721, broken down as follows:

1991 $ 82,380,841.00

1992 274,488,001.00

1993 292,128,653.00

1994 307,783,055.00

1995 317,547,171.00

Throughout the audit period, KPI maintained two bank accounts with the National Bank of Detroit, a Michigan bank. Account No. 905005958 was used primarily to pay KPI’s payroll expenses. Account No. 9488-23 was used to hold the royalty payments KPI received from Kmart, together with earnings from short term investments. Operating expenses as well as loans to Kmart were paid from this account.
Kmart paid KPI the royalty payments via wire transfers from Kmart’s operating account into KPI’s separate bank account on a quarterly basis, with both accounts being located in Michigan. KPI also utilized wire transfers to effectuate the loans it made to Kmart and to transfer and receive funds from the banks with which it placed short term investments.
Frank McClure, as the Assistant Treasurer for both Kmart and KPI, oversaw the investment of corporate monies for both entities.
Kmart, through its treasurer’s office, provides cash management services for all Kmart subsidiaries.
Teresa Mulawa was an Assistant Treasurer for Kmart who handled the day to day cash management and was supervised by Frank McClure.
Once KPI received the quarterly royalty payment, Frank McClure would typically instruct Teresa Mulawa to invest the monies in short term investments. These short terms investments were typically for terms of overnight to ten days, but could be for periods up to sixty days. Ultimately, the royalties received by KPI, less any operating expenses, were loaned back to Kmart, usually within two or three days from when they were received.
Mr. McClure directed the investment of KPI’s funds pursuant to KPI’s investment policy, which was essentially the same as the investment policy of Kmart’s other subsidiaries. Pursuant to that investment policy, excess funds were invested in time deposits with quality, low risk banks from an approved list.
During the audit period, KPI and the specialty retail subsidiaries of Kmart did not declare and/or pay a dividend to Kmart. This was in accord with the standard practice of Kmart subsidiaries not to declare of pay dividends to Kmart.
Excess funds on hand of subsidiaries are routinely transferred into Kmart accounts for cash management purposes.
Such funds swept into Kmart accounts are booked and treated for all purposes as a loan from the respective subsidiary to Kmart.
All such loans bear market rate interest.
Kmart and KPI entered into a loan agreement in the amount of $500,000,000, whereby KPI loaned its excess funds to Kmart.
KPI earned interest income from its own investments and from its loan to Kmart.
During the audit periods, KPI reported on its proforma federal form 1120 the following amounts of interest income:

1991	$ .00
1992	2,509,094.00
1993	8,934,166.00
1994	18,771,119.00
1995	48,516,828.00

Interest paid by Kmart to its subsidiary lenders is reflected on the books of account of both Kmart and the lending subsidiary.
The loan agreement between KPI and Kmart expired on March 12, 1997. KPI did not notice that the loan agreement had expired until after that date, and no action was taken to execute a new loan agreement until sometime after the loan agreement had expired.
At the end of 1995, KPI’s balance sheet indicated that it was owed $797,170,000 in notes receivable from Kmart. This amount far exceeds the $500,000,000 amount of the loan agreement between Kmart and KPI. No action was taken by KPI during the audit period to amend the loan agreement to cover the amounts it had loaned Kmart in excess of the stated amount of the loan agreement.
Lisabeth Coakley, KPI’s Treasurer, did not consider other ways of investing KPI’s excess capital, other than to allow it to be invested in short term time deposits and to loan it to Kmart. Although Ms. Coakley reviewed the loan agreement on behalf of KPI, she did not negotiate its terms.
The loan agreement contains no mechanism by which KPI can collect the loan debt from Kmart.
KPI doesn’t know if the loan will ever be repaid, and has not asked that Kmart repay its loan.

During the audit periods, KPI reported the following amounts as income and the following amounts as deductions on its proforma federal corporate income tax returns:

	Income	Deductions
1991	$ 82,380,841.00	$ 123,425.00
1992	277,152,761.00	275,085.00
1993	302,057,826.00	1,362,051.00
1994	326,564,763.00	6,334,699.00
1995	366,079,858.00	(854,922.00)

KPI’s income statement for the period through December 31, 1995 indicate that KPI’s actual operating expenses were $1,118,544.
KPI also performed intellectual property legal services for Kmart and its specialty retail subsidiaries. These legal services included defending Kmart against trademark infringement claims brought by third parties against Kmart not related to the marks KPI licenses to Kmart.
KPI billed and was paid for legal services rendered for Kmart and its specialty retail subsidiaries. These bills were paid by the entity for whom the legal services were performed.
About one-half of KPI’s attorney time was billed to Kmart or its subsidiaries. Ms. Coakley billed her time at $175/hour, based on comparable rates within the legal community, and Mr. Lisi’s time was billed out at $150/hour.
All legal services performed by KPI for others occurred in Michigan, with no legal services being performed in New Mexico.
KPI does not own, rent, lease nor license real or tangible personal property in New Mexico.
KPI has never had any employees or offices in New Mexico.
KPI has no bank accounts, addresses, post office boxes or offices in New Mexico.
KPI has never owned any vehicles used in New Mexico.
KPI has never had any equipment it owns used in New Mexico.
KPI performed no services in New Mexico.
All costs and expenses of KPI’s business operations are incurred in states other than New Mexico.
KPI licenses its intellectual property to Kmart for use in New Mexico as well as the other forty nine states.
Kmart uses KPI’s intellectual property and associated goodwill in New Mexico to promote and enhance its sales revenues.
KPI’s logo is displayed on Kmart’s stores in New Mexico.
Kmart requires that its employees wear either a smock or a shirt with the KPI logo displayed on it at all times while working in Kmart stores.
Kmart trains and requires its employees to maintain clean stores.
Kmart requires that its store employees be trained to be friendly to customers.
Kmart’s activities, including marketing products and services bearing KPI’s trademarks and tradenames, maintaining the quality of the products and services it sells, and otherwise providing its customers with a quality shopping experience inure to and enhance the value of KPI’s trademarks and tradenames.
Will Baca, an assistant store manager for Kmart in New Mexico, was unaware of KPI or its role as licensor of the trademarks, tradenames and service marks which it owns to Kmart.
The Department conducted its audit of KPI through a review of Kmart and KPI documents.
The Department’s auditor, Frank Schaffer, in selecting companies for audit, looked for companies which created subsidiaries to hold and license back intellectual property in order to create royalty expense deductions for the parent company.
Prior to attempting to audit KPI and to the assessments at issue herein, the Department’s auditor had contacted Kmart’s Tax Department to request a copy of the Licensing Agreement. Kmart’s Tax Department responded that it would not provide the Licensing Agreement except in the context of an on-premises viewing.
The Department scheduled an audit with Kmart’s Tax Department and requested, prior to the auditor’s arrival, that certain documents relating to the royalty payments made by Kmart to KPI be made available to the auditor at the time the audit commenced. Kmart agreed to make the documents available to the auditor when he arrived.
When the Department’s auditor arrived at Kmart’s Tax Department at the appointed time for the audit, Kmart would not provide the documents which the Department’s auditor had requested.
Ultimately, the Department only obtained the documents upon which the Department’s assessments were based by enforcing a subpoena issued to Kmart in the District Court for Santa Fe County.
KPI furnished the Department’s auditor with a breakdown of Kmart’s sales revenues attributable to its New Mexico stores. The auditor then applied the 1.1% royalty rate to Kmart’s New Mexico sales revenues to determine the royalties attributable to the licensing of KPI’s trademarks in New Mexico. Broken down by calendar year, KPI’s royalties from licensing its trademarks in New Mexico are as follows:

1991	$ 497,251
1992	2,076,460
1993	2,231,215
1994	2,277,093
1995	2,289,144
1996	190,828

The Department’s auditor used the amount of royalties attributable to the licensing of KPI’s trademarks in New Mexico as the base upon which gross receipts tax was calculated for purposes of the Department’s gross receipts tax assessment.
In 1991, by Laws 1991, ch. 203, § 1, the New Mexico legislature amended § 7-9-3(J) NMSA 1978, the definition of a lease, to provide that the granting of a license to use property is the sale of a license and not a lease.
In its audit, the Department determined that the three-factor formula was an inappropriate formula to apportion KPI’s income which it determined was apportionable.
In its audit the Department utilized a single-factor formula based upon sales to apportion KPI’s income which it determined to be apportionable.
The Department’s auditor utilized the Department’s corporate income tax instructions in determining that the three-factor formula was inappropriate to apportion KPI’s income.
The Department’s auditor used the amount of royalties attributable to the licensing of KPI’s trademarks in New Mexico, modified to reflect the amounts received during each of KPI’s fiscal years, which end in January of each year, and divided it by the amount of KPI’s total royalties from licensing its trademarks to Kmart, broken down by fiscal year, to arrive at a percentage, which was the New Mexico apportionment factor. This apportionment factor was applied to the amount of tax calculated under the tax tables in the New Mexico Corporate Income and Franchise Tax Act, to calculate the amount of corporation income tax , by year, for purposes of the Department’s corporation income tax assessment.
In formulating the sales factor, the Department’s auditor departed from the standard sales factor formula calculation under § 7-4-18, which, for sales of other than tangible personal property, sources the sales to one state only, either the state where all of the taxpayer’s income producing activity occurs, or the state where the taxpayer incurs the greatest proportion of the costs of performing the income producing activity. Instead, the Department’s auditor applied the method set forth in Regulation 3 NMAC 5.19.11.1(3), which provides that where the income producing activity with respect to business income from intangible property can be readily identified, if the income producing activity occurs in-state, it is included in the numerator of the sales factor.
The apportionment percentages arrived at by the Department’s auditor for each of KPI’s fiscal years is as follows:

FYE 1-29-92 .7911%

FYE 1-27-93 .8072%

FYE 1-26-94 .7788%

FYE 1-26-95 .7332%

FYE 1-31-96 .6568%

Kmart’s New Mexico apportionment factor arrived at by using the standard UDITPA three factor formula for the years covered by the Department’s audit was approximately .7% . This closely corresponds to KPI’s apportionment factor under the Department’s single factor methodology during the audit years.
On May 12, 1997, the Department mailed Assessment No. 2134646 to KPI, assessing $250.00 of franchise tax, $758,142.00 of corporation income tax, $75,839.20 of penalty, and $309,356.25 of interest for a total assessment of $1,143,577.45 for the periods of February, 1991 through January, 1996.
On May 12, 1997, the Department mailed Assessment No. 2134647 to KPI, assessing $478,099.55 of gross receipts tax, $47,810.02 of penalty, and $238,063.85 of interest for a total assessment of $763,973.42 for reporting periods November, 1991 through January, 1996.
On August 8, 1997, KPI timely protested both the Corporate Income Tax Assessment and the Gross Receipts Tax Assessment.
On June 5, 1997, KPI requested that the Department grant a sixty day extension of the time for KPI to protest the assessments.
On June 12, 1997, the Department granted KPI until August 10, 1997 to file protests to the assessments.

DISCUSSION

INTRODUCTION

This case presents issues which call for a determination of the constitutional limits of state jurisdiction to impose taxes on a non-domiciliary corporation which licenses its intellectual property for use in its parent corporation’s merchandising operations within the state. The constitutional limits of state jurisdiction to tax out-of-state corporations, and the limits on the nature and character of activities in which such corporations may engage without subjecting themselves to the State’s taxing jurisdiction, have been the subject of extensive Supreme Court jurisprudence. This case adds elements not heretofore addressed by the Court, namely, the licensing of intellectual property in the form of trademarks and tradenames for use in the taxing state by a licensee to generate royalty income for the owner of the trademarks and tradenames, where the owner of the intellectual property benefits from the state’s markets but has meticulously avoided directly engaging in activities which are known to subject it to the state’s taxing jurisdiction.

The genesis of this case is a tax minimization strategy marketed by the Price Waterhouse accounting and consulting firm to clients with valuable intellectual property in the form of trademarks and tradenames. This strategy purports to shield substantial amounts of income from taxation by states which allow tax reporting by corporations on a separate corporate entity basis¹.

____________

^{1New Mexico allows taxpayers to elect, with certain limitations,
from four different income tax reporting methods for reporting corporation income tax;
separate accounting, separate corporate entity, combination of unitary corporations and
federal consolidated group. See, Exhibits S-110 through S-113A.. Under the separate
corporate entity method of filing, corporations are allowed to file separate returns as a
stand-alone entity with the state even though they may be part of a group of affiliated
corporations which may be considered to be part of a group of unitary corporations or of a
group of corporations which file as part of a federal consolidated group with the Internal
Revenue Service. Under the separate corporate entity filing method, only those
corporations who are part of a unitary or federal consolidated group which have sufficient
activities or contacts with a taxing state so as to meet the nexus requirements under the
Due Process Clause are required to file with that taxing state.

_________________

Kmart hired Price Waterhouse to advise it about the tax benefits of
such a strategy and how to implement the strategy should it undertake to do so. Price
Waterhouse prepared a report to Kmart outlining the strategy (Exhibit S-108), which Kmart
then implemented. Based on the advice received from Price Waterhouse, Kmart formed a
wholly owned subsidiary, KPI, in Michigan and transferred its domestic trademarks and
tradenames to KPI, ("the Marks"), together with the goodwill associated with the
Marks. KPI then licensed the Marks back to Kmart for use in Kmart’s domestic
operations and charged Kmart a fair market royalty for their use. KPI manages its
intellectual property with a small staff of trademark attorneys and their support staff
from its office located in Michigan. Michigan imposes a tax denominated the Single
Business Tax, on domestic corporations for the privilege of doing business within the
state. Michigan excludes from the tax base upon which tax is calculated both royalty and
interest income. KPI generates about $300 million a year in royalty income, but has little
use for it, because of KPI’s minimal expenses when compared to this income. Kmart
does have a use for the funds, however. KPI makes the funds available to Kmart by
"loaning" them at market interest rates in transactions in which there is no
indication that the loans will ever be repaid. The net effect of these transactions for
Kmart is that its taxable income in the states in which it does business which allow it to
report on a separate corporate entity basis is reduced by both the royalties and interest
it pays to KPI. Although this income has been effectively transferred to KPI, Michigan
does not tax KPI on this income. KPI does not have employees or tangible property in
states other than Michigan and so hopes to avoid being subject to the taxing jurisdiction
of those states in which it licenses its intellectual property and which allow its parent
to report taxes on a separate entity basis. At the time Kmart implemented this strategy,
it was estimated to save Kmart approximately $12 million a year in state corporation
income taxes.

New Mexico has assessed KPI corporation income tax and corporate
franchise tax based upon KPI’s receipt of royalty income from licensing its
intellectual property to Kmart for use in New Mexico or otherwise engaging in business in
New Mexico. Additionally, the Department has assessed gross receipts tax upon KPI’s
gross receipts from those royalties generated by New Mexico sales. KPI has challenged New
Mexico’s jurisdiction to assess the taxes under both the Due Process Clause and the
Commerce Clause of the United States Constitution. Alternatively, it has challenged New
Mexico’s methodology for imposing such taxes.

As noted above, this case involves matters not previously addressed by
the United States Supreme Court in its cases addressing the constitutional limitations
upon the taxing powers of the states with regard to non-domiciliary corporations, namely,
the nature of the class of intellectual property known as trademarks and tradenames and
the body of law which governs their use and the relationships between licensors and
licensees of such property. An understanding of the nature of such property and the law
relating to such property is important to determining the issues raised by this
litigation, and so, it will be addressed first.

OVERVIEW OF TRADEMARK LAW

Trademarks, tradenames and service marks are a distinct form of
intellectual property which are generally regulated under the Trademark Act of 1946, also
known as the Lanham Act, 15 U.S.C. §§1051-1127, and are also recognized and protected
under the common law. Trademarks are defined to include any word, name, symbol or device
used by a person to identify and distinguish his or her goods from those manufactured or
sold by others. 15 U.S.C. § 1127. Tradenames are defined to mean any name used by a
person to identify his or her business or vocation. 15 U.S.C. § 1127. Service marks are
defined to mean any word, symbol or device used by a person to identify and distinguish
the services of one person from the services of others. 15 U.S.C.§ 1127. Collectively,
they will be referred to as trademarks.

Trademarks have a unique status as property because they do not exist
as a stand-alone property right. They have been characterized as follows:

There is no such thing as property in a trade-mark except as a right
appurtenant to an established business or trade in connection with which the mark is
employed The law of trade-marks is but a part of the broader law of unfair competition;
the right to a particular mark grows out of its use, not its mere adoption; its function
is simply to designate the goods [or services] of a particular trader and to protect his
good will against the sale of another’s product as his; and it is not the subject of
property except in connection with an existing business.

United Drug Co. v. Theodore Rectanus Co., 249 U.S. 90, 97, 39
S.Ct. 48, 50 (1918). Thus, it is through the use of a trademark in conjunction with a
product or service that the real value of a trademark, as a communication device, is
created. As noted in J. Gilson, Trademark Protection and Practice, Vol. 1, §
1.03[6][a]:

Indeed, to the marketer of products in a competitive society the
trademark is an indispensable means of communication. He uses it to stimulate brand
loyalty and greater sales by establishing purchase-motivating associations among
consumers….Once such favorable associations are established, through such factors as
effective advertising, high quality and, at times, price competition, further trademark
use on products and in advertising ordinarily continues and enhances the sales momentum. To
the extent the trademark owner succeeds in creating such a psychological current, his
trademark will function to symbolize good will, i.e., consumer willingness to purchase and
repurchase trademarked products and services. (emphasis added).

Thus, there is a special relationship between a trademark and the
goodwill of a business owning the trademark. As further noted in J. Gilson, Trademark
Protection and Practice, Vol. 1, § 1.03[7][b]:

There is a highly unique legal relationship between trademarks and the
good will they come to represent. This relationship is fundamental to the law of
trademarks, and several important consequences flow from it. First, a trademark may not
be assigned apart from the good will it symbolizes. Second, a trademark cannot exist apart
from the going business in which it is used. The trademark and the good will it represents
can thus be said to be inseparable. Since there can be no good will for the trade mark
to symbolize without such a going business and corresponding use of the trademark,
trademark rights in the United States, at least, are wholly dependent on actual use.
(emphasis added).

Thus, not only are trademarks inseparable from the goodwill of the
business with which they are associated, they must continue to be used in association with
that business to retain their status as a protected property right. Otherwise they may be
considered to be abandoned. Hanover Star Milling Co. v. Metcalf, 240 U.S.
403, 36 S.Ct. 357 (1916). The basis for this rule relates to the nature of trademarks as a
device to communicate or symbolize a certain product or service. If a mark is not used for
a long enough period of time, it loses it ability to communicate information as to the
quality, price, or nature of a business’ product or service and to distinguish it
from the products or services of others. See, definition of
"abandoned" in Lanham Act, 15 U.S.C. 1127.

The nature of trademarks as instruments which identify a particular
product or service and which symbolize the goodwill of the business selling the product or
service also creates certain legal requirements when trademarks are sold or licensed for
use by others. The term used in trademark law to signify the transfer of title to a
trademark is "assignment". Because the trademark and the goodwill it symbolizes
are inseparable, the law requires that they both be transferred by the assignment. A naked
transfer of the mark alone, known as a transfer in gross, is invalid. Visa, U.S.A.,
Inc. v. Birmingham Trust National Bank, 696 F.2d 1371, (C.A. Fed., 1982), cert.
denied, 464 U..S. 826, 104 S.Ct. 98 (1983). See, also, 15 U.S.C. §
1060. The Assignment executed by Kmart in this case met that requirement. Exhibit S-12.
The owner of a trademark may also allow others to use the trademark. The contractual
agreement by which this is done is called a license. While the law does permit a trademark
owner to license its use to others, the public interest in assuring that the public is not
deceived with respect to the nature and quality of the goods or services carrying the
trademark requires the licensor to control or police the nature and quality of the goods
and services sold under the mark by the licensee. See, J. Gilson, Trademark
Protection and Practice, Vol. 2, § 6.01[4]. The requirement of quality control was
incorporated into the Lanham Act through what is called the "related company"
doctrine. A "related company" is defined to mean:

Any person whose use of a mark is controlled by the owner of the mark with
respect to the nature and quality of the goods or services on or in connection with which
the mark is used.

15 U.S.C. § 1127. Provided that a licensor sufficiently controls the
nature and quality of the goods or services associated with the trademark, the
licensee’s use of the trademark is attributed to the licensor and protects the
licensor against a claim of abandonment pursuant to 15 U.S.C. § 1055, which provides in
pertinent part:

Where a registered mark or a mark sought to be registered is or may be
used legitimately by related companies, such use shall inure to the benefit of the
registrant or applicant for registration, and such use shall not affect the validity of
such mark or of its registration, provided such mark is not used in such manner as to
deceive the public.

As noted in findings 94-101, supra., the License Agreement
executed between KPI and Kmart imposes numerous obligations on Kmart to comply with
quality standards set by KPI, to provide it samples of products bearing the marks, to
protect the goodwill associated with the marks, to ensure proper use of the marks, etc.
Thus, the fact that KPI does not directly use the marks itself, but licenses them to Kmart
for its exclusive use, cannot be deemed an abandonment of the marks, provided the control
exercised by KPI is considered to be adequate.

Finally, it should be noted that the arrangement in this case, wherein
Kmart, the original owner of the marks, assigned them to KPI, which, in turn, licensed
them back to Kmart for use in the same manner in which they had been previously used and
in which the public had associated them, is apparently an accepted practice within the law
of trademarks. Such transactions have been held valid against charges of trademark
abandonment, provided the controls implemented by the licensing agreement ensure that the
mark is used in such a manner that the consumer is not misled by a separation of the
trademarked product or service from the goodwill it was associated with. Visa,
U.S.A., Inc. v. Birmingham Trust National Bank, supra., 696 F.2d at 1376-1377.

THE DUE PROCESS CLAUSE

The Due Process Clause requires "some definite link, some minimum
connection between a state and the person, property or transaction it seeks to tax." Miller
Brothers Co. v. Maryland, 344 U.S. 340, 344-345, 74 S.Ct. 535, 539 (1954). The
shorthand terminology for this concept is "minimum contacts" or
"nexus". It is comparable to concepts of nexus for purposes of the exercise of a
forum state’s power to adjudicate controversies involving non-residents. See,
e.g. Quill Corp v. North Dakota, 504 U.S. 298, 307-308, 112 S.Ct. 1904, 1910-1911
(1992) wherein the Court discusses its due process jurisprudence and makes no distinction
between its tax decisions and its decisions with respect to the jurisdiction of state
courts. The underlying concept which animates the Supreme Court’s due process
jurisprudence is whether, given a party’s conduct and contacts with a state, the
assertion of jurisdiction by a state offends traditional notions of fair play and
substantial justice. International Shoe Co v. Washington, 310 U.S. 310, 66
S.Ct. 154 (1945).

KPI argues that it does not have the requisite minimum contacts with
New Mexico for the imposition of tax to be sustained. It relies on the facts that it is a
Michigan corporation which has never had employees, tangible or real property in New
Mexico. The License Agreement by which it licensed its intellectual property to Kmart was
negotiated and executed in Michigan. KPI’s management of its intellectual property
occurs in Michigan where both corporations are located. Kmart makes its royalty payments
to KPI in Michigan. In essence, KPI argues that KPI undertakes no activity in New Mexico
which would provide the minimum contacts required for it to be subject to the state’s
taxing jurisdiction.

The modern test to determine whether minimum contacts exist between a
foreign corporation and a state is whether the corporation has purposefully availed itself
of the benefits of an economic market in the forum state. Burger King Corp. v.
Rudzewicz, 471 U.S. 462, 105 S.Ct. 2174 (1985). It does not matter that the
foreign corporation has no offices, employees, or other indicia of a physical presence in
the state. This was clearly established in the Court’s subsequent decision in Quill,
in which the Court quoted with approval the following language from Burger King,
supra.:

Jurisdiction in these circumstances may not be avoided merely because
the defendant did not physically enter the forum State. Although territorial
presence frequently will enhance a potential defendant’s affiliation with a State and
reinforce the reasonable forseeability of suit there, it is an inescapable fact of modern
commercial life that a substantial amount of business is transacted solely by mail and
wire communications across state lines, thus obviating the need for physical presence
within a State in which business is conducted. So long as a commercial actor’s
efforts are "purposefully directed" towards residents of another State, we have
consistently rejected the notion that an absence of physical contacts can defeat personal
jurisdiction there.

Id., 471 U.S at 476, 105 S.Ct. at 2184 (emphasis in original).
The Court in Quill, then went on to explicitly overrule its previous
decisions which indicated that the Due Process Clause requires physical presence in a
state for the state to impose a duty on an out-of-state mail order house to collect a use
tax with respect to sales to residents within the state. Id., 504 U.S. at
307-308, 112 S.Ct. 1910-1911.

Applying this test to the instant matter, KPI has purposefully availed
itself of the benefits of an economic market within New Mexico². KPI owns
highly valuable intangible property, in the form of the trademarks and the goodwill
associated with the Marks which it has licensed for use by Kmart within New Mexico. KPI
would have us think that somehow it was solely up to Kmart to determine where the Marks
would be used, and that KPI had no power in this regard. This is ridiculous. KPI, as owner
of the Marks had the power to control the terms of the license it granted, including where
those Marks could be used by Kmart. Indeed, KPI’s stream of anticipated royalty
income to be generated under the terms of the License Agreement depended upon the use of
the Marks by Kmart to generate sales revenues from its stores³. Given the fact
that KPI and Kmart have common officers and directors⁴, it would be hopelessly
naïve to assume that KPI had no idea that Kmart operated stores within New Mexico which
could be anticipated to generate a stream of royalty income to KPI based upon Kmart’s
sales in New Mexico.

___________
^{2While the License Agreement does not
specifically mention New Mexico, it grants a license to use the Marks within the United
States and its territories, which obviously includes New Mexico. Additionally, there can
be no dispute that KPI’s Marks are located in New Mexico. See, e.g., Wheeling
Steel Corporation v. Fox, 298 U.S. 193, 56 S.Ct. 773 (1936) (intangible acquires
situs of business location where intangible is used); Curry v. McCanless,
307 U.S. 357, 59 S.Ct. 900 (1939) (intangibles can be subject to taxation where they are
used or where owner of intangible resides.) .

^{3See Schedule E of the License Agreement, Exhibit s-13, which
sets the royalty rate as 1.1%of Kmart’s net sales from its Kmart stores in the United
States.}4The initial directors of KPI included Anthony N. Palizzi,
who was Senior Vice President and General Counsel for Kmart and Thomas F. Murasky, who was
Executive Vice President and Chief Financial Officer of Kmart.

_____________

Additionally, KPI’s arguments fail to take into account the
substantial congruence of interest between Kmart and KPI which is created by both the
License Agreement and the overlay of trademark law upon their relationship. Although KPI
owns the trademarks and the goodwill associated with those marks, it grants Kmart the
right to use them and to avail itself of the goodwill they represent to generate sales
revenues which create the very revenue stream the Department seeks to tax.

KPI strongly objects to this characterization that it allows Kmart to
use the goodwill associated with the marks, based upon the language in the License
Agreement in ¶ 2(b) wherein Kmart acknowledges that all rights and goodwill relating to
the marks are reserved by KPI except for the license granted to use and utilize the marks
as expressly allowed under the terms of the License Agreement. See, KPI’s
Post-Hearing Response Brief, pp. 5-7⁵. While this is an accurate summarization
of the language of the contract, I am not sure that it is accurate to read it as
preventing Kmart from utilizing the goodwill associated with the marks as part of its
license to use the mark. Even if the License Agreement were read to do this, the parties
to a contract cannot by contract, alter the very nature of the property with which they
are dealing. Trademarks are a creature of law. It would be the purest of legal fictions to
separate the trademarks from the goodwill they represent. As noted earlier in this
decision in the overview of trademark law, pp. 33-36, a trademark is a communication
device used to stimulate customer loyalty and sales by establishing purchase-motivating
associations with consumers. Once such associations are established, continued use of the
trademarks ordinarily enhances continued sales. Thus, the trademark is a communication
device which symbolizes the goodwill of a business. It cannot exist apart from the going
business in which it is used. A trademark and the goodwill it represents are inseparable. See,
J. Gilson, Trademark Protection and Practice, Vol. 1, §§ 1.03 [6][a],
1.03 [7][b]. Indeed, in this case there was no separation of the marks and the goodwill
they symbolized. Although assigned by Kmart to KPI and licensed back to Kmart by KPI in
simultaneous transactions, (both documents were executed on October 30, 1991), this
transaction was absolutely transparent or invisible to all but those within the highest
echelons of Kmar⁶. Kmart continued to use the trademarks as it always had and
Kmart’s customers continued to associate the trademarks with the same stores, same
merchandise, same sales staff, same price range of merchandise and all of the other
factors which go into a Kmart shopping experience. It is no mischaracterization of the
reality of the relationship between Kmart and KPI with respect to the use of the
KPI’s trademarks to conclude that KPI allows Kmart to use the goodwill associated
with the marks in Kmart’s stores in New Mexico to generate a stream of royalty income
arising from such sales.

___________

⁵KPI also relied upon the testimony of its
intellectual property valuation expert, Mr. Robert Reilly, that Kmart had substantial
goodwill not associated with the trademarks, which it retained. While this may be true, it
is irrelevant to the issue of whether
Kmart uses the goodwill associated with the trademarks in its retail operations in New
Mexico and elsewhere.
^{6Kmart made no public announcement of its formation of KPI or the
transfer of billions of dollars of intellectual property to KPI, Kmart made no mention of
the formation or existence of KPI in its annual reports to its shareholders, and its store employees are unaware of
the existence of KPI and that Kmart does not own the trademarks

_______________

The New Mexico Supreme Court has recognized that when a substantive
identity of interests exists between an in-state party conducting business in New Mexico
and an out-of-state party, that the acts of the in-state party may be attributed to the
out-of-state party such that nexus may be found with respect to the out-of-state party. In
FDIC v. Hiatt, 117 N.M. 461, 872 P.2d 879 (1994), the Court ruled that the
district court did not have jurisdiction over an out-of-state loan guarantor where the
loan was executed in New Mexico, the guaranty was executed by the guarantor out-of-state,
the guarantors had no other contacts with New Mexico and the guarantor had no interest in
the debtor corporation. It noted, however, that its decision would have been different had
the guarantors been officers or directors of the debtor corporation, such that the
guarantors could be found to share in the economic benefits afforded to the debtor
corporation, stating:

When a substantive identity between the guarantor and the debtor is
shown, as in the above cases, the guarantor may be said to have purposefully availed
himself of the benefits and protections of the laws of the forum state and may have the
minimum contacts with the forum state sufficient to meet the due process requirements of
the exercise of personal jurisdiction by the forum state.

Id., 117 N.M. at 466. In this case, as noted above, not only do
we have a substantive identity between KPI and Kmart based upon the directors and officers
they share in common, but more importantly, there is a direct correlation between
Kmart’s use of KPI’s trademarks in New Mexico to promote sales and enhance its
sales revenues and the revenues KPI receives in the form of royalties which are calculated
as a percentage of those New Mexico sales. Additionally, as noted in the discussion of
trademark law, above, KPI exercises substantial control under the terms of the License
Agreement over the manner in which Kmart may use the trademarks, and Kmart’s use of
the trademarks inures to the benefit of KPI, not only in terms of protecting KPI’s
trademarks from claims of abandonment, but more importantly, also in terms of protecting
and enhancing the goodwill associated with those trademarks⁷. On this basis
alone, one can easily distinguish World-Wide Volkswagen v. Woodson, 444 U.S.
286, 100 S.Ct. 559 (1980), upon which KPI relies for the proposition that the unilateral
acts of a related third party with a state do not constitute constitutionally required
minimum contacts over a nonresident. In no way are Kmart’s acts in promoting and
enhancing KPI’s trademarks unilateral acts. They are acts which Kmart and KPI have
mutually agreed upon and which they understand are undertaken with the acknowledged
purpose of enhancing the value of KPI’s property, wherever it is used. Where KPI has
entered into a Licensing Agreement which authorizes Kmart to use its valuable trademarks
to promote sales of merchandise in markets, including New Mexico, which will generate
royalty income for KPI, there is nothing fundamentally unfair or which would offend
notions of substantial justice, to find that KPI has sufficient contacts with New Mexico
for the purpose of finding jurisdiction to impose taxes on the revenue generated by those
royalties.

____________

⁷Paragraph 6 of the License Agreement recites
that "Licensor’s primary objective in entering into this Agreement is the
further protection and enhancement of its uniquely valuable trademarks and service
marks." It further provides that "Licensee recognizes the great value of the
goodwill associated with the Marks and acknowledges that the Marks and all the rights
therein, and the goodwill attached thereto, inure to, benefit and belong exclusively to
Licensor." Exhibit S-13

________________

THE COMMERCE CLAUSE

While the Due Process Clause is concerned with the fairness of
subjecting persons to state jurisdiction, given the extent of their contacts with a given
jurisdiction, the Supreme Court’s Commerce Clause jurisprudence is concerned with
whether state actions interfere with or unconstitutionally burden interstate commerce.
Although the Commerce Clause, Article I, §8, cl. 3, only speaks to the authority of
Congress to regulate commerce with foreign nations and among the states, and says nothing
about protecting interstate commerce in the absence of congressional action, it has been
recognized since Gibbons v. Ogden,22 U.S. ( 9 Wheat.) 1,
(1824) that even in the absence of congressional action, the Clause, by its own force, can
act to prohibit state actions that are considered to interfere with or burden interstate
commerce. This is called the "negative" or "dormant" Commerce Clause.

Probably no other clause of the Constitution has generated as much
Supreme Court jurisprudence over the years concerning the limitations on the power of
states to impose taxes. There has been a substantial evolution in the Court’s view as
to the operation of the dormant Commerce Clause, from early cases holding that the clause
acts as an absolute bar to state taxation of interstate commerce, to the modern view,
articulated in Complete Auto Transit v. Brady, 430 US. 274, 279, 97 S.Ct.
1076, 1079 (1977) which permits such taxation so long as the terms of its four pronged
test are met: that tax is applied to an activity with a "substantial nexus" with
the taxing state, is fairly apportioned, does not discriminate against interstate
commerce, and is fairly related to the services provided by the state.

It is the first prong of the Complete Auto test that we
are concerned with in this matter. KPI argues that because its lacks employees, real or
tangible property within New Mexico, it also lacks the substantial nexus required under
the Commerce Clause for New Mexico to impose a tax. Until the Court’s 1992 decision
in Quill, supra., the Court had never drawn a distinction between the
"nexus" required under the Due Process Clause and the "substantial
nexus" required under the Commerce Clause. In fact, in National Bellas Hess,
Inc. v. Department of Revenue, 386 U.S. 754, 87 S.Ct. 1389 (1967), the Court had
found that claims that imposition of a state tax violate the Due Process Clause and the
Commerce clause "are closely related", and likened the tests to be applied,
stating:

For the test whether a particular state exaction is such as to invade
the exclusive authority of Congress to regulate trade between the States, and the test for
a state’s compliance with the requirements of due process in this area are similar.
[citations omitted] As to the former, the Court has held that ‘State taxation falling
on interstate commerce . . . can only be justified as designed to make such commerce bear
a fair share of the cost of the local government whose protection it enjoys.’
[citations omitted] And in determining whether a state tax falls within the confines of
the Due Process Clause, the Court has said that the ‘simple but controlling question
is whether the state has given anything for which it can ask return.’ [citations
omitted].

Id., 386 U.S. at 756, 87 S.Ct. at 1391. In Quill, however,
the Court departed from this view, in which both tests looked at the fairness of
subjecting a person to a state’s taxing jurisdiction. It noted the different concerns
which animated the Due Process Clause and Commerce Clause. Citing to its four prong test
in Complete Auto, it stated:

The first and fourth prongs, which require a substantial nexus and a
relationship between the tax and state-provided services, limit the reach of state taxing
authority so as to ensure that state taxation does not burden interstate commerce. Thus,
the "substantial nexus" requirement is not, like due process’ "minimum
contacts" requirement, a proxy for notice, but rather a means for limiting state
burdens on interstate commerce. Accordingly, contrary to the State’s suggestion, 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.

Quill, 504 U.S. at 313, 112 S.Ct. at 1913-1914. In fact, this
was precisely the result in Quill, in which the Court found that Due Process
Clause minimum contacts had been satisfied but that substantial nexus under the Commerce
Clause was lacking for North Dakota to impose a duty upon Quill Corporation to collect use
taxes on its mail order sales.

In order to understand the Court’s current test to determine
whether a tax imposition complies with its Commerce Clause substantial nexus requirement,
a review of Quill and its predecessor, National Bellas Hess, will
be helpful. National Bellas Hess involved an attempt by the state of
Illinois to impose a use tax collection obligation upon Bellas Hess, an out-of-state mail
order house. Bellas Hess had no office, distribution house, warehouse or any other place
of business in Illinois. It had no agents, salesmen, canvassers solicitors or other types
of representatives to sell or take orders or deliver merchandise in Illinois, nor did it
own any tangible property, either real or personal, located in Illinois. Its only contact
with Illinois was to mail catalogues and occasional supplemental flyers to its customers
and to ship any merchandise orders, which were accepted out-of-state, to Illinois
customers by mail or common carrier. The Court ruled that imposition of the obligation to
collect use taxes for Illinois violated the Commerce Clause. In arriving at its decision,
the Court reviewed its prior decisions, which had upheld the power of a state to impose a
use tax collection on an out-of-state seller where the sales were arranged by local agents
in the taxing state or where the mail order seller maintained local retail stores, such as
Sears Roebuck & Company does. It noted that the furthest extension of a state’s
power to impose a use tax collection obligation on an out-of state seller which the Court
had sustained was in Scripto, Inc. v. Carson, 362 U.S. 207, 80 S.Ct. 619
(1960), where the out-of-state seller had a group of salesmen, working as independent
contractors on a commission basis, conducting continuous solicitation in the taxing state
on behalf of the seller, who accepted the orders and then shipped the goods into the
state. The Court then stated:

In order to uphold the power of Illinois to impose use tax burdens on
National [Bellas Hess] in this case, we would have to repudiate totally the sharp
distinction which these and other decisions have drawn between mail order sellers with
retail outlets, solicitors or property within a State, and those who do no more than
communicate with customers in the State by mail or common carrier as part of a general
interstate business. But this basic distinction, which until now has been generally
recognized by the state taxing authorities, is a valid one, and we decline to obliterate
it.

Id., 386 U.S. 758, 87 S.Ct. 1392. Of special concern to the
Court were the burdens on mail order sellers of complying with similar use tax collection
obligations in other state and local tax jurisdictions, noting:

And if the power of Illinois to impose use tax burdens on National
[Bellas Hess] were upheld, the resulting impediments upon the free conduct of its
interstate business would be neither imaginary nor remote. For if Illinois can impose such
burdens, so can every other State, and so, indeed, can every municipality, every school
district and every other political subdivision throughout the Nation with power to impose
sales and use taxes. The many variations in rates of tax, in allowable exemptions, and in
administrative and record-keeping requirements could entangle National’s interstate
business in a virtual welter of complicated obligations to local jurisdictions with no
legitimate claim to impose ‘a fair share of the cost of the local government.’
The very purpose of the Commerce Clause was to ensure a national
economy free from such unjustifiable local entanglements.

Id., 386 U.S. at 759-760, 87 S.Ct. 1392-1393.

Twenty-five years later, the Court agreed to revisit this issue in Quill.
Like Bellas Hess, Quill Corporation was an out-of-state mail order company that had no
sales outlets, employees or contract sales representatives in North Dakota, and either
insignificant or non-existent tangible property in the state⁸. It solicited
sales in North Dakota through catalogs and flyers, advertisements in national periodicals
and telephone calls, and it delivered the merchandise ordered to its North Dakota
customers by mail or common carrier. Like Illinois, North Dakota had sought to impose an
obligation upon Quill to collect and remit a use tax on its sales of merchandise to
in-state customers. The North Dakota Supreme Court, while acknowledging National
Bellas Hess, declined to follow it. It concluded that extensive changes in the
national economy, such as the explosive growth of the mail order business and advances in
computer technology, which eased the burden of compliance with the laws of multiple taxing
jurisdictions, made it inappropriate to follow National Bellas Hess. Equally
important to the North Dakota court’s refusal to follow National Bellas Hess
was what it saw as a significant shift in the Supreme Court’s nexus jurisprudence. It
noted that the Court’s subsequent Complete Auto Transit decision had
overruled the Court’s previous decisions rejecting direct taxation of interstate
commerce and changed the focus to a rational inquiry into the practical effect of the
challenged tax and that in Burger King v. Rudzewicz, the Court had abandoned
its physical presence nexus requirement. Quill Corporation v. North Dakota, 470
N.W. 2d 203.

__________

⁸Quill did license a computer software program
to some of its North Dakota customers that enabled them to check Quill’s current
inventories and prices, but the State of North Dakota had conceded that the existence of a
few floppy diskettes which Quill owned was an insufficient basis upon which to base a
finding of nexus. Quill, 504 U.S. at 315, n.8, 112 S.Ct. at 1914.

__________

The Supreme Court overruled the North Dakota Supreme Court. As noted
above, for the first time, it drew a distinction between Due Process Clause nexus and
Commerce Clause substantial nexus and concluded that under the Due Process Clause,
physical presence in the form of a business location, employees or contract salespersons,
was not required, so long as a business has purposefully availed itself of the benefits of
the state’s markets. Quill, 504 U.S. at 307-308, 112 S.Ct at 1910-1911.
Under the Commerce Clause, however, the Court declined to abandon the
"bright-line" physical presence test of National Bellas Hess,
stating:

In sum, although in our cases subsequent to Bellas Hess and concerning other
types of taxes we have not adopted a similar bright-line physical-presence requirement,
our reasoning in those cases does not compel that we now reject the rule that Bellas
Hess established in the area of sales and use taxes. To the contrary, the continuing
value of a bright-line rule in this area and the doctrine and principles of stare
decisis indicate that the Bellas Hess rule remains good law. For all these
reasons, we disagree with the North Dakota Supreme court’s conclusions that the time
has come to renounce the bright-line test of Bellas Hess.

Quill, 504 U.S. at 317-318, 112 S.Ct. at 1916 (emphasis in
original). Significant to the Court’s adherence to the bright line physical presence
requirement of National Bellas Hess were the benefits of a clear rule which
firmly established the boundaries of legitimate state authority to impose taxes and the
business investment decisions which may have been based upon the settled expectations
engendered by such well established rules on the basis of the principles of stare
decisis. Quill, 504 U.S at 315-316, 112 S.Ct. at 1914-1915. Otherwise,
the Court conceded, its contemporary Commerce Clause jurisprudence might not have
compelled the same result were the issue to have first arisen at the time it rendered its
decision in Quill. Id., 504 U.S. at 311, 112 S.Ct. at 1912.

Quill, thus establishes a bright-line physical presence
requirement under the Commerce Clause for states to impose sales and use taxes upon those
who are availing themselves of a state’s economic markets. Although, in rendering its
decision, the Court was careful to narrowly draw this rule with respect to sales and use
taxes only⁹, I concur with KPI’s arguments that I can find no principled
basis to distinguish between sales and use taxes, and income taxes under the Commerce
Clause¹⁰. The relevant inquiry is whether the tax burdens interstate commerce,
not what type of tax is being imposed. I disagree, however, with KPI’s allegation
that it lacks such physical presence in New Mexico.

__________

⁹The decision
is full of statements such as, "a bright-line rule in the area of sales and use
taxes…", 504 U.S. at 316, 112 S.Ct. at 1915, and, "we have never
intimated in our review of sales or use taxes that Bellas Hess was
unsound." 504 U.S. at 317, 112 S.Ct. at 1915-1916.

¹⁰On this basis, I
disagree with the portion of the South Carolina Supreme Court’s decision in Geoffrey,
Inc. v. South Carolina Tax Commission, 313 SC 15, 437 SE2d 13 (S.C. 1993), cert.
denied, 510 U.S. 992, 114 S.Ct. 550 (1993), which upheld the imposition of an income
tax, under facts nearly identical to this case involving the taxation of royalty income of
Geoffrey, Inc., derived from the licensing of the trademarks of Toys "R" Us for
use in the Toys "R" Us stores, on the basis that the Commerce Clause physical
presence requirement announced in Quill, was limited to sales and use taxes.}

__________

In Quill, the court discussed the cases in which it had
found physical presence:

Prior to Bellas Hess, we had held that that requirement was
satisfied in a variety of circumstances involving use taxes. For example, the presence of
sales personnel in the State or the maintenance of local retail stores in the State
justified the exercise of that power because the seller’s local activities were
‘plainly accorded the protection and services of the taxing State.’ [citation
omitted] The furthest extension of that power was recognized in Scripto, Inc. v.
Carson, [citation omitted] in which the Court upheld a use tax despite the fact
that all of the seller’s in-state solicitation was performed by independent
contractors. These cases all involved some sort of physical presence within the State,…(emphasis
added).

Id., 504 U.S. at 306, 112 S.Ct. at 1910¹¹. An
examination of Scripto, Inc. v. Carson, 362 US. 207, 80 S.Ct. 619 (1960)
will be helpful to this discussion. Scripto involved a Georgia corporation
which sold pens in Florida through continuous solicitation by salesmen or
"jobbers" who were not employees, but rather, were independent contractors who
were compensated on a commission basis. Florida sought to impose a use tax to be collected
and paid by Scripto, Inc. on pens sold to Florida customers. Scripto, Inc. had no office,
distribution house or other place of business in Florida. It accepted the pen orders in
Georgia and shipped them from Georgia. In rejecting Scripto’s claim of lack of nexus,
the Court stated:

True, the ‘salesmen’ are not regular employees of appellant
devoting full time to its service, but we conclude that such a fine distinction is without
constitutional significance. The formal shift in the contractual tagging of the salesman
as ‘independent’ neither results in changing his local function of solicitation
nor bears upon its effectiveness in securing a substantial flow of goods into Florida.
… To permit such formal ‘contractual shifts’ to make a constitutional
difference would open the gates to a stampede of tax avoidance. (emphasis added).

__________

¹¹Although this discussion occurred in the
context of the Court’s discussion of Due Process Clause nexus, and the Court
ultimately determined that physical presence was no longer required by the Due Process
Clause, the court made no distinction as to what constitutes physical presence in the
Commerce Clause portion of its decision.

__________

Id., 362 U.S. at 211, 80 S.Ct. at 622.

I have little difficulty determining that the contractual relationship
between KPI and Kmart under the License Agreement creates the requisite physical presence
required to subject KPI to New Mexico’s taxing jurisdiction under the Commerce
Clause. As noted in the Court’s discussion in Scripto, the fact that
KPI does not use its own employees to utilize its trademarks to generate sales to New
Mexico residents, to enhance the associated value of its trademarks by utilizing them as a
marketing tool, and to generate a stream of royalty income for itself should not be given
constitutional significance. The License Agreement, with its attendant obligations upon
Kmart to protect and enhance the value of KPI’s trademarks, creates a contractual
relationship between the parties in which Kmart uses the trqdemarks and their associated
goodwill as a marketing tool to continuously solicit New Mexico residents to purchase
merchandise associated with the trademarks, thereby creating the very income stream New
Mexico seeks to tax. Kmart’s relationship to KPI, particularly in light of the
requirements of trademark law which render the trademarks inseparable from the goodwill of
the business they are associated with, places Kmart in the same position as the salesmen
in Scripto and the independent salesmen in Tyler Pipe Industries, Inc.
v. Washington State Dept. of Revenue, 483 U.S. 232, 107 S.Ct. 2810 (1987). Kmart
is contractually obligated to do the very things which establish, maintain and enhance the
market for KPI’s trademarks in New Mexico in order to generate a revenue stream for
KPI derived from those marketing activities¹². These contractual obligations
give KPI a presence in New Mexico which goes far beyond those of Bellas Hess and Quill
Corporation, whose only contacts with the taxing states were by mail and common carrier.

__________

¹²The fact that Kmart also directly benefits
from these activities does not negate the benefits its activities provide to KPI, any more
than the fact that the independent salesmen marketing for Scripto, Inc. or Tyler Pipe
Industries, Inc.also benefited from the sales they
generated by earning commissions on such sales. The Court found no constitutional
significance to the manner by which the salesmen operated and were compensated.

__________

Not only is KPI’s physical presence established by its contractual
agreement with Kmart sufficient under the Supreme Court’s bright-line physical
presence requirement under the Commerce Clause, but this conclusion also does no violence
to the considerations relied upon by the Court in Quill in its reaffirmation
of the physical presence requirement. As noted above, KPI’s relationship with Kmart
with respect to the market for its trademarks goes far beyond the limited common carrier
and mail contacts the Court found so prevalent for the mail order industry. Additionally,
KPI cannot legitimately claim to have the substantial reliance interests the court found
so persuasive in the context of the mail order industry and under the principles of stare
decisis. The concept that a contractual relationship with an in-state party tied to
the establishment and maintenance of in-state markets can create sufficient physical
presence in the state has been the law since the Court issued its Scripto decision
in 1960, long before the present strategy involving the assignment and licensing of
intellectual property was ever conceived in state tax circles or considered by Kmart and
KPI. This principle was reaffirmed in 1987 when the Court decided Tyler Pipe
Industries. In spite of the Court’s warning in Scripto that it
would not grant constitutional significance to the shifting of obligations onto
contractors lest it open the gates to a "stampede of tax avoidance", the tax
professionals at Price Waterhouse, as well as Kmart, Toys "R" Us, and a host of
other corporations¹³ apparently failed to heed its warning.

In fact, in New Mexico, there are three cases, all predating the
formation of KPI, which rejected the taxpayers’ Due Process Clause and Commerce
Clause arguments and permitted the imposition of gross receipts tax upon franchise fees
generated by New Mexico sales and received by out-of-state franchisors. AAMCO
Transmissions, Inc. v. Taxation and Revenue Department, 93 N.M. 389, 600 P.2d 841
(Ct. App., 1979), cert. denied, 93. N.M. 205, 598 P.2d 1165 (1979), American
Dairy Queen Corp. v. Taxation and Revenue Department, 93 N.M. 743, 605 P.2d 252
(Ct. App. 1979) and Baskin-Robbins Ice Cream Co. v. Revenue Division, Taxation &
Revenue Department, 93 N.M. 301, 599 P.2d 1098 (Ct. App. 1979). In each of those
cases, the court was not persuaded that because the franchise agreements were negotiated
and executed out-of-state, the imposition of tax violated the Constitution. In each case,
the court found significant that the companies, through their franchise agreements,
permitted the use of their intangible property in New Mexico. Although the franchise
agreements involved different obligations and relationships than the License Agreement
herein¹⁴, they both involve the licensing of trademarks and their use in New
Mexico to generate a revenue stream the state seeks to tax. Because they were decided
before Quill and because Quill represents the most recent and
highest authority with regard to the federal constitutional questions presented, my
analysis herein has focused on Quill and the authority it relies upon, but I
have no doubt that the three New Mexico franchise cases, cited above, remain good
authority today. The franchise agreements amount to another type of contractual agreement
which create the requisite physical presence under the Commerce Clause. Thus, any claims
to upsetting settled expectations in the context of the facts of this case are groundless.

_________

¹³Apparently,
the transfer and licensing back of intellectual property is the hot new state taxation
issue around the country. See, Geoffrey, Inc. v. South Carolina Tax Commission,
supra., and Syl, Inc. v. Comptroller of the Treasury Compliance Division, Maryland
Tax Court Case No 96-0154-01, (April 26, 1999).

¹⁴In the typical franchise agreement, the
franchisee receives substantial services to assist them in their business from the
franchisor, a feature not present in the licensor-licensee agreement herein.

__________

Finally, the Court in Quill was concerned with the
burdens on interstate commerce which would be created by requiring out-of-state mail order
companies to comply with the "virtual welter of complicated obligations" to the
many state and local taxing jurisdictions which could seek to impose a tax. That concern
should be of little concern in the context of this case. Kmart, which already provides tax
preparation services to KPI, should be intimately familiar with the operation of New
Mexico’s tax provisions because of its numerous stores in New Mexico for which it
already reports and pays taxes. Given the fact that the taxes involved herein arise from
those same sales from those same stores, and those sales are already used by Kmart in
calculating its royalty payments to KPI, the filing of an additional monthly CRS-1 return¹⁵
and an annual corporate income tax return on behalf of KPI should hardly be considered an
undue burden.

__________

¹⁵In New Mexico, both state and local option
gross receipts taxes are reported to the Department on a monthly return under New
Mexico’s combined reporting system and the Department handles the distribution of the
local share of the taxes collected. §§ 7-1-6.12 and 6.13 NMSA 1978.

__________

In rendering this decision, I am also well aware of the Tennessee Court
of Appeals decision, provided to me by KPI’s counsel on December 21, 1999, J.C.
Penney National Bank v. Ruth E. Johnson, Commissioner of Revenue, State of Tennessee,
Tennessee Court of Appeals, Appeal No. M1998-00497-COA-R3-CV, decided December 17, 1999.
In that case the Tennessee court found that Tennessee lacked substantial nexus under the
Commerce Clause to impose income tax upon J.C. Penney National Bank’s income from
credit card activities in Tennessee based upon the activities conducted by its parent
company, J.C. Penney Company, which operated retail stores in Tennessee. The Tennessee
Court of Appeals conclusion was based upon the fact that J.C. Penney’s retail stores
conducted no activities which assisted J.C. Penney National Bank in maintaining its credit
card business in Tennessee. It thus distinguished Scripto and Tyler
Pipe Industries. As noted above, Kmart, pursuant to the terms of the License
Agreement, uses the licensed trademarks to promote and enhance their value and to generate
sales which generate royalty revenue for KPI and maintain a market for KPI’s
trademarks, in New Mexico and elsewhere where Kmart operates in the United States. I
believe that given these activities which substantially contribute to KPI’s ability
to maintain a market in New Mexico for its trademarks, the Tennessee Court of Appeals
would concur that substantial nexus exists under the facts of this case.

KPI’S ROYALTIES ARE SUBJECT TO NEW MEXICO GROSS RECEIPTS TAX

Even if the imposition of New Mexico’s corporation income and
gross receipts taxes are not prohibited by the Due Process Clause or the Commerce Clause,
KPI argues that its royalty receipts are not subject to gross receipts tax in New Mexico.
It bases its argument on the 1991 amendment to the definition of "leasing"
enacted by Laws 1991, Ch. 203, effective July 1, 1991. Specifically, the definition of
leasing was amended to define leasing to mean, "any arrangement whereby, for a
consideration, property is employed for or by any person other than the owner of the
property, except that the granting of a license to use property is the sale of a
license and not a lease." (emphasis supplied to language added by amendment). KPI
then refers to the definition of "gross receipts", which provides in pertinent
part:

‘gross receipts’ means the total amount of money or the value
of other consideration received from selling property in New Mexico, from leasing
property employed in New Mexico, from selling services performed outside New Mexico the
product of which is initially used in New Mexico or from performing services in New
Mexico….(emphasis added).

Section 7-9-3(F) NMSA 1978. KPI argues that because the License
Agreement was negotiated and executed between KPI and Kmart in Michigan, that the sale of
the license to use KPI’s trademarks occurred in Michigan and therefore does not fall
within the definition of gross receipts from selling property¹⁶ in New Mexico.

This argument fails to take into account the intangible property
characteristics of a license and involves a far too simplistic view of what constitutes a
sale. Although the change in the definition of leasing reflects a legislative intention
that license agreements not be considered leases, it does not change the nature of a
license. In its simplest terms, a license is a granting of permission or authorization to
do some act which, without such authorization, would be illegal. New Mexico Sheriffs
& Police Association v. Bureau of Revenue, 85 N.M. 565, 514 P.2d 616 (Ct. App.
1973). Although a license can be limited to a single, one-time permission to do something,
licenses more commonly involve an ongoing permission, for a specified period of time¹⁷.
KPI’s argument conceives of a sale as a single, one-time event. While, especially
with tangible property, sales are often isolated, single events in which the passing of
title and/or risk of loss and the delivery of property occur simultaneously, there are
also sales which are conditional or involve the purchase of property over time. In those
cases, the passage of title and the delivery of the property may not occur until all
conditions of the sale, such as payment in full, are met. The definition of "gross
receipts" specifically recognizes such conditional sales contracts and specifies how
receipts from such contracts may be reported. It provides:

When the sale of property or service is made under any type of
charge, conditional or time-sales contract or the leasing of property is
made under a leasing contract, the seller or lessor may elect to treat all receipts,
excluding any type of time-price differential, under such contracts as gross receipts as
and when the payments are actually received….(emphasis added).

__________

¹⁶The
definition of "property" specifically includes licenses. § 7-9-3(I) NMSA 1978.
^{17In the case of the License Agreement in this matter, its term is
until January 1, 2002, with an automatic renewal for ten year periods thereafter, unless
the parties notify each other at least six months prior to the expiration of the current
term. Exhibit S-13.

__________

Section 7-9-3(F)(3) NMSA 1978. In fact, KPI’s License Agreement
qualifies as a conditional contract because one of the grounds it specifies for
termination is the failure or inability of Kmart to make any payments due under the
agreement. Thus, any grant of a license by KPI is conditioned upon Kmart continuing to
meet its payment obligations under the agreement.

The concept of where a sale occurs also involves considerations such as
where the passage of title and/or risk of loss and where delivery of the property sold
occurs. Proficient Food Co. v. New Mexico Taxation & Revenue Dept., 107
N.M. 392, 758 P.2d 806 (Ct. App. 1988). These concepts can be applied far more neatly when
the property involved is tangible than when an intangible, such as a license, is involved.
This is probably due to the unique characteristics of intangible property. Unlike tangible
property, which can be in only one place at one time, intangible property can be used in
many places simultaneously. In determining where the sale occurred in this case, the first
element of that determination, ascertaining where title and/or risk of loss passed, has no
applicability. This is because the License Agreement is only the grant of the right,
license and privilege to use KPI’s trademarks. The agreement specifically provides:

Nothing contained in this Agreement shall be construed as an assignment
or grant to Licensee of any right title or interest in or to the Licensed Properties, it
being understood and acknowledged by Licensee that all rights and goodwill relating
thereto are reserved by Licensor except for the license granted hereunder to Licensee of
the right to use and utilize the Marks only as specifically and expressly provided in this
Agreement or amendments hereto.

Exhibit S-13, ¶ 2(b). Thus, we must examine the second element of a
sale, the delivery, to determine where the sale occurs. In this matter, permission has
been given to use KPI’s trademarks not only in Michigan, but everywhere in the United
States and its territories, including New Mexico. As discussed earlier in this decision,
intangible property can acquire a business situs for tax purposes wherever it is used.
Because the nature of intangible property allows it to be used in many places
simultaneously, and because KPI allows Kmart to use its trademarks in New Mexico, it can
be considered that the delivery of the license at issue herein occurred, at least in part,
in New Mexico.

The Department does not have any regulations directly on point
addressing the specific situation presented in this case. It does have, however,
regulations that may be considered analogous. They address the treatment of lease
receipts. Lease receipts are analogous in at least two respects: like a license, a lease
generally involves a relationship which is continuous or ongoing in time; and leases, like
licenses, do not involve the passage of title but involve the transfer of a lesser
interest in property. Regulation 3 NMAC 2.1.17.1 provides that, "[R]eceipts derived
from the rental or leasing of property employed in New Mexico are subject to the gross
receipts tax. Example 2 under that regulation, provides:

Y, a New York corporation, leases four block-making machines to X who
uses the machines in X’s block-making business in New Mexico. The rental contract is
signed in Nebraska. The receipts which Y receives from the rental of the equipment
employed in New Mexico are taxable.

Thus, even though the lease agreement is executed out-of-state and Y is
an out-of-state corporation, the receipts from the rental agreement are still considered
gross receipts subject to tax in New Mexico based upon the property being used in New
Mexico. Conversely, Regulation 3 NMAC 2.1.17.5 provides that, "[R]eceipts derived
from the rental or leasing of property employed outside New Mexico are not subject to the
gross receipts tax." The example given under this regulation states:

L, a resident of Hobbs, New Mexico, owns a sawmill in Wyoming which is
leased to S for $3,000 per year. These receipts are not derived from selling property in
New Mexico, leasing property employed in New Mexico, performing services outside of New
Mexico the product of which is initially used in New Mexico or performing services in New
Mexico. These receipts are not includable in L’s gross receipts

The License Agreement in this matter involves the licensing of property
throughout the United States. Thus, we are dealing with a transaction in interstate
commerce and any tax imposed on the licensing transaction must meet each of the prongs of
the four part test specified in the Supreme Court’s Complete Auto decision
in order to withstand scrutiny under the Commerce Clause. Assuming that states attempt to
tax transactions in interstate commerce to the extent allowed under the law¹⁸,
and given the unusual characteristic of intangible property that it can exist and be used,
simultaneously, in more than one locale, it makes sense to take those factors into
consideration in determining where and to what extent a taxable sale occurs in the various
states in which the trademarks are licensed. The second prong of the Complete Auto test
requires that a tax be fairly apportioned. Because the License Agreement contemplates the
use of KPI’s trademarks throughout the United States, and the fee arrangement under
the agreement calculates the royalties based upon net sales generated wherever the
trademarks are used, it makes no sense to treat the license as a single, one-time sale
occurring wholly in Michigan. It would also violate the fair apportionment requirement of
the Commerce Clause for Michigan to tax KPI’s receipts under the License Agreement
based upon the use of the licensed trademarks in states other than Michigan. This effect
of the requirement of fair apportionment is reflected in the Department’s regulations
involving leasing, discussed above. In the transaction at issue, New Mexico only seeks to
impose gross receipts tax on an apportioned part of the consideration for the license,
KPI’s receipts from licensing its trademarks for use by Kmart in its New Mexico
operations.

___________

¹⁸New Mexico does this. Although it provides
for a deduction from gross receipts tax for transactions in interstate commerce, the
deduction is limited "to the extent that the imposition of the gross receipts tax
would be unlawful under the United States Constitution." § 7-9-55 NMSA 1978.

__________

Kmart argues that the New Mexico royalties are only the measure
of the tax and the fact that the royalties are calculated based upon Kmart’s New
Mexico sales does not make this a sale occurring in New Mexico. As discussed above,
however, the royalties are more than just a measure of the tax, payment of those royalties
is also a condition of the sale and is the consideration for the sale, to the extent the
sale occurs in New Mexico. Given the fact that the sales transaction at issue involves the
granting of permission to use KPI’s marks in New Mexico and given the fact that New
Mexico only seeks to tax its apportioned share relating only to the use of the trademarks
in New Mexico, the granting of the license, to the extent the marks are used in New
Mexico, should be considered to be the sale of property in New Mexico.

THE DEPARTMENT ACTED PROPERLY IN MODIFYING THE APPORTIONMENT FORMULA

New Mexico, like many other states, has adopted the Uniform Division of
Income for Tax Purposes Act ("UDITPA") §§7-4-1 to 7-4-21 NMSA 1978, which
provides for how taxpayers having income which is taxable both within and without the
state shall allocate and apportion their income among the states in which they earn
income. Crucial to the determination of whether income is allocable to a single taxing
jurisdiction or whether it is to be apportioned among the various taxing jurisdictions is
whether the income is classified as business income or non-business income. Business
income is defined as:

…income arising from transactions and activity in the regular
course of the taxpayer’s trade or business and includes income from tangible and
intangible property if the acquisition, management and disposition of the property
constitute integral parts of the taxpayer’s regular trade or business operations.

Section 7-4-2(A) NMSA 1978. Nonbusiness income is defined as "all
income other than business income." Section 7-4-2(E) NMSA 1978. There is no dispute
in this matter that KPI’s income to which the Department’s apportionment formula
was applied is business income. The dispute between the parties is whether the
Department’s method of apportioning that income is proper.

UDITPA was adopted by the National Conference of Commissioners on
Uniform State Laws in 1957. UDITPA was designed to provide a uniform method for taxing the
income of multistate businesses among the various states. Such a uniform method would
assure that no more and no less than 100 percent of the income of a multistate business is
taxed. Because the national economy was primarily based upon manufacturing and
merchandising businesses, the allocation and apportionment provisions of UDITPA were
designed with those types of businesses in mind. W.J. Pierce, The Uniform Division of
Income for State Tax Purposes, 35 Taxes 747 (1957). Income from the licensing of
intangibles was not a significant part of the income tax base, and under UDITPA, it was
normally allocated to a single jurisdiction. Report of Benjamin F. Miller, Exhibit S-128.

Pursuant to § 7-4-10(B) NMSA 1978, business income is to be
apportioned to New Mexico "by multiplying the income by a fraction, the numerator of
which is the property factor plus the payroll factor plus the sales factor and the
denominator of which is three." The three factors are fractions in which the
numerator is the taxpayer’s tangible property, sales and payroll in New Mexico and
the denominator is the taxpayer’s tangible property, sales and payroll, everywhere,
respectively. Sections 7-4-11 (property factor), 7-4-14 (payroll factor) and 7-4-16 (sales
factor) NMSA 1978. Thus, the three-factor formula takes into account a taxpayer’s
activities in a given taxing state, measured by its payroll, tangible property and sales
in the state, as compared to its payroll, tangible property and sales everywhere to arrive
at an apportionment factor which is applied to a taxpayer’s income from everywhere to
arrive at the income to be apportioned to the taxing state. The Supreme Court has noted
that the UDITPA three-factor formula has become so widely accepted that it has become
"something of a benchmark against which other apportionment formulas are
judged." Container Corp. of America v. Franchise Tax Board, 463 U.S.
159, 170, 103 S.Ct. 2933, 2943 (1983). It further noted that the three-factor formula has
gained such wide approval "because payroll, property and sales appear in combination
to reflect a very large share of the activities by which value is generated." Id.,
463 U.S. at 183, 103 S.Ct. at 2949.

Since its enactment, however, UDITPA has recognized that the
three-factor formula will not always operate to fairly apportion a business’ income
and that some provision must be made for unusual cases or business activities that depart
from those normally contemplated by the formula, which relies upon property, payroll and
sales to reflect the manner in which the value taxed is generated. For this reason, §18
of UDITPA, codified at § 7-4-19 NMSA 1978 was included in UDITPA from the outset. It
provides:

If the allocation and apportionment provisions of the Uniform Division
of Income for Tax Purposes Act do not fairly represent the extent of the taxpayer’s
business activity in this state, the taxpayer may petition for, or the department may
require, in respect to all or any part of the taxpayer’s business activity, if
reasonable:

separate accounting;
the exclusion of any one or more of the factors;
the inclusion of one or more additional factors which will fairly represent the
taxpayer’s business activity in this state; or
the employment of any other method to effectuate an equitable allocation and
apportionment of the taxpayer’s income.

Professor William J. Pierce, the drafter of UDITPA, stated that this
provision:

necessarily must be used where the statute reaches arbitrary or
unreasonable results so that its application could be attacked successfully on
constitutional grounds. Furthermore, it gives both the tax collection agency and the
taxpayer some latitude for showing that for the particular business activity, some more
equitable method of allocation and apportionment could be achieved. Of course, departures
from the basic formula should be avoided except where reasonableness requires.
Nonetheless, some alternative method must be available to handle the constitutional
problem as well as the unusual cases, because no statutory pattern could ever resolve
satisfactorily the problem for the multitude of taxpayers with individual business
characteristics.

W.J. Pierce, supra, at 781.

As noted above, departures from the basic formula should be avoided
except where reasonableness requires. The Department has adopted Regulation 3 NMAC
5.19.8.2 under § 7-4-19. It provides:

Section 7-4-19 permits a departure from the allocation and
apportionment provisions of Sections 7-4-2 to 7-4-18 only in limited and specific cases.
Section 7-4-19 may be invoked only in specific cases where unusual fact situations
(which ordinarily will be unique and nonrecurring) produce incongruous results under
the apportionment and allocation provisions contained in 7-4-2 to 7-4-18. (emphasis
added).

KPI argues that its case is neither unique nor nonrecurring and,
because a taxpayer may claim estoppel against the Department when its actions are contrary
to any regulation pursuant to § 7-1-60 NMSA 1978, that the Department is estopped from
applying the provisions of § 7-4-19 to depart from the three-factor formula. I disagree.
KPI reads too much into the regulation. It speaks of unusual fact situations which ordinarily
will be unique and nonrecurring. It does not state that they must always be
unique and nonrecurring. If that were the case, it would only require that two taxpayers
of the thousands who report and pay taxes subject to apportionment be in the same
situation to create an absolute bar, prohibiting the Department from addressing their
situations to ensure that they pay an amount of tax which is reasonable and fair. The
regulation limits the application of § 7-4-19 to "unusual situations." As will
be discussed in more detail below, the facts of this case are more than sufficient to be
considered unusual. The Department is not estopped from applying § 7-4-19.

Before discussing whether the Department acted properly in using an
alternative formula for apportioning KPI’s income, an explanation of what the
Department did to arrive at its corporate income tax assessment will be helpful. Although
KPI did not furnish the Department’s auditor with a schedule of its royalties, broken
down by state, it did provide a breakdown of Kmart’s New Mexico sales, broken down
annually. The Department’s auditor applied the 1.1% royalty fee to these sales to
arrive at KPI’s New Mexico sales revenues. The Department’s auditor also had
available KPI’s pro-forma federal income tax returns for the audit years which broke
out KPI’s royalty income. The auditor then compared KPI’s New Mexico royalty
income to its total royalty income to arrive a ratio, called the New Mexico percentage.
Tax was computed by using New Mexico tax tables to calculate the tax on KPI’s federal
taxable income from its federal pro-forma returns, and applying the New Mexico percentage¹⁹.
Because the auditor only considered royalty revenues to determine the New Mexico
percentage or apportionment factor, and because the royalties were KPI’s sales for
purposes of calculating the sales factor, in effect, the auditor used a single factor
(sales) to arrive at the New Mexico apportionment factor, disregarding property and
payroll. The sales factor the Department used was a modified sales factor. KPI correctly
points out that under the standard UDITPA provision for calculating the numerator of the
sales factor for sales of "other than tangible personal property", codified at
§ 7-4-18 NMSA 1978, the numerator of its New Mexico sales factor would be zero.
Subsection A of that provision requires that if a taxpayer’s income producing
activity with regard to intangible property is performed wholly within a state, the
taxpayer’s receipts from intangible property are attributed to that state. If ,
however, a taxpayer performs activities generating receipts from intangible property in
more than one state, under Subsection B, its receipts are attributed to the single state
in which a greater proportion of the income producing activity takes place, based on costs
of performance. Under either scenario, all of a taxpayer’s receipts attributable to
intangible property are sited to only one state, for purposes of inclusion in the
numerator of the sales factor. Because KPI had income producing activity resulting from
the licensing of its trademarks throughout the United States, § 7-4-18(B) would be
applied, which requires an examination of where KPI would have incurred the greatest
proportion of the costs attributable to managing its trademarks. Presumably, this would be
in Michigan, where its staff and offices are located. In his treatise on corporation
income taxes, KPI’s own expert witness, Walter Hellerstein, has criticized this
"all-or-none" approach under UDITPA with respect to sourcing income from
intangibles such as licenses as "distorting" and one which "ordinarily will
not reflect fairly the source of income" because "[S]ervices by the
licensor’s employees and agents are likely to be of comparatively minor importance in
the realization of income from such intangible property, except in some types of
franchising arrangements requiring inspection or supervision of the franchisees’
operations." See, Hellerstein and Hellerstein, State Taxation:
Corporate Income and Franchise Taxes, Vol. 1, 2^nd edition, ¶9.09[4], p.
9-44. Indeed, he cites to the Multistate Tax Commission special rule for apportionment of
business income from intangible property, adopted in New Mexico as Regulation 3 NMAC
5.19.11.1(3) as one response to the problem and agrees that it is a more reasonable way to
source income from intangibles. This regulation, adopted under the equitable adjustment
provisions of § 7-4-19, provides:

Where the income producing activity in respect to business income from
intangible personal property can be readily identified, such income is included in the
denominator of the sales factor and, if the income producing activity occurs in this
state, in the numerator of the sales factor as well….

Because the income producing activity, the licensing of KPI’s
trademarks, can be readily identified, the Department followed the regulation methodology
by including KPI’s royalty income from licensing its trademarks in New Mexico in the
numerator of the sales factor and its total royalty income in the denominator.

__________

¹⁹KPI has not challenged the numbers the
Department used to calculate its corporate income tax assessment, only the
Department’s methodology and the constitutionality of imposing such a tax. Because
there is a presumption of correctness which attaches to any assessment of tax, § 7-1-16
NMSA 1978, the tax calculations, in the absence of evidence from KPI that they are
erroneous, are presumed to be correct.

___________

New Mexico courts have adopted the Supreme Court’s standard as to
the burden a taxpayer must meet to challenge a state’s apportionment formula as
violating the Due Process Clause and the Commerce Clause of the United States
Constitution. See, Taxation and Revenue Department v. F.W. Woolworth Co., 95
NM. 519, 624 P.2d 28 (1981), reversed on other grounds, 458 US. 354, 102 S.Ct. 3128
(1982), (one who attacks the apportionment formula must show by clear and cogent evidence
that it results in taxing extraterritorial values). NCR Corp. v. Taxation &
Revenue Department, 115 N.M. 612, 856 P.2d 982 (Ct. App., 1993), cert. denied, 512
U.S. 1245, 114 S.Ct. 2763 (1994) (in order to successfully challenge state apportionment
of corporate income the taxpayer must prove by clear and cogent evidence that the income
attributed to the state is in fact out of all appropriate proportion to the business
transacted in the state or has led to a grossly distorted result). Our courts have not
been confronted with determining what is required, however, when there is not a challenge
of constitutional proportion to the apportionment factor, but a party seeks to apply the
provisions of § 7-4-19 in order to depart from the standard three-factor UDITPA
apportionment formula. Case law from other states that have adopted UDITPA indicates that
the party who desires to depart from the standard three-factor formula has the burden of
proving that 1) the three-factor formula does not fairly represent the taxpayer’s
business activity in the state and, 2) the alternative formula is reasonable. Twentieth
Century-Fox Film Corp. v. Department of Revenue, 700 P.2d 1035, 1042-1043. (Ore.
1985).

In this case, the Department has met its burden of proving that the
three-factor formula does not fairly represent KPI’s business activity in the state.
As discussed above, the three factor formula was developed when the country’s economy
was largely based upon manufacturing and merchandising. The underlying assumption of the
three-factor formula is that the business activities generally employed by a taxpayer to
generate income are a function of the property and personnel employed to generate sales
revenues, wherever it conducts business. Thus, those are the three factors the formula
employs to measure a taxpayer’s business activities as a means of apportioning its
income among the taxing jurisdictions where it engages in business. Section 7-4-19
requires that we focus on a taxpayer’s "business activity within this state"(emphasis
added) to determine whether the UDITPA three-factor formula fairly represents that
activity before another apportionment method may be used. With respect to KPI, its only
business activity in New Mexico is the licensing of its trademarks for use in New Mexico.
As explained above, this is the source of its revenues accounted for in the sales factor.
What is the relationship between KPI’s business activity in New Mexico and its
property and payroll factors? In this case, there is no relationship whatsoever.
Significantly, the property factor only considers real and tangible property²⁰,
reflecting the fact that at the time UDITPA was drafted, income from intangible property,
such as intellectual property, was not a significant portion of the national economy.
Thus, the very property KPI employs to generate the sales revenues for inclusion in the
three-factor formula is not even considered by the formula. This fact alone plainly
indicates that inclusion of the property factor would not fairly represent KPI’s
business activities in New Mexico. Focusing on KPI’s business activities in New
Mexico, KPI has no employees, real or tangible property in New Mexico that play any role
whatsoever in carrying out KPI’s business activity in New Mexico, the licensing of
its trademarks for use here. KPI has contracted with Kmart, under the Licensing Agreement,
to perform any activities related to the use of its trademarks here. Kmart uses its
employees and property to advertise, market, display and perform other activities in
relationship to the use of KPI’s trademarks in New Mexico to ensure that the
trademarks and their associated goodwill are protected and enhanced by the manner in which
Kmart puts them to use. Thus, the numerator of both the property and the payroll factors
for KPI is zero. An examination of the factors going into the denominator of the property
and payroll factors and their relationship to KPI’s business activities is also
revealing. Any way you look at it, KPI is highly unusual with respect to its ability to
generate revenue compared to its costs of payroll and tangible property²¹. It
generates approximately 300 million a year in royalties based upon a payroll of less than
$200,000 per year for its two attorneys and their support staff, and tangible property
valued at between $40,000 and $85,000. The ratio of its payroll to sales and its property
to sales is measured in the hundredths of a percent. See, Exhibit S-114, p. D1.1.
Rounding the payroll and property factors up to $300,000 per year, this still represents a
profit factor of $1,000 for every one dollar of payroll and property expense. This kind of
profitability ratio is simply unheard of in the normal course of business. It is
indicative of the fact that KPI’s personnel and tangible property costs have little
to do with its ability to earn the royalties it does²². It largely earns those
royalties based upon the value²³ of the trademarks it owns. Those trademarks
were simply transferred to KPI by Kmart. Of course, Kmart received 100% ownership of the
shares of KPI in exchange for the assignment of the trademarks, and as between a parent
and a wholly owned subsidiary, for Internal Revenue Service purposes, the transaction is a
wash. But in the context of the issues in this case, where KPI and Kmart are considered as
separate corporate entities, the effect of the transfer between Kmart and KPI was that
extremely valuable trademark property was simply transferred to KPI. KPI had incurred none
of the attendant costs incurred by Kmart over the years to develop the products, services
and goodwill associated with those trademarks to create their value. KPI had no investment
in the Marks, yet they returned an incredible profit to KPI when compared to the
relatively small investment KPI was required to make in them to maintain and increase
their value subsequent to their transfer. This is the reason that there is such a
disconnect between KPI’s business activities which generate sales and the other
factors, property and payroll, generally associated with the generation of sales. It is
also the reason that even were we to calculate KPI’s property and payroll factors,
they would represent such a small fraction that they can be considered de minimis
and the inclusion of them into the apportionment factor would only serve to dilute²⁴
and distort the apportionment factor ultimately applied to apportion KPI’s income to
New Mexico. The distortion created by the inclusion of factors which are de minimis is
the reason that the Department’s instructions²⁵ contained in New
Mexico’s corporation income tax returns during each of the audit years instruct
taxpayers to exclude any factors if the denominator (sales, property or payroll
everywhere) is less than 3% of net income.

__________

²⁰§ 7-4-11 lists property to
be included in the numerator and denominator of the property factor as "real and
tangible property

²¹KPI rents its offices. There
is nothing in the record to indicate that it owns any real property. Presumably, then, the
property to be included in its property factor is limited to tangible property and would
represent such things as its office furniture, computers, and office equipment such as
phone systems, copying and fax machines, etc.

²²As noted above in the discussion on page 65, Walter Hellerstein’s treatise
recognizes that with respect to royalty income from intangibles, the activities "of a
licensor’s employees are likely to be of comparatively minor importance in the
realization of income from such intangible property." Recognizing this potential to
distort the apportionment formula, Mr. Hellerstein recommends instead, the approach taken
by the Department in its audit, which is to source royalties to a state by inclusion in
the numerator of the sales factor "to the extent of the use by the payor of the
rights granted under the license…" in the state. Hellerstein and Hellerstein,
supra., ¶ 9.09[4], p. 9-44.

²³At the time of their
assignment to KPI, Kmart’s trademarks were valued at a range between $2.7 billion and
$4.1 billion.

²⁴For each factor included in the apportionment factor calculation, the denominator
by which the sum of the factor numerators is divided is increased by one. Thus, with the
inclusion of each factor which has little or no relation to the in-state business
activities of a taxpayer, the denominator is increased by one, which reduces the ultimate
apportionment factor by one-third.

²⁵The Department’s
instructions are presumed to be a proper implementation of the laws that are charged to
the Department. § 9-11-6.2(G) NMSA 1978.

__________

It being established that the three-factor UDITPA formula does not
fairly represent KPI’s business activity in New Mexico, it must also be established
that the alternative methodology is reasonable. In its 20^th Century Fox decision,
supra., the Oregon Supreme Court set forth the following test for reasonableness:

We believe that in the context of UDITPA, reasonableness has at least
three components: (1) the division of income fairly represents business activity and if
applied uniformly would result in taxation of no more or no less than 100 percent of
taxpayer’s income; (2) the division of income does not create or foster lack of
uniformity among UDITPA jurisdictions; and (3) the division of income reflects the
economic reality of the business activity engaged in by the taxpayer in Oregon.

Id., 700 P.2d at 1043. Parts 1 and 3 of the Oregon court’s
test are really merely restatements of the standard for judging the fairness of an
apportionment formula under the Due Process and Commerce Clauses of the Constitution, as
set for in Container Corp. of America, supra. In that decision, the Court
described its "internal consistency" and "external consistency" tests
thusly:

The first, and again obvious, component of fairness in an apportionment
formula is what might be called internal consistency—that is, the formula must be
such that, if applied by every jurisdiction, it would result in no more than all of the
unitary business income being taxed. The second and more difficult requirement is what
might be called external consistency—the factor or factors used in the apportionment
formula must actually reflect a reasonable sense of how income is generated.

Id., 463 U.S. at 169, 103 S.Ct. 2942. The Department’s
apportionment formula easily meets the internal consistency test. If every state in which
KPI licenses its trademarks applied New Mexico’s single sales factor formula to
apportion KPI’s income, because the formula is based upon KPI’s royalties
received from licensing its trademarks in the taxing state divided by its royalty income
from everywhere, no more than 100% of KPI’s income would be subject to tax.

The external consistency test is also easily met. The factor used in
the apportionment formula closely reflects how KPI’s income is generated since it is
tied directly into the activity which generates all but the smallest fraction of
KPI’s income, the licensing of its trademarks. Additionally, the formula is designed
to source income to New Mexico in proportion to the royalty income KPI derives from
licensing its trademarks in New Mexico compared to its total licensing royalties. Thus,
the formula reflects the economic reality of how KPI earns its income in New Mexico.

Finally, the formula does not create or foster a lack of uniformity
among UDITPA jurisdictions. The Department’s method for creating KPI’s sales
factor to source its income derived from licensing its intangible property is in
accordance with the Multistate Tax Commission’s regulation, a regulation which is
likely to be implemented and followed by UDITPA jurisdictions. As discussed earlier in
this decision, this regulation specifically addresses sourcing income from intangibles
because the "all or none" sourcing approach taken by the more general sales
factor formula for sourcing income from "other than tangible personal property"
does not accurately reflect that a taxpayer’s activities generating income from
intangibles can occur in many taxing jurisdictions simultaneously. It would also be
reasonable to expect other taxing jurisdictions to eliminate the property factor and the
payroll factor, given the fact that the property factor does not take into account the
very property KPI uses to generate its income and because of the almost non-existent
relationship between KPI’s property and payroll in Michigan and its ability to
generate revenues from the licensing of its intangible property throughout the country,
which intangible property it acquired at no real cost.

Lest there be the slightest doubt about the reasonableness of the
Department’s formula, one need only consider the fact that the apportionment factor
arrived at under the formula to apportion KPI’s income closely tracks the
apportionment factor for Kmart during the audit years. Thus, had Kmart not formed KPI to
shift a portion of its income to avoid state taxation in states like New Mexico, that
income would end up being taxed at essentially the same rate. Given the fact that Kmart
uses KPI’s property and the goodwill which is inseparable from that property to
generate its apportionable income in New Mexico, the fact that that income ends up being
taxed in the same ratio, no matter which entity it is attributed to, confirms the
reasonableness of the Department’s formula.

THE DEPARTMENT WAS NOT REQUIRED TO PROCEED BY PROSPECTIVE RULE-MAKING

KPI argues that the Department’s modification of the apportionment
formula pursuant to the authority of § 7-4-19 to a single sales factor formula, which
also departed from the standard sales factor formula, is illegal because it amounts to the
establishment of policy of general application by adjudication rather than through the
statutory procedures outlined for rule-making. In making this argument, KPI relies upon a
New Jersey decision, Metromedia, Inc. v. Director, Division of Taxation, 478
A.2d 742 (N.J. 1984), in which the court invalidated the New Jersey tax department’s
attempt to adjust the sales factor of a multi-state broadcaster to reflect audience share,
finding that it was a form of rule-making which should have been accomplished by
regulation, notice and a public hearing. In Metromedia, the court held that
statutory rule-making procedures rather than adjudication must be used when an agency
determination 1) is intended to be a general standard applicable to all similarly situated
taxpayers in an industry; 2) addresses broad policy issues; 3) prescribes a legal standard
not expressly provided by statutory authority; 4) reflects an administrative policy not
previously expressed or effects a material change in the law and; 5) is intended to be
prospective, notwithstanding attempted retroactive enforcement in the pending litigation. Metromedia
is distinguishable from the facts of this case. In that case, the New Jersey Tax
Commissioner testified that the sales factor modification at issue was intended to be
"of unvarying application" to other broadcasters, establishing that the
Department was proposing an industry wide rule. Id., 478 A.2d at 753. We
have no such evidence in this matter. Only the facts pertinent to KPI and its relationship
with Kmart were presented in this case, and the Department’s basis for the
modification of the apportionment factor was expressly tied in to the facts pertaining
only to KPI’s property, payroll and royalties. This case does not amount to a
rule-making in which the Department is attempting to create an industry standard through
litigation. The Department’s auditor testified that after he became aware of the Geoffrey
case²⁶, he reviewed the returns of about two dozen large retailers to determine
whether there were any with substantial royalty deductions which might indicate the sort
of trademark assignment and license back situation presented herein. He found Kmart and
only one other company. Two retailers out of the many multistate retail businesses
operating in New Mexico hardly constitutes an "industry". Even were we to
consider licensing of intellectual property an "industry", the fact situation in
this case, in which a parent assigns its intellectual property to a subsidiary which
licenses it back to the parent to be used in the same manner it was previously, is a far
cry from the far more ordinary intellectual property licensing situations in which such
property is licensed between unrelated parties. The decision in this case hinges on the
practically alter-ego relationship created under the relatively uncommon facts of this
case. Nothing in this decision is intended to address other intellectual property
licensing situations which involve far different relationships²⁷. This case,
which has been argued, presented and decided upon its specific facts should not be read as
any sort of industry-wide rule of unvarying application amounting to a rule-making²⁸.

__________

²⁶Geoffrey v. South Carolina Tax
Comm’n, 437 S.E. 2d 13 (S.C. 1993) cert. denied 510 U.S. 992, 114
S.Ct. 550 (1993). Geoffrey was the first state tax case which addressed the
same nexus issues presented herein with reference to a company set up to hold and manage
the parent company’s trademarks and license them back for use in the parent’s
in-state retail operations. As noted earlier in this decision in footnote 8, this decision
maker does not agree with the South Carolina Supreme Court’s reasoning in support of
its conclusion that substantial nexus existed under the commerce clause, although he would
agree that substantial nexus existed for the same reasons stated herein with regard to
KPI.

²⁷KPI’s
parade of horribles in which states will seek to tax celebrity sponsors, such as Michael
Jordan, wherever their name is used in association with products marketed, involves a far
different relationship than the one addressed herein.

²⁸The definition of "rule" in the
State Rules Act states that a "..decision or other document issued …in
connection with the disposition of any case…or agency decision upon a particular
matter as applied to a specific set of facts shall not be deemed such a rule nor shall
it constitute specific adoption thereof by the agency." § 14-4-2 NMSA 1978.

___________

Also significant to the court’s decision in Metromedia,
as well as another case relied upon by KPI, CBS v. Comptroller of the Treasury
(Maryland), 575 A.2d 324 (1990), were the taxpayer’s reliance interests. I
find it difficult to give any weight to any presumed reliance interests of KPI with
respect to the apportionment of its royalty income in New Mexico. In the first place, KPI
appears to have relied on the advice of Price Waterhouse that such income would not be
subject to any sort of apportionment based upon lack of nexus with the state. There was no
evidence whatsoever that KPI (or Kmart) even considered the issue of how KPI’s
royalty income might be apportioned among the separate entity reporting states where it
paid no taxes. Additionally, I find it difficult to find any substantial reliance
interests for KPI when New Mexico has enacted § 7-4-19, which puts all taxpayers on
notice that if the application of the standard three-factor formula does not fairly
represent a taxpayer’s activities in a state, that the Department can seek to modify
the apportionment formula. Section 7-4-19 even expressly mentions that one form of
modification which can be sought is the elimination of one or more factors²⁹.
Finally, the Department did apply one of its regulations, 3 NMAC 5.19.11.1(3), to modify
the sales factor with respect to income from intangibles. Any taxpayer with income from
intangibles should have been aware of this regulation and would have been on notice that
it could be applied if its sales factor under the standard formulation did not fairly
reflect its in-state activities with respect to its receipt of income from intangibles.

__________

²⁹In a related argument, KPI argues that the
Department is estopped from applying its corporate income tax instruction which directs
the elimination of factors from the apportionment factor calculation if the denominator of
the factor is less than 3% of a taxpayer’s net income because the Department’s
instruction was not enacted through a rulemaking proceeding. While the Department’s
actions in eliminating the property and payroll factors may have followed the terms of its
instructions, they also were done pursuant to the explicit authority of § 7-4-19. KPI
can’t honestly claim a failure of notice, which is the purpose of a rulemaking, when
a statute authorizes the action complained of.

__________

Even though the cases cited by KPI are distinguishable from the matter
presented herein, the most important reason why they are not persuasive is that New Mexico
law is not in accord with those decisions. New Mexico’s courts have wisely endorsed
the concept that it should be left it to the informed discretion of the administrative
agency to determine whether to proceed through rulemaking or adjudication. This concept
was endorsed by the New Mexico Supreme Court in Hobbs Gas Co. v. Public Service
Commission, 115 NM 678,682, 858 P.2d 54, 58 (1993), wherein it cited to SEC
v. Chenery Corp., 332 U.S. 194, 67 S.Ct. 1575 (1947) for that proposition. Hobbs
Gas Co. was an appeal from a Public Service Commission ruling imposing a new sales
ratio calculation methodology upon a utility whose sales ratio methodology had been
tacitly approved in two prior commission cases and making the new interpretation
retroactive to past periods. The result of changing the sales ratio calculation
methodology resulted in the gas company having to refund over $ 1.5 million in
overcollections from its customers. Rather than striking down the commission’s new
methodology as an unauthorized rulemaking by adjudication, the court cited to Chenery
Corp., effectively upholding the commission’s authority to impose a new rule
by adjudication. The court, however applied the test set out in Chenery Corp.
to determine whether an adjudicatory rulemaking should be applied prospectively only.
Because of the substantial reliance interests of the gas company upon its former tacitly
approved methodology, the court prohibited the retroactive application of the new
methodology.

The United States Supreme Court’s analysis of the tension between
adjudication and rule-making by administrative agencies in Chenery Corp. is
quite illuminating:

Since the Commission, unlike a court, does have the ability to make new
law prospectively through the exercise of its rule-making powers, it has less reason to
rely upon ad hoc adjudication to formulate new standards of conduct within the framework
of the Holding Company Act. The function of filling in the interstices of the Act should
be performed, as much as possible, through this quasi-legislative promulgation of rules to
be applied in the future. But any rigid requirement to that effect would make the
administrative process inflexible and incapable of dealing with many of the specialized
problems which arise. …Not every principle essential to the effective
administration of a statute can or should be cast immediately into the mold of a general
rule. Some principles must await their own development, while others must be adjusted to
meet particular, unforeseeable situations. In performing its important functions in these
respects, therefore, an administrative agency must be equipped to act either by general
rule or by individual order. To insist upon one form of action to the exclusion of the
other is to exalt form over necessity.
In other words, problems may arise in a case which the administrative
agency could not reasonably foresee, problems which must be solved despite the absence of
a relevant general rule. Or the agency may not have had sufficient experience with a
particular problem to warrant rigidifying its tentative judgment into a hard and fast
rule. Or the problem may be so specialized and varying in nature as to be impossible of
capture within the boundaries of a general rule. In those situations, the agency must
retain power to deal with the problems on a case-to-case basis if the administrative
process is to be effective. There is thus a very definite place for the case-by-case
evolution of statutory standards. And the choice made between proceeding by general
rule or by individual, ad hoc litigation is one that lies primarily in the informed
discretion of the administrative agency. (emphasis added).

Id., 332 U.S. at 202-203, 67 S.Ct. at 1580. Under the
circumstances of this case, where the Department found through audit a situation in which
KPI acquired its income producing property in a transaction without true economic
substance (having incurred none of the costs which made Kmart’s trademarks valuable)
in a tax-motivated transaction designed to shift profits beyond a tax jurisdiction,
where the scope of the problem was apparently small (two taxpayers) and the case required
extensive factual development, the Department was well-justified in addressing the problem
through application of the equitable provisions of § 7-4-19 in a context of adjudication,
rather than through prospective rule-making.

THE IMPOSITION OF PENALTY IS IMPROPER

KPI challenges the Department’s imposition of penalty with respect
to both its assessment of corporation income tax and gross receipts tax. The Department
assessed penalty pursuant to § 7-1-69(A) NMSA 1978, which imposes a penalty "in the
case of failure due to negligence or disregard of rules and regulations, but
without intent to evade or defeat any tax, to pay when due any amount of tax required to
be paid…." (emphasis added). Taxpayer "negligence" for purposes of
assessing penalty is defined in Regulation 3 NMAC 1.11.10 as:

failure to exercise that degree of ordinary business care and prudence which reasonable
taxpayers would exercise under like circumstances;
inaction by taxpayers where action is required;
inadvertance (sic), indifference, thoughtlessness, carelessness, erroneous belief or
inattention.

The Department’s regulations also provide examples of situations
which may indicate that a taxpayer has not been negligent. The example pertinent to this
case is found at 3 NMAC 1.11.11.4, which indicates a taxpayer is not negligent where:

[T]he taxpayer proves that the failure to pay tax or to file a return
was caused by reasonable reliance on the advice of competent tax counsel or accountant as
to the taxpayer’s liability after full disclosure of all relevant facts;…

Applying this provision, KPI was not negligent for purposes of the
imposition of penalty. The evidence established that Kmart received advice from Price
Waterhouse that if it structured its intellectual property subsidiary in accordance with
its report to Kmart, (Exhibit S-108) that separate corporate entity states would not have
nexus to tax a properly structured intellectual property investment/holding company. Kmart
followed the advice in the report carefully when it created KPI. Given the shared
directors and officers between KPI and Kmart, the advice given to Kmart may also be
considered to have been received by KPI’s management. I have little doubt given all
of the facts and circumstances in this case, that KPI relied upon the advice from Price
Waterhouse, which is an accounting firm. Under these circumstances, KPI was not negligent
in failing to report and pay either corporation income, franchise or gross receipts tax
based upon its understanding that New Mexico, which is a separate corporate entity
reporting state, would not have nexus to impose those taxes.

CONCLUSIONS OF LAW

KPI filed timely, written protests, pursuant to § 7-1-24 NMSA 1978, to Assessment Nos.
2134646 and 2134647 and jurisdiction lies over both the parties and the subject matter of
this protest.
During the audit years, KPI had property in New Mexico in the form of trademarks,
tradenames and service marks and their associated goodwill which it licensed for use by
Kmart in New Mexico.
Trademarks symbolize the goodwill of the business with which they are associated and are
inseparable from that business.
By virtue of its ownership of the tradenames, trademarks and service marks, KPI has the
right to control where its marks were used.
KPI has actual and imputed knowledge of where its trademarks, tradenames and service
marks are used.
KPI has purposefully directed its efforts towards residents of New Mexico and availed
itself of the benefits of New Mexico’s markets by licensing its trademarks to Kmart
for use in New Mexico. Therefore, KPI has sufficient minimum contacts with New Mexico to
be subject to New Mexico’s tax jurisdiction under the Due Process Clause of the
United States Constitution.
The contractual relationship between KPI and Kmart under the License Agreement and the
relationship created between KPI and Kmart under the principles and concepts of trademark
law are such that KPI has the requisite physical presence of KPI in New Mexico and
substantial nexus exists under the Commerce Clause of the United States Constitution for
KPI to be subject to New Mexico’s taxing jurisdiction.
KPI did not have a justified reliance interest through established precedent in not
being subject to New Mexico’s tax jurisdiction.
Because Kmart already provides tax preparation services for KPI and because Kmart
already files taxes in New Mexico and is familiar with the requirements of New Mexico tax
law, it would not burden interstate commerce to require KPI to file and report New Mexico
taxes.
KPI’s grant of a license to Kmart to use KPI’s intellectual property
constitutes the sale of property in New Mexico to the extent that KPI’s intellectual
property is used by Kmart in New Mexico.
KPI’s royalty receipts attributable to Kmart’s sales in New Mexico are gross
receipts from the sale of property in New Mexico pursuant to § 7-9-3(F) NMSA 1978.
This case presents an unusual fact situation which warrants the modification of the
UDITPA three-factor apportionment formula under the provisions of § 7-4-19, as applied to
KPI.
The Department is not estopped by Regulation 3 NMAC 5.19.8.2 from invoking the
provisions of § 7-4-19 to modify the apportionment formula applied to KPI.
Application of the standard three-factor UDITPA apportionment formula to KPI under the
facts of this case would not fairly represent KPI’s business activities in New
Mexico.
The Department’s modification of the apportionment formula to be applied to KPI to
modify the sales factor in accordance with 3 NMAC 5.19.11.1(3) and to eliminate the
property and payroll factor was reasonable in that the Department’s formula meets the
test of internal consistency, external consistency and the division of income under the
formula reflects the economic reality of KPI’s business activities in New Mexico.
This litigation does not amount to an industry-wide rulemaking, but is limited to the
specific facts and circumstances of this taxpayer.
The Department had the discretion to determine whether to address the situation
presented herein through rule-making or ad hoc litigation.
KPI had actual and imputed knowledge of the advice contained in the Price Waterhouse
report and it relied upon that advice in determining that it was not subject to the taxing
jurisdiction of New Mexico.
KPI was not negligent in failing to report and pay taxes to New Mexico. Therefore the
assessment of penalty by Assessment Nos. 2134646 and 2134647 was improper.

For the foregoing reasons, KPI’s protest is hereby granted with
respect to the assessment of penalty and in all other respects its protest is denied.

Done, this 1^st day of February, 2000.}}}

FYE 1-29-92	.7911%
FYE 1-27-93	.8072%
FYE 1-26-94	.7788%
FYE 1-26-95	.7332%
FYE 1-31-96	.6568%