More States Challenge Trademark Holding Companies

By Christine C. Bauman and Michael S. Schadewald

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The United States’ economic slowdown has caused a loss of state tax revenues at a time when state spending pressures continue to increase. This gap between taxes and spending has created a fiscal crisis for many states, which are generally required to balance their budgets each year. One avenue that states are pursuing to raise revenues is to close perceived loopholes in their corporate income tax systems. Enron, WorldCom, and other accounting scandals have created an environment in which the income reporting practices of corporate America are increasingly scrutinized. In addition, in recent decades there has been a significant erosion of the state corporate income tax base. According to the Census Bureau, corporate income taxes accounted for only 6.3% of total state tax revenues in 2000, down from 10.2% in 1979 ( Studies also suggest that the average effective state corporate income tax rate has declined during this time.

Some commentators have argued that the decline in state corporate income tax revenues is largely due to the use of tax avoidance strategies, such as the widespread use of trademark holding companies, also know as intangible property companies or passive investment subsidiaries. A recent Wall Street Journal article (“Diminishing Returns: A Tax Maneuver in Delaware Puts Squeeze on States,” August 9, 2002) highlighted the impact that trademark holding companies are having on state tax revenues, noting that a large number of well-known companies—Limited Brands, Toys“R”Us, ConAgra Foods, Home Depot, Kmart, Gap, Sherwin-Williams, Circuit City, Stanley Works, Staples, and Burger King—are involved in state tax proceedings regarding their trademark holding companies.

The trademark holding company strategy typically involves transferring an operating company’s trademarks, trade names, and service marks to a separately incorporated subsidiary, which then licenses the marks to the operating affiliates. The subsidiary is incorporated in a state like Nevada, which does not have a corporate income tax, or Delaware, which does not tax the income of a corporation whose only activity in Delaware is the ownership, maintenance, and management of intangible assets [Del. Code section 1902(b)(8)]. As long as the holding company has nexus only in the tax haven state, this structure provides the operating affiliates with a royalty expense deduction, while the corresponding royalty income is not subject to tax in any state.

The trademark holding company strategy does not provide any state tax savings if the holding company is required to file a consolidated or combined tax return with its operating affiliates, but only about a dozen states (including California, Illinois, Maine, and New Hampshire) require unitary affiliates to file returns on a combined group basis. Five states—Delaware, Maryland, Pennsylvania, Texas, and Wisconsin—do not permit consolidated returns or combined reporting under any circumstances. The other states that impose corporate income taxes either give affiliated corporations the option of filing separate returns or electing to file a state consolidated return (e.g., Alabama, Florida, Georgia, Massachusetts, and South Carolina), or generally allow affiliated corporations to file separate returns but under certain conditions may require or permit the filing of a combined unitary report (e.g., New Jersey, New York, North Carolina, and Virginia).

Economic Nexus

States have used a number of approaches to try to deny the tax benefits of setting up a trademark holding company. One approach uses the theory of economic nexus. Asserting that the out-of-state holding company has nexus prevents the erosion of the state tax base by, in effect, offsetting the in-state operating company’s royalty expense deduction with the corresponding royalty income. The Commerce Clause of the U.S. Constitution prohibits a state from taxing an out-of-state corporation unless that corporation has a “substantial nexus” with the state [Complete Auto Transit, 430 U.S. 274 (1977)]. The substantial nexus requirement is not satisfied with respect to out-of-state mail-order vendors, which are not required to collect sales tax unless the vendor has some physical presence in the state [Quill Corporation, 504 U.S. 298 (1992)].

In Geoffrey, Inc. [S.C. Sup. Ct., No. 23886 (July 6, 1993)], the South Carolina Supreme Court ruled that Geoffrey, Inc., the Delaware trademark holding company of retailer Toys“R”Us, had constitutional nexus in South Carolina for income tax purposes, despite the lack of a physical presence, because it licensed its intangibles for use in South Carolina. The South Carolina Supreme Court stated that it did not apply the Quill physical presence test because, in its view, the Quill nexus standard applies only for sales tax purposes.

The Geoffrey decision created considerable consternation for taxpayers after it was handed down in 1993. A number of states adopted Geoffrey-type nexus rules (e.g., Florida, Massachusetts, and New Jersey). In addition, there was additional litigation regarding the issue of whether the Quill physical presence test applies for income tax purposes. For example, in Kmart Properties, Inc. [N.M. Ct. of App., No. 21,140 (Nov. 27, 2001)], a New Mexico appellate court ruled that the Quill physical presence requirement does not apply to income taxes, and that the licensing of intangibles in New Mexico was sufficient to create constitutional nexus for Kmart Properties, Inc., the trademark holding company of the retailer Kmart. Likewise, in A&F Trademark, Inc. [No. 02-CVS-7467, N.C. Superior Ct. Div., Wake Cty. (May 22, 2003)], a North Carolina court ruled that nine trademark holding companies had income tax nexus in North Carolina, despite having no physical presence in the state, based on the licensing of intangibles to affiliates located in the state. The holding companies in question held the trademarks used by retailers such as Lane Bryant, Lerner, Victoria’s Secret, Abercrombie & Fitch, Limited Too, Express, and Structure.

In contrast to the ruling in Geoffrey, courts in several other states have ruled that the Quill physical presence requirement does apply to income tax nexus [e.g., J.C. Penney National Bank, Tenn. Ct. of App., No. M1998-00497-COA-R3-CV (Dec. 17, 1999); Bandag Licensing Corp., Tex. Ct. of App., No. 03-99-00427-CV (May 11, 2000) and Lanco, Inc., N.J. Tax Ct., No. 005369-97 (Oct. 23, 2003)]. Finally, in ACME Royalty Co. and Brick Investment Co. [Mo. S.Ct., No. SC84225 and SC84226 (Nov. 26, 2002)], the Missouri Supreme Court ruled that the two trademark holding companies were not subject to Missouri corporate income tax because they did not have any activity in Missouri in the form of payroll, property, or sales.

Economic Substance and Business Purpose Doctrines

A second approach that states have used to challenge the use of trademark holding companies is to invoke the judicial doctrines of economic substance and business purpose as a means of disallowing deductions for royalty payments made by an operating company to a related trademark holding company. The U.S. Supreme Court ruled that a transaction is respected only if it has economic substance and serves a business purpose other than tax avoidance [Gregory v. Helvering, 293 U.S. 465 (1935)]. As with the theory of economic nexus, states have had limited success in using economic substance and business purpose arguments to challenge trademark holding company structures.

For example, in Syms Corp. [No. SJC-08513, Mass. Sup. Jud. Ct. (2002)], the Massachusetts Supreme Judicial Court ruled that the transfer and licensing back of trademarks between a retailer and its trademark holding company was a sham transaction, and therefore no deduction was allowed for the royalty payments. In this case, the royalties paid to the holding company were immediately returned to the parent as a dividend, and the parent paid all of the expenses of maintaining and defending the trademarks. The court concluded that the holding company was little more than a conduit for the circular flow of funds related to the intangibles, serving no purpose other than to provide a tax benefit.

Just months later, the same state court ruled that the two trademark holding companies in Sherwin-Williams [No. SJC-08516, Mass. Sup. Jud. Ct. (2002)] had economic substance and served valid business purposes. In the court’s view, the facts in Sherwin-Williams were substantially different from those in Syms. The royalties paid to the holding companies were not immediately returned to the parent company as a dividend, but were instead retained and invested as part of the holding companies’ business operations. The holding companies also incurred the expense of maintaining and defending their trademark assets, and licensed the intangibles to unrelated parties [see also Carpenter Technology Corp., No. SC16438, Conn. Sup. Ct. (June 18, 2001)]. In an interesting twist, the New York Tax Appeals Tribunal ruled that the same Sherwin-Williams trademark holding companies did not have economic substance and served no valid business purpose other than tax avoidance. This ruling is discussed below.

In another recent taxpayer loss, the Maryland Court of Appeals held that the trademark holding companies in question had no economic substance as separate business entities apart from their parent corporation, and therefore had nexus with Maryland because they were unitary with their parent companies, which were doing business in Maryland [SYL, Inc., and Crown Cork & Seal Co. (Del.), Inc., Nos. 76 and 80, Md. Ct. of App. (June 9, 2003)]. Factors that the court believed indicated that the holding companies lacked economic substance included the lack of full-time employees, corporate offices that were little more than mail drops, and little operational activity related to the management or protection of the trademarks.

Involuntary Combined Reporting

A third approach to denying taxpayers the benefits of a trademark holding company is involuntary combined reporting. Requiring an operating company to file a combined report with an out-of-state trademark holding company eliminates the tax benefits of the intercompany royalty payments because the operating company’s royalty deduction is, in effect, offset by the holding company’s royalty income. About a dozen states require combined unitary reporting, and approximately 20 other states generally allow affiliated corporations to file separate returns, but also may require or permit a combined unitary report under certain conditions, such as the need to clearly reflect the group’s income earned in the state or to prevent the evasion of taxes.

For example, North Carolina tax authorities may require commonly controlled corporations to file a combined report if separate returns do not “disclose the true earnings” of an affiliate due to the use of intercompany transfer prices that are “in excess of fair compensation” (N.C. Gen. Stat. section 105-130.6). Likewise, New York tax authorities may require commonly controlled corporations that are engaged in a unitary business to file a combined report if reporting on a separate basis “distorts” income in New York (N.Y. Regulations section 6-2.1 and 6-2.3). Such distortion is presumed to exist if a corporation engages in “substantial” intercompany transactions. To rebut this presumption, the taxpayer must prove that it used arm’s-length transfer prices to account for the intercompany transactions. The taxpayer also must demonstrate that the holding company structure has economic substance and serves valid business purposes.

In the high-profile case of Express, Inc., Lane Bryant, Inc., The Limited Stores, Inc., and Victoria’s Secret Stores, Inc. [Nos. 812330, 812331, 812332 and 812334, N.Y. Div. of Tax App. (Sept. 14, 1995)], New York tax authorities failed in their attempt to require a combination of the Delaware trademark holding companies in question with the related retailers doing business in New York. The taxpayers avoided a combination by establishing that the holding companies had economic substance, served valid business purposes, and charged arm’s-length royalty and interest rates. The taxpayer was also able to avoid a forced combination in the New York City case of Toys“R”Us-NYTEX [No. 93-1039, N.Y.C. Tax App. Trib. (Aug. 4, 1999)]. The New York City combination rules (N.Y.C. Tax Law section 11-605.4) mirror those of the state.

In Burnham Corp. [No. 814531, N.Y. Div. of Tax App. (July 10, 1997)], New York tax authorities successfully argued that filing separate returns distorted New York taxable income, and therefore the taxpayer was required to file a combined return that included both the operating company doing business in the state and the Delaware trademark holding company. Likewise, in Sherwin-Williams [No. 816712, N.Y. Tax App. Trib. (June 5, 2003)], the New York Tax Appeals Tribunal ruled that the state can require the combination of two Delaware trademark holding companies with the operating company doing business in New York because the holding companies did not have economic substance, served no valid business purpose, and the royalties were in excess of an arm’s-length rate. In the court’s view, the stated objectives for establishing the holding companies were not credible, and the operating company continued to perform all the primary functions of managing the trademarks [see also Tropicana Products Sales, Inc., No. 815253 and 815564, N.Y. Tax App. Trib. (June 12, 2000)].

Trend Toward Statutory Deduction Disallowance Provisions

An increasing number of states have enacted provisions that directly target the use of trademark holding companies. Although the specifics vary from state to state, the trend is to deny deductions for royalty and interest payments made to a holding company based in a tax haven state. In 1991, Ohio was the first state to enact such legislation (Ohio Rev. Code section 5733.042), followed by Connecticut in 1998 (Conn. Gen. Stat. section 12-218c), and, in 2001, Alabama (Ala. Rev. Stat. section 40-18-35), Mississippi [Miss. Code Ann. section 27-7-17(2)], and North Carolina (N.C. Gen. Stat. section 105-130.7A). Most recently, anti-holding company provisions were enacted by New Jersey in 2002 (N.J. Rev. Stat. section 54:10A-4.4) and Massachusetts (Mass. Gen. Law, Ch. 63, section 31I), New York (N.Y. Tax Law section 208), and Arkansas (Ark. Code section 26-51-423) in 2003.

There are several different ways the states have implemented such disallowance provisions. Under the Alabama provision, a corporation generally may not deduct royalty payments made to a related corporation unless the taxpayer can show that the payee’s royalty income was subject to taxation in a U.S. state or foreign country, or that the transaction that gave rise to the expense was not engaged in for tax avoidance purposes and the related payee is not primarily engaged in the acquisition, licensing, and management of intangible property. Under the North Carolina provision, if a North Carolina corporate taxpayer pays royalties to an out-of-state affiliate for the use of a trademark, either the company receiving the royalty must file a North Carolina return and report the royalties as income (in which case the payer may deduct the related royalty expense), or the company cannot deduct the royalty expense related to the use of the intangibles in North Carolina. Under the Massachusetts provision, royalty payments made to related parties are generally not deductible unless the transaction that gave rise to the royalty does not have as a principal purpose the avoidance of tax. An exception applies if the taxpayer establishes by clear and convincing evidence that the adjustment is unreasonable, or if the taxpayer and commissioner agree to an alternative method of apportionment.

How Should Taxpayers Respond?

The current state income tax planning environment is characterized by pressure on state lawmakers to find politically palatable ways to raise revenues. Combined with a general decline in the public’s confidence in corporate reporting practices, this means that corporate taxpayers must be more vigilant in defending trademark holding company structures against state scrutiny (see Genetelli, “State Tax Implications of Intercompany Transactions: Hazards and Opportunities in the Current Business Environment,” Tax Management Multistate Tax Report, April 25, 2003). For example, it is essential to create a separate corporate identity for the holding company, establish valid business purposes for the holding company, structure arm’s-length royalty agreements, and ensure that the holding company avoids contacts with other states that may create nexus. Creating contemporaneous documentation for the economic substance and business purpose of the holding company, as well as for the arm’s-length royalty agreements, is equally important. It is also important that taxpayers stay informed of and closely analyze new legislation, administrative pronouncements, and case law concerning trademark holding companies.

Christine C. Bauman, PhD, CPA, is an assistant professor of taxation, and Michael S. Schadewald, PhD, CPA, is an associate professor of taxation, both at the school of business administration, the University of Wisconsin–Milwaukee.




















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