State Taxing Authorities Challenge Intellectual Property Holding Companies
 
August 7, 2003
 
Raymond P. "Ray" Carpenter- Atlanta

It is not uncommon for corporations to hold intellectual property and other intangibles in special purpose entities for a variety of reasons.  One tool used by many companies to manage and protect intellectual property interests is a trademark protection company established in a tax-favored jurisdiction.  These entities have been used for many years and can have very favorable state tax consequences if managed properly.  Recently, state taxing authorities have shown an increased interest in challenging, to limit or eliminate, deductions for intercompany interest and intangible costs and expenses paid to such a related entity. Additionally, state taxing authorities have attempted to expand their authority to deny deductions for intercompany payments when the commissioner determines that the payments and their related transactions fail to meet certain tax principles, such as the business purpose or economic substance doctrines. As states increasingly seek to eliminate budget deficits, successful challenges to tax planning strategies will likely encourage state activity in this area. Many corporations have established such companies and are now concerned that negative consequences may flow from the use of these companies because of reported cases in states that have disallowed the tax benefits flowing from such companies.

For instance, in a recent decision, the Maryland Court of Appeals found that two Delaware intangible holding companies “had no real economic substance as separate business entities,” and, thus held that a portion of their income is subject to Maryland corporate income tax, based upon their parent corporations’ Maryland business activities. The court held that Maryland may tax income earned by an intellectual property holding company based on the Maryland business activity of its parent corporation where (1) the company is unitary with its parent, (2) the company lacks economic substance, and (3) the company was formed predominantly for sheltering income from state taxation. Comptroller of the Treasury v. SYL, Inc. and Comptroller of the Treasury v. Crown Cork & Seal Co. (Delaware), Inc., Nos. 76 & 80 (Md. Ct. App. June 9, 2003).

The SYL case in Maryland involved the same parties and tax years as the Massachusetts case of Syms Corp. v. Commissioner of Revenue, 436 Mass. 505 (2002). In Syms, the Supreme Judicial Court of Massachusetts upheld the Appellate Tax Board’s ruling that the transactions at issue lacked economic substance and disallowed the taxpayer’s royalty deductions. The Supreme Judicial Court subsequently issued a decision in Sherwin-Williams Co. v. Commissioner of Revenue, 438 Mass. 71 (2002) in which the Court reversed the Appellate Tax Board and allowed the deductions relating to the intercompany trademark licensing activities. In response to the Sherwin-Williams case, the Massachusetts legislature enacted new legislation granting the Commissioner of Revenue broad discretionary authority to challenge intercompany transactions by invoking the sham transaction doctrine and similar federal tax principles. The deduction may be allowed if a taxpayer can show, through “clear and convincing evidence,” that the addback is unreasonable. Historically, the taxpayer’s evidentiary burden has been by a preponderance of the evidence (i.e., more probable than not). The clear and convincing standard falls somewhere between the traditional civil preponderance standard and the burden of beyond a reasonable doubt imposed in criminal cases. It remains to be seen how the Appellate Tax Board will apply the new standard of proof.

Finally, in a case involving Sherwin-Williams and the same set of facts as the Massachusetts case, the New York Tax Appeals Tribunal ruled against Sherwin-Williams. The tribunal held that the intangible holding companies served no legitimate business purposes and were formed solely as a means to avoid tax, and that the transfer and license back transactions involving Sherwin-Williams’ trademarks, trade name, and service marks were not done for valid business reasons and lacked economic substance. Further, the tribunal determined that the royalties, interest rate on the intercompany loan and the charges for intercompany trademark services were not arm’s length. An appeal is expected. In re: The Sherwin-Williams Co., No. 816712 (N.Y. Tax App. Trib. June 5, 2003).

In light of this recent increased activity by state taxing authorities, corporations utilizing special purpose entities or intangible holding companies should take appropriate steps to ensure that the strategy would have a reasonable chance of withstanding a challenge.   While a number of states have attacked trademark protection companies, other states continue to recognize the tax and business benefits to a company structure.  Anticipate that state tax auditors will continue to raise questions about the business purpose of the intangible holding companies and review your procedures in utilizing these companies prior to your next scheduled state tax audit.  

For more information, e-mail Phil Olsen or Ray Carpenter at philip.olsen@hklaw.com and ray.carpenter@hklaw.com, respectively, or call toll free 1-888-688-8500.