HUF CALIDAD PASCUAL

The Connecticut Supreme Court held that a parent corporation could deduct interest expenses incurred on a loan to a wholly-owned subsidiary because the subsidiary had economic substance and business purpose, and the transactions between the companies were legitimate. Carpenter Tech. Corp. v. Comm’r of Revenue Services.382

The subsidiary, which was established with a $300 million capital contribution from the taxpayer, was created to own a number of foreign subsidiaries and thus shield the taxpayer from potential foreign liabilities.383 Each of the five installments of the $300 million contributed by the taxpayer to the subsidiary as capital was immediately loaned back to the taxpayer.384 The Commissioner had attempted to disallow the deductions on the basis of the sham transaction doctrine.385 However, the lower court held that, since there was a valid business purpose for setting up the subsidiary, the parent could deduct

382

772 A.2d 593 (Conn. 2001).

383

Carpenter Tech. Corp. v. Comm’r of Revenue Services, 779 A.2d 239, 241 (Conn. Super. Ct. 2000).

384

Id.

385

the interest expense on the inter-company loans.386 In a per curium decision affirming the lower court’s ruling, the Connecticut Supreme Court adopted the lower court’s reasoning without further analysis.387

In Carpenter Tech. Corp. v. Comm’r of Taxation & Fin.,388 the Supreme Court of New York, Appellate Division, affirming a decision of the New York Tax Appeals Tribunal reached the exact opposite conclusion and disallowed a parent corporation’s deduction for interest payments made on a loan from its subsidiary.389 In upholding the disallowance, the court held that although the subsidiary may have been formed for a legitimate business purpose, such as insulating the parent from liability, the interest payments were non-deductible under the provision in the law disallowing deductions for interest directly attributable to subsidiary capital.390

The Massachusetts Supreme Judicial Court has also applied the federal doctrines of economic substance and business purpose, holding that Sherwin-Williams, was entitled to a deduction for royalties and interest paid to its subsidiary intangible holding companies for use of trademarks and trade names391. The court concluded that the Appellate Tax Board erred when it found that the transfer and licensing back transactions at issue were without economic substance and therefore a sham. Further, because the royalties paid by Sherwin-Williams reflected fair value, there was no basis to support the elimination of such payments. The court disagreed with the Commissioner’s position

386

Id. at 242-43.

387

Carpenter Tech. Corp. v. Comm’r of Revenue Services, 772 A.2d 593, 594 (Conn. 2001).

388

745 N.Y.S.2d 86 (N.Y. App. Div. 2002).

389

Id. at 91.

390

Id. at 90.

391

Subsequent to the decision in Sherwin Williams, the Massachusetts statute was amended to allow the Commissioner to exercise his discretion to disallow the tax benefits resulting from transactions he regards, as shams or otherwise invalid. If challenged, the taxpayer bears the burden of demonstrating by clear and cogent evidence that the transaction possessed both (i) a valid good-faith business purpose other than tax avoidance and (ii) economic substance apart from the asserted tax benefits. Mass. Gen. Law. Ch. 63 §311.

that because the transfer of the trademarks to the holding companies was tax motivated, the transfer and subsequent licensing should be disregarded. The court found motive to be irrelevant and noted that the analysis of business purpose and economic substance must look at the totality of the business operations, not just the initial reorganization transaction.

The court found that the holding companies had a legitimate business in licensing their marks to the taxpayer and to third parties, and in investing the proceeds from these licensing agreements with third parties. The fact that the taxpayer incurred advertising expenses to sell its product did not affect the result because the advertising expenses were not incurred for the primary purpose of strengthening the holding companies’ marks but were intended primarily to sell more of the taxpayer's products.392

A similar conclusion was reached by the Massachusetts Appellate Tax Board in

Cambridge Brands, Inc. v. Comm’r of Revenue.393 The Board concluded that royalties paid by a candy manufacturer to an affiliate for use of trademarks and other intellectual property were deductible as ordinary and necessary business expenses. Both companies were subsidiaries of the same parent company. The taxpayer produced the candy while the affiliate held and managed trademarks relating to the products manufactured by the parent and various affiliates. The licensing arrangement had a valid business purpose and economic substance because the taxpayer realized higher profit margins through the use of the trademarks and benefited from the marketing, sales forecasts and production schedules created by the affiliate. There was no evidence that the “arrangement was a tax scheme designed to create deductions while at the same time creating a circular tax-free

392

Id.

393

distribution [of payments] back to the paying entity.” The amount of the royalty fees did not exceed fair market value. Therefore, the Commissioner’s statutory authority to eliminate deductions in excess of fair market value did not apply394.

In the consolidated case of Comptroller of the Treasury v. SYL Inc.,395 the Maryland high court applied the business purpose and economic substance doctrine to uphold the income tax assessments against corporations. Syms Inc. (Syms) is a New Jersey corporation that sells clothing in several states, including Maryland. In 1986, Syms created SYL Inc. (SYL) as its wholly owned subsidiary. SYL is a Delaware corporation, which owns Syms’ intellectual property assets. SYL granted Syms the right to use the intellectual property in exchange for a four percent royalty on Syms’ sales. SYL had no presence in Maryland. In 1996, the Comptroller of the Treasury issued SYL corporate income tax assessment for 1986 through 1993 tax years. SYL protested the assessment, which the hearing officer affirmed. because SYL lacked economic substance.396 The hearing officer cited the fact that the company’s employees were merely employees of nexus service providers and all of SYL's income was generated by Syms.

The Maryland Tax Court overturned the assessment concluding that SYL was not merely a "phantom" and that it lacked sufficient nexus with Maryland. The Tax Court also found that the foundation of the Comptroller's argument in Comptroller v. Atlantic Supply Co.397 and Comptroller v. Armco398 applied only when the subsidiary had no economic substance.399 394 438 Mass. 71; 778 N.E. 2d 504 (2002). 395 825 A.2d 399 (Md. 2003). 396 Id. 397 448 A.2d 955 (Md. 1982).

In Comptroller of the Treasury v. Crown Cork and Seal Co., the case consolidated with Comptroller of the Treasury v. SYL Inc., Crown Cork & Seal (Subsidiary) is the wholly owned subsidiary of Crown Cork & Seal Company, Inc. (Crown).400 Both entities are Delaware corporations.401 Crown and Subsidiary, which owned the intellectual property, operated in a similar fashion to Syms and SYL. The Subsidiary had no contacts with Maryland and operated primarily through an unrelated third party. All royalty payments made by Crown to Subsidiary were immediately loaned back to Crown. Between 1989 and 1993, the years in issue, Crown’s indebtness to the subsidiary increased by the amount of the royalties.

The Maryland Court of Appeals held that there was sufficient nexus between Maryland and SYL and the Crown Subsidiary to constitutionally tax the state portion of their incomes. First, the court noted that under Maryland law, corporate income is taxable to the full extent ‘constitutionally permissible.” Second, the court determined that SYL and the Crown Subsidiary had “no real economic substance as separate business entities.” In reaching that conclusion, the court noted the lack of employees, the “mail drop”-type corporate offices, and absence of change in operations following the subsidiaries’ incorporation. Thus, the court ruled that, under the rule established in

Armco, a portion of SYL's and the Crown subsidiary's income was subject to Maryland income tax.

I. Conclusion

398

572 A.2d 562 (Md. Ct. Spec. App. 1990).

399 Id. at 405. 400 Id. at 407. 401 Id.

With the enactment of tax shelter legislation at the state level one could argue there has been a trend by the states to place less of reliance on the federal government to identify abusive transactions. However, when determining if such legislation should be enacted the legislators should ask themselves a number of questions. First what is the goal that the legislature is seeking to achieve? If, the goal is to stop or curtail the use of abusive or impermissible transactions, i.e. those that lack economic substance or business purposes, is legislation actually required or may that goal be achieved through a partnership with the Internal Revenue Service. In the alternative if that is the stated goal then it should be determined if the goal can be achieved by adopting and administering a tax scheme that mirrors the federal approach. From a taxpayer perspective this type of approach would provide both clarity and certainty.

If the goal is to not only curb the use of transactions that are determined to be abusive at the federal level but also curb the use of transactions that do not fall with those that are listed or reportable transactions for federal tax purposes taxing authorities must ask themselves what is the best way to achieve that goal. In analyzing the best approach to achieve that goal legislatures and tax administrators should take into consideration the burden of administering a new law or policy both on the part of the state and the taxpayer. As evidenced by a number of recent court decisions, without consistent definitions or uniform applications of the federal doctrines a transaction may pass muster in one state but not another. The result is a taxpayer due to this uncertainty may be heavily penalized in one state due to the form of a transaction that is perfectly acceptable

in a number of other states. The real question is can tax administrators achieve this goal without enacting specific tax shelter legislation by using existing statutes and policies.