NYC ruling upholds royalty deductions.

The New York City Tax Appeals Tribunal (City Tribunal) affirmed a 1999 administrative law judge (ALJ) ruling, holding that, for New York City (City) general corporation tax (GCT) purposes, the Geoffrey, Inc. trademark licensing company and two other affiliates were not required to be combined with the Toys "R" Us entities subject to the City tax (In the Matter of TOYS "R" US--NYTEX, Inc., TAT(E)93-1039(GC), NYC Tax App. Trib., 1/14/04). The City Tribunal found that the taxpayer established that the royalties were priced at arm's length, and that the City did not adequately rebut this showing. The ruling is favorable and is the first City precedential ruling on this issue. However, the effect is limited by the recent enactment of related-party royalty expense disallowance legislation, effective for tax years beginning on or after Jan. 1, 2003.

Although the City Tribunal agreed that the taxpayer had satisfied the three presumptive criteria for combination--common ownership, unitary business and distortion (as evidenced by substantial inter-corporate transactions)--it also agreed with the ALJ's determination that the taxpayer successfully rebutted the presumption by establishing that the royalty rates were arm's length.

The City Tribunal rejected the City's attempt to inject a business-purpose /economic-substance requirement into the arm's-length analysis. The City had argued that the Sec. 482 regulations in effect for the tax years at issue required a business-purpose and economic-substance finding as a condition precedent to establishing arm's-length conditions. However, according to the City Tribunal, the City did not raise this issue timely and, in any event, a taxpayer seeking to rebut a distortion presumption must merely establish that intercompany transactions were conducted at arm's-length rates employing Sec. 482 methods. Further, the City Tribunal found that the City failed to challenge--let alone rebut--the taxpayer's valuation studies or expert testimony on the arm's length issue.

By statute, the City Tribunal must adhere to precedents set by the State "Tax Appeals Tribunal (State Tribunal), but the State Tribunal is not bound to follow City Tribunal precedents. With this mandate in mind, the City Tribunal distinguished the recent State Tribunal decision on this issue in The Sherwin-Williams Company, DTA No. 816712, NYS Tax App. Trib., 6/5/03.Thus, the City Tribunal concluded that, although the State Tribunal did find that the royalty transactions at issue in Sherwin-Williams lacked nontax business purpose and economic substance, the taxpayer in the State case failed to establish that its royalties were arm's length.

In contrast, the City Tribunal found that the taxpayer in TOYS "R" US presented sufficient expert testimony and studies to demonstrate that its transactions were conducted under arm's-length terms. Notwithstanding the City Tribunal's analysis, the prevailing reading, by practitioners, of the State Tribunal's Sherwin-Williams case has been that a taxpayer will be combined with its nonnexus royalty affiliate if it cannot prove that the (1) pricing met Sec. 482 standards and (2) existence of the royalty company served a (non-tax) business purpose and had economic substance. The TOYS "R" US decision surprisingly leaves one wondering about the role business purpose and economic substance play in determining GCT combination in general.

This is a favorable precedential ruling and, because the City cannot appeal City Tribunal rulings, the decision is final and binding for GCT purposes. However, the effect is limited, because (1) as noted above, the City, like New York State (State), enacted related-party royalty expense disallowance for tax years beginning after 2002; (2) the only precedential State ruling on this issue is unfavorable (and, so, State auditors are unlikely to be persuaded by the City Tribunal's decision); and (3) the taxpayer's victory seemed to hinge, in part, on the fact that the City did not rebut its arm's-length evidence, choosing instead to pursue (and late, at that) the business-purpose/economic-substance avenue of attack.

Conclusion

Given the City Tribunal's ruling in this decision, in future disputes, the City would probably shift its focus to refute arm's-length evidence. Nevertheless, for taxpayers with open GCT years, this ruling is controlling and may be relied on by taxpayers under audit, as well as those that have filed protective claims or have open years for which they may claim a refund. Although determinations will be based on each taxpayer's specific facts and circumstances, the ruling suggests that strong arm's-length evidence may be sufficient to refute forced combination and, thus, claim royalty deductions for City purposes for pre-expense-disallowance years.

David Madden, J.D., LL.M.

Principal

Washington National Tax Service

KPMG LLP 

Washington, DC

FROM SHARLENE AMITAY, J.D., CPA, WASHINGTON, DC