Sherwin-Williams can deduct intercompany royalties and interest.

On Oct. 30, 2002, the Massachusetts Supreme Judicial Court (SJC) determined that The Sherwin-Williams Co. (SW) can deduct royalty and interest payments made to an affiliated company, as they were expenses "necessary to the conduct of its business"; see The Sherwin-Williams Company v. Comm'r of Rev., MA Sup. Jud'l Ct., No. SJC-08516 (10-31-02).

The SJC reversed a ruling of the Appellate Tax Board (ATB) that disallowed royalty and interest payments made by SW to two of its wholly owned subsidiaries, Sherwin-Williams Investment Management Company, Inc. (SWIMC) and Dupli-Color Investment Management Company, Inc. (DIMC). The disallowed payments were for the use of certain intangible properties that SW had transferred to the subsidiaries and licensed back as part of a corporate reorganization. The disallowed interest payments were made in connection with a loan from SWIMC.

Background

SW is an Ohio corporation, headquartered in Cleveland, and is engaged in the manufacture, distribution and sale of paints and paint-related products. In 1991, it formed SWIMC and DIMC under Delaware law to hold certain tradenames, trademarks and service marks that it had developed. After the formation of these subsidiaries, an appraisal of the value of the marks, the establishment of a royalty rate based on the appraisals, and the transfer of the intangibles, SW and the subsidiaries entered into nonexclusive licensing agreements for the right to use these various intangibles.

In filing its 1991 state income tax return, SW deducted all royalty and interest expenses accrued under the agreement, in computing taxable income. On audit, the Department of Revenue (DOR) disallowed the deductions and assessed additional tax, because the (1) transfer and license back of the marks was a "sham" disallowed under the "sham-transaction doctrine," (2) royalty payments were not deductible, because the transactions had no valid business purpose and (3) transactions were not at "arm's-length."

ATB

The ATB sustained the DOR's determination, finding that the transactions lacked any economic substance other than tax avoidance. Further, the expenses were not ordinary and necessary and the transactions were not at arm's length.

SJC

Sham-transaction doctrine. In quoting from its decision in Syms Corp., 436 Mass. 505 (2002), the SJC stated that the sham-transaction doctrine gives the commissioner the authority to "disregard, for taxing purposes, transactions that have no economic substance or business purposes other than tax avoidance." Syms dealt with transferring and licensing back trademarks between a parent and its newly formed subsidiary. Whether a transaction is a sham is primarily a factual analysis; the taxpayer bears the burden of proof. In sustaining the ATB in Syms, the SJC determined that the only reason for the transaction was tax avoidance, and the transaction was not operated in a manner normally taken by a business organization (e.g., payment of royalties annually, and continuation of the parent to pay all the subsidiary's fees and expenses).

However, the SJC determined that the facts in SW were substantially different from those in Syms. First, the royalty income was not immediately paid back to SW as a dividend, but was retained and invested as part of ongoing business operations. Second, the licensing agreements were nonexclusive for both SW and other third parties. Third, the subsidiaries assumed and paid their own expenses of maintaining and defending their trademark assets.

The SJC determined that the evidence of economic substance beyond the creation of tax benefits for SW was substantial. Further, because the transaction created viable businesses, the commissioner could not disregard the structure just because it was partially tax motivated.

Ordinary and necessary business expenses. The ATB determined that the royalty payments were not ordinary and necessary under Sec. 162. The SJC disagreed that no royalty should have been charged in the transaction. As the SJC stated, when SW conveyed the intangible property to its subsidiaries, it received "full consideration for the conveyance" in the 100% stock ownership of the subsidiaries. Once the property was conveyed, SW did not have any legal right to the marks without a licensing agreement. Because the subsidiaries had business expenses to pay, they needed to charge for the use of the property. Thus, the royalty payments were ordinary expenses.

Reasonableness of the royalty payment. The SJC determined that the report by an outside professional appraiser was reasonable and satisfied the requirement that royalty rates were determined to be at arm's length.

Analysis

This decision, along with other recent SW decisions in New York, Maryland and Missouri, further demonstrates that intangible holding companies are still a viable option. The SJC found that if a corporation initiates a structure that moves its intangible assets from its operational assets, and it has a valid business purpose with economic substance, any expenses related to the use of the intangibles by the operational entity should be allowed.

Essentially, all corporations structured should review their current policies and procedures and obtain an updated transfer-pricing analysis. When looking at the alternative to creating this type of a structure, they should establish the new entity as a viable economic corporation and to ensure that the business operates correctly.

Taxpayers with outstanding DOR assessments for the disallowance of royalty and interest expense should contact the DOR to have the matter resolved. They should review their operations beforehand and determine whether they fall within the parameters of SW or Syms.

FROM SCOTT KING, CHARLOTTE, NC, AND JEFFREY M. RHINES, PHILADELPHIA, PA