New York Has New Weapons Against Out-of-State Holding Companies

Client Advisory

July 11, 2003
by Dan Pittman and Richard Horne

Echoing similar developments in many other states, new legislation and a recent decision by the Tax Appeals Tribunal have diminished the prospects for businesses looking to reduce their New York tax liability through the use of out-of-state holding companies.   

For many years it has been common practice for companies to establish finance subsidiaries, whose function it is to raise capital from the outside, and lend it within the group.  If this subsidiary was organized in Delaware (or certain other states), it would generally not be liable for state income tax, because Delaware does not tax such income and (it is maintained) the subsidiary is not “doing business” in any other state.  At the same time, the interest paid to it by other companies within the group was generally deductible for income tax purposes in those states in which they operated.

In the past ten to fifteen years, many companies have also established subsidiaries in Delaware to hold trademarks and other intellectual property.  The IP subsidiary then licenses the trademarks to its affiliates, charging them a royalty.  These royalties are likewise not taxable in Delaware, but are deducted for state income tax purposes by the licensees. 

Recent legislation in New York, inspired by similar laws in  neighboring Connecticut and New Jersey, is intended to make it very difficult for any of these arrangements to be successfully employed in the future.  Also, a recent decision by the New York State Tax Appeals Tribunal (the “Tribunal”) casts doubt on the efficacy of some of these arrangements even under prior law. 

Legislative Background

Tax Law §211(4) has long given the Division of Taxation (the “Division”) the discretion to require or permit corporations subject to New York State tax to file combined reports with certain other corporations if reporting on a separate basis distorts the activities, business, income or capital of the taxpayers. The Division’s regulations provide that the Division may require or allow the filing of a combined report where three tests are satisfied: (1) a stock ownership test; (2) a unitary business test; and (3) a distortion of income test.  The distortion of income test provides, in part, that the Division:

may permit or require a group of taxpayers to file a combined report if reporting on a separate basis distorts the activities, business, income or capital in New York State of the taxpayers.  The activities, business, income or capital of a taxpayer will be presumed to be distorted when the taxpayer reports on a separate basis if there are substantial intercorporate transactions among the corporations.

The regulation goes on to provide that “[t]he substantial intercorporate transaction requirement may be met where as little as 50 percent of a corporation’s receipts or expenses are from one or more qualified activities described in this subdivision.”  However, taxpayers may rebut the presumption of distortion of income by demonstrating that the transactions were made at arm’s length.

The Sherwin-Williams Decision

Sherwin-Williams Company is a manufacturer, distributor and seller of paints and related products.  The company holds a number of trademarks, trade names and service marks (the “Marks”) on products it has developed or purchased over the years.  Until 1990, the Marks were owned by Sherwin-Williams Company itself, and management of Sherwin-Williams’ Marks was handled at the divisional level.  In mid-1990, Sherwin-Williams determined that it would be more efficient to create two Delaware trademark protection subsidiaries to hold and manage the Marks.  In support of the proposal to establish the two Delaware corporations, a business plan listing the many benefits of the proposed structure was drawn up.  Not listed among the benefits, but presumably also factoring into the decision to restructure the corporation, was the fact that the subsidiaries would potentially not be subject to corporate income tax in Delaware or elsewhere. 

Whatever the motivation, in January 1991 Sherwin-Williams formed two Delaware trademark protection subsidiaries, both directly or indirectly 100-percent owned by Sherwin-Williams Company.  An independent appraisal firm determined the fair market value of the Marks, and the Marks were transferred to the subsidiaries.  In February 1991 the subsidiaries signed license agreements allowing Sherwin-Williams to use the Marks in return for royalties (also intended to reflect arm-length pricing).  The subsidiaries also entered into a contract with Sherwin-Williams Company, under the terms of which Sherwin-Williams would provide various trademark support services.

Sherwin-Williams Company filed its franchise tax returns on a separate basis, deducting the royalties paid to its new affiliates, resulting in significantly lower tax liability than would have been reported had it owed no royalties or had it filed on a combined basis with the two affiliates.  The Division challenged Sherwin-Williams, arguing that the license agreements were not made at arm’s length and that the fact that Sherwin-Williams performed certain functions normally performed by a licensor demonstrated that the transaction lacked economic substance.  Sherwin-Williams countered with independent transfer pricing reports, which concluded that the subsidiaries were charging appropriate, arm’s length rates.

In 2001, an Administrative Law Judge (ALJ) of the New York Division of Tax Appeals ruled in favor of Sherwin-Williams, holding that the assignment of the Marks to the subsidiaries would not be disregarded for tax purposes if those transactions were effected for legitimate business purposes and were not entered into merely to avoid taxation.  The ALJ reasoned that two factors were critical in determining whether transactions between controlled corporations would be respected: (1) whether the transactions were made for valid business purposes, and (2) whether the transactions had economic substance.  The ALJ concluded that the transactions had a number of valid business purposes, and that the transfer of the Marks to the subsidiaries had economic substance.  The ALJ also accepted the taxpayer’s expert testimony to the effect that the licenses reflected arm’s length charges.  In sum, the ALJ ruled that the taxpayer had overcome the adverse presumption of distortion, and thus upheld the tax treatment as reported by the taxpayer.  (For a more complete description of the facts of the case, and of the ALJ’s decision, please see our Client Advisory dated July 9, 2001.) 

The Tribunal has now overturned the ALJ’s ruling.  Although the Tribunal did not disagree with the ALJ’s summary of the relevant law, it found that Sherwin-Williams had not presented sufficient evidence to overcome the presumption of distortion of income.  Significantly, the Tribunal carefully reviewed the transfer pricing reports, concluding that they had several internal errors which rendered them non-probative. The Tribunal also concluded that the business purposes documented in the business plan were not bona fide, and that the only real purpose of the transaction was to avoid taxation.  Thus, Sherwin-Williams was ordered to amend its returns for the tax years at issue by filing on a combined basis with the two IP subsidiaries.  Sherwin-Williams has the right to appeal.

The Tribunal’s decision is one of a somewhat confusing welter of similar cases.  For example, on an almost identical record, the Supreme Judicial Court of Massachusetts recently upheld the right of the same taxpayer to deduct the royalty payments for purposes of that state’s corporate income tax.   (The court did not address the potential liability of the IP subsidiaries for Massachusetts tax; nor did the case involve forced combined filing, as the New York case did.)  On the other hand, the high courts in both Massachusetts and Maryland have recently held that Syms, the clothing retailer, could not deduct royalties paid to its Delaware IP subsidiary. 

Anti-Passive Investment Company Legislation

More or less concurrently with the Tribunal’s decision in Sherwin-Williams, the New York State legislature was enacting legislation that will make it very difficult for companies to use either IP subsidiaries or finance subsidiaries to reduce their New York tax liability in the future.  In so doing, New York was following the lead of several other states, including neighboring New Jersey and Connecticut.  Effective beginning this year, for the purpose of computing its New York taxable income, taxpayers must add back royalty and interest payments made to related parties, to the extent that those payments were deductible in calculating Federal taxable income.   The payee, in turn, may exclude those payments in calculating its New York taxable income, assuming it files in New York.

Taxpayers will not need to add those amounts back if certain conditions are met.  Specifically, payments are not disallowed if the transaction has a valid business purpose and the payments are made pursuant to a contract reflecting an arm’s-length charge.  The statute defines “valid business purpose” to mean any purpose other than the desire to avoid taxation, and state that a valid business purpose will generally exist when the transaction creates a meaningful change in the taxpayer’s economic position.  The statute also provides that if the majority of the intra-group payments generated by the transaction are not reportable as income to the State by the recipient, there will be a rebuttable presumption that the transaction was not motivated by a valid business purpose.  A proposed bill to correct certain perceived defects in the recently enacted legislation did not pass before the legislature adjourned for the summer. 


Taken together, the new legislation and the Tribunal’s decision in Sherwin-Williams may severely limit taxpayers’ ability to reduce their New York tax burden through the use of out-of-state holding companies.   We continue to monitor developments in this area.

Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2020 Carter Ledyard & Milburn LLP.
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