New York Division of Tax Appeals Sides with Taxpayer in Dispute Concerning Use of Delaware Holding Company for Intangibles

Client Advisory

July 9, 2001
In a decision of potentially great significance, an Administrative Law Judge of the New York Division of Tax Appeals ("DTA") has ruled that a corporate taxpayer does not have to file on a combined basis with its two Delaware trademark protection subsidiaries for state income tax purposes. In re Sherwin-Williams Co., DTA No. 816712 (June 7, 2001).

Applicable Law and Regulations Concerning Combined Reporting

Article 9-A of the New York Tax Law imposes a tax on out-of-state corporations doing business in New York State. In order to properly reflect that tax liability, Tax Law § 211(4) gives 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. The statute requires that the parent own or control substantially all of the stock of the subsidiary. The statute further limits the Division's discretion by providing that "no combined report covering any corporation not a taxpayer shall be required unless the [Division] deems such a report necessary, because of inter-company transactions . . . in order properly to reflect the tax liability."

The Division's regulations provide that the Division may require or allow the filing of a combined report where three conditions are met: (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."

Factual Background

Sherwin-Williams is engaged in the manufacture, distribution and sale of paints and related products, and is one of the largest manufacturers of paints and varnishes. The company has developed many products over the years and it also has a long history of acquiring product lines. Sherwin-Williams possesses many trademarks, trade names, and service marks (the "Marks") related to these products.

Until 1990, the Marks were owned by Sherwin-Williams itself, and management of Sherwin-Williams' Marks was handled at the divisional level under Sherwin-Williams' decentralized operating approach. In mid-1990, an idea for the more efficient management of Sherwin-Williams' Marks was presented - the creation of two Delaware trademark protection corporations to hold and manage the Marks. In support of the proposal to establish the two Delaware trademark management and protection corporations, a business plan was prepared. Although the plan listed 11 benefits that would result from establishing the corporations, one might well speculate whether the state tax benefits were in fact paramount to Sherwin-Williams' executives.

In January 1991, Sherwin-Williams formed SWIMC and DIMC to hold and manage its trademarks, trade names, and service marks. Two corporations were used because of various environmental and legal issues related to the use of aerosol products. Both companies are directly or indirectly 100 percent owned by Sherwin-Williams. The transfers of the Marks to these two companies qualified as tax-free under Section 351 of the Internal Revenue Code.

In November 1990, just prior to forming the subsidiaries, Sherwin-Williams engaged the services of American Appraisal Associates ("AAA"), the world's largest independent appraisal firm, to determine the fair market value of the domestic trademarks and trade names of Sherwin-Williams. Based upon AAA's valuation study, valuations were placed on the Marks and royalty rates were determined with respect to the Marks. In February 1991, license agreements under which SWIMC and DIMC licensed certain of their respective Marks to Sherwin-Williams were signed.

Also in February 1991, SWIMC and DIMC each contracted with Sherwin-Williams to provide certain trademark services. Under the terms of each Services Agreement, Sherwin-Williams, as trademark service provider, was to provide various trademark support services, including identifying renewal and affidavit dates for the trademarks, providing registration services, licensing assistance and advice relating to trademark protection and enforcement.

Sherwin-Williams filed its franchise tax returns on a separate basis, resulting in a significantly lower tax liability than they would have incurred had the Delaware companies' income simply been included in Sherwin-Williams' return, or had they filed on a combined basis.

ALJ's Application of the Law

Upon audit, the Division concluded that Sherwin-Williams should be required to file on a combined basis with SWIMC and DIMC. The Division found that two of the three requirements for combination were met. First, Sherwin-Williams owned, directly or indirectly, 100 percent of the stock of SWIMC and DIMC and therefore satisfied the stock ownership requirement. Second, Sherwin-Williams and its subsidiaries SWIMC and DIMC were operated as a unitary business. In addition, the Division found that there were substantial inter-company transactions between both SWIMC and DIMC and Sherwin-Williams, since almost all of their income was from transactions with Sherwin-Williams, giving rise to a presumption of distortion. There really was no controversy about the application of the first two tests, and the ALJ agreed with the Division. The focus of the case, then, was the distortion of income test.

Sherwin-Williams, in an effort to rebut the presumption of distortion, commissioned a large accounting firm to prepare a transfer pricing report which analyzed the transactions between Sherwin-Williams and SWIMC and DIMC in accordance with the regulations promulgated under Internal Revenue Code section 482, and concluded that they were at arm's length rates. The ALJ essentially adopted the conclusions of the report, and rejected the Division's objections to it. The ALJ likewise concluded that the transfer pricing report demonstrated that the fees charged by Sherwin-Williams to SWIMC and DIMC for its provision of trademark and licensing legal services fell within the range of rates charged by independent legal practitioners for such services and thus indicates that such charges were made at arm's length. Accordingly, the ALJ concluded that Sherwin-Williams had rebutted the presumption of distortion arising from the existence of a unitary business and substantial intercorporate transactions. Therefore, the ALJ ruled that the Division could not require Sherwin-Williams to file a combined corporation franchise tax report with SWIMC and DIMC.

In the course of its decision, the ALJ also held that the assignment of the Marks by Sherwin-Williams to SWIMC and DIMC and the license back of those Marks to Sherwin-Williams 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 then reasoned that two factors are considered in determining whether transactions between controlled corporations will be respected: (1) whether the transactions were accomplished for a valid business purpose; and (2) whether they had economic substance. The "business purpose" test looks to the taxpayer's motives for entering into the subject transaction, while the "economic substance" test looks to whether there was a reasonable possibility of profit apart from tax benefits.

The ALJ then concluded that the record was clear that SWIMC and DIMC were formed for valid business purposes, including: (a) to hold and manage the Marks; (b) to increase the protection of the Marks; (c) to license the Marks to both related and unrelated entities; (d) to incorporate in a favorable corporate jurisdiction; (e) to avert hostile takeovers; (f) to maximize the return on the stream of royalty income to SWIMC and DIMC through investment in longer-term investments; and (g) to have an additional source of financing through the securitization of the royalty income stream to SWIMC and DIMC. The ALJ also noted that SWIMC and DIMC actively managed and protected their respective Marks, paid for and filed trademark applications and renewals for their respective Marks, pursued potential infringers of their respective Marks, and employed third-party service providers to assist in servicing the Marks. Finally, the ALJ noted that over time the investment returns realized by SWIMC and DIMC have been greater than those achieved by Sherwin-Williams.

Accordingly, the ALJ ruled that the assignment of the trademarks by Sherwin-Williams to SWIMC and DIMC and the license back of those trademarks to Sherwin-Williams were accomplished for valid business purposes, were characterized by economic substance, and were not motivated solely by tax avoidance.


Due to the amount of tax revenue potentially at stake, the Division of Taxation is likely to appeal this decision to the Tax Appeals Tribunal. However, barring a reversal of the ALJ's decision, the ruling indicates that a taxpayer can organize a Delaware intangible holding company and may well be able to file separate New York State franchise tax returns. Any taxpayer considering this strategy should establish and document valid business reasons and be able to demonstrate economic substance. Additionally, a taxpayer must be able to demonstrate that any intercompany transactions are occurring at arm's length. For this purpose, an independent transfer pricing report should be secured prior to entering into any related party transactions

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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