by Roger Russell

A favorable decision for Sherwin-Williams Co. by the Massachusetts Supreme Judicial Court may open the door for thousands of other companies that wish to contest their legal rights to seek tax advantages through transactions with their subsidiaries and affiliates.

The decision by the state’s highest court overturned an earlier Appellate Tax Board ruling, and paves the way for Sherwin-Williams and other companies that do business in Massachusetts to individually contest the Department of Revenue’s routine across-the-board arbitrary disallowance of deductions for payments to affiliates. The decision has national implications as well, since the same issue is being contested in a number of other states.

Sherwin-Williams, based in Cleveland, formed The Sherwin-Williams Investment Management Corp. and The Dupli-Color Investment Management Co., Inc., in 1991. Sherwin-Williams transferred all of its domestic trademarks to these subsidiaries, whose sole focus was on trademark maintenance and management.

The two subsidiaries operated as ongoing businesses, and entered into nonexclusive licensing agreements with Sherwin-Williams and other companies. They received royalties, set up their own investment policies and earned a return on their investments that exceeded the return earned on comparable funds by their parent.

Massachusetts urged the court to reject Sherwin-Williams’ deductions to its subsidiaries on several theories: (1) the transfer and licensing-back transactions between Sherwin-Williams and its subsidiaries were without economic substance and were therefore "a sham in substance;" (2) the expenses were not ordinary and necessary; and (3) the payments were not made at arm’s-length rates.

The Supreme Judicial Court concluded that the transactions between Sherwin-Williams and its subsidiaries did have substance and therefore were not shams, and that the royalty and interest expenses paid by Sherwin-Williams for the use of its subsidiaries’ trademarks and trade names were valid and properly deductible.

It was Sherwin-Williams’s payments to its subsidiaries that initially ran them afoul of the Massachusetts Department of Revenue, which focused on the tax benefits that the subsidiaries offered the parent as the basis for its disallowance.

"Not anymore," said Morrison & Foerster attorney Paul Frankel, lead counsel for Sherwin-Williams. "The court has clearly held that companies that establish subsidiaries with a legitimate business purpose have a right to use those entities for tax advantages."

"This is truly justice served because the decision overturns a stereotype," said Frankel. "Up until now, the tax commissioner painted all companies doing business in Massachusetts with the same guilty brush. Now the legitimacy of each company’s subsidiaries will be examined individually."

"Whether or not a company is motivated by tax breaks in setting up a subsidiary is now irrelevant provided the entities are proven legitimate," said Craig Fields, a member of the State and Local Tax Group at Morrison & Foerster that represented Sherwin-Williams.

"This decision sets a precedent with national implications not only because of the number of companies around the country that do business in Massachusetts, but also because there

are numerous similar cases in other states, including Mary-land, Wisconsin, New York, Louisiana, Missouri, New Mexico, North Carolina and Tennessee," Fields added.

Walter Hellerstein, a nationally known expert in state taxation, agreed. Hellerstein, the author of "State Taxation, 3rd Edition," (published by Warren, Gorham & Lamont, a Thomson business), said "Sherwin-Williams is the most thoughtful and well-reasoned opinion that we have to date from a state court addressed to circumstances under which a tax-motivated transaction will survive judicial scrutiny. In my judgment, the opinion will have significant influence on the analysis of these issues by other state courts, although it by no means gives a green light to all tax-motivated transactions."

Although the Massachusetts court left intact the Appellate Tax Board’s rejection of the numerous business purposes offered by Sherwin-Williams for forming the subsidiaries, it found that "tax motivation is irrelevant where a business reorganization results in the creation of a viable business entity engaged in substantive business activity."

As a result of the decision, companies will have the opportunity to have inter-company payments respected by Massachusetts by demonstrating that the affiliated corporations are real, regardless of whether the sole purpose motivating the formation of such affiliates was the avoidance of tax, according to Frankel.

The decision is momentous for corporate taxpayers that have sought to structure their businesses to maximize operating efficiency while taking advantage of tax incentives offered in states such as Delaware to companies that solely hold and manage intangible property in their state, according to Frankel.

"The monetary figure this decision represents cannot be quantified, nor can its importance be overestimated," Frankel added. "We hope this decision may be used as a model for other states, and perhaps on the federal level."

Hellerstein noted that the analysis of these cases is primarily factual. "Accordingly," he said, "I believe that most of the cases of this genre will be decided on the basis of their individual facts. The great service that the Sherwin-Williams opinion provides, however, is to establish the proper analytical framework for addressing these issues - focusing on whether the transaction had economic substance."

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