DETERMINATION - archive.citylaw.orgarchive.citylaw.org/tat/1999/931039det.0899.pdf · Corporate...
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TOYS "R" US-NYTEX, INC. – DETERMINATION – 08/04/99 In the Matter of TOYS "R" US-NYTEX, INC. TAT(H) 93-1039(GC) – DETERMINATION NEW YORK CITY TAX APPEALS TRIBUNAL ADMINISTRATIVE LAW JUDGE DIVISION GENERAL CORPORATION TAX - THE COMMISSIONER OF FINANCE COULD NOT REQUIRE PETITIONER, WHICH OWNED AND OPERATED STORES IN NEW YORK, TO FILE A COMBINED GENERAL CORPORATION TAX RETURN WITH RELATED FOREIGN CORPORATIONS WHICH HELD INTANGIBLE PROPERTY INCLUDING TRADEMARKS, MORTGAGES AND LOANS/PETITIONER REBUTTED THE REGULATORY PRESUMPTION OF DISTORTION BY ESTABLISHING, THROUGH UNCHALLENGED EXPERT TESTIMONY, THAT ITS SUBSTANTIAL INTERCORPORATE TRANSACTIONS WITH RELATED CORPORATIONS WERE EITHER AT ARMS LENGTH OR ON SUCH TERMS THAT REPORTING ON A COMBINED BASIS WAS NOT REQUIRED TO ELIMINATE DISTORTION AS THE NON-ARM'S LENGTH PRICING INCREASED THE CITY GENERAL CORPORATION TAX LIABILITY OR WAS DE MINIMUS/THE CORPORATIONS WHICH HELD THE INTANGIBLES HAD ECONOMIC SUBSTANCE AND THEIR FORM COULD NOT BE DISREGARDED/THE ORIGINAL TRANSFER OF TRADEMARKS, TRADENAMES AND OTHER PROPERTY COULD NOT BE DISREGARDED FOR TAX PURPOSES AS THEY WERE VALID TRANSFERS WHICH HAD ECONOMIC SUBSTANCE AND GENUINE BUSINESS PURPOSES AND WERE NOT ENTERED INTO SOLELY FOR TAX AVOIDANCE PURPOSES. AUGUST 4, 1999
NEW YORK CITY TAX APPEALS TRIBUNAL ADMINISTRATIVE LAW JUDGE DIVISION_ : In the Matter of the Petition : : : DETERMINATION of : : TAT(H) 93-1039(GC) TOYS “R” US-NYTEX, INC. : : __________________________________:
Murphy, A.L.J.:
Petitioner, Toys “R” Us-NYTEX, Inc., filed a Petition
with the Commissioner (the “Commissioner” or “Respondent”)
of the New York City (“City”) Department of Finance (the
“Department”) requesting redetermination of a deficiency of
General Corporation Tax (“GCT”) under Chapter 6 of Title 11
of the Administrative Code (the “Code”) of the City of New
York (the “City”) for the tax years ended February 2, 1986,
February 1, 1987 and January 31, 1988 (the “Tax Years”).
Pursuant to the provisions of sections 168 through 172
of the City Charter as amended by act of the New York State
Legislature on June 28, 1992, Ch. 808, Laws 1992, section
140, this case, which was pending before the Hearings Bureau
on October 1, 1992, was transferred to the City Tax Appeals
Tribunal for determination.
A formal hearing was held before the undersigned on
July 22, 1997, July 23, 1997 and July 24, 1997, at which
time evidence was admitted and testimony was taken.
Petitioner was represented by Paul H. Frankel, Esq., Hollis
J. Hyans, Esq., and Irwin M. Slomka, Esq. of Morrison &
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Foerster LLP. Robert J. Firestone, Esq., Frances J. Henn,
Esq. and Martin Nussbaum, Esq., Assistant Corporation
Counsels, represented the Respondent.
The parties entered into a Stipulation of Facts and
Exhibits (the “Stipulation”) dated July 16, 1997, which was
admitted into evidence at the formal hearing. The
stipulated facts have been substantially incorporated in the
Findings of Fact below.
Following the hearing, the representatives submitted
briefs in support of their positions.1 Petitioner’s initial
Brief was filed on January 9, 1998. Respondent filed a
Reply Brief on July 15, 1998. On November 2, 1998
Petitioner filed its Reply Brief, and on December 23, 1998
Respondent filed his Sur Reply Brief.
ISSUE
Whether, pursuant to Code §11-605.4, Respondent may
require Petitioner to file its City GCT reports for the Tax
Years on a combined basis with certain related corporations
because the substantial intercompany transactions which were
the predicate for requiring such combination: (1) were not
made on an arm’s length basis; or (2) must be “integrated”
with the earlier 1984 transfers of underlying property to
those related corporations and therefore disregarded for GCT
purposes.
1 The representatives also entered into a “Stipulation as to the
Transcript of Hearing” on October 22, 1998, agreeing to certain changes in the transcript.
3
FINDINGS OF FACT
1. Petitioner, Toys “R” Us-NYTEX, Inc., is a New York
State (“State”) corporation which operates retail toy and
children’s clothing stores in the State and in Texas.
Petitioner was formed on January 30, 1984, and is a wholly-
owned subsidiary of Toys “R” Us, Inc. (“Toys Inc.”). During
the Tax Years Petitioner operated six stores in the State.
2. Toys Inc., a Delaware corporation with principal
offices located in Rochelle Park, New Jersey, is the parent
corporation of: Petitioner, Toys “R” Us-Penn (“Toys-Penn”),
Toys “R” Us-Mass (“Toys-Mass”), and Toys “R” Us-NJ (“Toys-
NJ”) (collectively referred to as the “Operating Com-
panies”). Toys Inc. is also the parent corporation of TRU,
Inc. (“TRU”) and certain international subsidiaries. In
addition to holding the stock of subsidiaries, Toys Inc.
operates retail toy and children’s clothing stores outside
the State. Toys Inc. maintains warehouse and distribution
centers, and owns and operates its own fleet of trucks.
Corporate History
3. Charles Lazarus founded the first Toys “R” Us store
in 1957. The store was organized on principles of
supermarket retailing. In 1966, in an effort to secure
capital to expand his business, Mr. Lazarus sold his four
stores to Interstate Department Stores, Inc. (“Interstate”),
a conglomerate comprised of retail businesses.
4. In 1974, Interstate declared bankruptcy. The
bankruptcy court permitted Mr. Lazarus to continue to run
the operations of Interstate. He restructured the company
4
with an emphasis on the toy business, selling many of the
non-toy operations. Interstate emerged from bankruptcy in
1978 with sixty stores nationwide. Interstate was
subsequently reorganized under the corporate name Toys “R”
Us, Inc.2
5. During the 1980s, the business of Toys “R” Us
continued to expand. From 1980 to 1990, Toys “R” Us grew
from 85 stores in 13 states to 404 stores in 41 states and
Puerto Rico with a 22% market share. During this time, Toys
“R” Us opened stores in other countries, and broadened its
merchandise offerings to include children’s clothing.
Eventually, separate children’s clothing stores were opened
under the Kids “R” Us name.
6. Prior to the Tax Years, Toys Inc. conducted all the
operations of the business of Toys “R” Us. At that time,
TRU Realty, Inc. (“Realty”), a wholly-owned subsidiary of
Toys Inc., held title to all real property owned and used by
the business.
The Group as Reorganized
7. In 1984, Toys Inc. substantially reorganized its
corporate structure. Several new corporations were formed
and the functions of the existing corporations were changed.
Toys Inc. remained the parent corporation, holding the stock
of Petitioner and the other Operating Companies, as well as
the stock of TRU, certain international subsidiaries and
alien corporations. TRU held the stock of Geoffrey, Inc.
(“Geoffrey”), ABG, Inc. (“ABG”), Toys “R” Us-UK Inc. (“Toys-
2 According to the organizational chart, reproduced infra at page
5, and the Exhibits to the Stipulation, Interstate maintained an active
5
UK”), Interstate, and certain international subsidiaries.
The following organizational chart reflects the corporate
structure as of April 1985:
The corporations shown above comprised the Toys “R” Us Group
(the “Group”) during the Tax Years.
8. As Michael Goldstein, the present Chief Executive
Officer of Toys Inc.,3 credibly testified at hearing with
respect to the bases for the 1984 restructuring, Geoffrey,
ABG and TRU (the “Related Corporations”) were formed to
protect the Group from hostile takeovers and other potential
litigation, as well as for tax-planning reasons; and
Geoffrey was specifically formed for the purposes of
holding, protecting and creating trademarks and trade names.
corporate existence as a subsidiary of Toys Inc. after the restructuring in the 1980s. See, generally, Stip. Ex. 34-36.
3 Mr. Goldstein joined the Toys “R” Us organization in 1983 as its
senior vice president and chief financial officer. During the course of his association with Toys Inc., he has variously held the positions of senior vice president, executive vice president and chief financial officer. During the Tax Years Mr. Goldstein was an officer and member of the Board of Directors of several corporations in the Group, including the Related Corporations.
TOYS INC.
TOYS-NJ TOYS-MASS TOYS-PENN PETITIONER INT’L SUBS
TRU
GEOFFREY ABG TOYS-UK INTERSTATE INT’L SUBS
UK SUBS
6
9. Toys-NJ is a New Jersey corporation which operates
retail toy and children’s clothing stores in New Jersey.
Toys-NJ also provides management and financial services to
the Related Corporations pursuant to separate agreements
with the other corporations; i.e., the “Geoffrey Service
Agreement,” the “ABG Service Agreement,” and the “TRU
Service Agreement” (collectively, the “Agreements”). The
Agreements also provide that Toys-NJ will “advanc[e]
sufficient working capital for the conduct of the business”
of the Related Corporations.
During the Tax Years, Toys–NJ was responsible for
performing centralized operational functions for the Group,
including purchasing, pricing, staffing of the stores, and
providing other services such as managerial, tax, accounting
and legal services. Toys-NJ also determined store site
locations, layout, merchandise selection, and pricing for
the regional Operating Companies. Toys-NJ administered the
Group’s advertising, although actual advertisement placement
was the responsibility of the Operating Companies. The
costs of many of the services performed by Toys-NJ were
allocated to the Operating Companies according to those
companies’ sales. Services which Toys-NJ provided the
Related Corporations were separately charged, pursuant to
the Agreements. Toys-NJ maintained an in-house legal staff,
which included between five and ten attorneys during the Tax
Years.4
10. Toys-Penn and Toys-Mass operate retail toy and
children’s clothing stores in Pennsylvania and
Massachusetts, respectively.
4 All Operating Companies, including Toys-NJ, had a division which
operated the Kids “R” Us stores.
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11. Toys-UK is a wholly-owned subsidiary of TRU.
Toys-UK is affiliated with other Toys “R” Us corporations
doing business in the United Kingdom (the UK Subs), as well
as with TRU(UK) Inc., the United Kingdom subsidiary of TRU.
12. Geoffrey, a Delaware corporation, was formed on
January 24, 1984 as a wholly-owned subsidiary of Toys Inc.
Since 1985, Geoffrey has been a wholly-owned subsidiary of
TRU. Geoffrey licensed the Toys “R” Us and Kids “R” Us
trademarks and tradenames to members of the Group as well as
to unrelated corporations.
13. ABG, a Nevada corporation, was formed on January
24, 1984. Since 1985, ABG has also been wholly owned by
TRU. During the Tax Years, ABG provided the Group with
mortgage financing so that the Operating Companies could
finance their real estate development.5
14. TRU, a Delaware corporation formed on January 12,
1984, is a wholly-owned subsidiary of Toys Inc. During the
Tax Years, TRU held the stock of foreign and domestic
affiliated companies, including Geoffrey and ABG. TRU
invested assets of affiliated corporations and made loans to
Toys Inc. and other Group corporations.
15. For purposes of this proceeding only, Petitioner
agrees that it was engaged in a unitary business with the
Related Corporations within the meaning and intent of §11-
91(e)(2) of the Rules and Regulations of the City of New
York (“RCNY”).
5 Michael Goldstein testified that ABG was also engaged in
developing parcels of property with unrelated developers which would be occupied by unrelated corporations as well as by Toys “R” Us stores. Tr. at 296-7.
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16. Simon, Master & Sidlow (the “Simon firm”), an
unrelated accounting firm located in Wilmington, Delaware,
performed accounting and financial services for Geoffrey and
TRU during the Tax Years. The Simon firm provided one
employee to serve as a part-time employee of TRU and
Geoffrey. The firm billed fees which covered the employee’s
salary and “audit and advisory fees.” The firm usually
billed these fees to TRU and Geoffrey separately. Stip. Ex.
13, 29. Two of the firm’s principals, Howard H. Simon and
William H. Master, also served as officers and directors of
affiliated Group corporations.
Geoffrey
17. Prior to the reorganization, Toys Inc. performed all
tasks involving the various Toys “R” Us trademarks and trade
names. Mr. Goldstein testified that during this earlier
period, the corporation was not particularly diligent in
trademark protection and there were infringements which were
not addressed. Tr. at 328-9.
18. Effective August 1, 1984, Toys Inc. assigned
various Toys “R” Us and Kids “R” Us trademarks and trade
names to Geoffrey.6 According to the assignment agreement,
Toys Inc.: (a) transferred to Geoffrey “the entire right
title and interest in and to the [listed] marks . . .
together with the goodwill of the business symbolized by
6 As part of the 1984 reorganization, Toys Inc. transferred to
Geoffrey the following intangible assets: the Toys “R” Us trademark to identify a line of children’s goods, including toys; the Toys “R” Us service mark; the Kids “R” Us trademark for wearing apparel; the Kids “R” Us service mark; the “term” Toys “R” Us; U.S. and foreign registration of the marks ‘Toys “R” Us,’ ‘Kids “R” Us,’ and other registrations terminating in “R” Us. Toys Inc., however, did not transfer merchandising skills, techniques and expertise. Ex. 2, vol. 1, Ernst & Young “Toys “R” Us Transfer Pricing Analysis” (the “E&Y Report”), pp. 28-9.
9
said marks, and the respective registrations and appli-
cations for registration thereof;” and (b) assigned to
Geoffrey:
. . . any and all causes of action, claims, demands, or other rights occasioned from or because of any and all past infringements . . . together with the right . . . to sue and recover therefore including the right to bring suit in its own name and to receive, retain, hold and enjoy for its own use and behalf . . . any and all damages, profits or other recov- eries . . . .
At the end of 1985, Toys Inc. transferred the stock of
Geoffrey to TRU.
19. Geoffrey is registered with the United States
Patent and Trademark Office as the owner of the Toys “R” Us
and Kids “R” Us trademarks, service marks and trade names,
including those transferred on August 1, 1984 and those
subsequently developed.
20. Geoffrey licensed the Toys “R” Us and Kids “R” Us
marks and names to affiliated domestic and foreign operating
companies, joint ventures and franchise partners, pursuant
to written licensing agreements.7 In such agreements, Geof-
frey granted the licensee (e.g., the operating companies and
Toys Inc.): “a non-exclusive right and license to use the
mark(s) . . . for the products and services listed . . .
and as a trade name to identify the licensee’s business, and
to use said Licensed Mark in advertisements and promotional
materials relating thereto.” The licensees were granted “a
non-exclusive right and license to use the Licensor’s
7 Mr. Goldstein testified that agreements with foreign affiliates
or partners included a component for licensing of the marks, and a component for “knowhow.” Tr. at 288-90.
10
merchandising skills, techniques and know-how . . . in the
operations of the Licensee’s business.” The agreements
identified the marks and placed certain geographical
limitations on their use. The agreements with affiliates
have a term of twenty years, with five-year renewal
provisions. See, e.g., Stip. Ex. 9.
21. Each licensing agreement provides for “Quality
Control” whereby the licensee agrees that the products and
services to which the marks are applied will be of “high
standard and of such quality, workmanship, style and
appearance as shall, in the sole judgement of the Licensor,
be reasonably adequate and suited to their exploitation to
the best advantage and to the protection and enhancement of
the Licensed Mark and Licensed trade name, and the goodwill
pertaining thereto.” Each agreement also provides for
enforcing quality control; for example, by requiring the
licensee to submit samples of the products and services
using the marks to Geoffrey for approval. See, Stip. Ex. 6,
Art. VI – “Quality Control.”
22. Geoffrey charged Petitioner, the other Operating
Companies, and Toys Inc. a royalty for the non-exclusive use
of the trade names and other intangibles pursuant to the
separate licensing agreements. During the Tax Years,
Geoffrey charged the Operating Companies a royalty at a rate
of one percent (1%) of their net sales. Geoffrey also
licensed the right for specific products and services and
the right to use the marks in promotional materials to the
Operating Companies. Advertising expenses were borne by the
licensees.
23. The royalty rate Geoffrey charged the Operating
Companies was determined after an internal review of rates
11
charged by other unrelated corporations,8 as well as a
review of certain agreements Toys “R” Us had with an
unaffiliated corporation. Geoffrey’s Board of Directors
approved the royalty rate at their November 30, 1984
meeting.
24. During the Tax Years, Geoffrey maintained an office
in Delaware. The corporation had no full-time employees,
but had one part-time employee who was responsible for
keeping the corporation’s books and paying its bills. The
Simon firm performed accounting and financial services for
Geoffrey.
25. The law firm of McAulay, Fields, Fisher, Goldstein
& Nissen (the “McAuley firm”) provided Geoffrey with legal
services during the Tax Years, primarily in the areas of
trademark and trade name protection and related litigation.
Paul Fields generally performed these services, and Geoffrey
paid the McAulay firm for this work. Mr. Goldstein
testified that outside counsel fees charged by the McAulay
firm for work for Geoffrey exceeded $100,000 per year during
the Tax Years. Tr. 291.
26. Geoffrey’s principal expenses during the Tax Years
were the fees it paid Toys-NJ and the McAulay firm. Other
expenses related to trademarks and trade names, such as
advertising, were borne by the individual licensees.
8 After the Tax Years, the royalty rates charged to affiliates
were increased to three percent (3%) for Toys “R” Us marks and names, and two percent (2%) for Kids “R” Us marks and names. Mr. Goldstein testified that Toys Inc. commissioned a study by a national accounting and consulting firm to review royalty rates charged for use of trademarks and trade names. Tr. at 287. See, also, Finding of Fact 30, infra, concerning the advance pricing arrangement between Toys Inc. and the Internal Revenue Service (“IRS”).
12
27. In 1982, Toys Inc. entered into an agreement with
an unrelated company located in Kuwait. The agreement
provided for the licensing of the Toys “R” Us trademarks and
the furnishing of technical advice and assistance. Pursuant
to the agreement, the Kuwaiti corporation paid Toys Inc. a
fee of three percent (3%) of its net sales for a term of
five years with a 2-year renewal provision. That fee
represented a one percent (1%) payment for specific uses of
the trademarks and a two percent (2%) payment for the
furnishing of technical services. In 1984, after the
trademarks were transferred to Geoffrey, Geoffrey received
the allocable portion of the fee attributed to the license
of the trademarks to the Kuwaiti corporation, while the
Operating Companies received the portion of the fee
allocated to the furnishing of technical services.
28. Prior to 1984, Toys Inc. licensed the Toys “R” Us
trademarks to two unrelated companies which operated their
businesses within Toys “R” Us stores: an unrelated shoe
manufacturer and an unrelated portraiture corporation. The
subsequent licensing agreements between Geoffrey and the
Operating Companies were based on the form of these third-
party agreements and were considered when Toys Inc.
established the 1% royalty rate which Geoffrey charged the
Operating Companies. Stip. Ex. 10 (“Minutes of the Special
Meeting of the Board of Directors of Geoffrey, Inc. held on
November 30, 1984”).
29. During the Tax Years, Geoffrey received royalty
income from Toys Inc. at a rate of one per cent of the sales
of Toys Inc.’s operating affiliates. Geoffrey received
royalty income from Toys Inc.’s “domestic sources” in the
following amounts: $18,893,974 in 1986; $23,048,528 in
1987; and $28,829,148 in 1988. Geoffrey also received
13
royalty income from Toys Inc.’s “foreign sources,” in the
following amounts: $287,276 in 1986; $679,066 in 1987; and
$1,561,144 in 1988. E&Y Report Ex. 21.
30. Subsequent to the Tax Years, Toys Inc. entered
into an advance pricing arrangement with the IRS which set
the Geoffrey royalty rate at 3% for the licensing of the
Toys “R” Us trademarks and trade names and 2% for the
licensing of the Kids “R” Us trademarks and trade names.
31. On November 30, 1984, Geoffrey and Toys-NJ entered
into the Geoffrey Service Agreement. Toys-NJ agreed to
provide Geoffrey with certain legal, administrative, and
financial services. In exchange, Geoffrey agreed to pay
Toys-NJ an annual fee of $50,000, which represented an
estimate of the cost of the time which Toys-NJ employees
would spend working for Geoffrey. Toys-NJ also agreed to
advance working capital to Geoffrey as necessary. Geoffrey
paid Toys-NJ the $50,000 annual fee during each of the Tax
Years.
32. Toys-NJ coordinated information which it received
from employees of Group affiliates concerning licensing and
trademark infringement with the McAulay firm. Toys-NJ also
prepared the monthly calculations of royalties due Geoffrey
from affiliates and performed a limited cash management
function for Geoffrey involving arranging intercompany loans
and short-term investments.
33. Until November 15, 1985, Lario M. Marini was
President of Geoffrey, David P. Fontello was its Vice
President/Treasurer, and Emmett R. Harmon was its Assistant
Secretary. After that time, Howard H. Simon was Geoffrey’s
President and William H. Master was its Vice
14
President/Treasurer. Michael Goldstein was Geoffrey’s
Secretary during the Tax Years. These officers were also
Directors of Geoffrey.
34. Geoffrey had an office in Wilmington, Delaware
and, during the Tax Years, employed first Charles Campbell
and then Sherri L. Bednash.
ABG
35. Prior to the 1984 reorganization, Toys Inc. loaned
funds to Realty on an interest-free basis to allow Realty to
acquire real property and/or construct buildings thereon.
Realty charged Toys Inc. rent for the use and occupancy of
the real property. These transactions were accounted for
through an “open accounts receivable” from Realty which
reflected a net amount owed by Realty to Toys Inc.
36. As of January 29, 1984, Realty transferred to
Petitioner and the other Operating Companies, real property
located in the states in which those entities conducted
their operations.
37. As of February 24, 1984, Realty mortgaged its real
property holdings to Toys Inc. as security for the accounts
receivable. Petitioner and the other Operating Companies
also mortgaged their property holdings as security for the
accounts receivable. On that same date, Toys Inc. began to
charge interest on the outstanding loan balances.
38. Effective February 28, 1984, Toys Inc. made a
capital contribution to ABG of mortgage notes in the amount
of approximately $136 million. The mortgage notes were
15
issued for a term of thirty years and bore an interest rate
of 12%.
39. On March 1, 1984, Realty was merged into Toys Inc.
40. During the Tax Years, ABG held 112 mortgages on
real property owned by Petitioner, Toys Inc. and the other
Operating Companies. Of these mortgages, 83 had been
transferred to ABG by Toys Inc. in 1984. The remaining 29
mortgages were made by ABG directly. The mortgages were
made from ABG to Toys Inc. and totaled in excess of $222
million. All mortgage loans were for a 30-year term.
41. The interest rates charged by ABG on mortgage
loans to affiliates during the Tax Years ranged from 9.5% to
12%, with the average interest rate being 11.9%. The rates
were determined following consultation with real estate
professionals and developers and were similar to rates
charged between unrelated parties.
42. ABG received the following interest income during
the Tax Years: $18,636,124 in 1986; $20,765,835 in 1987; and
$21,466,716 in 1988. E&Y Report Ex. 23.
43. On January 24, 1985, ABG and Toys-NJ entered into
the “ABG Service Agreement.” Toys-NJ agreed to provide
services to ABG in exchange for an annual fee of one half of
one percent (.5%) of ABG’s gross annual interest income for
the preceding fiscal year. Pursuant to the ABG Service
Agreement, Toys-NJ provided ABG accounting, administrative
and financial services, as well as specific real estate
services (e.g., insurance placement). Toys-NJ also agreed
to provide “financing advice,” to assist in formulating
mortgage policy, and to provide minimal cash management for
16
ABG. The ABG Service Agreement provided, as did the
Geoffrey Service Agreement, that Toys-NJ would advance
working capital to ABG as necessary.
44. Individuals in the Toys-NJ real estate group
assisted ABG in preparing the documentation for the
refinancing of Toys Inc.’s properties and were responsible
for “the movement of cash,” including the payment of
interest, between Toys Inc. and ABG. E&Y Report, p. 90.
45. During the Tax Years ABG paid the following fees
to Toys-NJ: $93,181 in 1986; $103,829 in 1987; and $107,344
in 1988. E&Y Report Ex. 23, 35.
46. ABG rented an office in Nevada.
47. Kafoury, Armstrong & Company (the “Kafoury firm”),
an unrelated Nevada accounting firm, provided general
accounting services to ABG during the Tax Years,
particularly in the area of real estate transactions.
48. An associate of the Kafoury firm was a part-time
employee of ABG, and two partners of the firm, Thomas L.
Booker and Wayne Mark Stewart, were directors of ABG.
During the Tax Years, Mr. Brooker was President of ABG.
Steven J. Meyer was ABG’s Vice President/Treasurer until
August 29, 1985. Thereafter, Mr. Stewart was its Vice
President/Treasurer. Mr. Meyers an was employee of ABG for
the calendar year 1985 and Mr. Stewart was an employee of
ABG for the calendar year 1986. Michael Goldstein was ABG’s
Secretary during the Tax Years.
17
49. Principal and interest payments on mortgages held
by ABG were required to be paid on a quarterly basis. The
interest income paid by Toys Inc. was used to refinance
other Group properties. Toys-NJ was responsible for
transferring funds for mortgage refinancing to Toys Inc. and
interest payments to ABG.
TRU
50. TRU was formed in 1984 as a wholly-owned
subsidiary of Toys Inc. to hold the stock of subsidiaries,
to make loans to Group affiliates, and to oversee and manage
Group investments.
51. In December 1985, the stock of Geoffrey and ABG
were contributed to TRU.
52. Toys Inc. funded TRU with an initial contribution
of approximately $150 million of investment assets, in
exchange for which Toys Inc. received all the stock of TRU.
During the period in issue, TRU had common stock and paid-in
capital worth between $295 million and $400 million. This
amount was the principal source for loans which TRU made to
Toys Inc. for the working capital needs of the Operating
Companies, as well as loans to other Toys “R” Us
affiliates.9
53. Initially, TRU chose the Wilmington Trust Company
as the depository for its moneys and investments and as
trustee to manage its investments. In 1984, TRU’s Board of
9 The minutes of the June 6, 1986 meeting of TRU’s Board of
Directors state that TRU also made loans directly to Toys-UK and to the Toys “R” Us affiliate in Canada. Stip. Ex. 26.
18
Directors established extensive guidelines for investing,
which were revised periodically. See, Stip. Ex. 26.
54. TRU periodically10 received funds from Group
affiliates. TRU’s subsidiaries (including Geoffrey) also
transferred their excess funds to TRU in the form of
dividends. The cash balance in TRU’s accounts would
fluctuate accordingly. When affiliates required working
capital, TRU made short-term loans to Toys Inc., which were
accounted for as intercompany loans.
55. Any excess funds which TRU did not lend to Toys
Inc. were usually fully invested in short-term instruments.
Establishing TRU as a separate investment affiliate
benefited the Group by, among other advantages, maximizing
foreign tax credits.
56. TRU received income for the Tax Years from two
sources: interest on loans and income from investments. For
1986, TRU received taxable interest income of $11,455,214;
federal tax exempt income of $1,559,588; and dividend income
of $1,886,434. For 1987, TRU received taxable interest
income of $13,293,020; federal tax exempt interest income of
$618,023; dividend income from unrelated sources of
$430,551; and dividend income from Geoffrey of $6,500,000.
For 1988, TRU received federal taxable interest income of
$15,711,598; federal tax exempt interest income of $583,041;
dividend income from unrelated sources of $138,398; and
dividend income from Geoffrey of $15,711,598. E&Y Report
Ex. 17.
10 The Operating Companies generally earned almost half of their
annual sales income in the fourth quarter, from November through January. Mr. Goldstein testified that after January, “cash balances decline as [the Group affiliates] build up inventory and construct new stores.” Tr. at 347.
19
57. Toys-NJ entered into the TRU Service Agreement on
April 27, 1984 and the agreement was retroactive to January
30, 1984. Toys-NJ agreed to provide TRU with basic
accounting, insurance and incidental services. Toys-NJ also
agreed to provide TRU with investment advice and to act as
TRU’s agent in purchasing securities, including obligations
of affiliates. Toys-NJ’s asset management group and its
accounting group performed these activities and employees of
Toys-NJ administered the intercompany loans.
58. TRU agreed to pay Toys-NJ one half of one percent
(.5%) of its “gross annual investment income” pursuant to
the TRU Service Agreement. Gross annual investment income
was not defined in the TRU Service Agreement. However, the
E&Y Report states that “based on a management fee
calculation . . . gross annual investment income would
include capital gains, all interest income, and dividend
income from unrelated parties.” E&Y Report, p. 73, fn. 37.
59. During the Tax Years, TRU paid Toys-NJ the
following fees: $74,506 in 1986; $71,540 in 1987; and
$82,165 in 1988. E&Y Report Ex. 17.
60. The chairman and president of Toys, Inc., and the
officers and directors of some of its subsidiaries, were
responsible for TRU’s investment decisions, which were made
pursuant to investment guidelines adopted by TRU’s Board of
Directors. Stip. Ex. 11, 26.
61. From 1985 forward, the Simon firm also performed
accounting services for TRU. The firm billed TRU directly,
at a rate of approximately $110 to $250 per month.
20
62. From April 1984 until November 15, 1985, Lario M.
Marini was TRU’s President, David P. Fontello was its Vice
President/Treasurer, and Emmett R. Harmon was its Assistant
Secretary. After that time, Howard H. Simon was TRU’s
President and William H. Master was its Vice-President-
Treasurer. Michael Goldstein was TRU’s Secretary during the
Tax Years. These officers of TRU were also its Directors.
63. During the Tax Years, TRU maintained an office in
Wilmington, Delaware. Mr. Campbell and Ms. Bednash were
part-time employees of TRU in 1985, 1986 and 1987, primarily
performing accounting services for the corporation.
Petitioner’s Filings and The City GCT Audit
64. Petitioner filed City GCT returns for the Tax
Years, reporting on a separate basis, and paid GCT in the
amounts of: $247,745 for the period ended February 2, 1986;
$342,782 for the period ended February 1, 1987; and $465,317
for the period ended January 31, 1988.
65. In 1991 and 1992, Respondent conducted a GCT field
audit of Petitioner’s books and records for the Tax Years.
The audit was performed by Leopold C. de la Torre, an
auditor with the Department.
66. On February 24, 1992, Respondent issued to
Petitioner a Notice of Determination (the “Notice”) of GCT
due for the Tax Years, in the following amounts (with
interest computed to February 28, 1992):
21
TAX PERIOD PRINCIPAL INTEREST PENALTY TOTAL FYE 2/2/86
FYE 2/1/87
FYE /31/88
TOTAL
$ 50,768.73
48,574.31
71,258.23
$170,601.27
$37,949.69
28,260.80
33,140.65
$99,351.14
$ 5,077.00
4,857.00
7,126.00
$17,060.00
$ 93,795.42
81,692.11
11,524.88
$287,012.42
67. The Notice included several specific audit
adjustments which are not at issue in this proceeding.11 In
response to the Notice, Petitioner paid approximately
$27,000. At that time, Respondent did not assert that
Petitioner be required to file its GCT returns on a combined
basis with any affiliated corporations.12 Mr. de la Torre
testified, however, that during the course of his audit he
reviewed spreadsheets which were filed with the federal
consolidated return for Toys Inc., Petitioner’s parent. Tr.
at 547, 556, and 558.
68. On May 18, 1992, Petitioner timely filed a
Petition for Hearing with the Department of Finance,
protesting the specific audit adjustments.
69. On April 30, 1992, as required by 19 RCNY §11-
91(g)(6), Petitioner timely informed Respondent of State
changes made to its reported State entire net income and
11 These adjustments include: (1) increasing the add-back to
entire net income of interest paid to more than five percent shareholders; (2) imputing interest income on certain Industrial Revenue Bond receivables; (3) disallowing of certain partnership losses; (4) increasing the add-back for ACRS depreciation; and (5) adjusting Petitioner’s reported business allocation percentage.
12 The City Audit Comments specifically state that Toys Inc. “does
not have intercompany sales with [Petitioner]. The issue of combination is therefore not applicable in this audit.” Stip. Ex. 2. Mr. de la Torre confirmed this audit determination at hearing. Tr. at 555.
22
State corporation franchise tax liability (the “State
Changes”). The State Changes reflected the requirement that
Petitioner file its State franchise tax reports on a
combined basis with certain affiliated corporations for the
periods ended January 31, 1984, January 31, 1985 and
February 2, 1986.
70. For the period ended February 2, 1986, which
period is at issue in this proceeding, the State required
Petitioner to file on a combined basis with Toys Inc., Toys-
NJ, Toys-Penn, Toys-Mass, Toys-UK and the Related
Corporations.
71. The State did not issue a determination to
Petitioner with respect to the period ended February 1,
1987, which period is at issue in this proceeding, as the
statute of limitations on State corporation franchise tax
assessment had expired.
72. For the period ended January 31, 1988, which
period is also at issue in this proceeding, Petitioner filed
its State corporation franchise tax report on a combined
basis with Toys Inc., Toys-NJ, Toys-Penn, Toys-Mass, Toys-UK
and the Related Corporations.
73. Petitioner filed City GCT returns for the Tax Years
on a separate reporting basis.
74. Based on the reported State changes, Respondent
performed a re-audit of Petitioner in 1995. On August 10,
1995, Respondent issued to Petitioner a Consent to Audit
Adjustment, setting forth a revised deficiency which
reflected the Commissioner’s determination that Petitioner
should be required to file its GCT returns for the Tax Years
23
on a combined reporting basis with certain affiliated
corporations (the “Revised Deficiency”). The Revised
Deficiency asserted that the following GCT and interest
(computed through September 30, 1995) were due from
Petitioner for the Tax Years:
Tax Year Ended GCT Interest
2/2/86 $44,051.67 $58,828.04
2/1/87 49,672.44 56,088.32
1/31/88 43,554.65 42,316.58
With respect to the period ended February 1, 1987,
Respondent limited the amount of the revised deficiency to
the principal GCT amount originally asserted in the Notice,
$48,574.31, to avoid having to bear the burden of proof on a
greater deficiency asserted after the Notice was issued and
the petition was filed. See, Code §11-680(5)(c). Respondent
does not assert any penalties with respect to this revised
determination and has abated all penalties asserted in the
Notice.
75. During the course of pre-hearing proceedings, I
requested Respondent’s representative to articulate
Respondent’s basis for the Revised Deficiency. On January
11, 1996, Respondent’s representative wrote Petitioner’s
representative, explaining that audit adjustments relating
to interest to stockholders, interest income imputed from
IRB receivables, and the disallowance of partnership losses
were no longer being asserted. Respondent’s representative
noted that Petitioner would be required to file a combined
report for the Tax Years which would include the following
related corporations: Toys Inc., Toys-Penn, Toys-NJ, Toys-
Mass, Toys-UK (for the 1988 Tax Year only), and the Related
Corporations, stating:
24
During the three years ending in 1989, 1990 and 1991, Petitioner filed combined New York State Corporation franchise tax reports with those cor- porations required, in the prior New York State audit, to file combined returns with petitioner. Petitioner did not however, file combined New York City general corporation tax returns for that same period. Petitioner has not indicated any change in the facts material to the issue of combina- tion, between the period covered by the prior New York State audit and the subsequent period in which petitioner filed combined New York State returns. Thus, in addition to the findings of the New York State audit, petitioner’s own signed New York State tax returns provides [sic] further support for the reasonableness of the Combined Deficiency. Stip. Ex. 5.
76. For purposes of this proceeding only, Petitioner
does not contest Respondent’s proposed adjustment to the
extent that it requires Petitioner to file its City GCT
returns for the Tax Years on a combined reporting basis with
Toys, Inc., the Operating Companies, Toys-NJ, Toys-Penn,
Toys-Mass and Toys-UK (for Tax Year 1988 only).
77. Petitioner’s capital stock and the capital stock of
the Related Corporations and other Operating Company
subsidiaries are owned or controlled, directly or indirectly
by Toys Inc. within the meaning and intent of 19 RCNY §11-
91(e)(1).
The South Carolina Geoffrey Case
78. On April 7, 1993, the Supreme Court of South
Carolina issued Geoffrey, Inc. v. South Carolina Tax
Commission, 313 S.C. 15, 437 S.E.2d 13; 1993 S.C. LEXIS 134
(1993). The issue in that case was whether Geoffrey had
nexus with the State of South Carolina sufficient to subject
its royalty income to the South Carolina income tax on
25
corporations and business license fees pursuant to South
Carolina Code Annotated §12-7-230 (Supp. 1992). The periods
in issue in that proceeding were the fiscal years ending
January 1986 and January 1987. During the course of those
proceedings, the testimony of Mr. Louis Lipschitz, Vice
President of Finance and Treasurer of Toys Inc., was
offered. A copy of the transcript of that testimony was
made a part of the record of this proceeding.
Generally, Mr. Lipschitz’s testimony in the South
Carolina proceeding concerned the business of Toys Inc. in
South Carolina, the incorporation of Geoffrey, the ownership
of Geoffrey, Geoffrey’s corporate activities (including
activities performed on behalf of Geoffrey to enforce and
protect the Toys “R” Us marks), and the licensing agreement
between Geoffrey and Toys Inc. That testimony was offered
in the context of the Toys Inc.-Geoffrey agreement as it
affected Geoffrey’s South Carolina tax liability.13 The
South Carolina Supreme Court found that Geoffrey had
sufficient nexus with South Carolina, through the presence
in that state of intangible property (trademarks, et al.),
so that the tax imposed upon Geoffrey did not violate
requirements of the Due Process Clause and the Commerce
Clause of the United States Constitution.
Transfer Pricing Analyses
79. Petitioner offered the testimony of Dr. Irving H.
Plotkin of Arthur D. Little, Inc. and submitted into
evidence a report prepared by Dr. Plotkin entitled “Testing
13 Respondent offered other testimony from that proceeding into
evidence in this case. Petitioner objected to the introduction of such other testimony on grounds that it was not relevant to this proceeding, and the objection was sustained. See, generally, Tr. at 577-588.
26
A Related-Party Royalty for Compliance With the Arm’s-Length
Standard” (the “Plotkin Report”).14 Dr. Plotkin was
qualified at hearing as an expert in the field of
microeconomics and the study of intercompany pricing under
Internal Revenue Code [“IRC”] §482. The Plotkin Report
deals generally with valuing intangibles and specifically
addresses the issue whether the royalties paid Geoffrey by
the Operating Companies are “consistent with those that
might be charged between unrelated parties:” i.e., whether
they conform to an arms’ length standard.15 Plotkin Report,
p. 1.
Dr. Plotkin defines an intangible asset to be “any non-
physical asset that allows a firm to earn higher profits
than would be expected given its stock of tangible
(physical) assets.” Plotkin Report p. 25. Dr. Plotkin
notes in his report that the value of an intangible varies
according to the “ability” of the intangible to generate
above-average profits and according to the economic
environment in which it exists. Dr. Plotkin believes that
an “income approach,” which is premised on the principle
that the value of the intangible should “be equal to the
difference between income that would have been earned absent
use of the intangible and the income that is earned with its
use,” is the best method for valuing an intangible. Plotkin
Report, p. 27.
14 Dr. Plotkin is the author of several articles and publications, and has testified in many proceedings as an expert in the field of economics on behalf of the Internal Revenue Service, plaintiffs, and defendants.
15 A copy of Dr. Plotkin’s November 1994 working paper, “The Eye
of the Needle: Uses of Ranges and Results in §482,” was submitted with his report.
27
The Plotkin Report analyzes the royalties paid by the
Operating Companies for the license to use Geoffrey’s
intangibles according to a “rate of return” model; that is,
where it is not possible to identify an exact uncontrolled
comparable (the preferred valuation methodology under IRC
§482), the arm’s length nature of a royalty payment may be
determined by looking to whether its rate of return falls
within a reasonable range of such rates. The reasonable
range is referred to as the “interquartile” range, a range
of rates of return which represents between 25% and 75% of
the comparable universe.16 See, also, Treasury Regulation
(“Treas. Reg.”) §1.482-1(e)(2)(iii)(C), which defines
“interquartile range” in the context of determining a
comparable arm’s length range.
Dr. Plotkin computes rate of return by multiplying
profit margin by turnover. In his report, he expressed this
computation as the formula “R = M x T,” where R is the rate
of return (which equals the ratio of profit to assets);
M is the margin (which equals the ratio of profit to sales);
and T is the turnover (which equals the ratio of sales to
assets). Dr. Plotkin applies a “frequency distribution”
methodology to arrive at a “median retailer” arm’s length
rate of return.
Examining comparable transactions, Dr. Plotkin points
out that assertedly comparable profit margins (the ratio of
profits to sales) must be adjusted for factors which are
different between the comparables or which have a “definite
and ascertainable effect” on the variable.
16 Acknowledging that some economists believe that rate of return
analysis is simply an accounting exercise, Dr. Plotkin states that the “universal standard for judging the attractiveness of any type of business activity is its rate of return.” Plotkin Report, p.14.
28
The rate of return on the Geoffrey intangibles was
compared to: (a) data from 2,198 United States corporations
reported in Standard & Poor’s COMPUSTAT data base for a ten-
year period which included the Tax Years; and (b) data from
212 of those corporations which were retailers operating
during the same period.
Dr. Plotkin observed that the Operating Companies had
higher rates of return after paying royalties to Geoffrey
than did approximately 80% of the considered retailers.
Accordingly, he concluded that the royalty charged to the
Operating Companies was an “arm’s length” charge pursuant to
IRC §482.
80. Petitioner also offered the testimony of Mohamed
Sherif Lotfi, a member of the economics group of the
international accounting firm of Ernst & Young, LLP. Mr.
Lotfi contributed to and supervised the preparation of the
E&Y Report which was submitted into evidence. Mr. Lotfi was
qualified at the hearing as an expert in economics.
The E&Y Report analyzes three types of transfer pricing
transactions between Toys Inc.’s affiliates during the Tax
Years: (a) the royalty payment to Geoffrey by the Operating
Companies for their use of certain trademarks and trade
names; (b) the management fees paid to Toys-NJ by Related
Corporations for the provision of various services; and (c)
the intercompany loans between TRU and Toys Inc. (the “TRU
Loans”) and between ABG and Toys Inc. (the “ABG Loans”).
The E&Y Report tested the three categories of
transactions to determine if they were made at arm’s length
according to the principles of IRC §482. The Report was
limited to a review of the Tax Years’ transactions. Mr.
29
Lotfi did not consider any antecedent transactions and
specifically did not consider the substance of the initial
incorporation and capitalization of the Related Corporations
at the time of the 1984 reorganization.
The E&Y Report took into account IRC §482 and
applicable Treasury Regulations which pertain to the three
types of transactions examined. With respect to its review
of the royalty payments to Geoffrey, the E&Y Report applied
the final Treasury Regulations which were effective for
periods beginning after October 6, 1994. E&Y Report, p. 33.
According to the E&Y Report, when intercorporate
transactions are examined pursuant to IRC §482, the “best
method rule” applies; that is, the method which provides
“the most reliable measure of an arm’s length result” must
be used. Treas. Reg. §1.482-1(c)(1).
(a) The E&Y Report first examined Geoffrey’s licensing
of intangibles to the Operating Companies and their payment
of royalties to Geoffrey. The Report noted that the
principal Treasury Regulation methods for examining
transactions involving intangible property include the
comparable uncontrolled transaction method (“CUT”) (Treas.
Reg. §§1.482-3(a)(1), 1.482-3(b)), the comparable profits
method (“CPM”) (Treas. Reg. §§1.482-3(a)(4) and 1.482-5),
the profit split method (Treas. Reg. §§1.482-3(a)(5) and
1.482-6), and/or any “unspecified” method which “provides
the most reliable measure of an arm’s length result under
the principles of the best method rule.” Treas. Reg.
§1.482-3(e)(1).
Mr. Lotfi applied both the CUT and CPM methods. Under
the CUT method he performed two analyses: (1) an internal
30
CUT analysis which compared a transfer of intangibles
between Geoffrey and an unrelated third party (in this case,
the licensing agreement with the Kuwaiti company, infra at
Finding of Fact ¶27) to the transfer of intangibles between
Geoffrey and the Operating Companies; and (2) an external
CUT analysis which compared licensing agreements between two
unrelated parties to the licensing agreement between
Geoffrey and the Operating Companies.
The E&Y Report concluded that the internal CUT analysis
could not be used. Notwithstanding that the royalty rate
for the transfer of intangibles was the same between the
Kuwaiti company and Geoffrey as it was between the Operating
Companies and Geoffrey, in Mr. Lotfi’s opinion, an
adjustment in the analysis could not be made to compensate
for the differences in territory, markets, and terms of
exclusivity between the Kuwaiti company and the U.S.
Operating Companies.
An external CUT analysis was then performed, to the
extent that a search was undertaken for license agreements
between two independent parties comparable to the agreements
between Geoffrey and the Operating Companies. Eighteen
agreements were identified for comparison.17 However, the
Report concluded that there were significant differences
between these eighteen agreements and the Geoffrey
agreements as none of the agreements involved licensing of a
trade name which identified a business (rather than a
product) and only two agreements were non-exclusive. In Mr.
17 The external CUT analysis first identified agreements between
companies active in wholesale and retail sales based on Standard Industrial Classification (SIC) codes and using the internal data resources of Ernst & Young LLP. Initially 163 agreements were identified which were reduced to 18 agreements when classifications of time period, territory, and form of agreement (i.e., trademark vs. patent) were applied.
31
Lotfi’s opinion, these differences reduced the reliability
of this type of analysis and, therefore, an external CUT
analysis also was not appropriate.
The Geoffrey transactions were next examined according
to a CPM analysis; i.e., the profitability of the Operating
Companies after royalty payments was compared to the
profitability of functionally comparable companies which do
not have or use any valuable intangibles. The premise of
this analysis is that where the profitability of the
Operating Companies falls within the interquartile range of
profitability computed for the group of comparable
companies, the royalty should be deemed to have been made at
arm’s length.
Mr. Lotfi used specific ratios, referred to as Profit
Level Indicators (“PLI”s),18 to make his comparison: the
rate of return on capital employed (measured by return on
net assets), the ratio of operating profit to sales (i.e.,
operating margins), and the ratio of gross profit to
operating expense (the “Berry ratio”).
Six functionally comparable companies (the “CPM
comparables”) were identified according to the following
parameters: (1) companies that engaged in mass merchandise
retail sales and did not engage in other activities (i.e.,
manufacturing); (2) companies that experienced seasonal
sales; (3) companies that did not sell merchandise on
credit; (4) companies that were sufficiently large to enjoy
“economies of scale”; (5) companies that did not own their
own non-routine intangible assets; (6) companies that were
18 See, Treas. Reg. §1.482-5(b)(4), which defines PLIs as “ratios
that measure relationships between profits and costs incurred or resources employed.”
32
publicly held; and (7) companies that were in operation
during the Tax Years 1985-1988.19
Asset return PLIs (total assets less current
liabilities) and operating margin PLIs were computed for
each of the CPM comparables, and three-year average
interquartile ranges for the combined CPM comparables’
indices were developed.20 After Operating Companies’ PLIs
were compared to the CPM comparables’ PLIs,21 the report
concluded that the best method for establishing an arm’s
length range was the asset return PLI. The report found
that the Operating Companies’ return on net assets (after
royalties) was within the appropriate comparables’
interquartile range. Mr. Lotfi concluded that the one
percent royalty charge was at arm’s length. Tr. at 401.
(b) The E&Y Report next examined the Agreements between
the Related Corporations and Toys-NJ to determine whether or
not an arm’s length fee was paid by the affiliates to Toys-
NJ.
19 The comparable companies were: Burlington Coat Factory
Warehouse Corp., Deb Shops, Inc., Jamesway Corp., Rose’s Stores Inc., Ross Stores Inc., and Wal-Mart Corp.
20 For the 1986 and 1987 fiscal years, data from FYE 85, 86 and 87
were used. For the 1988 fiscal year, data from FYE 86, 87 and 88 were used.
21 For example, the Report compared adjusted operating margins as
follows: FYE 86 FYE 87 FYE 88
Comparables: Average Inter- Quartile Range
7.65%-11.03%
7.65%-11.03%
6.89%-10.55%
Operating Companies
8.61% 8.61% 9.32%
33
The Report found that, pursuant to the Agreements,
Toys-NJ performed similar services for all three companies
(e.g., accounting, administrative, incidental and advancing
working capital), and other services only for certain of the
companies (e.g., acting as TRU’s agent in purchasing
securities). Each Agreement was reviewed separately in the
E&Y Report in the context of the Treas. Reg. §1.482-2(b)
rules for examining the performance of services by one
member of an affiliated group and the compensation paid for
those services by another member.
Initially, the E&Y Report found that the services
provided by Toys-NJ were not stewardship expenses, but were
expenses which could be charged to the affiliates.22
The E&Y Report considered two methods to determine
whether an intercompany charge for services met the IRC’s
arm’s length standard: (1) the comparable uncontrolled price
method (“CUP”); and (2) the mark-up on total costs method.
The report concluded that the information required for the
mark-up method, principally information on actual costs
incurred by Toys-NJ to perform the services, was not readily
available. Therefore, the CUP method was applied.
Three types of services provided by Toys-NJ pursuant to
the Agreements were isolated: cash management, accounting,
and legal services. Data with respect to comparable charges
between unrelated parties for accounting and legal services
was identified (“CUP rates”). For accounting services, the
22 The E&Y Report relied on Young & Rubicam v. U.S., 410 F.2d 1233
(Ct. Cl. 1969), as well as a published IRS Private Letter Ruling 8806002 (1988), to determine whether the services provided were stewardship expenses. The report defines a stewardship expense as an expense “allocable to the parent . . . limited to items that do not benefit an affiliate in the conduct of business operations.” E&Y Report p. 95.
34
report computed “average billing rates” for senior
accountants and partners, based on information published by
the National Society of Public Accountants. For legal
services, the report developed a range comprised of fees
charged for junior partners and/or junior associates in
metropolitan New York City law firms as published in a
survey by The National Law Journal.23
The E&Y Report extrapolated the time each Toys-NJ
employee spent on each of the three types of services (cash
management, accounting and legal) for each of the Related
Corporations.24 The CUP fee range for each type of service
was then multiplied by the hours of such service provided by
employees of Toys-NJ.
Although the greater percentage of services which Toys-
NJ performed for ABG were specific mortgage accounting
services performed by the Toys-NJ real estate group, they
were accounted for in the E&Y Report as “real estate manager
time,” were not separately considered in the comparative
study, and were treated generally as “accounting type
services.” E&Y Report, p. 88-91.
For Geoffrey and ABG, the range of CUP accounting fees
was added to the range of CUP legal fees to arrive at a
basis for comparison. For TRU, the report made the
23 The National Law Journal, “Hourly Rates for Partners and
Associates,” New York Law Publishing Company, 1987 and 1988. 24 The specific information available concerning the provision of
actual cash management services to TRU was limited to records for February through April 1986, December 1986 and January 1988. For the remaining months, TRU’s general ledger opening and closing balances were reviewed to arrive at monthly and annual averages. The report estimated that between 880 and 900 hours per year were spent on cash management services, the largest category of services provided by Toys NJ to TRU.
35
comparison to only the CUP accounting fees range based on
the nature of the services performed.
The costs of the separate services rendered to each
affiliate, calculated according to this methodology, were
combined to arrive at a range of total costs to Toys-NJ.
The report calculated the range of CUP accounting and legal
fees charged each affiliate as follows:
GEOFFREY ABG TRU
FYE 86 $35,474-$91,944
$48,257-$99,465
$51,440-$76,247
FYE 87 $40,329-$98,385
$39,926-$107,067
$61,342-$90,294
FYE 88 $45,183-$104,827
$43,558-$114,668
$60,983-$90,392
Total costs were then compared to the fees actually charged
(i.e., the annual fee of $50,000 paid by Geoffrey and the
sales percentage amounts paid by ABG and TRU).25
The E&Y Report concluded that the fees charged by Toys-
NJ for the services provided each of the three affiliates
were within an acceptable range of fees charged by unrelated
parties performing the same services and therefore were at
arm’s length.
25 For example, applying a range of FYE 87 fees for accounting
services for unrelated parties of from $65-$96 per hour to the extrapolated 849 hours of cash management services which the report identified as performed for TRU in that period, it was concluded that it would have been appropriate for Toys-NJ to charge TRU between $54,994 and $81,515 for these services. This amount was added to the other estimated range of costs of services to arrive at a range of “total fees based on unrelated transactions” of between $61,342 and $90,924. The actual charge of $71,540 was within that accepted range.
36
Although Geoffrey paid the unrelated McAulay firm for
legal services, and Geoffrey and TRU paid the unrelated
Simon firm for accounting work, Mr. Lotfi testified that he
did not look to those transactions as evidence of comparable
uncontrolled transactions. Rather, it was his testimony
that the transactions between Geoffrey and the McAulay firm
were not similar to those between Geoffrey and Toys-NJ, and
therefore would not qualify as comparables. Tr. at 514-515.
Similarly, the fees paid the Simon firm and the compensation
paid the part-time Simon employee were not used as bases for
comparison.
(c) The E&Y Report also analyzed the mortgage loans
between ABG and Toys Inc. and the intercorporate loans
between TRU and Toys Inc. The ABG Loans, used to finance
real estate development for the Operating Companies, were
for 30-year fixed terms with an average interest rate of
11.90%. The TRU Loans, made for the purpose of meeting the
working capital needs of the Operating Companies, were
short-term loans (on an average, for terms of eight months)
made at an average interest rate of 7.79%.
The Report examined whether the interest rates charged
on these loan transactions fell within Treas. Reg. §1.482-2
“safe haven” rates which the IRS would have accepted as
arm’s length for the particular Tax Year in issue.26 Treas.
Reg. §1.482-2(a)(2)(iii)(A) and (B).
For the 1986 Tax Year, the Treasury Regulation safe
haven interest rate range was 11% to 13% simple interest per
annum. For the 1987 and 1988 Tax Years, the Treasury
26 Treas. Reg. §1.482-2(a)(1)(i) addresses loans and advances between affiliates, and provides for allocation of interest where an arm’s length rate has not been charged.
37
Regulation safe haven interest rate was calculated as a
percentage (from 100% to 130%) of the Applicable Federal
Rate (“AFR”), computed using a three percent range; i.e., if
the AFR rate was 9%, the acceptable range was from 9% to
11%. Treas. Reg. §1.482-2(a)(2)(iii)(B)(1). The AFR for
the last two Tax Years as determined under the IRC, is based
on the yield of U.S. securities, taking into account the
term of the loan.
Since the ABG loans were for a fixed 30-year term, the
E&Y Report used long-term rates, while the report used semi-
annual compounding of a range of rates for short-term loans
for the TRU Loans. For the TRU Loans for the 1986 Tax Year,
the study developed a range starting from the lower arm’s
length interest rate (7.85%), which was based on Treasury
bill rates adjusted for borrowing rates, and extending to
the lowest AFR (11%). For 1987 and 1988, the report used
the “safe haven” AFRs (of 6.13% to 13%) and arm’s length
interest rates (of 6.12% to 8.25%).
Of the 112 ABG Loans reviewed, 108 were within the safe
haven range. Of the 78 TRU Loans examined, 50 were within
the safe haven range. The E&Y Report concluded, and Mr.
Lotfi testified, that as the majority of the loans were
within the safe haven ranges, both the ABG mortgage loans
and the TRU intercorporate loans met an arm’s length
standard. Tr. at 415, 417.
STATEMENT OF POSITIONS
Respondent argues that Petitioner’s income and GCT
liability will not be properly reflected unless the Related
Corporations are required to be included in a combined
38
report with Petitioner and other Toys “R” Us affiliates.
Respondent asserts that the 1984 initial capital
contributions made by Toys Inc. to the Related Corporations
in return for 100% of the stock of each Related Corporation,
and the subsequent transactions between the Related
Corporations and Toys Inc. (including the Tax Years
intercorporate transactions), should be considered together
as integrated transfers-licensebacks and disregarded as
separate transactions for GCT purposes. Respondent asserts
that since, for tax purposes, no transfers took place,
Petitioner’s income was not properly reflected regardless of
whether the subsequent Tax Years intercompany transactions
were at arm’s length; i.e., that any intercompany charge for
property not owned is distortive. Respondent neither argues
nor abandons his prior position that the subsequent Tax
Years transactions between the Related Corporations and
their affiliates were not made at arm’s length.
Petitioner asserts that Toys Inc.’s initial transfers
to and capitalization of the Related Corporations were valid
separate transactions which should be respected for GCT
purposes and should not be integrated with subsequent
transactions. Petitioner asserts that the subsequent Tax
Years transactions between the Related Corporations and
their affiliates were made at arm’s length. Therefore,
Petitioner argues, its income and GCT liability would be
properly reflected by combined returns which do not include
the Related Corporations.27
27 Petitioner concedes, for purposes of this proceeding only, that
it should file its City GCT returns for the Tax Years on a combined basis with the following affiliated corporations: Toys, Inc., Toys-NJ, Toys-Penn, and Toys-Mass, and for the 1988 Tax Year only, Toys-UK Group. Stip. ¶1, fn. 1.
39
CONCLUSIONS OF LAW
The statutory preference for corporations doing
business in the City is to file GCT reports on an individual
basis, as each corporation is considered to be a separate
taxable entity. Code §11-605.1. See, also, 19 RCNY §11-91.
However, the statute grants Respondent the discretion to
require a taxpayer to file its GCT reports on a combined
basis with related corporations if it is necessary to
properly reflect income and tax liability. Code §11-605.4.
The Commissioner may require a combined filing where:
(1) there is common ownership among the corporations to be
combined;28 (2) the corporations in the proposed combined
group are engaged in a unitary business;29 and (3) filing on
a separate reporting basis “distorts” a taxpayer’s income
and GCT liability. Code §11-605.4; 19 RCNY §§11-91(a)(3)
and (f)). The Commissioner may not require a foreign
corporation (i.e., one which does not do business in the
City) to be included in a combined report “unless . . . such
report [is] necessary, because of inter-company transactions
or [an agreement pursuant to Code §11-605.5] in order
properly to reflect” GCT tax liability. Code §11-605.4.
Petitioner concedes that the ownership and unitary business
28 The statute speaks to “substantial” ownership or control among
the proposed corporations, and the GCT regulations establish a threshold of 80% ownership of voting stock. See, 19 RCNY §11-91(e)(1).
29 For purposes of this proceeding only, Petitioner does not
dispute that it is engaged in a unitary business with the Related Corporations within the meaning and intent of 19 RCNY § 11-91(e)(2). As these corporations are engaged in a unitary business, there is no question that the Related Corporations have nexus to the City sufficient to subject them to City taxation. See, Allied Signal, Inc. v. Division of Taxation, 504 U.S. 768 (1992); Matter of USV Pharma-ceutical Corp., DTA No. 801050, 92-2 NYTC T-822 (NYS Tax Appeals Tribunal, July 16, 1992). Therefore, cases decided in other tax jurisdictions (e.g., the South Carolina Geoffrey case, supra, at Finding of Fact ¶78) which speak primarily to issues of nexus, are not relevant to this determination.
40
criteria are met with respect to the foreign Related
Corporations. Stip. ¶¶56, 57.
The GCT regulations establish a presumption of
distortion where there are substantial intercorporate
transactions between members of a related group. 19 RCNY
§11-91(f). “Substantial” is defined as that circumstance
where “as little as 50 percent of a corporation’s receipts
or expenses are from one or more qualified activities.” 19
RCNY §11-91(f)(3).
There were substantial intercorporate transactions
between the Related Corporations and members of the
affiliated group30 during the Tax Years. Geoffrey’s income
was primarily from royalties which it received from
licensing intangibles to affiliates. ABG’s income was
primarily interest paid by affiliates on mortgages it held
on properties used for the benefit of Group members. TRU’s
income was primarily interest income from investments
transferred from its parent. It also received contributions
of excess cash from affiliates. In addition, many expenses
of the Related Corporations were incurred and paid
intercompany. Respondent therefore is entitled to the
regulatory presumption that Petitioner’s income was
distorted when GCT reports were filed on a basis which
excluded the Related Corporations. 19 RCNY §11-91(f).
To overcome this presumption of distortion, Petitioner
must establish that the subject transactions were carried on
at arm’s length. Matter of Standard Manufacturing Co.,
Inc., DTA No. 801415, 92-2 NYTC T-202 (NYS Tax Appeals
30 For federal income tax purposes, Toys Inc., the Operating
Companies and the Related Corporations comprise the “affiliated group.” Stip. ¶16; Stip. Ex. 34-36.
41
Tribunal, February 6, 1992); USV Pharmaceutical, supra.
Petitioner asserts that it has overcome the presumption of
distortion by demonstrating that the transactions which gave
rise to that presumption were made on an arm’s length basis.
Although there is no express statutory or regulatory
incorporation of the IRC §482 arm’s length standard,31 State
decisions have consistently looked to that principle to
determine whether the presumption of distortion is overcome
and income is properly reflected. USV Pharmaceutical,
supra; Matter of The New York Times Co., DTA. No. 809776
95-1A NYTC 1045 (NYS Tax Appeals Tribunal, August 10, 1995).
Under IRC §482, transactions between corporations are
adjusted to the extent that “the results of the transactions
are consistent with the results that would have been
realized if uncontrolled taxpayers had engaged in the same
transaction under the same circumstances.” Treas. Reg.
§482-1(b)(1).
Petitioner has presented thorough and credible evidence
that the Tax Years transactions between the Related
Corporations and affiliated corporations were: (1) at arm’s
length; or (2) on such terms that combined reporting should
not be required.
Petitioner’s two expert witnesses, Dr. Irving Plotkin
and Mohamed Sherif Lotfi, testified that the royalty which
Geoffrey charged the Operating Companies and Toys Inc. was
an arm’s length charge and each witness submitted a detailed
report supporting his conclusion. See, Findings of Fact
31 The IRC permits the Secretary of the Treasury to adjust items
of income, deduction and expense between members of an affiliated group of corporations if he determines that the adjustment is required “to clearly reflect the income” of the examined corporations. IRC §482.
42
¶¶79 and 80. Dr. Plotkin examined the “operating rates of
return” for 212 unrelated corporations which were in
business from 1985-1994. His analysis took into account
profit margins and turnovers, compared the Operating
Companies’ pre-royalty and post-royalty rates of return, and
determined that the Operating Companies had higher rates of
return after paying royalties to Geoffrey than did the
majority of the unrelated corporations examined.
Mr. Lotfi examined Geoffrey’s licensing of the
intangibles to the Operating Companies. He applied a
detailed IRC §482 analysis, examining the subject
transactions against transactions entered into by comparable
unrelated parties according to several IRC §482 methodo-
logies. See, Finding of Fact ¶80(a). Mr. Lotfi also
examined two additional categories of transactions between
the Related Corporations and Toys Inc. affiliates: (1) the
Service Agreements between Toys-NJ and the Related
Corporations; and (2) the intercorporate ABG Loans and TRU
Loans. See, Findings of Fact ¶80(b) and 80(c). He
concluded that in each of the three instances, the
transactions between the Related Corporations and affiliates
were at arm’s length pursuant to the IRC §482 standard.
Respondent did not argue that intercompany transactions
which did not involve transfers of intangible property and
rights (i.e., payments pursuant to the Service Agreements)
were distortive. Further, Respondent did not offer any
expert testimony to rebut, or even challenge, the
conclusions of Petitioner’s witnesses that the Tax Years
royalty or interest charges were at arm’s length (assuming
the tax validity of the initial 1984 transfers of the
underlying properties). Respondent did not attack the
different valuation methodologies used by the experts or the
43
factual bases on which they relied. Nor did he rebut the
specific evidence which they presented.
Petitioner therefore has established that the Tax
Years’ intercorporate transactions between Geoffrey and the
Operating Companies, and between the Related Corporations
and Toys-NJ, were made at arm’s length, thus overcoming the
presumption of distortion occasioned by those transactions.
The same conclusion cannot be reached, though, with
respect to the third category of transactions examined: the
TRU Loans and the ABG Loans. Mr. Lotfi examined 78 TRU
Loans and found that the interest charged on 50 of the 78
was within the “safe haven” range. The interest rates on
the remaining 28 loans, however, were not within that
parameter, and he concluded that there was a “total net
undercharge of about $300,000.” Tr. at 416. Nevertheless,
Mr. Lotfi posited that as the majority of the loans
reviewed were made at safe haven rates, the totality of
these intercorporate transactions should be considered to be
arm’s length. Tr. at 417. I disagree.
Mr. Lotfi’s conclusion that all TRU loans were made at
an arm’s length rate cannot be accepted where approximately
one-third of those transactions were outside the IRS
sanctioned fair market range. Nor is an undercharge of
approximately $300,000 de minimus.
Although the presumption of distortion therefore has
not been overcome with respect to TRU, the inquiry is not
ended. Respondent may require a foreign corporation to be
included in a combined report only to remedy a distortion of
income and tax liability which results from reporting on
another basis. USV Pharmaceutical, supra. Toys Inc.’s
44
payment of less than fair market value interest on some TRU
Loans resulted in Toys Inc. incurring a smaller interest
deduction than it should have, and therefore overstating its
income to the extent of the undercharge. Consequently the
GCT liability of the combined group (excluding the Related
Corporations) would be greater than if the interest actually
charged by TRU was at fair market value. Requiring that TRU
be included in the combined filing on this factual basis
would disproportionately increase the Group’s allocated
combined income and not fulfill the statutory purpose. See,
e.g., Matter of Campbell Sales Co., DTA No. 805017 and
805018, 93-2 NYTC T-1071 (NYS Tax Appeals Tribunal, December
2, 1993).
The E&Y Report also notes that of the 112 ABG Loans, 4
were not made within the federal AFR safe harbor interest
rate range. E&Y Report, p. 111. These 4 mortgage loans,
all transacted in Tax Year 1987, represented an overcharge
outside the safe haven range of $21,006, or 0.38% of the
total interest charged by ABG for the Tax Years. On a
reporting basis which excludes ABG, the overcharge would
result in an understatement of GCT liability because it
would increase ABG’s income and decrease the Group’s
combined income. While it therefore cannot be found that
there is no distortion, the amount of the understatement is
so small that it is de minimus. Under these circumstances,
Respondent should not require items of ABG’s income, gain
and deduction to be included in the combined report.
Transfer of the Underlying Property
Respondent argues that the inquiry whether the Related
Corporations should be included in the combined report
cannot be resolved merely by examining whether the Tax
45
Years’ transactions between these corporations and Group
affiliates were at arm’s length, notwithstanding that this
characterization of the transactions was the sole issue
presented throughout pre-hearing conference proceedings.
See, generally, Stip. Ex. 75 (the January 11, 1996 Letter
from Respondent’s Representative). Only in the middle of
the formal hearing did Respondent change his theory of
assessment and raise a substantively new basis for the
Revised Deficiency.
Respondent now asserts that combination is appropriate
because the 1984 transfers of intangibles and other property
interests to the Related Corporations and the subsequent
transactions between the Related Corporations and affiliates
lacked economic substance for GCT purposes. As a result, he
argues, Group income was not properly reflected on a basis
which excluded those corporations.
Specifically, Respondent posits that the initial
capitalizations were ineffective as discrete transactions
and should be integrated with any subsequent transactions
involving the intangibles, including the Tax Years’
licensing of trademarks and payment of royalties or
interest.32 Respondent argues that Toys Inc. remained in
the same economic position during the Tax Years that it
enjoyed before the 1984 transfers and that Petitioner’s
income would therefore be improperly reflected if the
combined reports exclude the Related Corporations. In his
post-hearing written arguments, Respondent supports his
32 Respondent’s representative stated at the close of the hearing:
“the question isn’t whether the royalty that was charged was overstated, which means it wasn’t arm’s length, there was no basis for any royalty to be charged whatsoever . . .” Tr. at 529. Later, he stated that the: “payment under the license is one transaction.” Tr. at 537.
46
position by reference to federal tax law and federal patent
and trademark law.
The belated articulation of this new position is
problematic, particularly since Respondent’s representative:
(1) was directed before the formal hearing to advise
Petitioner of his position; (2) waived an opening statement
of that position; and (3) relied upon his cross-examination
of Petitioner’s witnesses to apprise Petitioner of the new
basis for the deficiency asserted.33
Until Respondent’s representative responded to my
inquiries after the close of Petitioner’s direct case (Tr.
at 525-540), there is nothing in the record which directly
advised Petitioner of the Commissioner’s new basis for
asserting combination or of the transactions on which
Respondent was relying to assert the Revised Deficiency.
This is of particular concern since, in combined reporting
cases where the agency determination is based upon the
presumption of distortion arising from substantial
intercorporate transactions, it is “incumbent upon the
[agency] to first identify those transactions which it
claims give rise to the distortion” (U.S. Trust Corporation,
DTA No. 810461, 96-1 NYTC T-486 (NYS Tax Appeals Tribunal,
April 11, 1996)), and the agency must specify those
transactions with particularity. See, Matter of Silver King
Broadcasting of N.J., Inc., DTA No. 812589, 96-1 NYTC T-537
(NYS Tax Appeals Tribunal, May 9, 1996).
33 It is noted the testimony of Respondent’s sole witness was
primarily confined to his audit activities which are not in issue in this proceeding, or to mechanical revisions he made in response to the State changes. Tr. at 540-573. Respondent also waived any closing arguments. Tr. at 590.
47
Petitioner argues that it has been prejudiced in
meeting its burden of proof because Respondent has raised
new factual issues at a point in the administrative process
when such action is precluded. See, Matter of U.S. Trust
Corp. and Subsidiaries, TAT(E) 93-204(BT), TAT(E) 94-
205(BT), and TAT(E) 93-804 (BT), 97-1 NYTC CT-233(NYC Tax
Appeals Tribunal, November 25, 1997). Although Petitioner
correctly points to the potential prejudice inherent in the
timing of Respondent’s new arguments, the record in this
matter was not closed at the time the new argument was made.
Moreover, Petitioner did not request that the proceeding be
continued or that the record remain open in order to present
additional evidence. Accordingly, Respondent’s arguments
will be addressed.
Respondent relies on a series of ostensibly
interrelated legal principles to support its argument that
the Related Corporations must be included in the proposed
combined filing because the 1984 capitalization transactions
were integrated with the subsequent Tax Years transactions
between the Related Corporations and Toys Inc. Respondent
argues that the 1984 transactions were not transfers for GCT
purposes sufficient to make the Related Corporations the
owners of the transferred property, although he does not
affirmatively assert that the 1984 transactions were
ineffective IRC §351 transfers.34
34 IRC §351 provides:
No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control. . . of the corporation. IRC §351(a).
To qualify for non-recognition under IRC §351, the transfer must be of property (IRC §351(d)), which includes intangible property. E.I. Du Pont de Nemours and Company v. U.S., 471 F.2d 1211 (Ct. Cl. 1973). A parent corporation’s transfer of property to a subsidiary in exchange
48
The Toys Inc. transfers to the Related Corporations
(the transfer of the Toys “R” Us trademarks and trade names
to Geoffrey in exchange for all of Geoffrey’s stock; the
transfer of mortgages on Group properties to ABG in exchange
for all of ABG’s stock; the transfer of cash and investments
to TRU in exchange for all of TRU’s stock) will not be
disregarded for tax purposes if they were effected for
legitimate business purposes and were not entered into
merely to avoid taxation. See, Frank Lyon Company v. U.S.,
435 U.S. 561, 577, 580 (1978).
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. Lyon, supra, at 572-3, 584. See also,
Rice’s Toyota World, Inc. v. Commissioner, 752 F.2d 89, 91-2
(4th Cir. 1985). 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.” Rice’s Toyota, supra, at 94-95.
A tax avoidance motivation does not preclude respecting a
transaction if that was not the only basis for entering into
the transaction. Lyon, supra, at 573, 580; Rice’s Toyota,
supra, 96.
The 1984 transactions between Toys Inc. and the Related
Corporations, and the subsequent transactions between the
Related Corporations and Group affiliates (including the
for all of the subsidiary’s stock satisfies the “control” requirement, and gain on that transaction is not recognized for federal tax purposes. See, also, USV, supra, and Matter of Mohasco Corp., DTA Nos. 808901 and 808956, 94–1A NYTC T-1283 (NYS Tax Appeals Tribunal, November 10, 1994), which involved IRC §351 transfers.
49
identified Tax Years transactions), are separate trans-
actions which satisfy the Lyon requirements. With respect
to the Toys Inc.-Geoffrey transfer (intangible property for
stock), the facts overwhelmingly establish that Geoffrey
received the actual benefit of the ownership of the intan-
gibles. Lyon, supra, at 572-73. Geoffrey was created for
several valid business purposes, including but not limited
to owning and protecting the existing Toys “R” Us trademarks
and trade names; establishing and registering new trademarks
and trade names; licensing those trademarks and trade names
to both related and unrelated entities; and defending the
integrity of the trademarks in litigation with third
parties. Geoffrey paid its own expenses, including fees to
unrelated law firms and accounting firms. The credible
testimony and evidence demonstrate not only that it was
anticipated that Geoffrey would realize a profit from its
licensing activities, apart from any tax benefit, but that
in fact Geoffrey did realize such a profit.
Similarly, ABG was established to consolidate and
manage real estate holdings which were essential to the
operation of the Group’s business. Each of the mortgage
notes contributed to ABG was fully secured by real property
and the majority bore interest at an arm’s length recognized
rate. ABG realized interest income and profit.
Finally, TRU was established for a legitimate business
purpose: to perform cash management and investment functions
for the Group. See, Matter of Sears, Roebuck and Co., DTA
No. 801732, 94–1 NYTC T-328 (NYS Tax Appeals Tribunal, April
50
28, 1994).35 TRU realized substantial income from a
diversified portfolio of short term investments.
In sum, Toys Inc.’s 1984 capitalization transactions
with the Related Corporations were accomplished for valid
business purposes, were characterized by economic substance,
and were not motivated solely by tax avoidance. They were
independent transactions which must be recognized.
Respondent also invokes a variation on the federal
“step-transaction doctrine”36 in an attempt to establish
distortion. Respondent maintains that, for GCT purposes,
the 1984 transactions were not separate transactions but
rather were only steps in integrated transactions.
Respondent’s position is most fully articulated with respect
to the transactions between Geoffrey and Toys Inc., where he
avers that Toys Inc.’s transfer of intangibles to Geoffrey
in exchange for Geoffrey’s stock37 should be integrated with
35 In Sears, supra, SRAC, a wholly-owned captive finance company
was engaged primarily in investing and loaning the proceeds of its investments only to its parent, Sears. SRAC was not required to file on a combined basis with its parent corporation notwithstanding its participation in the unitary business of the Sears Group, as its intercorporate transactions were found to be at arm’s length.
36 For purposes of this determination, the issue of whether a “transfer-licenseback” may be analogized to a “sale-leaseback” was not raised and is not addressed.
37 Petitioner correctly notes that Respondent’s “transfer/license-
back” analysis ignores the fact of the intervening 1985 transfer of the stock of Geoffrey to TRU. See, addendum to Petitioner’s Reply Brief. As a result, Geoffrey held intangibles in which TRU had the more direct interest, as sole shareholder, and Toys Inc. had a less direct interest as sole shareholder of TRU. TRU was not an operating company, and therefore it cannot be argued that TRU benefited directly from the goodwill associated with the trademarks, etc. This is not simply form over substance. The foundation for Respondent’s argument is that Toys Inc. in reality never relinquished control of the marks because the contribution of the marks to Geoffrey is simply one step in a leaseback transaction which left Toys Inc. in the same position that it was before the 1984 reorganization. However, the intervening stock transfer to TRU belies this interpretation.
51
Geoffrey’s subsequent licensing of the intangibles to Toys
Inc. and the Operating Companies.
Under step-transaction principles, the separate
identity of transactions is disregarded for tax purposes if
they have no economic substance and/or the transactions were
entered into solely to avoid taxation. Carroll v.
Commissioner, T.C. Memo 1978-173 1978 Tax Ct. Memo LEXIS
340 (May 10, 1978); Peck v. Commissioner, T.C. Memo 1982-17;
1982 Tax Ct. Memo LEXIS 732 (January 12, 1982).
Similar to the IRC §351 analysis, an integrated
transaction inquiry looks to the business purpose for the
transaction to determine motivation and economic substance.
Peck, supra; Carroll, supra. The ownership relationship
between Toys Inc. and the Related Corporations is not
determinative as transactions entered into for legitimate
business objectives (i.e., which have economic substance)
are respected as individual transactions and their integrity
is not ignored simply because the parties are related
entities.38
While the United States Tax Court has held that tax
planning plays a role in corporate development, the
independence of transactions which are “simply motivated by
a desire to minimize taxes” will be disregarded. Carroll,
supra. However, transactions will not be integrated simply
38 As the Tax Court noted in Carroll, supra: “[I]f the element of
retention of control were considered the determining factor, no transfer and leaseback between a corporation and its shareholders could be sustained. Any such tenet would raise havoc in situations that otherwise have all elements of a normal commercial transaction and fails to recognize the realities of the use of the corporate structure in the business world.”
52
because they were structured to take advantage of a
particular tax scheme. As the Court in Carroll acknow-
ledged, referencing their decision in McLane v. Commis-
sioner, 46 T.C. 140 (1966), aff’d per curiam, 377 F.2d 557
(9th Cir. 1967): “the building may not be constructed
entirely from the tax advantage, but if the foundation and
bricks have economic substance, the economic or financial
inducement of the tax advantage can provide the mortar.”
Carroll, supra.
The 1984 reorganization had legitimate business
purposes39 and the transfers from Toys Inc. to the Related
Corporations, and the subsequent transactions between the
Related Corporations and Toys Inc., had economic substance.
The reorganization transactions were not simply motivated by
a desire to minimize GCT liability. Under a step-trans-
action analysis, it is clear that the subject transactions
did not lose their independent identities and their form may
not be disregarded. Therefore, the 1984 capitalization of
the Related Corporations, and the subsequent Tax Years
intercorporate transactions, must be respected for GCT
purposes.
Finally, to support his argument that the 1984
capitalization transactions lacked economic substance,
Respondent argues that when Toys Inc. transferred the Toys
“R” Us trademarks and trade names to Geoffrey, it retained
all associated goodwill.
39 See, Finding of Fact ¶8 which references the uncontroverted
testimony of Michael Goldstein with respect to the motivations for the 1984 reorganization.
53
Goodwill is that element associated with a product or
service which protects consumers against confusion or
deception.40 Under principles of trademark law, a transfer
of trademarks without goodwill is in essence an assignment
in gross or an assignment of a “naked” trademark. Marshak
v. Green, 746 F.2d 927 (2nd Cir. 1984)].41 See, also, Visa,
40 Goodwill is the “sum total of those imponderable qualities
which attract the custom of a business, - - what brings patronage to the business.” Grace Bros., Inc. v. Commissioner, 37 AFTR 1006, 173 F.2d. 170, 175 (9th Cir. 1949). The Court in Grace Bros., stated that good will:
may attach to (1) the business as an entity, (2) the physical plant in which it is conducted, (3) the trade- name under which it is carried on and the right to conduct it at the particular place or within a particular area, under a trade-name or trademark; (4) the special knowledge or the “know-how” of its staff; (5) the number and quality of its customers.” Id. at 1012.
See, also, Nestle Holdings, Inc. v. Commissioner, TC Memo 1995-441, aff’d in part, vacated in part, remanded in part, 82 AFTR 98-5467, 152 F.3d 83 (1998), where the Tax Court noted (citing Stokely USA Inc. v. Commissioner, 100 T.C. at 447, and Philip Morris Inc. v. Commissioner, 96 T.C. at 634) that: “although trademarks represent goodwill, . . . they do not equal goodwill and are only one straw in the bundle than makes up goodwill.”
41 Respondent places great reliance on the U.S. Tax Court’s memorandum decision in Medieval Attractions, N.V. v. Commissioner, TC Memo 1996-455, 1996 Tax Ct. Memo Lexis 471 (appeal pending). Medieval Attractions is a lengthy and complex case, only a portion of which deals with royalty payments for the use of intangibles. The facts involve consideration of several levels of corporate relationships, and a series of transactions between U.S. and alien corporations and partnerships. The royalty issue in Medieval Attractions is raised in the context of whether the royalty payments deducted by the taxpayer were “ordinary and necessary business expenses” pursuant to IRC §162, and whether the alleged transfer of certain unprotected intangibles occurred and was at arm’s length.
Respondent is correct that the Tax Court in Medieval Attractions discussed issues of control of rights and economic benefits, as well as the principle that original transactions may be taken into account in determining the tax status of subsequent transactions. However, the case involves such factual issues as whether an intangible existed, whether and when it was protected, whether back-dated documents were used to support the taxpayer’s position that a transfer existed which would justify a deduction, and whether there was a subsequent transfer for which no compensation was paid. The Court emphasized that the record revealed “a complete lack of arm’s length dealing.” As there are
54
Inc. v. Birmingham Trust National Bank, 696 F.2d 1371, 1375
(Fed. Cir. 1982).
In his Sur-Reply Brief at p. 46, Respondent admits that
Toys Inc. made a valid transfer of the intangibles to
Geoffrey, and that Geoffrey was their legal owner.42
Nevertheless he argues that since Geoffrey and Toys Inc.
were affiliated “under tax law,” the “beneficial ownership”
of the marks was not transferred and therefore neither was
the goodwill associated with those marks. This is a
distinction without a difference: either Respondent argues
that the marks were transferred without goodwill or he
agrees they were transferred with goodwill.
Where an intangible such as a trademark is assigned
between affiliated companies which are “united in a common
enterprise,” goodwill is not separated from the marks as a
matter of federal trademark law. Browne-Vintners Co., Inc.
G.H. Mumm & Co., Societe Vinicole de Champagne Successeurs,
G. H. Mumm & Co. of New York, Inc. v. National Distillers
and Chemical Corporation, 151 F.Supp. 595, 602 (S.D.N.Y.
1957). Further, the assignment of a trademark or trade name
which includes the transfer of goodwill is valid as long as
the licensor maintains “control” over the licensee. Arthur
Murray, Inc. v. Horst, 110 F. Supp. 678, 679 (D. Mass.
1953).
At the time that Toys Inc. transferred the trademarks
and trade names to Geoffrey in 1984, it also transferred
no similar facts presented in the instant case, the Tax Court’s findings in Medieval Attractions are distinguishable.
42 Meeting the responsive criticism that he was arguing that the
transfer was an assignment in gross, Respondent states that he “never argued” that position and “certainly never argued that Geoffrey was not the legal owner under trademark law.” Brief at p. 44-45.
55
goodwill associated with those marks. When Geoffrey
licensed the right to use the trademarks and trade names to
the Operating Companies and to Toys Inc., it licensed
intangible property to which goodwill attached. The
Licensing Agreements require the licensees to protect the
marks and names and to provide Geoffrey with recourse to
enforce that protection, including the right to protect and
maintain the goodwill. See, e.g., Stip. Ex. 9, License
Agreement, Art. VI, 6.1-6.3; Art, VII. The subsequent
actions by the registered owner, Geoffrey, to protect the
marks and names (including litigation with third parties)
establishes not only that Geoffrey owned the intangibles,
but that Geoffrey assumed the responsibility for overseeing
and protecting the associated goodwill and only transferred
that responsibility under defined circumstances pursuant to
licensing agreements. Neither the Group’s retention of some
undefinable goodwill associated with the Toys “R” Us
business, nor the subsequent licensing of the marks to which
goodwill attached, in any way establishes that Toys Inc. did
not transfer goodwill to Geoffrey when it contributed the
names and marks to that affiliate in 1984. Since the
transfer of the trade names and trademarks to Geoffrey was
not an assignment in gross, the substance of the 1984
capitalization transactions may not be disregarded on this
basis.
ACCORDINGLY, IT IS CONCLUDED THAT:
A. The Tax Years’ transactions between the Related
Corporations and Toys Inc. and other affiliates were: (1) at
arm’s length; or (2) on such terms that reporting on a
combined basis with other Group affiliates is not required
to eliminate distortion.
56
B. The 1984 capitalization transactions between Toys
Inc. and the Related Corporations, and the Tax Years’
transactions between the Related Corporations and Toys Inc.
and other affiliates, are: (1) separate transactions which
evidence economic substance and genuine business purpose;
and (2) were not entered into solely for tax avoidance.
These transactions cannot be disregarded for GCT purposes.
C. Toys Inc.’s transfer of trademarks and trade names
to Geoffrey in 1984 was a valid transfer of the intangibles
and the associated goodwill.
D. Petitioner has overcome the regulatory presumption
of distortion.
For the reasons set forth above, the Revised Deficiency
asserted against Petitioner is cancelled to the extent that
such combined filing includes income, gain and deduction
attributable to the Related Corporations.
DATED: August 4, 1999 New York, New York
________________________
ANNE W. MURPHY Administrative Law Judge