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Kids may love Geoffrey Giraffe, but tax officials in some states see the Toys “R” Us mascot as an emblem of a rancorous tax-collection issue involving many corporations. To the tax man, Geoffrey stands for Geoffrey Inc., the Toys “R” Us Inc. intangible holding company, an entity that collects royalties and other payments from the toy retailer’s own outlets. Intangible holding companies�used by many companies�are like repositories for trademarks and trade names. Some states worry about red ink on their books when local outlets make hefty payments to these intangible holding companies, including fees for use of corporate logos, like Geoffrey Giraffe. Depending on the tax structure of a state, royalties and fees might be deducted from the pool of income generated in the state, reducing the corporate tax bill there. The so-called “ Geoffrey issue” gets its name from a seminal 1993 decision from the South Carolina Supreme Court that rocked the corporate world by allowing the state to impose corporate income tax on money flowing out of state to the Toys “R” Us intangible holding company. Geoffrey Inc. v. South Carolina Tax Comm’n, 437 S.E.2d 13. New attacks Sometimes called “passive investment companies,” or “Delaware holding companies,” these corporate entities are coming under a new wave of attacks. Serious money woes give states an extra incentive. States face deficits calculated at $70 billion to $85 billion in fiscal year 2003-04, according to the Center on Budget and Policy Priorities in Washington. The showdown among tax officials in some states and some of the nation’s biggest companies is partly due to a change in heart among states. They tended to embrace pro-business tax policies during boom times of the 1990s, said Harley Duncan, executive director of the Federation of Tax Administrators in Washington. Corporations were paying greater attention to federal than state tax planning, Duncan said, and fewer of them had intangible holding companies. In 1992, the U.S. Supreme Court barred North Dakota from imposing sales and use taxes on an out-of-state catalog company that lacked an in-state physical presence, such as offices and workers. Quill Corp. v. North Dakota, 504 U.S. 298 (1992). That case sounded like good news for intangible holding companies. “No physical presence, no taxation,” said Paul H. Frankel, one of the nation’s business-side gurus on litigation involving intangible holding companies, and a partner in the New York office of San Francisco’s Morrison & Foerster. Frankel filed the petition for certiorari on the South Carolina case with the U.S. Supreme Court for Geoffrey Inc. in 1993, and now he represents dozens of companies facing administrative or court action on these issues. He is counsel to the intangible holding companies for The Gap Inc. and Toys “R” Us facing litigation in Louisiana. Since the South Carolina ruling, courts have split over the question of whether the U.S. Constitution’s commerce clause and the finding in Quill bars states from collecting corporate income tax from intangible holding companies that do not have a physical presence there. Reform by state legislatures can be thorny, both logistically and politically. Tax system overhauls can generate their own breed of litigation, some observers note, pointing out that even specific laws aimed at closing the loophole may be subject to attack in court. Tax officials argue that economic presence-like the sales generated from the use of trademarks and trade names-is enough. They also counter that some out-of-state intangible holding companies do not have much of a physical presence in Delaware, either, apart from a postal address and a bank account. “These intangible holding companies, they do not have a true business substance or business purpose,” said Otha Curtis Nelson Jr., attorney supervisor with the corporate income and franchise tax litigation team at the Louisiana Department of Revenue. “The company is often nothing more than a drop-off mailbox in Delaware or Nevada,” or some similar state, Nelson said. In Louisiana, three tax years generated a claim for more than $800,000 in tax, interest and penalties that the state is pursuing in court against the intangible holding company for Toys “R” Us. Bridges v. Geoffrey Inc., No. 502,769 (La. 19th Jud. Dist. Ct.). Louisiana also wants about $15.4 million in a similar suit against the intangible holding company for Wal-Mart Stores Inc. The state is a litigation hot spot on the issue. Its Department of Revenue is going after intangible holding companies for other consumer giants, including The Gap, Marshall’s, Wendy’s and Home Depot. “We’re spending our money in these corporations’ stores,” Nelson said. “It is only fair that these corporations pay their fair share of state taxes.” Company’s view Toys “R” Us has its own view of the issue. “Toys “R” Us always has and will continue to adhere to the tax laws of our country and each state we do business in,” said Ursula H. Moran, vice president, investor relations and corporate communications, with Toys “R” Us in Wayne, N.J. “The state of New York recently ruled in a tax case supporting this claim.” In the Matter of Toys “R” Us-NYTEX Inc., No. TAT (E) 93-1039 (N.Y. City Tax App. Trib.). “With over 1,000 stores across the United States, Toys “R” Us makes meaningful tax payments to every state we do business in,” Moran added. “To suggest otherwise is to not understand the laws of each state.” Dan Fogleman, a Wal-Mart spokesman, declined to comment, citing pending litigation. Big dollars are on the table elsewhere. In its last fiscal year, New Jersey faced the threat of a $5 billion budget gap. The state closed the deficit for the current fiscal year, but still faces a “sizeable problem” for the next fiscal year, according to Thomas Vincz, director of communications for the New Jersey Department of the Treasury. Yet New Jersey’s Division of Taxation was stymied by a recent tax court ruling barring the state from collecting corporate income tax on royalties and fees paid by local outlets for apparel retailer Lane Bryant Inc. to Lanco Inc., its Delaware intangible holding company. Lanco Inc. v. Director, Division of Taxation, Docket No. 005329-97. The Multistate Tax Commission, based in Washington, issued a report in July 2003 on the income lost to states as a result of corporate tax shelters, including intangible holding companies. Shelters reduced state corporate income tax revenue by more than one-third of actual collections in 2001, the commission concluded. The commission is an organization of state governments that works with taxpayers to administer tax laws that apply to multistate and multinational enterprises. Dan R. Bucks, the group’s executive director, said that efforts to close the loophole started before the states’ current fiscal crisis, and that states have been responding to aggressive corporate tax planning. Following federal tax reforms of the mid-1980s, state corporate tax bills started to look large compared to federal tax bills, Bucks said. He noted that major accounting firms then began to market state tax-planning services to address the issue. For their part, corporate lawyers say that the flow of income to intangible holding companies is legitimate and represents sound state corporate tax planning. As long as an intangible holding company is for real, they say, companies have every right to direct certain kinds of income their way. “It is a fundamental concept that taxpayers have absolutely every right to structure their transactions in such a way to minimize their taxes-so long as they have business purpose and economic substance,” said William M. Backstrom Jr., a partner with Jones, Walker, Waechter, Poitevent, Carrère & Denègre, in New Orleans. Backstrom said that he has eight to 10 “ Geoffrey” matters on his plate for corporate clients, mostly in Louisiana. He declined to name the companies. “Until 1993, very few thought that a state would have the ability to impose its taxing jurisdiction on a company that did not have physical presence,” said John M. Allan, partner in the Atlanta office of Jones Day, referring to the South Carolina case. Allan’s current docket involves a handful of companies facing enforcement disputes in five to 10 states, most of them administrative matters. He declined to identify his clients. “It just gets expensive litigating these cases in every state in which your trademark or trade name is present,” said Robert W. Nuzum, a Metairie, La., solo practitioner who is local counsel to a number of national retailers facing Geoffrey suits in Louisiana. He is local counsel for the intangible holding companies for Taco Bell and KFC, both units of fast-food company Yum! Brands Inc. John A. Swain, professor at the University of Arizona James E. Rogers College of Law, contends that corporations and their tax advisors are not to blame. “People want to point the finger at tax advisors for advising their clients to set up these intangible holding companies,” said Swain, a former corporate tax attorney. “It would almost be unethical for them not to recommend it.” How it works Despite the controversy, the mechanics of intangible holding companies is fairly simple. Sheldon H. Laskin, director of the Multistate Tax Commission’s national nexus program, which works with corporations to help companies comply with their state tax obligations, describes the basics behind the loophole. First, a national retailer creates an intangible holding company in a state that does not tax royalty income, such as Delaware. The retailer then assigns its trademarks to the holding company, which it owns. The holding company licenses the trademarks to the retailer, which, in turn, pays the holding company for the use of the marks. In states where it may do so, the retailer taxes a deduction on its corporate income tax returns for the royalty or licensing fees paid to the holding company. That leads to less taxable income in those states. Roughly half of the states should be immune to the loophole, said Michael Mazerov, an analyst with the Center on Budget and Policy Priorities in Washington. Sixteen states have adopted a combined reporting system for corporate income taxation, including California and Illinois, he said. Eight states have existing laws aimed at closing the loophole, including Massachusetts and New York, Mazerov said. Combined reporting systems treat related corporate entities as a whole, using a formula to figure out the amount of in-state taxable corporate income. Loophole-closing statutes, by contrast, are more limited in scope. They may disallow a deduction for payments made to out-of-state intangible holding companies, or add these sums back into the pot when tallying a company’s instant taxable income. Closing the loophole through legislation is easier said than done, as at least seven states found out in 2003, when their proposals failed to make it into law. Anti-loophole legislation was vetoed by the governor of Maryland, where fierce corporate lobbying attacked it, Mazerov said. Legislatures did not approve proposed changes in Rhode Island, Pennsylvania, Tennessee, Missouri, Texas and Wisconsin, according to Mazerov.

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