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New York’s attempt to close a controversial corporate tax loophole has been significantly bolstered by a recent administrative decision accusing Sherwin-Williams Co. of setting up sham subsidiaries solely to evade taxation. The 118-page decision by the Tax Appeals Tribunal is the latest development in a national debate over companies that cleverly avoid taxes by stashing assets in states with favorable tax laws. Its implications are enormous: if the loophole remains closed, New York stands to collect roughly $100 million more annually in corporate income taxes, and observers expect the decision will garner national attention. Matter of The Sherwin-Williams Company, 816712, involves the Cleveland-based paint firm. About a decade ago, the firm set up two subsidiaries in Delaware, which has a high corporate tax rate but imposes no tax whatsoever on “intangibles,” as trademark-holding firms. Then, it assigned company trademarks to the subsidiaries, had an operating subsidiary in New York pay royalties to the entities in Delaware, and thereby avoided taxes in both New York and Delaware. Sherwin-Williams did the same thing in Massachusetts, where taxing authorities disallowed $47 million in royalty deductions on the grounds that the Delaware entities were shells set up solely for tax avoidance. After the Massachusetts Supreme Judicial Court last year held in The Sherwin-Williams Co. v. Commissioner (438 Mass 71, 778 NE2d 504) that the subsidiaries did fulfill a legitimate business purpose in managing the trademarks, the Massachusetts legislature changed the law. Similar activity has occurred in several other states. New Jersey last year closed the loophole statutorily as part of a general tax reform bill. The Pennsylvania governor is pushing a reform measure. The Maryland legislature recently passed a bill changing its tax law, but that measure was vetoed for reasons unrelated to the loophole issue. And in New York, the Legislature this year passed a reform measure. The ramifications of the New York bill, however, remains in dispute. Although the Legislature claimed it would garner $115 million for New York this year and $95 million next year, Gov. George E. Pataki’s budget office contends it is so poorly written that it will have no impact at all. Bills to technically amend the legislation passed both houses, but did not match, and the issue will most likely be revisited in the fall. In its recent decision, the New York Tax Appeals Tribunal distilled the issue to whether the subsidiaries had a legitimate business purpose. It flatly rejected Sherwin-Williams’ claim that the holding firms were established to manage its intellectual property. “[T]he purpose for creating the subsidiaries was a tax avoidance tool and there is absolutely no economic substance to the transactions … ” the Tribunal said in a decision signed by President Donald C. DeWitt and Commissioner Carroll R. Jenkins. The ruling overturned a determination of the administrative law judge. Paul Frankel and Craig B. Fields of Morrison & Foerster in Manhattan appeared for Sherwin-Williams. James P. Connolly, James Della Porta and Brian J. McCann represented the Division of Taxation. Connolly and Barbara G. Billet, counsel for the division, said a key point in the decision is the Tribunal’s focus on the nature of an intangible, and conclusion that a trademark is not a passive asset that can reasonably be transferred. Rather, according to the Tribunal, a trademark is something that is managed, and that management is conducted by the parent firm. Billet said a number of ongoing audits involving Delaware holding companies are based on the theory upheld by the Tribunal. Counsel for Sherwin-Williams were not immediately available for comment. State budget analyst Frank Mauro of the Fiscal Policy Institute, a think-tank near Albany, said tax departments around the country are “trying to pierce the view firms have created to avoid taxes,” and this ruling reflects that effort. “A lot of tax breaks can be argued,” Mauro said. “But in this case, I don’t think there is any real policy defense. This is purely a created loophole, an invented tax loophole.” Michael Mazerov of the Center on Budget and Policy Priorities in Washington said New York’s attempt to deal with Delaware holding companies is unique. He said that while the Tribunal’s decision is significant, the real test is whether it stands up in court. An Article 78 challenge to the Appellate Division, 3rd Department, is anticipated. “There are a number of strategies states have been pursuing to attack Delaware holding companies,” Mazerov said. “This is a case where they have basically authorized forced combination of the Delaware holding company with the parent … In the most recent cases, that is not the strategy other states have used. They tend to either disallow the deduction or they upheld the assertion of taxing jurisdiction over the Delaware company.”

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