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Kids may love Geoffrey Giraffe, but tax officials in somestates see the Toys “R” Us mascot as an emblem of a rancoroustax-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 collectsroyalties and other payments from the toy retailer’s own outlets. Intangible holding companies — used by many companies — arelike repositories for trademarks and trade names. Some states worry about redink on their books when local outlets make hefty payments to these intangibleholding companies, including fees for use of corporate logos, like GeoffreyGiraffe. Depending on the tax structure of a state, royalties andfees might be deducted from the pool of income generated in the state, reducingthe corporate tax bill there. The so-called “ Geoffrey issue” gets itsname from a seminal 1993 decision from the South Carolina Supreme Court thatrocked the corporate world by allowing the state to impose corporate income taxon money flowing out of state to the Toys “R” Us intangible holdingcompany. 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 comingunder a new wave of attacks. Serious money woes give states an extra incentive. Statesface 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 ofthe 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 the1990s, said Harley Duncan, executive director of the Federation of TaxAdministrators in Washington. Corporations were paying greater attention to federal thanstate tax planning, Duncan said, and fewer of them had intangible holdingcompanies. In 1992, the U.S. Supreme Court barred North Dakota fromimposing sales and use taxes on an out-of-state catalog company that lacked anin-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 holdingcompanies. “No physical presence, no taxation,” said Paul H.Frankel, one of the nation’s business-side gurus on litigation involvingintangible holding companies, and a partner in the New York office of SanFrancisco’s Morrison & Foerster. Frankel filed the petition for certiorari on the SouthCarolina case with the U.S. Supreme Court for Geoffrey Inc. in 1993, and now herepresents dozens of companies facing administrative or court action on theseissues. He is counsel to the intangible holding companies for The Gap Inc. andToys “R” Us facing litigation in Louisiana. Since the South Carolina ruling, courts have split over thequestion of whether the U.S. Constitution’s commerce clause and the finding in Quill bars states from collecting corporate income tax from intangible holdingcompanies that do not have a physical presence there. Reform by state legislatures can be thorny, bothlogistically and politically. Tax system overhauls can generate their own breed oflitigation, some observers note, pointing out that even specific laws aimed atclosing the loophole may be subject to attack in court. Tax officials argue that economic presence — like the salesgenerated from the use of trademarks and trade names — is enough. They alsocounter that some out-of-state intangible holding companies do not have much ofa physical presence in Delaware, either, apart from a postal address and a bankaccount. “These intangible holding companies, they do not havea true business substance or business purpose,” said Otha Curtis NelsonJr., attorney supervisor with the corporate income and franchise tax litigationteam at the Louisiana Department of Revenue. “The company is often nothingmore than a drop-off mailbox in Delaware or Nevada,” or some similarstate, Nelson said. In Louisiana, three tax years generated a claim for morethan $800,000 in tax, interest and penalties that the state is pursuing incourt against the intangible holding company for Toys “R” Us. Bridgesv. Geoffrey Inc., No. 502,769 (La. 19th Jud. Dist. Ct.). Louisiana also wants about $15.4 million in a similar suitagainst the intangible holding company for Wal-Mart Stores Inc. The state is alitigation hot spot on the issue. Its Department of Revenue is going afterintangible 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 paytheir 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 toadhere to the tax laws of our country and each state we do business in,”said Ursula H. Moran, vice president, investor relations and corporatecommunications, with Toys “R” Us in Wayne, N.J. “The state ofNew York recently ruled in a tax case supporting this claim.” In theMatter of Toys “R” Us-NYTEX Inc., No. TAT (E) 93-1039 (N.Y. CityTax App. Trib.). “With over 1,000 stores across the United States, Toys”R” Us makes meaningful tax payments to every state we do businessin,” Moran added. “To suggest otherwise is to not understand the lawsof each state.” Dan Fogleman, a Wal-Mart spokesman, declined to comment,citing pending litigation. Big dollars are on the table elsewhere. In its last fiscalyear, New Jersey faced the threat of a $5 billion budget gap. The state closedthe deficit for the current fiscal year, but still faces a “sizeableproblem” for the next fiscal year, according to Thomas Vincz, director ofcommunications for the New Jersey Department of the Treasury. Yet New Jersey’s Division of Taxation was stymied by arecent tax court ruling barring the state from collecting corporate income taxon royalties and fees paid by local outlets for apparel retailer Lane BryantInc. 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, issueda report in July 2003 on the income lost to states as a result of corporate taxshelters, including intangible holding companies. Shelters reduced state corporate income tax revenue by morethan one-third of actual collections in 2001, the commission concluded. Thecommission is an organization of state governments that works with taxpayersto administer tax laws that apply to multistate and multinational enterprises. Dan R. Bucks, the group’s executive director, said thatefforts 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, statecorporate tax bills started to look large compared to federal tax bills, Buckssaid. He noted that major accounting firms then began to market statetax-planning services to address the issue. For their part, corporate lawyers say that the flow of incometo intangible holding companies is legitimate and represents sound statecorporate tax planning. As long as an intangible holding company is for real,they say, companies have every right to direct certain kinds of income theirway. “It is a fundamental concept that taxpayers haveabsolutely every right to structure their transactions in such a way tominimize their taxes — so long as they have business purpose and economicsubstance,” said William M. Backstrom Jr., a partner with Jones, Walker, Waechter,Poitevent, Carr�re & Den�gre, in New Orleans. Backstrom said that he has eight to 10 “ Geoffrey“matters on his plate for corporate clients, mostly in Louisiana. He declined toname the companies. “Until 1993, very few thought that a state would havethe ability to impose its taxing jurisdiction on a company that did not havephysical presence,” said John M. Allan, partner in the Atlanta office ofJones Day, referring to the South Carolina case. Allan’s current docket involves a handful of companies facingenforcement disputes in five to 10 states, most of them administrative matters.He declined to identify his clients. “It just gets expensive litigating these cases inevery state in which your trademark or trade name is present,” said RobertW. Nuzum, a Metairie, La., solo practitioner who is local counsel to a numberof national retailers facing Geoffrey suits in Louisiana. He is localcounsel for the intangible holding companies for Taco Bell and KFC, both unitsof fast-food company Yum! Brands Inc. John A. Swain, professor at the University of Arizona JamesE. Rogers College of Law, contends that corporations and their tax advisors arenot to blame. “People want to point the finger at tax advisors foradvising their clients to set up these intangible holding companies,” saidSwain, a former corporate tax attorney. “It would almost be unethical forthem not to recommend it.” HOW IT WORKS Despite the controversy, the mechanics of intangibleholding companies is fairly simple. Sheldon H. Laskin, director of the Multistate TaxCommission’s national nexus program, which works with corporations to helpcompanies comply with their state tax obligations, describes the basics behindthe loophole. First, a national retailer creates an intangible holdingcompany in a state that does not tax royalty income, such as Delaware. Theretailer then assigns its trademarks to the holding company, which it owns. Theholding company licenses the trademarks to the retailer, which, in turn, paysthe holding company for the use of the marks. In states where it may do so, the retailer taxes adeduction on its corporate income tax returns for the royalty or licensing feespaid to the holding company. That leads to less taxable income in those states. Roughly half of the states should be immune to theloophole, said Michael Mazerov, an analyst with the Center on Budget and PolicyPriorities in Washington. Sixteen states have adopted a combined reportingsystem for corporate income taxation, including California and Illinois, he said.�Eightstates have existing laws aimed at closing the loophole, includingMassachusetts and New York, Mazerov said. Combined reporting systems treatrelated corporate entities as a whole, using a formula to figure out theamount of in-state taxable corporate income. Loophole-closing statutes, by contrast, are more limited inscope. They may disallow a deduction for payments made to out-of-stateintangible holding companies, or add these sums back into the pot when tallyinga company’s instant taxable income. Closing the loophole through legislation is easier saidthan done, as at least seven states found out in 2003, when their proposalsfailed to make it into law. Anti-loophole legislation was vetoed by thegovernor of Maryland, where fierce corporate lobbying attacked it, Mazerovsaid. Legislatures did not approve proposed changes in Rhode Island,Pennsylvania, Tennessee, Missouri, Texas and Wisconsin, according to Mazerov.

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