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The Sherwin-Williams Co. painted itself into a corner by setting up Delaware holding companies and then seeking a New York tax break, an appellate panel said last week. The Appellate Division, 3rd Department, unanimously affirmed a Tax Appeals Tribunal decision that suggested the Cleveland-based paint manufacturer established Delaware subsidiaries to siphon otherwise taxable profits out of New York state. It said Sherwin-Williams is liable for a combined corporate franchise tax on income apportioned out of New York. Tax Department spokesman Thomas Bergin said Friday that the ruling will serve as a “building block in the department’s attempt to thwart abusive corporate tax planning schemes.” Matter of Sherwin-Williams, 94107, is a nationally watched case involving what critics say is a common corporate accounting maneuver: the transfer of valuable trademarks to a holding company. Sherwin-Williams set up subsidiaries in Delaware, where the corporate tax rate is high but there is no tax on “intangibles,” a category that includes trademark-holding firms. Sherwin-Williams assigned company trademarks to those subsidiaries while an operating unit in New York paid royalties to the Delaware entities. That way, it avoided taxes in both New York and Delaware. Several companies have done precisely the same thing, depriving New York of an estimated $100 million in annual corporate tax receipts. In the past year, however, both New York state and the City of New York have enacted laws to preclude the sort of tax planning at issue here. Regardless, there are still a number of large companies with Delaware trademark holding subsidiaries and their tax status remains somewhat unclear. Neither the New York Court of Appeals nor any of the other three appellate divisions has addressed the issue. “The decision provides the department strong precedent with respect to evaluating and challenging corporations with similar tax avoidance structures,” Bergin said. “While many corporations have already voluntarily complied, the department expects that the Sherwin-Williams ruling will result in additional voluntary compliance.” Last week’s ruling represents the latest episode in a long-running battle between the state and Sherwin-Williams, but it is the first to result in a judicial rather than administrative decision. It centers on what is known as a “presumption of distortion,” an unusual provision in New York’s Tax Law governing corporate franchise taxes. Under the provision, the tax commissioner can require a corporation paying New York tax to file a combined report that includes the proceeds of other corporations controlled by the taxpayer. However, several elements must be present for the commissioner to exercise that authority. One of those elements is evidence that a “distortion of income” would result if the corporations were permitted to report their earnings separately. A presumption of distortion occurs “when the taxpayer reports on a separate basis if there are substantial intercorporate transactions among the corporations” (see 20 NYCRR 6-2.3-5). In this matter, debate over the presumption and related issues generated extensive writings long before the matter came to the 3rd Department. An administrative law judge wrote 150 pages on the issue, ultimately coming down in favor of Sherwin-Williams. The Tax Appeals Tribunal added another 118 pages in reversing and ruling for the state. THE APPEAL On appeal, Sherwin-Williams argued that the intercorporate transactions should be viewed solely from the perspective of the parent company and not the subsidiaries. From that vantage point, Sherwin-Williams claimed, the transactions accounted for only a small part of the company’s business and therefore did not constitute the type of “substantial intercorporate transactions” necessary to trigger the presumption. But the 3rd Department, through Justice John A. Lahtinen, said the law does not require “such a constricted analysis.” It added that the “narrow application urged by [Sherwin-Williams] … would essentially foreclose combined reporting whenever a taxpayer was a large corporation.” After finding that the presumption applies, the court then considered whether Sherwin-Williams effectively rebutted the presumption of distortion. That analysis requires an inquiry into whether the transaction “is compelled or encouraged by business or regulatory entities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached” ( Frank Lyon Co. v. U.S., 435 US 561 [1978]). The court considered evidence that Sherwin-Williams formed the Delaware subsidiaries to control its trademarks and to provide flexibility in warding off hostile takeovers. It also considered evidence that the subsidiaries were run on a part-time basis by a professor with no background in trademark management. Justice Lahtinen said an analysis of the “evidence … and the voluminous record reveals facts and opinions providing support for the positions” advocated by both Sherwin-Williams and the state. However, he said the court must defer to the tribunal “even if we disagree with a determination,” so long as the determination is rational and supported by the evidence. “Here, the Tribunal’s determination that petitioner failed to rebut the presumption of distortion since the assignment and license-back transaction lacked a business purpose or economic substance apart from tax avoidance is supported by substantial evidence,” Lahtinen wrote. “We are unpersuaded that the Tribunal erred in crediting the expert testimony offered by the Division over petitioner’s experts.” In sum, the 3rd Department held that the state properly combined Sherwin-Williams with the two Delaware holding companies for tax purposes; Sherwin-Williams failed to rebut the distortion presumption; and the licensing arrangement between Sherwin-Williams and the subsidiaries lacked a business purpose other than avoiding taxation. Lahtinen and four colleagues rejected Sherwin-Williams’ claim that requiring it to file a combined corporate franchise tax violated its Commerce Clause and due process rights. They also placed no significance on the fact that Sherwin-Williams prevailed in a similar action in Massachusetts ( Sherwin-Williams Co. v. Commissioner of Revenue, 438 Mass 71 [2002] ). “With respect to the case from Massachusetts, that case does not control because, in addition to being from another jurisdiction, the applicable laws in Massachusetts and New York are not identical,” Lahtinen wrote. Joining the opinion were Justices D. Bruce Crew III, Karen K. Peters, Anthony J. Carpinello and Carl J. Mugglin. Paul H. Frankel and Amy F. Nogid of Morrison & Foerster in Manhattan represent Sherwin-Williams. Assistant Attorney General Robert M. Goldfarb defended the tribunal. The City of New York appeared amicus curiae in a brief filed by Assistant Corporation Counsel Robert J. Firestone. Nogid said Sherwin-Williams believes the case was wrongly decided and is considering its options.

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