March 10, 2023
Wisconsin Tax Appeals Commission disallows deductions for intercompany royalty and interest expenses
On February 24, 2023, the Wisconsin Tax Appeals Commission (WTAC) issued a ruling1 disallowing a taxpayer's deduction for certain intercompany royalty and interest expenses the taxpayer paid to an affiliate.
The taxpayer, a California-based corporation, is a seller of branded footwear. In the course of its operations, the taxpayer developed and purchased intellectual property, including trademarks, service marks, copyrights, patents, and patent applications. In 1999, the taxpayer engaged an outside tax advisor to design and implement an intellectual property holding company structure. As part of the restructuring, a wholly owned subsidiary was formed under Delaware law and headquartered in California. The taxpayer contributed its intellectual property to the subsidiary which, in turn, conveyed the intellectual property back to the taxpayer under a licensing agreement. The taxpayer also paid interest to the subsidiary based on an unpaid balance of net royalty fees. The taxpayer then took a deduction for these amounts on its Wisconsin income/franchise tax return as Wisconsin was a separate company reporting state in the years at issue.
The Wisconsin Department of Revenue (Department) audited the taxpayer for the years 2000-03 and denied the royalty and interest expense deductions taken by the taxpayer. The assessment reflected the Department's determination that the intercompany transactions2 were sham transactions or otherwise lacked a valid business purpose. Under Wisconsin law, the Department is authorized to adjust income or deductions based on discretionary criteria, such as lack of business purpose or economic substance. The taxpayer appealed the assessment, and the Department denied the protest, which the taxpayer appealed to the WTAC.
In affirming the Department's assessment, the WTAC focused on the tax advisor's planning documents, which stressed the reduction of the state tax liability. The WTAC noted that while some of the planning documents included other potential non-tax reasons for implementing the structure, those other reasons were "window dressing" to "obscure" the primary motivation of obtaining a state tax reduction. The WTAC also noted that there were no substantive changes to the taxpayer's business as a result of implementing the strategy. Finally, the WTAC rejected the taxpayer's expert witness testimony that suggested that it was possible to have a valid business purpose other than tax avoidance even if the taxpayer was not aware of such a purpose. The WTAC agreed that not every employee must understand the structure but noted that the record indicated that none of the taxpayer's employees understood any benefit beyond tax minimization.
The WTAC's decision is subject to further appeal, and it is unknown at this time whether the taxpayer will file an appeal in this matter. While Wisconsin has been a combined reporting state since 2009, the WTAC's decision is still relevant as the Department, in audits, has challenged, under similar provisions, intercompany transactions entered into with non-US affiliates that would not be in the Wisconsin water's edge combined group. Having contemporaneous documentation supporting intercompany transactions with non-tax business purposes and economic substance remains an important consideration in Wisconsin.
Published by NTD’s Tax Technical Knowledge Services group; Jennifer A Brittenham, legal editor
1 Skechers USA, Inc. v. Wisconsin Dep't. of Rev., Docket Nos. 10-I-071, 10-I-072 (Wis. Tax App. Comm'n. Feb. 24, 2023).
2 The intercompany transactions were supported by a transfer pricing study, but the Department's challenge did not focus on that and instead focused on the underlying motivation for entering into the arrangements.