A Wisconsin Circuit Court recently upheld¹ a Wisconsin Tax Appeals Commission's (WTCA) decision that disallowed a taxpayer's deduction for certain intercompany royalty and interest expenses paid to an affiliate.

The taxpayer, a California-based corporation that sells branded footwear, had developed and purchased intellectual property, including trademarks, service marks, copyrights, patents, and patent applications throughout the time it has operated. In 1999, the taxpayer engaged an outside tax advisor to design and implement an intellectual property holding company structure, under which the taxpayer contributed all its intellectual property to a wholly owned subsidiary formed under Delaware law and headquartered in California. The subsidiary then licensed the intellectual property back to the taxpayer and charged the taxpayer interest on unpaid balances of net royalty fees. The taxpayer deducted the royalty payments and interest expenses on its Wisconsin income/franchise tax return, as Wisconsin was a separate-company-reporting state for the tax years at issue.

The Wisconsin Department of Revenue (Department) denied the royalty and interest expense deduction after auditing the taxpayer's 2000-03 tax returns on the basis the intercompany transactions were sham transactions or otherwise lacked a valid business purpose. The Department is authorized under Wisconsin law² to adjust income or deductions based on discretionary criteria, such as lack of business purpose or economic substance.

The taxpayer appealed to the WTAC after the Department denied the taxpayer's protest to the assessment. In affirming the Department's assessment, the WTAC focused on the tax advisor's planning documents, which stressed the reduced state tax liability without any substantive changes to the taxpayer's business resulting from implementing the strategy.³

The Circuit Court focused on the "substance and reality" of the transactions in affirming the WTAC, which involved evaluating economic substance, business purpose, and whether the transaction was shaped solely by tax avoidance. The Circuit Court referenced the WTAC's findings of fact, specifically, that the taxpayer told its advisors the tax-saving measures needed to be "invisible" to its employees and customers, as well as the circular flow of funds between the affiliates.

The Circuit Court dismissed the taxpayer's argument that the transactions at issue should have been respected because they were between "viable business entities," an argument based on a Massachusetts court decision containing similar facts. The District Court, however, concluded that Wisconsin courts have not adopted such a test and that the taxpayer's facts were distinguishable from those in the Massachusetts case. The District Court concluded its analysis by observing that the taxpayer's facts were a "near textbook example" of what Wis. Stat. 71.30(2) was designed to prevent.

Implications

It is unknown at this time if the taxpayer will pursue further appeals in this matter. While Wisconsin has required the use of combined reporting for tax years beginning on or after January 1, 2009, the Department has challenged, under similar theories, intercompany transactions with non-US affiliates that would not be in the Wisconsin water's-edge combined group. Maintaining contemporaneous documentation that supports intercompany transactions with non-tax business purposes and economic substance remains an important consideration in Wisconsin. Taxpayers should also consider the disclosure requirements associated with such transactions, as it is a gating issue for such transactions to be respected.