In Skechers USA, Inc. v. Wisconsin Dep't. of Rev.,¹ the Wisconsin Court of Appeals (Court) upheld a determination by the Wisconsin Tax Appeals Commission² (WTAC) that certain intercompany royalty and interest expenses paid to an affiliate were not deductible expenses.

The taxpayer, a California-based corporation that sells branded footwear, has 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 2000–2003 tax returns on the basis that the intercompany transactions were sham transactions or otherwise lacked a valid business purpose. The Department is authorized under Wisconsin law³ 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. The taxpayer appealed the WTAC's decision to the Circuit Court, which upheld the decision.⁴ The taxpayer then appealed to the Wisconsin Court of Appeals (Court).

The Court focused its inquiry on the WTAC's determination that the company did not have a valid business purpose for creating the subsidiary. The Court said that the WTAC's determination that the evidence associated with the formation of the subsidiary "pointed to one reason for its creation — 'tax savings'" was "amply supported by the record." The record showed that the creation of the subsidiary was prompted by a recommendation from its outside auditor as part of a larger strategy to minimize state tax liabilities and that the specific transfer and license transactions did not have a valid nontax business purpose. The Court also echoed the WTAC's observation that the taxpayer's facts were a "near textbook example" of what the statute 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 otherwise be in the Wisconsin water's-edge combined group. Maintaining contemporaneous documentation that supports the economic substance of intercompany transactions with non-tax business purposes 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.