United States: New York City Tribunal Decision in Toys "R" Us-NYTEX Confirms Arm’s Length Pricing As Key to Combination

The New York City Tax Appeals Tribunal recently issued what may be the most significant taxpayer victory in New York to date on when the New York tax authorities may forcibly combine a corporate taxpayer with an affiliated intangibles holding company. In Matter of Toys "R" Us-NYTEX, Inc., TAT(E) 93-1039(GC) (N.Y.C. Tax App. Trib., Jan. 14, 2004), the New York City Tribunal ("City Tribunal") held that Toys "R" Us-NYTEX, Inc. ("Toys-NYTEX") proved that its transactions with its affiliated intangibles companies — principally royalty payments for the use of trademarks held by Geoffrey, Inc. ("Geoffrey") and interest payments made to affiliated financing companies - were at arm’s length rates, thereby overcoming the presumption of distortion. Therefore, New York City could not forcibly combine Geoffrey and the financing companies with Toys-NYTEX for New York City general corporation tax ("GCT") purposes. Most noteworthy was the City Tribunal’s clear holding that the proper analysis for New York City combination is not whether there is economic substance and a valid business purpose, but whether the transactions at issue reflect an arm’s length charge.

For New York City (and New York State) corporate tax purposes, a taxpayer can be forced to file its returns on a combined basis with a nontaxpayer affiliate only if there is (1) substantial ownership (2) a unitary relationship and, of critical importance, (3) distortion resulting from separate filing, such as by non-arm’s length intercompany transactions. The presence of substantial intercorporate transactions creates a rebuttable presumption of distortion. See19 R.C.N.Y. § 11-91.

Toys-NYTEX, one of several corporations that comprise the Toys "R" Us organization, operates retail toy and children’s clothing stores in New York. In 1984, Toys "R" Us underwent a major restructuring, which included the formation of separate corporations, such as Toys-NYTEX, to operate in certain states, and the formation of Geoffrey to hold, protect, and maintain the Toys "R" Us trademarks and trade names ("Marks"). Following the formation of Geoffrey, Toys "R" Us contributed the Marks to Geoffrey in exchange for stock in a nonrecognition transfer pursuant to Internal Revenue Code ("IRC") section 351. As a result, Geoffrey became the registered owner of the Marks. Geoffrey granted a non-exclusive license of the Marks to its retail affiliates, including Toys-NYTEX, in exchange for a royalty based on a percentage of the retail companies’ net sales.

As part of the restructuring, Toys "R" Us also formed a corporation to provide real estate mortgage financing to the Toys "R" Us retail companies, and formed another corporation that principally made intercompany loans to those companies ("the financing companies").

Toys-NYTEX filed its own separate New York City GCT returns. The New York City Department of Finance ("New York City") claimed that Toys-NYTEX must file its returns on a combined basis with Geoffrey, as well as with the financing companies.

New York City took the position that the combination of Toys-NYTEX and Geoffrey was required because the 1984 transfer of the intangibles, coupled with the license of these intangibles from Geoffrey, lacked economic substance, and that Toys-NYTEX’s income was not properly reflected without including Geoffrey in its tax return. In effect, New York City argued that there was distortion - the third requirement for combination — because Geoffrey was not entitled to any royalty payments.

Toys-NYTEX maintained that the initial transfers of the Marks - made several years prior to the years in controversy - were valid transactions for both tax and business purposes and that the royalty payments were made at arm’s length. At the administrative hearing, Toys-NYTEX presented extensive evidence - from two independent economists - that the royalty payments were at arm’s length rates under IRC section 482. No evidence was introduced by New York City to rebut the proof of arm’s-length pricing.

In 1999, a New York City Administrative Law Judge ("ALJ") held that Toys-NYTEX was not required to file on a combined basis with Geoffrey or the financing companies. Although the presence of "substantial intercorporate transactions" between Toys-NYTEX and Geoffrey, and between Toys-NYTEX and the financing companies, created a rebuttable presumption of distortion, the ALJ held that the evidence established that the intercompany transactions between them — particularly the royalty payments made to Geoffrey — were at arm’s length. Thus, the company had successfully rebutted the "presumption of distortion." The ALJ found that the formation of Geoffrey and the licensing of the Marks were bona fide transactions having economic substance and genuine business purpose and was not entered into solely for tax avoidance purposes. The ALJ also found that Toys "R" Us had made a valid transfer of the Marks, along with the associated goodwill. The fact that there were also acknowledged state tax benefits could not, the ALJ held, cause the transactions to be disregarded.

New York City appealed the determination to the New York City Tribunal, raising the same arguments as it did before, and challenging more than half of the ALJ’s 80 findings of fact. While the City Tribunal was deliberating, a potential complication arose when the New York State Tax Appeals Tribunal ("State Tribunal") issued its decision in the matter of Sherwin-Williams Companies, DTA No. 816712 (N.Y.S. Tax App. Trib., June 5, 2003), a case involving issues similar to those in Toys "R" Us-NYTEX. Reversing a 150-page ALJ determination, the State Tribunal, in Sherwin-Williams, held that New York State properly combined The Sherwin-Williams Company with its two intangibles holding companies. The State Tribunal found that Sherwin-Williams had failed to rebut the presumption of distortion. Moreover, it held that the licensing arrangement lacked a valid business purpose. (The Sherwin-Williams decision is currently on appeal.) Since the City Tribunal is required to follow the prior precedential decisions of the State Tribunal, the City Tribunal also had to consider the impact of Sherwin-Williams.

In Toys "R" Us-NYTEX, the City Tribunal upheld the ALJ’s determination that combination was not required, but on somewhat different grounds. The City Tribunal held that under the City’s own rules and the New York case law on combination, whether or not distortion exists depends on whether the taxpayer is able to rebut the presumption of distortion arising from substantial intercorporate transactions. Here, Toys-NYTEX had introduced evidence regarding the arm’s length nature of the intercompany pricing, and New York City had not introduced any evidence to the contrary. Therefore, the City Tribunal held that Toys "R" Us had successfully rebutted the presumption of distortion and should not be combined. The City Tribunal also rejected the relevance of the business purpose and economic substance analysis in determining whether combination is appropriate. New York City may not appeal this decision, and it is now final. See N.Y.C. Charter § 171.

Reading the Toys "R" Us-NYTEX decision (which is final) together with the Sherwin-Williams decision (which is on appeal to the New York courts) necessarily raises the question whether the two decisions can be reconciled. In the City Tribunal’s view, the answer is clearly, "Yes." According to the City Tribunal: "It is important to note that the State Tribunal [in Sherwin-Williams] did not rest their decision on the basis of their conclusion that the transfer of the Marks and license-back had neither economic substance nor a valid business purpose. The State Tribunal undertook an analysis of whether the charges at issue were arm’s length before deciding that the taxpayer had not met its burden of overcoming the presumption of distortion, and that combination was appropriate." Put another way, if the State Tribunal in Sherwin-Williams truly believed that its conclusions about the alleged lack of business purpose was determinative, there was no need to address the arm’s length pricing issue as it did. Thus, it seems reasonable to view the City Tribunal and State Tribunal as having applied the same analysis, but as having reached different conclusions because, in Toys "R" Us-NYTEX, New York City failed to rebut the pricing evidence, while in Sherwin-Williams, the State Tribunal found that New York State did rebut the pricing evidence.

A different view is that the two Tribunals have now gone in different directions on issues of combination, and that the State Tribunal (unlike the City Tribunal) will uphold forced combination where New York State perceives that an intercompany transaction lacks a business purpose. One problem with this view is that if a "sham transaction" is found to exist, the more appropriate remedy would be to either disregard the deduction resulting from the transaction or to disregard the intangible holding company itself as a "sham."

What will New York City do in light of the taxpayer victory in Toys "R" Us-NYTEX? The City Tribunal has clearly held that arm’s length pricing is the critical factor in rebutting the presumption of distortion. Early indications from the City are that it may delay meaningful resolution of intangibles holding company combination disputes pending the eventual outcome of Sherwin-Williams. Yet, it is questionable that the City Tribunal would have ruled any differently if a court had rendered the Sherwin-Williams decision, rather than the State Tribunal.

Since most intercompany royalties must be added back under recent New York legislation for tax years beginning on or after January 1, 2003, some may view the Toys "R" Us-NYTEX decision as being of limited importance. This would be a mistake. While the New York royalty addback legislation may have addressed the narrow issue of royalties, there is little doubt that there will be other instances in which New York City and New York State attempt to address other perceived distortions from intercompany transactions that allegedly lack a business purpose. The Toys "R" Us-NYTEX decision makes clear, as no New York decision has before, that arm’s length pricing will determine the outcome of those other combination cases as well.

Paul H. Frankel, Hollis L. Hyans, and Irwin M. Slomka served as co-counsel for Toys "R" Us-NYTEX, Inc. in this matter.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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