In its first decision involving combination under Article 9-A in more than three years, the New York State Tax Appeals Tribunal has upheld the forced combination of an out-of-state factoring subsidiary with its parent apparel manufacturer. Based on a “sham transaction” analysis, the Tribunal held that the transactions under which the factoring subsidiary was formed and operated “do not merit tax respect,” and therefore the taxpayer failed to rebut the presumption of distortion resulting from substantial intercorporate transactions under the pre-2007 law. Matter of Kellwood Company, DTA No. 820915 (N.Y.S. Tax App. Trib., Sept. 22, 2011).
Creation of Factoring Subsidiary
Kellwood Corporation (“Kellwood”) is a supplier of mid-priced apparel to retailers and other businesses. Its headquarters are in Missouri, but it also conducts business in New York State and is subject to Article 9-A.
Kellwood was formed in 1961 and initially manufactured clothing for Sears Roebuck & Co. under its private label. By the mid- 1980s, Sears had sold its stock interest in Kellwood, and Kellwood diversified its customer base to include a wide range of retailers, such as Macy’s, The Gap and Wal-Mart. By the late 1980s and 1990s, the U.S. apparel industry had begun to decline, and many manufacturers faced the possibility of bankruptcy and consolidation. In the face of these challenges, in the late 1990s Kellwood’s management considered a plan to consolidate several of its diverse operations, which were spread out among many business units.
At the same time, Kellwood’s management considered securitization of its accounts receivable from its retail customers as an alternative financing tool. However, it had been unable to enter into a securitization arrangement because, at the time, its accounts receivable were owned by multiple affiliated legal entities, and to securitize would require that the receivables be owned by a single, bankruptcy-remote special purpose entity.
To further explore these possibilities, Kellwood employed a prominent CPA firm to advise on multistate tax planning ideas. One of the firm’s recommendations was the formation of a factoring company. The firm prepared a report in which it proposed a “tax strategy” that would enable Kellwood to realize losses on the sales of its accounts receivable to that factoring company, with substantial gains in the factoring company. The firm’s report discussed the tax savings that would result in various non-unitary states, and also identified various business purposes for forming a factoring company. The CPA firm was to be paid by Kellwood based on 40% of Kellwood’s first full-year state tax savings.
To effectuate this plan, in late 1999, Kellwood formed a factoring subsidiary, Kellwood Financial Resources (“KFR”), in Tennessee staffed with as many as 30 credit and collection employees. Kellwood contributed $273 million of customer accounts receivable to KFR upon its formation in exchange for KFR’s stock. Thereafter, on a weekly basis, KFR purchased all of Kellwood’s net accounts receivable at a discount rate determined by the CPA firm. Kellwood entered into a revolving credit agreement with KFR pursuant to which Kellwood would loan KFR any funds necessary to purchase Kellwood’s net receivables.
At the same time, Kellwood formed another subsidiary, Kellwood Shared Services (“KSS”), based in Missouri, to provide centralized payroll, accounts payable, and accounts receivable services. Among KSS’s various services was to service and collect KFR’s receivables, for which KFR paid it a servicing fee at an 8% mark-up determined by the CPA firm.
KFR was not a bankruptcy-remote entity when created, and was never used by Kellwood as a securitization vehicle.
The Article 9-A Dispute
For the tax years ending January 2000 through January 2003, Kellwood filed its own Article 9-A returns but did not file a combined return with either KFR or KSS. Following an audit, the Department sought to combine both KFR and KSS with Kellwood. Until 2007, the Article 9-A law and regulations provided for combination of related corporations where there was substantial ownership, a unitary relationship, and distortion resulted from separate filing. The presence of substantial intercorporate transactions resulted in a presumption of distortion, and the party challenging that presumption had the burden of proving that no distortion existed, by demonstrating arm’s-length pricing. (Under current law, the presence of substantial intercorporate transactions automatically results in combination, regardless of proof of arm’s-length pricing.) Kellwood did not dispute that the ownership and unitary business requirements for combination were met or that there were substantial intercorporate transactions. The sole issue in Kellwood involved whether the taxpayer successfully rebutted the presumption of distortion.
The Administrative Hearing and Appeal
At the administrative hearing held in 2007, fact witnesses for Kellwood testified about the purpose and implementation of the restructuring that resulted in the formation of KFR and KSS. Kellwood also submitted expert testimony from and a report prepared by an economist regarding the business purpose and arm’s-length nature of KFR’s intercompany charges. The preparers of the CPA firm report recommending the formation of the factoring company did not testify. The Department retained two of its own experts; one testified that there was no business purpose or economic rationale for the existence of KFR; the other testified that Kellwood’s transfer pricing analysis was flawed.
The case proceeded on a somewhat circuitous route. In March 2008, the ALJ held that the transactions at issue involving KFR lacked economic substance and business purpose. On appeal, the Tribunal remanded the case back to the ALJ solely to address combination of KSS, the centralized servicing company. Eventually, in March 2010, the ALJ, on remand, determined that Kellwood did meet its burden of proof with respect to KSS. The case was then returned to the Tribunal for consideration of combination involving both KFR and KSS.
The Tribunal Decision
In a 92-page decision, the Tribunal affirmed the ALJ’s determination, upholding the combination of KFR, the factoring subsidiary. Citing to Matter of Sherwin-Williams Co., DTA No. 816712 (N.Y.S. Tax App. Trib., June 5, 2003), confirmed, 12 A.D.3d 112 (3d Dep’t 2004), app. denied, 4 N.Y.3d 709 (2005), the Tribunal held that it was proper to first apply a twopronged test for determining whether the distortion test required combination: First, it was necessary to determine whether the subject transactions – here, the initial contribution and subsequent sales of net receivables to KFR – were entered into for valid, nontax business purposes (the “subjective prong”) and had purpose and substance apart from their anticipated tax consequences (the “objective prong”). Even if the transactions merit tax respect under those two prongs, the taxpayer must then rebut the presumption of distortion by showing that the transactions reflect arm’s-length pricing consistent with Internal Revenue Code § 482.
The Tribunal held that the ALJ correctly applied the business purpose and economic substance test of Sherwin-Williams. It pointed out that the avowed non-tax business purpose to securitize the receivables as a financing tool could not have been realized since Kellwood was aware that KFR was not a bankruptcy-remote entity and could not be used for securitization. The Tribunal also noted that “the record does prove that tax avoidance in noncombined reporting jurisdictions . . . was a well-considered and contemplated objective behind the factoring arrangements.” Thus, the Tribunal held that the transactions involving KFR did not “merit tax respect.” Having found that the KFR transactions failed the “objective prong,” the Tribunal did not rule on the “subjective prong” – whether the transactions were entered into for a valid, non-tax business purpose, and whether Kellwood proved the arm’s-length nature of the transactions.
The Tribunal did reject the forced combination of KSS, the servicing subsidiary. It pointed out that the Department, in its post-hearing briefs, acknowledged that KSS served a valid business purpose, and that the Department only adduced evidence to challenge the arm’s-length nature of the Kellwood-KFR transactions, not those involving KSS. It therefore concluded that the Department did not meet its burden to show that the KSS service charges (set at cost plus 8%) were anything other than an arm’s-length charge.
Additional Insights. In some respects, the Tribunal’s decision is unsurprising, given that the record showed that the factoring subsidiary could not have served as a securitization vehicle – the alleged principal purpose for its formation – because it was not a bankruptcy-remote entity. Moreover, the ample evidence of the state tax minimization purposes for the factoring subsidiary, while not dispositive, undoubtedly gave the Tribunal additional grounds for concluding that the transactions had no purpose or substance other than tax savings.
However, the Tribunal’s decision is puzzling in certain respects. For one thing, its statement that, under Sherwin-Williams, “the party opposing combined reporting bears the burden of proving that the subject transactions merit tax respect,” is overbroad. Since Sherwin-Williams involved the presumption of distortion, it seems questionable that the burden of proof is automatically placed on the taxpayer even in situations where the presumption has not been triggered, such as where the Department alleges the existence of actual distortion.
In addition, the Tribunal’s application of a “potential profit” test to evaluate whether the transactions have economic substance, and its view that the potential profit test “require[s] taxpayers to show increasing profit,” is ripe for confusion. While it may be true that the economic substance test involves ascertaining whether a reasonable possibility of profit exists for a transaction, KFR did make a profit, and the Tribunal cites no authority for placing the burden on a taxpayer to show that its profitability actually increased as a result of the transactions.