In the Matter of the Petition of The Sherwin-Williams Company

New York State Tax Appeals Tribunal Decision

In early 1991, Sherwin-Williams set up two wholly-owned Delaware holding companies – SWIMC and DIMC – to which it transferred ownership of its trademarks for use in domestic sales. SWIMC and DIMC, in turn, licensed the parent’s operating units to use these transferred trademarks in return for specified royalty payments.

In 2002, the New York State Tax Appeals Tribunal heard an exception filed by the State Division of Taxation to the determination of an Administrative Law Judge with respect to a petition filed by Sherwin-Williams asserting that the Division erred in requiring it to file a combined corporation franchise tax report with SWIMC and MIMC and asserting that the Division erred in including certain royalty income received by Sherwin-Williams in computation of its entire net income base.

Dr. Shapiro testified before the Tribunal. He was asked by the New York State Department of Taxation and Finance to examine two issues: (1) the economic substance of this arrangement and (2) the arm’s length nature of the royalty rates set in these licensing agreements.

In his written report, Dr. Shapiro concluded that:

After a thorough review of the evidence along with a consideration of the business and economic issues involved, I find that there is no economic substance underlying the formation of SWIMC and DIMC. The basis for my opinion is that these Delaware holding companies are unable to add value to the trademarks owned by Sherwin-Williams (SW) and so we would not expect to–and do not–see such sale-and-license-back trademark transactions take place between independent companies. Further, because setting up and using a DHC adds costs and complexity to a company without offsetting benefits, we would also not expect to see such arrangements between related parties absent tax considerations. Simply put, you cannot manage a trademark independently of the core branded products and the knowledge that comes from managing those products. Any attempt to do so in a serious way would damage the trademark and would likely result in organizational chaos. It is for this reason that DHCs typically outsource any real trademark work to the parent company.
(Executive Summary of Shapiro Report)

In 2003, the Tribunal granted the exception of the Division, reversed the determination of the Administrative Law Judge, denied the petition of Sherwin-Williams, and sustained the Notice of Deficiency. In its opinion, the Tribunal relied heavily on Dr. Shapiro’s testimony in determining that the transactions in question lacked economic substance and that the royalties paid by Sherwin-Williams to SWIMC and DIMC were not at arm’s length.

For example, with respect to economic substance, the Tribunal favorably cited Dr. Shapiro’s testimony regarding the signaling function of trademarks, how trademarks have no intrinsic value on a stand-alone basis, and what is required to establish a brand-value proposition.

As explained by Dr. Shapiro, a trademark is a signal which connotes a certain package of features and qualities at a particular price which enhances the ability to sell certain good and earn an above-average rate of return. In other words, to earn a return above the cost of capital which Dr. Shapiro defined as the required return on capital that is based on what investors could expect to earn elsewhere in the economy on investments with the same risk. If the return on capital is less than the cost of capital, the transaction involved would be considered to be destroying value.

According to Dr. Shapiro, the trademark, standing alone, has no intrinsic value. Its value is based on its recognition of representing the quality and services associated with products bearing the trademark. These attributes are supplied by the trademark owner's other intangible assets such as its organizational capital, which includes marketing and advertising capabilities. In order to realize a value from its trademarked products, a company needs such other intangible assets which enable the company to provide the quality features sought by customers in a cost-effective way. The profits earned on branded products are directly related to the amount of other intangible assets that the company is using.

Dr. Shapiro explained that a name becomes a branded product when customers associate it with a set of intangible and tangible benefits which are referred to as the product's brand value proposition which represents the core promises or values associated with the brand that are what customers expect when they see a particular company's product.

It is the understanding of this brand value proposition which is critical in order to set quality control standards as well as ensuring that your product is keeping up with changing customer tastes and other competitors' products.

In order to successfully establish a brand value proposition and manage the branded products, Dr. Shapiro explained that:

you require marketing skills. You have to be able to identify customer desires. You have to be able to identify the trade-offs that customers are willing to make; both the physical tradeoffs, this quality versus that quality, the economic trade-offs, more of this at a higher cost, and consequently higher price. So you need to be able to weigh those. It is a matter of skill, but also, critically, it's a matter of experience. You need a lot of knowledge.

You have to also understand what the company is capable of delivering . . . and then you have to understand the company's sales channels (Hearing tr., pp. 3231-3232).

(Tribunal Decision, pp. 52-53)

Based upon the testimony of Dr. Shapiro, the employees of the subsidiaries would have no knowledge upon which to base any decisions made with respect to the use of the Marks.

The Tribunal Opinion then discussed (p. 54) the benefits to forming the subsidiaries as determined by the Administrative Law Judge. These included the benefits if incorporating in Delaware, the ability to use SWIMC and DIMC as investment and financing vehicles, tax considerations, the ability to insulate the Marks from liabilities of petitioner, to increase the focus on third-party licensing and limiting petitioner’s liability with regard to third-party licenses.

Dr. Shapiro addressed many of these supposed benefits in his expert report. For example, with respect to limiting liability, he noted that there are more simple, direct ways to limit liability (for example, purchasing insurance), that setting up a separate royalty subsidiary can actually create additional legal liability (a successful litigant against SWIMC could collect against the trademarks because they are assets of SWIMC), and that the separation provides no protection for the marks because SWIMC and DIMC are wholly-owned, rather than sister, subsidiaries of Sherwin-Williams.

Regarding the alleged financing advantages, Dr. Shapiro’s report explained that, while there may be financing advantages if the parent is at its debt limit, Sherwin-Williams does not appear to be close to its debt limit. As a result, having one of its subsidiaries borrow money would encumber the parent’s ability to borrow funds on its own in the future.

The Tribunal agreed that the benefits as outlined by the Administrative Law Judge were not achievable (p. 54).

The Tribunal concluded its economic substance analysis by favorably citing Dr. Shapiro’s testimony.

We agree with the analysis of Dr. Shapiro that there would be serious economic risk in any business arrangement which separates the responsibility for trademarks and brand management from those in a company who work with the branded products on a daily basis and have actual knowledge of the brands, customer requirements, customer expectations and corporate capabilities. Decisions about how the trademarks should be used, whether they should be extended to new products, licensed to third-parties or whether the quality of the products on which they are used is sufficient, require on-going knowledge of the business in which the trademarks are used to sell products.

Therefore, we conclude that the form of this transaction does not match the substance since the purpose for creating the subsidiaries was a tax avoidance tool and there is absolutely no economic substance to the transactions since the many objectives in the business plan were wholly unattainable, the evidence failed to establish the pursuit of any of the proposed business plans following the creation of SWIMC and DIMC and there was not any economic benefit to be derived.

With respect to the arm’s length nature of the royalty rates paid by Sherwin-Williams to SWIMC and DIMC, the Tribunal again relied heavily on Dr. Shapiro’s analysis, particularly his written report critiquing the expert report of Richard Genetelli (exhibit “M”) to the Tribunal Opinion.

We next turn our attention to the AAA appraisal report and whether such report establishes that the royalty rates paid by petitioner to SWIMC and DIMC were at arm's length. The Administrative Law Judge in her determination summarily rejected the Division's arguments and accepted the report. Our analysis reaches an opposite result.

Primarily, we note that the record indicates that the use of applying the profit split rule of thumb to operating profits rather than petitioner's residual profits results in inflated royalty rates. Proof of this point is demonstrated by Dr. Shapiro's cost of capital analysis and his overlay analysis.

In reviewing exhibit "M," the cost of capital analysis is conducted in order to establish whether Sherwin-Williams could have afforded to pay the royalty rates set by AAA's application of the 25%-33 1/3% split to its operating profit for the year in question, 1991, and the two preceding years. The report concludes that Sherwin-Williams would be unable to achieve its cost of capital. An example set forth in exhibit "M" (see, pp. 20-22) demonstrates that using a 33 1/3% split applied to operating profit would have left petitioner earning over two percentage points less than its cost of capital for each of the years 1989 through 1991. Since a company must earn a profit in order to cover its cost of capital to remain viable, we conclude that the royalty rates set by the AAA appraisal were too high and, thus, unreasonable.

Dr. Shapiro also concluded that the valuation of the Marks was too high. The Administrative Law Judge disagreed stating that she was not convinced by his opinion that trademarks account for only a fraction of the intangible assets of a corporation. We reject this premise made by the Administrative Law Judge.

As stated in exhibit "M":

the income earned on a trademarked product increases with the amount of organizational capital supporting that mark. Hence, trademarks and organizational assets are synergistic - each enhances the value of the other. Thus, any analysis that ignores a company's organizational assets will overvalue its trademarks - and that overvaluation will be in direct proportion to the amount of its organizational assets (exhibit "M," p. 6).

Thus, we conclude that other intangible assets such as multiple distribution channels, ability to maintain quality control and the ability to adapt to a changing marketplace comprise the total intangible assets of a corporation.

In his report, Dr. Shapiro discounted the royalty income streams using the royalty rates set by AAA and also by a corrected discount rate that he computed. His analysis determined that the present value of the trademarks using AAA's royalty rates was more than $658 million which resulted in representing 76% of the total value of Sherwin-Williams' intangible assets. We agree with his conclusion that this percentage is extremely exorbitant in light of the fact that other intangible assets such as multiple distribution channels, ability to maintain quality control and the ability to adapt to a changing marketplace would only be represented by a mere 24% of petitioner's intangible assets.(pp. 54-55)

Appeals Court Decision

Sherwin-Williams appealed the New York State Tax Appeals Tribunal decision to the New York Supreme Court, Appellate Division. In a decision dated October 28, 2004, the Appeals Court dismissed the appeal and confirmed the Appeals Tribunal determination.

The Appeals Court decision favorably cited Dr. Shapiro’s testimony:

The Division's primary expert was Alan Shapiro, a professor of economics and finance at the University of Southern California. Shapiro testified that the subsidiaries were unable to add value to the trademarks and that, objectively viewed, the transaction lacked economic substance because there was no reasonable expectation of benefits exceeding costs. He explained that the value of a trademark is principally tied to it being recognized and reflecting the quality and service associated with products bearing that trademark. Thus, according to Shapiro, trademarks cannot be managed "independently of the core branded products and the knowledge that comes from managing those products." He further set forth the reasons for his conclusions that the subsidiaries failed to provide any meaningful quality control, that the arrangement did not protect against a hostile takeover and that creating the subsidiaries did not advance the goal of limiting liability. Shapiro also addressed, in a separate report as well as in his testimony, the issue of the royalty rates, and he opined they were not arm's length transactions. The Division elicited testimony from another expert, attorney Lee Bromberg, who asserted that the transfer and license-back of the trademarks provided no advantage from the perspective of trademark law and practice and, in fact, created disadvantages, including a risk of invalidation.

Analysis of this evidence and the rest of the voluminous record reveals facts and opinions providing support for the positions advocated by both petitioner and the Commissioner.
…
Here, the Tribunal's determination that petitioner failed to rebut the presumption of distortion since the assignment and license-back transaction lacked a business purpose or economic substance apart from tax avoidance is supported by substantial evidence. We are unpersuaded that the Tribunal erred in crediting the expert testimony offered by the Division over petitioner's experts. Having found substantial evidence to support the Tribunal's determination of a lack of a business purpose and economic substance, it is not necessary to address the separate ground of whether the royalty rates reflected market rates.