Stingers: The 2004 State Tax Survey

Tough times can make for tense relations between corporate tax executives and state tax authorities. Our survey suggests that even if economic conditions improve, the stage is set for more contentiousness than ever.

New Jersey was not so lucky—the court cited South Carolina as an aberration and ruled that without physical nexus, Lanco was not subject to the state’s income tax. The case also didn’t do much for New Jersey’s reputation: it rocketed to number one among the states considered by our survey respondents to be the most aggressive about asserting economic nexus. (South Carolina, which was first in 1998 and fifth in 2000, dropped to eighth on the list.)

Yet New Jersey’s failure to tax a Delaware holding company was not an unalloyed win for corporate tax planning. Earlier in 2003, Maryland pierced the corporate veil of two Delaware holding companies by arguing that they had no real business purpose other than to avoid tax. That’s a classic anti-tax-shelter argument, and one that may signal a much more aggressive approach by the states.

The Maryland Court of Appeals ruled simultaneously in Comptroller of the Treasury v. SYL Inc. and in Comptroller of the Treasury v. Crown Cork & Seal Co. (Delaware) Inc. that the Delaware holding companies of Syms and Crown Cork & Seal could be taxed—not individually, as New Jersey attempted in Lanco, but as part of their parent companies—because they “had no real economic substance as separate business entities.”

The court noted that all of the characteristics of a functioning company—employees, office space, travel expenses, and so on—”were virtually nonexistent on Crown Delaware’s balance sheets.” Where such expenses did exist, they were provided by Organization Services Inc., a “nexus services” provider.

Although Crown Delaware claimed revenues of about $37 million per year, total annual wages for its nine “employees” averaged $568 for each year between 1989 and 1993. Indeed, Crown Delaware’s total operating costs averaged just over $2,000 per year. “Over the five-year period in question,” the court noted, “Crown Delaware incurred a total of $20 in meals and entertainment, about $60 in telephone charges, and about $100 in postage. Travel costs for the entire period…amounted to less than $7.” And despite the fact that Crown Delaware theoretically existed to manage intellectual property, it never incurred any legal fees associated with patents or trademarks.

Those who defend moving intellectual property to a Delaware holding company as a legitimate tax-planning strategy admit that the Crown case is not the most flattering example. But even more-persuasive fact patterns are no sure thing. In a similar case decided in 2002—Sherwin-Williams v. Commissioner of Revenue—Massachusetts failed to convince a court that the paint company’s Delaware subsidiary was a sham, because, the court ruled, it did engage in legitimate business activities. This past June, New York’s Tax Appeals Tribunal looked at the same affiliate and found just the opposite to be the case.

SYL, Crown, and New York’s version of Sherwin-Williams make Delaware-style holding companies far more likely to be attacked in court these days—much as Enron’s abuses resulted in greater scrutiny of all special-purpose entities. “If you are a publicly traded company, you need to be far more cautious today than in the past with regard to aggressive tax planning,” says Stuart L. Rosow, an attorney with Proskauer Rose LLP. Although such planning is still possible for many companies, he says, “the level of scrutiny that it will be subjected to is much greater.”

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