Sherwin-Williams v. Commissioner of Revenue

• Decision Date: 31 October 2002
• Citation: 438 Mass. 71,778 N.E.2d 504
• Parties: The SHERWIN-WILLIAMS COMPANY v. COMMISSIONER OF REVENUE.
• Court: United States State Supreme Judicial Court of Massachusetts Supreme Court

Page 504

778 N.E.2d 504

438 Mass. 71

The SHERWIN-WILLIAMS COMPANY v. COMMISSIONER OF REVENUE.

Supreme Judicial Court of Massachusetts, Suffolk.

Argued September 10, 2001.

Decided October 31, 2002.

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Paul H. Frankel, of New York (Craig B. Fields, of New York, & Maxwell D. Solet, Boston, with him) for the taxpayer.

Edward J. DeAngelo, Special Assistant Attorney General, for Commissioner of Revenue.

William E. Halmkin, Boston & Andrew H. Lee, for the Massachusetts Tax Coalition, amicus curiae, submitted a brief.

Present: MARSHALL, C.J., GREANEY, IRELAND, SPINA, COWIN, SOSMAN, & CORDY, JJ.

CORDY, J.

The Sherwin-Williams Company (Sherwin-Williams) appealed from a decision of the Appellate Tax Board (board) upholding the denial by the Commissioner of Revenue (commissioner) of its request to abate $59,445.40 in corporate excise taxes assessed for tax year 1991 and we transferred the case to this court on our own motion. The contested assessment was the result of the commissioner's disallowance of approximately $47 million that Sherwin-Williams had deducted from its taxable income for royalty payments to two wholly owned subsidiaries, Sherwin-Williams Investment Management Company, Inc. (SWIMC), and Dupli-Color Investment Management Company, Inc. (DIMC) (collectively referred to as the subsidiaries),¹ for the use of certain trade names, trademarks, and service marks (marks), that Sherwin-Williams had transferred to the subsidiaries and licensed back as part of a corporate reorganization of its intangible assets in January, 1991. The commissioner also disallowed $80,000 that Sherwin-Williams had deducted for interest payments to SWIMC, in connection with a $7 million loan made to it by SWIMC in the fourth quarter of 1991, which was repaid in the first quarter of 1992.

After a protracted evidentiary hearing, the board found that Sherwin-Williams had not sustained its burden of establishing its entitlement to an abatement, and that the commissioner had properly disallowed the deductions on three alternative grounds: (1) the transfer and license back of the marks was a sham and could be disregarded under the "sham transaction doctrine"; (2) the royalty payments were not deductible as ordinary and necessary business expenses when there was no valid business purpose justifying the expense; and (3) G.L. c. 63, § 39A, permitted the commissioner to adjust the taxable income of Sherwin-Williams by eliminating the royalty payments because they were not made at arm's length and distorted the actual income of Sherwin-Williams. The board also affirmed the elimination of the interest expense deduction based on the commissioner's contention that Sherwin-Williams should never have paid the royalties that generated both the need to borrow money from SWIMC, and the source of the funds loaned to it.

We conclude that the board erred when it found that the transfer and licensing back transactions between Sherwin-Williams and its subsidiaries were without economic substance and therefore a sham. We also conclude that: the payment of royalties and interest to SWIMC and DIMC were properly deductible by Sherwin-Williams because obtaining licenses to use the marks was necessary to the conduct of its business; even assuming G.L. c. 63, § 39A, empowers the commissioner to eliminate payments made between a foreign parent corporation and its subsidiaries, it does so only to the extent that such payments are in excess of fair value, and in light of the substantial evidence that the royalties paid by Sherwin-Williams reflected fair value, there is no basis to support the elimination of these payments; and, because the transactions were not a sham, and the loan between SWIMC and Sherwin-Williams was genuine, interest was properly chargeable to Sherwin-Williams when it borrowed the funds and was, accordingly, properly deductible.

1. Background. From the uncontested evidence presented at the evidentiary hearing, we set forth the following backdrop to the issues presented for decision. Sherwin-Williams is a corporation that has manufactured, distributed, and sold paints and related products for more than 125 years. It was incorporated under the laws of the State of Ohio, and has its principal place of business in Cleveland. It manufactures and sells its products under many brand names, including its own signature brand, "Sherwin-Williams," and other brands, including "Dutch Boy," "Martin-Senour," "Kem-Tone," "Dupli-Color," and "Krylon." Sherwin-Williams also uses hundreds of marks, including the "Sherwin-Williams" trademark, several "Dutch Boy" trademarks, and "The Look that Gets the Look" slogan.

In June, 1990, one of Sherwin-Williams's attorneys suggested it Robert E. McDonald, Sherwin-Williams's senior corporate counsel for patents and trademarks, the idea of forming two subsidiary companies to hold and manage the Sherwin-Williams marks and to invest and manage royalty proceeds earned therefrom. McDonald discussed this idea with other senior corporate officials, who asked him to evaluate the potential benefits and risks of establishing such subsidiaries and transferring the Sherwin-Williams marks to them. After concluding that the potential benefits would be substantial, Mc-Donald traveled to Delaware, along with another Sherwin-Williams employee, to meet with individuals who had experience in the management of intangible asset holding companies there. They met with lawyers, bankers, and investment managers, including Donald J. Puglisi.

Puglisi was a professor of business and finance at the University of Delaware, the founder and owner of an investment management and services firm (Puglisi and Associates), and a member of the board of directors of many investment companies and Delaware subsidiaries of foreign corporations. His expertise was principally in business management, portfolio management, and corporate finance. Puglisi and McDonald discussed how intangible asset subsidiaries might be created in Delaware to manage and protect Sherwin-Williams's marks, increase their value, and maximize the investment of royalty income. They also discussed Puglisi's expertise and interest in assisting the companies if Sherwin-Williams decided to create the Delaware subsidiaries.

Delaware was a jurisdiction with which Sherwin-Williams was very familiar, having previously established a number of corporate subsidiaries there. It afforded significant legal and tax advantages to corporations that confined their activities to holding, maintaining, and managing intangible assets. In particular, under Delaware law, royalties and other income earned by such corporations were exempt from State taxation. Del.Code Ann. tit. 30, § 1902(b)(8) (1997). These advantages were known and considered by McDonald and Sherwin-Williams in evaluating the trademark subsidiary plan.

On his return from Delaware, McDonald had further meetings with senior corporate officials, including Sherwin-Williams chief financial officer and its general counsel, to discuss and evaluate the benefits of transferring the company's marks into separate corporations. McDonald also assessed the legal risks attendant to the transfer of the marks to ensure that it could be done without jeopardizing their continued validity. He further directed an effort to fully identify, catalogue, and document properly the hundreds of marks that Sherwin-Williams had developed or acquired during its many years of operation, including common-law trademarks that had never been recorded with the United States Patent and Trademark Office. These efforts continued over many months, culminating in the preparation by McDonald and others of a business plan for consideration by senior management, and ultimately the Sherwin-Williams board of directors, in January, 1991.

On January 23, 1991, the Sherwin-Williams board of directors voted to form SWIMC and DIMC under Delaware law, and to transfer to them all of Sherwin-Williams's domestic marks.² The minutes of the January 23, 1991, board meeting set forth the reasons for the board vote, including:

(1) improvement of quality control oversight and increased efficiencies with regard to the marks by virtue of having profit centers separate from Sherwin-Williams;

(2) easier profit analysis of Sherwin-Williams by having profit centers for the marks that were separate from it;

(3) enhanced ability to enter into third-party licensing arrangements at advantageous royalty rates;

(4) increased over-all profitability because of the availability of Delaware's corporate income tax exemption for investment management and trademark holding companies;

(5) maximized investment returns associated with the marks due to separate and centralized investment management;

(6) enhanced borrowing capabilities; (7) subsidiaries could be used in certain instances to acquire businesses;

(8) provided ability to take advantage of the well-developed body of corporate law and expeditious legal system in Delaware;

(9) insulated the marks from Sherwin-Williams's liabilities;

(10) provided flexibility in preventing a hostile takeover; and

(11) increased liquidity.

Under the board-approved plan, all of the marks affiliated with aerosol products were assigned to DIMC, and all of the marks affiliated with nonaerosol products were assigned to SWIMC.³ These assignments were recorded in the United States Patent and Trademark Office, and SWIMC and DIMC became the owners of the marks. Sherwin-Williams also contributed $50,000 and $42,000 respectively to SWIMC and DIMC to help finance the startup of the companies. In return, Sherwin-Williams and another of its subsidiaries, Dupli-Color Products Company, received one hundred per cent of the stock of both subsidiaries, and agreements that licensed most, but not all, of the marks back to Sherwin-Williams for ten-year terms on a nonexclusive basis. Under the licensing agreements Sherwin-Williams agreed to...