In a summary disposition, the Massachusetts Appeals Court affirmed a decision of the Massachusetts Appellate Tax Board that applied the "sham transaction doctrine" to disregard the taxpayer's corporate transfers.1 The taxpayer transferred nexus-creating property and payroll to its corporate parent so that the parent's losses could be used in the post-apportionment nexus consolidated return filed by other group members in Massachusetts. The Appeals Court agreed with the Board's conclusion that the taxpayer failed to demonstrate that the transfer of the tax and insurance departments was a not a sham transaction. Also, the taxpayer did not meet its burden of showing that the transfer of the internal audit department had economic substance other than tax avoidance.
Background
Allied Domecq, PLC (Allied) was the ultimate parent company located in Bristol, England and it owned numerous subsidiaries worldwide. It had two main business lines: (i) the wine and spirits division, which included brands such as Kahlua and Beefeater Gin; and (ii) the retail division, which included Dunkin' Donuts and Baskin Robbins.
Allied was an indirect owner of Allied Domecq North America Corporation ("Parent") which was a Delaware corporation headquartered in Canada. Parent served as the parent corporation for several U.S. subsidiaries, included Allied Domecq Spirits and Wines USA, Inc. ("Subsidiary"). Subsidiary was the principal reporting corporation for the affiliated group of corporations that were operating in Massachusetts. Prior to the 1996 tax year, Parent was not included in Subsidiary's Massachusetts post-apportionment nexus consolidated return.
In 1996, members of Parent's tax department produced several internal communications advocating a plan in which Parent could obtain a taxable presence in Massachusetts so that Parent (and its large net operating loss) could be included in Subsidiary's nexus consolidated return in Massachusetts. In order to provide Parent with a taxable presence in Massachusetts, it was decided to transfer several tax, insurance and internal audit employees from Subsidiary to Parent. Under the plan, Parent would pay rent to Subsidiary for the use of office space, and Subsidiary would pay Parent an administrative service fee.
Asserting that the presence of the tax, insurance and internal audit employees in Massachusetts created nexus to subject Parent to tax, Subsidiary included Parent in its nexus consolidated returns for the 1996 through 2004 tax years and deducted a portion of Parent's substantial losses to offset Subsidiary's income. The Commissioner of Revenue determined that Parent should not be included in the Massachusetts nexus consolidated returns.2 Subsidiary appealed to the Appellate Tax Board, which disallowed the tax benefit of the transfers under the sham transaction doctrine. The Board found no indication on the record that Subsidiary "had any business concerns which were addressed by purportedly transferring its tax, insurance and internal audit departments from [Subsidiary] to [Parent], or that the tax-planning project had any economic effect beyond the creation of tax benefits." Subsidiary appealed this decision to the Massachusetts Appeals Court.
Reporting Method
Massachusetts adopted mandatory combined reporting beginning with the 2009 tax returns.3 For years prior to 2009, Massachusetts was a separate company reporting state, though the state allowed companies to elect to file a post-apportionment nexus consolidated return (termed a "combined return" in Massachusetts).4 In order to be included in the Massachusetts post-apportionment nexus consolidated return, the entity must have been included in the group's federal consolidated return and the entity must have had a taxable presence (nexus) in Massachusetts. Under this reporting method, each entity's taxable income was separately determined and apportioned to the state. The apportioned income or loss of each entity included in the consolidated return was then added together to determine the group's taxable income in the state.
Sham Transaction Doctrine
In a 2002 decision, the Massachusetts Supreme Judicial Court adopted the "sham transaction doctrine" and provided the Commissioner with authority "to disregard, for taxing purposes, transactions that have no economic substance or business purpose other than tax avoidance."5 Furthermore, in 2003, Massachusetts enacted a law effective for tax years beginning on or after January 1, 2002, which provides the Commissioner with authority to "disallow the asserted tax consequences of a transaction by asserting the sham transaction doctrine."6
Evidence Supported Disallowance of Transactions
In affirming the Appellate Tax Board's decision, the Appeals Court explained that the 1996 transfer of the tax and insurance departments to Parent "had no practical economic effect other than the creation of a tax benefit and that tax avoidance was its motivating factor and only purpose."7 According to the Court, the tax department memos demonstrated a tax purpose for the transfers, and the assurance that there would be "no impact to the management results" supported a conclusion that there would be no practical economic effect. While the impacted tax and insurance employees were purported to have been transferred from Dunkin' Donuts to Parent, the W-2 was never changed and Parent merely reimbursed Dunkin' Donuts for the payroll expense. Also, the employees' work responsibilities did not change after the transfer. Furthermore, office space leased to Parent was insufficient to accommodate all of the transferred employees, and the rent decreased each year until the lease ended in 1999. As a result, the Court agreed with the Board's conclusion that Parent failed to demonstrate that the transfer of the tax and insurance departments to Parent was not a sham transaction.
The Court also determined that Parent did not meet its burden of showing that the transfer of the internal audit department had economic substance other than tax avoidance. In contrast to the transfer of the tax and insurance departments, the Parent indicated that there were no memos to explicitly demonstrate a tax motivation behind the transfer of the internal audit department and also, unlike the tax and insurance employees, the internal audit employees received W-2 tax forms from Parent after the transfer rather than continuing to receive them from Subsidiary. However, the Court noted a tax department memorandum, dated in 1999 which backdated the effective date of the transfer of impacted audit individuals to 1998. The transfers of the employees was "retroactive and initiated by the tax department, with no indication of business purpose or economic effect." Although the internal audit department transfer had a "stronger appearance of a true transfer" to Parent than the alleged transfer of the tax and insurance employees, Parent did not meet its burden of showing that the transfer had a purpose other than tax avoidance. The Court also found that there was no evidence that the work of the internal audit department changed when the employees were transferred to Parent. Furthermore, there was no evidence that a nontax benefit resulted from or motivated the transfer.
Commentary
The Court's decision to affirm the Board's disallowance of the transactions is not surprising considering the facts of the case. As explained by the Court, the memos issued by Subsidiary's tax department and the following transactions did not support Subsidiary's argument that there were non-tax business reasons for the transfers. Of course, cases concerning corporate tax restructuring transactions are very fact-specific. This decision highlights the need for businesses considering major changes in their structure that are driven by both operational reasons and potential state tax savings to be both careful in how they document these changes and attentive to the details of the implementation process. As demonstrated by the state's enactment of an economic nexus statute and this decision, the Massachusetts Department of Revenue and likely many other states will closely examine transactions that produce substantial state tax savings. Documentary evidence should be carefully considered and maintained to demonstrate the intended operational results as well as the non-tax results actually achieved by the planning. Engagements of this type which are solely conceived and implemented by the tax department, with little operational evidence of a non-tax business purpose, will likely receive much greater scrutiny in the future.
Footnotes
1 Allied Domecq Spirits & Wines USA, Inc. v. Commissioner of Revenue, Massachusetts Appeals Court, No. 13-P-984, June 18, 2014. Note that this decision was issued pursuant to Massachusetts Appeals Court Rule 1:28. Under this rule, decisions are primarily addressed to the parties and may not fully address the facts of the case or the panel's decisional rationale. Also, these decisions are not circulated to the entire court and represent only the views of the panel that decided the case. This decision may be cited for its persuasive value but not as binding precedent. For a discussion of the Massachusetts Appellate Tax Board's decision, see GT SALT Alert: Massachusetts Appellate Tax Board Applies "Sham Transaction Doctrine."
2 As a result, the Commissioner assessed an additional $20.6 million in tax.
3 MASS. GEN. LAWS ch. 63, § 32B.
4 Former MASS. GEN. LAWS ch. 63, § 32B, repealed for tax years beginning on and after January 1, 2009.
5 The Sherwin-Williams Co. v. Commissioner of Revenue, 778 N.E.2d 504 (Mass. 2002).
6 MASS. GEN. LAWS ch. 62C, § 3A.
7 Quoting Sherwin-Williams, 778 N.E.2d 504.
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