Can a restaurant company deduct, for Tennessee franchise and excise tax purposes, the royalty payments it makes to its own wholly-owned trademark-holding subsidiary?

Subject

Whether a restaurant franchisor may deduct royalty payments made to its affiliated trademark-holding subsidiary.

Plain-English summary

The Tennessee Department of Revenue ruled that a restaurant company can deduct, for franchise and excise tax purposes, the royalty payments it makes to its own Delaware trademark-holding subsidiary for the use of its brand marks -- as long as loans between the two stay current.

Tennessee law (Tenn. Code Ann. § 67-4-2006(d)) generally requires taxpayers to disclose "intangible expenses" (like royalty payments) made to affiliates, and the Department can add such expenses back to taxable income if the transaction lacks substance. To evaluate that, the Department applied the framework from two out-of-state cases it found persuasive: Syms Corp. v. Commissioner (Massachusetts), where the court disallowed a nearly identical royalty deduction because the trademark subsidiary was a bare-bones shell with one part-time employee and royalties flowed back to the parent as dividends within weeks; and Sherwin-Williams Co. v. Commissioner (Massachusetts), where the court allowed the deduction because the subsidiaries were real operating businesses with independent staff, their own investment decisions, and arm's-length licensing to third parties too.

Applying an eight-factor test drawn from these cases (nature of the IP, how it was transferred, formal legal agreements, how value/royalty rates were set, whether cash actually changed hands, whether the subsidiary has real property/payroll in its home state, corporate formalities, and non-tax economic effects), the Department found the Taxpayer's subsidiary looked like Sherwin-Williams, not Syms: it has its own Delaware office and bank accounts, three dedicated administrative employees, quarterly board meetings, an arm's-length 4% royalty rate independently benchmarked against third-party franchise agreements (an internal "Comparable Uncontrolled Transaction" under IRC § 482 transfer-pricing rules), and it makes its own investment and lending decisions rather than automatically funneling cash back to the parent. The one condition the Department attached: any loans the subsidiary makes to the parent and its affiliates must be repaid by the agreed due date, or the deduction is off the table -- because unpaid loans would look like the very "circular flow of royalties" that doomed the deduction in Syms.

What this means for you

Companies using an affiliated IP or trademark holding company

A related-party royalty deduction survives scrutiny if your holding subsidiary is a genuine operating business -- its own office, its own staff, its own investment decisions, arm's-length royalty rates backed by real appraisal or comparable-transaction data, and observed corporate formalities. It fails if the subsidiary is a shell that just passes royalty cash straight back to you. Also watch cross-affiliate loans: unpaid loans back to the parent can retroactively undermine an otherwise-solid royalty deduction.

Accountants and tax professionals

This is the clearest application in the TN corpus of the Syms/Sherwin-Williams eight-factor related-party intangible-expense test, and pairs with Tenn. Code Ann. § 67-4-2006(d)'s mandatory disclosure schedule for such transactions (attach the letter ruling, disclose on the return, affirm facts haven't materially changed). Also see the same-day Letter Ruling 06-34, which applies overlapping royalty-recharacterization case law to a much smaller family-owned licensing LLC's exemption eligibility.

Common questions

Q: Are royalty payments to an affiliated IP-holding company automatically deductible?
A: No. Tennessee requires disclosure of such "intangible expense" transactions and can disallow the deduction if the holding company is a sham with no real economic substance.

Q: What makes a trademark-holding subsidiary a genuine operating entity rather than a sham?
A: Its own office and bank accounts in its state of domicile, dedicated employees performing real functions, independent investment/lending decisions, arm's-length royalty rates backed by objective valuation methods, and consistently observed corporate formalities.

Q: Does paying dividends back to the parent automatically make the arrangement a sham?
A: No, as long as dividends aren't a systematic mechanism for returning the very royalty payments the subsidiary just received -- occasional, discretionary dividends from a genuinely operating subsidiary are fine.

Q: What happens if a loan from the holding subsidiary to the parent isn't repaid on time?
A: The Department conditioned this ruling on timely repayment -- if the loans aren't repaid by the specified due date, the royalty deduction is no longer permitted.

Q: Does this ruling bind the Department for other companies with similar holding-company structures?
A: No. A Tennessee letter ruling binds the Department only as to the taxpayer addressed and cannot be relied on by any other taxpayer, though the eight-factor analysis is broadly instructive.

Citations and references

Statutes:

• Tenn. Code Ann. § 67-4-2006(d) (intangible expense disclosure requirement for related-party transactions)
• Tenn. Code Ann. § 67-4-2006(b)(1)(L) (add-back of otherwise-deductible intangible expense paid to an affiliate)
• Tenn. Code Ann. § 67-4-2004(1) (definition of "affiliate": >50% common ownership)
• Tenn. Code Ann. § 67-4-2004(18)-(20) (definitions of "intangible expense," "intangible income," "intangible property")
• Tenn. Code Ann. § 67-1-804(b)(2) (negligence penalty for failure to disclose)

Cases:

• Syms Corp. v. Commissioner of Revenue, 765 N.E.2d 758 (Mass. 2002) (royalty deduction disallowed -- shell subsidiary, circular cash flow)
• Sherwin-Williams Co. v. Commissioner of Revenue, 778 N.E.2d 504 (Mass. 2002) (royalty deduction allowed -- genuine operating subsidiaries)
• Moline Props., Inc. v. Commissioner, 63 S.Ct. 1132 (1943) (tax motivation doesn't invalidate a transaction with real economic substance)
• Frank Lyon Co. v. United States, 98 S.Ct. 1291 (1978) (reorganization respected if "real" or "genuine," not just form)

Source

• Landing page: https://www.tn.gov/revenue/tax-resources/legal-resources/tax-rulings.html
• Original PDF: https://www.tn.gov/content/dam/tn/revenue/documents/rulings/fae/06-35fe.pdf

Original ruling text

TENNESSEE DEPARTMENT OF REVENUE
LETTER RULING # 06-35
WARNING
Letter rulings are binding on the Department only with respect to the individual
taxpayer being addressed in the ruling. This presentation of the ruling in a
redacted form is informational only. Rulings are made in response to particular
facts presented and are not intended necessarily as statements of Department
policy.

SUBJECT
For purposes of computing net earnings for Tennessee excise tax purposes, whether
[NUMBER 2] may deduct the payments that it makes to [NUMBER 3] as expenses for
the licensing of intangibles.
SCOPE
This letter ruling is an interpretation and application of the tax law as it relates to a
specific set of existing facts furnished to the Department by the Taxpayer. The rulings
herein are binding upon the Department, and are applicable only to the individual
Taxpayer being addressed.
This letter ruling may be revoked or modified by the Commissioner at any time. Such
revocation or modification shall be effective retroactively unless the following conditions
are met, in which case the revocation shall be prospective only:
(A) The Taxpayer must not have misstated or omitted
material facts involved in the transaction;
(B) Facts that develop later must not be materially different
from the facts upon which the ruling was based;
(C) The applicable law must not have been changed or
amended;
(D) The ruling must have been issued originally with respect
to a prospective or proposed transaction; and
(E) The Taxpayer directly involved must have acted in good
faith in relying upon the ruling and a retroactive revocation of
the ruling must inure to his detriment.
FACTS
ALL FACTS ARE REDACTED

QUESTION PRESENTED
For purposes of computing net earnings for Tennessee excise tax purposes, will
[NUMBER 2] be permitted to deduct the payments that it makes to [NUMBER 3] as
expenses for the licensing of intangibles?
RULING
Yes, provided that all loans by [NUMBER 3] to [NUMBER 1] and affiliates are paid by
the specified due date of [LOAN DUE DATE].
ANALYSIS
APPLICABLE TENNESSEE LAW
Effective for tax periods beginning on or after January 1, 2004, Tenn. Code Ann. § 67-42006(d) makes the following provisions:
(d) (1) Any taxpayer that pays, accrues or incurs intangible expenses as a result
of a transaction with one (1) or more affiliated business entities must
disclose such intangible expenses on the face of the franchise and excise
tax return filed in accordance with § 67-4-2015 and complete the
appropriate schedule as required by the commissioner.
(2) Any taxpayer that deducts intangible expenses arising from a transaction
with one (1) or more affiliated business entities in determining Tennessee
net earnings that fails to disclose such intangible expenses will be subject
to a negligence penalty as set forth in § 67-1-804(b)(2).
(3) If a taxpayer does not meet the disclosure requirements set forth in
subdivision (d)(1), the commissioner shall make the adjustments set forth
in subdivision (b)(1)(L). As such, the taxpayer will have the remedies set
forth in chapter 1, part 18 of this title.
Tenn. Code Ann. § 67-4-2006(b)(1)(L) referenced in Tenn. Code Ann. § 67-4-2006(d)(3)
set forth above provides for an addition to a taxpayer’s net earnings or losses as
follows:
(L) Any otherwise deductible intangible expense paid, accrued or incurred in
connection with a transaction with one or more affiliates[.]
As used in the above cited statutes, Tenn. Code Ann. § 67-4-2004(1) defines an
“affiliate” to mean a business entity:
(i) In which the taxpayer, directly or indirectly, has more than fifty percent (50%)
ownership interest;

2

(ii) That, directly or indirectly, has more than fifty percent (50%) ownership
interest in the taxpayer; or
(iii) In which a person described in subdivision (1)(B) directly or indirectly has
more than fifty percent (50%) ownership interest.
The terms “intangible expense,” “intangible income” and “intangible property” are
defined by Tenn. Code Ann. § 67-4-2004(18), (19) and (20) as follows:
(18) “Intangible expense” means an expense related to, or in connection with, the
acquisition, use, maintenance or management, ownership, sale, exchange,
license, or any other disposition of intangible property to the extent such
amounts are allowed or allowable as deductions or costs in determining
federal taxable income[.]
(19) “Intangible income” means income related to, or in connection with, the
acquisition, use, maintenance or management, ownership, sale, exchange,
license, or any other disposition of intangible property to the extent such
amounts are included or includable in determining federal taxable income[.]
(20) “Intangible property” means patents, patent applications, trade names,
trademarks, service marks, franchise rights, copyrights, licenses, research,
formulas, designs, patterns, processes, formats, and similar types of
intangible assets.
Tenn. Code Ann. § 67-1-804(b)(2) makes the following penalty provisions for failure to
disclose a transaction as required by law:
(2) When any person fails to disclose any transaction in the manner prescribed
by this title and fails to report and pay the total amount of taxes due, if such
failure is determined by the commissioner to be due to negligence, there shall
be imposed a penalty in the amount of fifty percent (50%) of the
underpayment.
APPLICABLE CASE LAW
Although Tennessee courts have not had opportunity to consider facts and issues
similar to those presented in this Letter Ruling request, there is case law in other states
that is helpful in resolving this matter. The two cases that stand out as being most
applicable to the issues presented here are Syms Corp. v. Commissioner of Revenue,
765 N.E.2d 758 (Mass. 2002) and Sherwin-Williams Company v. Commissioner of
Revenue, 778 N.E.2d 504 (Mass. 2002).
An analysis of the facts and issues considered by the court in both these cases is of
value in establishing a set of criteria by which to evaluate the facts presented in this
Letter Ruling request. Accordingly, the following is a brief examination of the issues
considered and the results reached by the court in each of these cases.
3

Syms Corp. v. Commissioner of Revenue
In Syms, the court upheld the Commissioner of Revenue’s disallowance of
deductions of royalty payments made by the taxpayer to its wholly owned
subsidiary, SYL, for the use of trade names, trademarks and service marks (the
“marks”) that Syms had transferred to SYL. The Commissioner disallowed the
deductions on the following grounds:

1. The transfer and leaseback of the marks was a sham transaction.
2. There was no valid business purpose justifying the royalty payments
   and SYL added little or no value to the marks.
3. The royalty payments were in excess of the fair value of the marks.
   Syms was a corporation engaged in the retail sale of brand name clothing at
   prices lower than those in department stores and used a number of marks in
   conducting its business.
   A consultant proposed the idea of setting up a trademark holding subsidiary to
   Syms as a way to reduce state income tax. Under the plan, Syms would transfer
   its marks to SYL, a wholly owned Delaware corporation. Syms would continue to
   use the marks as it had before the transfer and, pursuant to a License Agreement,
   would pay SYL a large royalty. This would generate a large state income tax
   expense deduction for Syms. SYL would not have to pay state income tax on the
   royalty income because such income is exempt under Delaware law. Federal
   income tax would not be affected by this plan because Syms and SYL would file a
   consolidated federal return in which inter-company transactions are eliminated.
   In reaching its decision to uphold the Commissioner’s disallowance of Syms’
   expense deductions for royalty payments, the court noted the following points:
4. SYL’s board of directors consisted of the president of Syms, Syms’
   Chief Financial Officer, and a partner in the accounting firm used by
   both Syms and SYL.
5. SYL’s office consisted of an address rented from the accounting firm
   used by both Syms and SYL. The accounting firm provided an address
   renting service for approximately 200 other corporations who used
   Delaware subsidiary corporations to hold their intangible assets.
6. SYL’s only employee was the partner in the accounting firm which
   rented an address to SYL and was used by both Syms and SYL. This
   employee was also a board member of SYL. He was employed part
   time by SYL and paid $1,200 per year.
7. Royalties amounting to 4% of Syms annual sales were paid to SYL. The
   royalties paid increased from approximately $2.8 million in 1986 to
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approximately $12.7 million in 1991. These royalties were paid once
each year and were held by SYL for a few weeks and then paid back to
Syms as a dividend with interest, less expenses amounting to
approximately 1/10th of 1% of the income.

5. Business operations of Syms did not change after the transfer and
   license-back of the marks. All work necessary to maintain goodwill and
   protect the value of the marks continued to be done by the same New
   York law firm that had previously done the work and Syms continued to
   pay all expenses thereto. All advertising using the marks was
   controlled and paid for by Syms or a wholly owned subsidiary formed by
   Syms for that purpose. The choice of products sold under the marks
   and quality control of such products remained the responsibility of the
   same persons, namely the president of Syms and Syms’ staff of buyers.
6. The court found the following relevant with regard to the case law cited:
   •

Usually, transactions that are invalidated by the sham transaction
doctrine are those motivated by nothing other than the taxpayer’s
desire to secure the attached tax benefit, and are structured to
completely avoid economic risk. See Horn v. Commissioner of
Internal Revenue, 968 F.2d 1229 at 1236 (D.C.Cir. 1992).

•

If a transaction has no economic substance and no business
purpose other than tax avoidance, it may be invalidated for tax
purposes. See ACM Partnership v. Commissioner of Internal
Revenue, 157 F.3d 231 at 247 (3rd Cir. 1998).

•

A tax avoidance motive is, of course, not necessarily fatal. A
corporation created, or a transaction engaged in for the purpose of
reducing taxes may not be disregarded so long as it has some
economic substance or valid business purpose. See Moline
Props., Inc. v. Commissioner of Internal Revenue, 63 S.Ct. 112, at
87 (1943).

•

A taxpayer must show both that a transaction was supported by a
business purpose other than tax avoidance and that it had
economic substance other than creation of a tax benefit. See
Casebeer v. Commissioner of Internal Revenue, 909 F.2d 1360 at
1365 (9th Cir. 1990).

•

Deductions are not permitted if the expense was created solely for
the purpose of effectuating a camouflaged assignment of income.
See United States v. Estate Preservation Servs., 202 F.3d 1093,
1101 (9th Cir. 2000).

5

The court found that Syms’ transfer and license back transaction had no practical
economic effect other than the creation of tax benefits and that tax avoidance was
the clear motivating factor and its only business purpose.
Among the business purposes proffered by Syms and rejected by the court were the
following:

1. The assertion that the transfer would protect the marks from claims of
   Syms’ creditors was rejected because creditors could reach the assets of
   SYL, Syms’ wholly owned subsidiary.
2. The claim that the transfer would protect the marks from a hostile takeover
   was rejected because Syms could only have achieved that goal by
   transferring the marks to an independent third party, and with 80% of the
   stock controlled by the company founder, such a takeover was only
   hypothetical.
3. The assertion that the transfer would enhance Syms’ ability to borrow
   money was rejected because creditors would have viewed the two entities
   as intermingled and would not have offered different financing
   arrangements because of the transfer. Besides, Syms never borrowed
   any money.
   The Commissioner’s position that the royalty payments were not ordinary and
   necessary business expenses was upheld and it was noted that:
4. The value of the marks was created entirely by Syms and SYL added little
   or no value to the marks.
5. Even after the transfer, Syms continued to pay the expenses associated
   with owning them, thus the royalty payments were unnecessary and, in
   effect, Syms was paying twice for use of the marks.
6. The royalty payments were not for services provided by SYL, but rather
   were part of a contrived mechanism by which income was shifted, tax free,
   between Syms and SYL for the benefit of Syms. Thus, it was irrelevant
   that the measure of the royalty payments might have been equivalent to
   what would have been paid in an arms-length transaction.
7. The fact that payment of royalties was the result of a contractual obligation
   does not, standing alone, render the royalties paid an ordinary business
   expense. See Interstate Transit Lines v. Commissioner of Internal
   Revenue, 130 F.2d 136 at 139 (8th Cir. 1942).
   Sherwin-Williams Company v. Commissioner of Revenue
   In Sherwin-Williams, the court refused to uphold the Commissioner of Revenue’s
   disallowance of deductions of royalty payments made by the taxpayer to two
   6

wholly owned subsidiaries, Sherwin-Williams Investment Management Company,
Inc. (“SWIMC”) and Dupli-Color Investment Management Company, Inc.
(“DIMC”), (collectively, the “Subsidiaries”), for the use of trade names, trademarks
and service marks (the “marks”) that Sherwin-Williams had transferred to the
Subsidiaries. The court also allowed the deduction of interest payments on a loan
from SWIMC. The court held that:

1. Sherwin-Williams’ transfer of its marks to its Subsidiaries and
   subsequent royalty payments to those Subsidiaries were not sham
   transactions for taxation purposes.
2. Sherwin-Williams’ royalty payments to its Subsidiaries were ordinary
   and necessary business expenses.
3. The royalty payments made by Sherwin-Williams to its Subsidiaries
   were reasonable.
4. The Commissioner could eliminate payments made by a parent to a
   subsidiary only to the extent such payments exceeded fair market value
   of the marks licensed.
5. The royalty payments made by Sherwin-Williams to its Subsidiaries
   were not in excess of the fair market value of the marks licensed from
   such Subsidiaries.
6. Interest payments made by Sherwin-Williams on a loan from SWIMC
   were necessary.
   Sherwin-Williams manufactured, distributed and sold paints and related products
   under many brand names and, in the process, used hundreds of marks. For a
   number of years, Sherwin-Williams’ senior management had expressed concerns
   about maintenance and effective management of its marks. These concerns
   resulted from the fact that one of its marks had been lost and decentralized
   management and use of many marks across divisions created uncertain authority
   and diffuse decision-making regarding the maintenance and exploitation of the
   marks. This contributed to ineffective and inadequate management of the marks
   as a company asset.
   One of Sherwin-Williams’ attorneys suggested the idea of forming two
   subsidiaries to hold and manage its marks and to invest and manage royalty
   proceeds earned therefrom. As a representative of Sherwin-Williams evaluating
   the potential benefits and risks of such a plan, the attorney traveled to Delaware
   and met with lawyers, bankers and investment managers. One of the persons
   consulted was a professor from the University of Delaware and owner of an
   investment management firm.
   This professor is an expert in business
   management, portfolio management, and corporate finance and serves as a
   board member of many investment companies.
   7

Of particular concern in this evaluation process was how intangible asset
subsidiaries might be created in Delaware to manage and protect SherwinWilliams’ marks, increase their value, and maximize the investment of royalty
income. Discussions also took place regarding the fact that, under Delaware law,
royalties and other income earned by subsidiaries formed to hold, manage and
license intangibles were exempt form taxation in Delaware.
A business plan was developed for consideration by Sherwin-Williams’ senior
management and, ultimately by its board of directors. Sherwin-Williams’ board
voted to form SWIMC and DIMC under Delaware law and to transfer to them all
domestic, but not international, marks. The board set forth the following reasons
for such a vote:

1. Improvement of quality control oversight and increased efficiencies with
   regard to the marks by having profit centers separate from SherwinWilliams.
2. Easier profit analysis of Sherwin-Williams by having profit centers for
   the marks that were separate.
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. The Subsidiaries could be used, in certain instances, to acquire
   businesses.
8. Ability to take advantage of the expeditious legal system in Delaware
   would be provided.
9. The marks would be insulated from Sherwin-Williams’ liabilities.
10. Flexibility in preventing a hostile takeover would be provided.
11. Increased liquidity would be provided.
    Most, but not all, of the marks were licensed back to Sherwin-Williams for 10 year
    terms on a nonexclusive basis. Royalty payments were to be made quarterly
    based on a percentage of the sale of the products bearing those marks. The
    8

value of the marks transferred and fair market value royalty rates were to be
determined by an independent appraisal company.
In its decision refusing to uphold the Commissioner of Revenue’s disallowance of
deductions of royalty payments, the court noted the following points:

1. Original board members of each Subsidiary were the comptroller of
   Sherwin-Williams, who also served as chairman, the vice-president and
   treasurer of Sherwin-Williams, and the University of Delaware professor
   and consultant, who was not affiliated with Sherwin-Williams, and who
   also served as president and treasurer of both Subsidiaries. A partner
   in the law firm engaged as corporate counsel for both Subsidiaries was
   elected secretary of both Subsidiaries and later was elected to both
   boards.
2. The board chairman of both Subsidiaries, who also served as president
   and treasurer of both Subsidiaries, was paid $18,000 annually. The
   secretary and board member of both Subsidiaries was paid $500
   annually.
3. The Subsidiaries leased office space and space for record storage from
   the Bank of Delaware, where each opened their own bank accounts.
4. Each Subsidiary arranged for the Bank of Delaware to take physical
   custody of its marks.
5. The board chairman, president and treasurer of both Subsidiaries
   worked out of his own office but charged rent to each Subsidiary for the
   use of his office.
6. Each Subsidiary hired and paid independent corporate legal counsel
   and an independent auditing firm to perform audits as well as
   occasional quality control testing. They also hired and paid their own
   lawyers to represent them in multiple trademark proceedings.
7. The Articles of Organization of each Subsidiary limited its activities to
   maintenance and management of its intangible investments and placed
   restrictions and prohibitions, which were reiterated in company by-laws,
   on transactions in which it could engage.
8. Sherwin-Williams engaged an independent appraisal company to
   appraise the value of the marks being transferred to the Subsidiaries in
   exchange for their stock and to help establish arms-length royalty rate
   for the license back of the marks.
9. SWIMC and DIMC operated as ongoing businesses and entered into
   Nonexclusive Licensing Agreements with Sherwin-Williams and other
   unrelated licensees.
   9

10. The Subsidiaries set their own investment policies and invested their
royalty income to earn a greater return than that earned by its parent on
comparable funds.

11. The Subsidiaries paid Sherwin-Williams contracted market rates
    charged on periodic invoices for services received and observed all
    corporate formalities meticulously.
12. Concerns about maintenance and management of Sherwin-Williams’
    marks were effectively addressed by the creation of SWIMC and DIMC,
    the transfer/lease-back of the marks, and the described subsequent
    operations of the Subsidiaries.
    The Commissioner offered expert testimony that the many nontax business
    reasons advanced by Sherwin-Williams were illusory, unrealistic, contradictory,
    not achievable, or could have been better achieved by internal business
    adjustments. However, in the opinion of the court, none of the Commissioner’s
    experts contended that the subsidiaries were not ongoing, profit-making
    businesses, engaged in business activities apart from the licensing of their marks
    to Sherwin-Williams. The Commissioner’s experts were also unable to show that
    the royalty rates paid by Sherwin-Williams were outside the range of royalties that
    would be paid by parties acting at arms-length.
    In Syms, the court found that the transaction was specifically designed as a tax
    avoidance scheme. Royalties were paid once a year and quickly returned to the
    parent and the subsidiary did not do business other than to act as a conduit for
    the circular flow of royalties. The parent continued to pay all expenses of
    maintaining and defending the trademarks.
    However, in Sherwin-Williams, the court found the facts to be substantially
    different in that there was no evidence that the transfer and lease-back of the
    marks was specifically devised as a tax avoidance scheme, although tax benefits
    were involved. Revenue, including royalties, earned by the Subsidiaries was
    retained and invested as a part of their ongoing operations. License Agreements
    were entered into not only with Sherwin-Williams, but also with unrelated parties.
    The Subsidiaries assumed and paid the expenses of maintaining and defending
    their trademark assets.
    Citing Helvering v. Gregory, 69 F.2d 809 (2nd Cir. 1934) and Frank Lyon Co. v.
    United States, 98 S.Ct 1291 (1978), the court pointed out that a business
    reorganization that results in tax advantages must be respected for tax purposes
    if the taxpayer demonstrates that the reorganization is “real” or “genuine,” and not
    just form without substance.
    The taxpayer must demonstrate that the
    reorganization results in a “viable business entity,” that is “formed for a substantial
    business purpose or actually engage[s] in a substantive business activity.”
    Northern ind. Pub. Serv. Co. v. Commissioner of Internal Revenue, 115 F.3d 506,
    10

at 511 (7th Cir. 1997), quoting Bass v. Commissioner of Internal Revenue, WL
1442 (1968).
Citing a number of cases, the court stated that it agreed with courts that have
concluded that whether a transaction that results in tax benefits is real, such that it
ought to be respected for tax purposes, depends on whether it has had practical
economic effects beyond the creation of those tax benefits. The court concluded
that the Sherwin-Williams reorganization, including the transfer and licensing back
of the marks, had economic substance because it resulted in the creation of
viable business entities engaging in substantive business activities.
Although Sherwin-Williams incurred advertising expenses, such expenses were
incurred to sell its products rather than to strengthen the marks, although the
marks undoubtedly benefited from the advertising. Thus, Sherwin-Williams
properly expensed its advertising costs against its sales. Citing Moline Props. v.
Commissioner of Internal Revenue, 63 S.Ct. 1132 (1943), the court further
concluded that tax motivation is irrelevant where a business reorganization results
in the creation of a viable business entity engaged in substantive business
activity rather than a “bald and mischievous fiction.”
Sherwin-Williams’ payment of royalties was found to be an ordinary and
necessary business expense because Sherwin-Williams had irrevocably divested
itself of all title to the marks and had the right to enjoy the property thereafter only
upon payment of reasonable rental. Stearns Magnetic Mfg. Co. v. Commissioner
of Internal Revenue, 208 F.2d 849, at 853 (7th Cir. 1954). Such payments were
reasonable and at arms-length in that they followed rates recommended by
independent professional appraisers.
Because the court concluded that the transfer and license back of the marks was
not a sham and the royalty payments were necessary and ordinary expenses of
Sherwin-Williams, and because there was no dispute that SWIMC did make a
short term $7 million loan to Sherwin-Williams at fair market value, the court held
that the interest paid by Sherwin-Williams to SWIMC was properly deductible as a
business expense.
EXAMINATION OF THE FACTS PRESENTED
In analyzing the points considered by the court in Syms and Sherwin-Williams, the
following key factors seem to be of upmost importance in determining whether a
taxpayer may deduct the payments that it makes for the licensing of intangibles as
expenses in determining its net earnings:

1. The nature of the intangible property and how it is used.
2. The method by which the taxpayer transferred its patents, trademarks,
   franchise rights, or other intangibles to its subsidiary.

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3. The existence of formal legal agreements between the parties that govern
both the transfer and the use of the intangibles.

4. The method by which the value of the intangibles transferred was established.
5. Whether actual cash was exchanged in the relevant transactions.
6. Whether the company holding the intangibles has property and payroll in its
   state of domicile.
7. Whether corporate forms were established with regard to relevant
   transactions and whether the corporate requirements and formalities are
   being met.
8. Whether there are practical economic effects resulting from the transaction
   aside from tax planning.
   It should be kept in mind that, in each situation, the Department will consider all related
   and relevant factors. In some cases, it may be necessary to consider related and
   relevant factors in addition to those listed above. No single factor will necessarily lead
   to a conclusion that is favorable or unfavorable to a taxpayer.
   In applying each of the factors listed above to the facts presented, we reach the
   following conclusions:
9. The nature of the intangible property and how it is used.
   The intangible property held by [NUMBER 3] is described as [NUMBER 1®]
   trademarks, service marks, logos and other such intangibles used by
   [NUMBER 1] concept restaurants. These Marks are extremely valuable to
   [NUMBER 2] and its subsidiaries and affiliates in the conduct of their business
   operations.
   The intangible assets described and their use by licensees is typical of those
   to which Tenn. Code Ann. § 67-4-2006(d) applies.
10. The method by which the taxpayer transferred its patents, trademarks,
    franchise rights, or other intangibles to its subsidiary.
    In [DATE], in exchange for an ownership interest in a no longer existing
    subsidiary, the Marks were contributed to the subsidiary as a capital
    contribution. On [DATE], [NUMBER 2] formed [NUMBER 3] as a wholly
    owned subsidiary under Delaware law. [NUMBER 3] came to own the Marks
    when they were contributed to it by a corporate predecessor, [NUMBER 4],
    on [DATE] pursuant to a General Assignment Agreement. Following the
    assignment, [NUMBER 4] was liquidated into [NUMBER 2] effective [DATE].

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The facts presented state that [NUMBER 3] retains legal title to the Marks and
is responsible for managing and safeguarding them. New intangible property,
trademarks and service marks are contributed to [NUMBER 3] as they are
developed, typically by a legal Contribution Agreement.
Of essential importance is the fact that legal title and possession of the Marks
is not retained by [NUMBER 1] or any of [NUMBER 3’s] licensees.

3. The existence of formal legal agreements between the parties that govern
   both the transfer and the use of the intangibles.
   As explained in #2 above, the Marks were contributed by [NUMBER 1] to
   [NUMBER 4] in exchange for an interest in such entity. [NUMBER 4] is the
   predecessor to [NUMBER 3], the current owner of the Marks. A General
   Assignment Agreement evidenced the contribution of the Marks to [NUMBER
   3] by [NUMBER 4].
   An Exclusive Licensing, Concept Development and Advertising Services
   Agreement was then entered into whereby [NUMBER 2] was granted the right
   to use the Marks in its company owned restaurants and to sublicense the
   Marks to its franchisees.
   [NUMBER 3] retains legal title and interest in the Marks at all times. New
   trademarks and service marks are contributed to [NUMBER 3] as they are
   developed and this is typically documented by a legal Contribution
   Agreement. Under this Agreement, [NUMBER 2] agreed to pay a 4% royalty
   fee for use of the Marks. This royalty is based on [NUMBER 2’s] company
   owned [BUSINESS] sales.
   [NUMBER 1] franchises its restaurants through a “franchise partnership
   program” documented by Franchise Partnership Agreements. Development
   Agreements require a franchisee to develop restaurants within a specified
   territory and grant the exclusive right to do so. As a part of the Franchise
   Agreement, the franchisee agrees to pay a royalty fee equal to 4% of the
   restaurant’s monthly gross sales, as defined in the Agreement.
   [NUMBER 3] also has Employment Agreements with three individuals. When
   necessary, [NUMBER 3] enters into Services Agreements and Sublease
   Agreements.
   Lines of credit and promissory notes resulting from loans made by [NUMBER
   3] to other entities in its affiliated group are documented by legal Agreements
   between the companies.
   The legal Agreements and other documentation described are typical in
   transactions of this nature and are sufficient to legally establish the
   transactions between the parties.
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4. The method by which the value of the intangibles transferred was established.
The facts presented state that a royalty fee of 4% of restaurant sales was
initially established as a part of Franchise Agreements with third parties.
Because the 4.0% royalty fee had been established as part of the Franchise
Agreements with third parties, the same rate was applied to the transactions
with the company-owned [BUSINESSES].
U.S. Treasury Regulations promulgated under IRC § 482 outline transfer
pricing methods for determining an arm’s length price for intercompany
transactions. For transfers or use of intangible property such as [NUMBER]
1’s license of the Marks, several methods are specified, including the
Comparable Uncontrolled Transaction Method (“CUT Method”) under §
1.482-4(c). The CUT Method establishes an arm’s length royalty rate by
reference to an uncontrolled transaction that is substantially similar to the
controlled transaction that one is trying to benchmark.
The CUT method may be applied using either external comparable
transactions or internal comparable transactions (external CUTs or internal
CUTs). When internal CUTs are not available, practitioners perform industry
research to identify arm’s length royalty rates for transfers of similar
intangibles under similar circumstances in the target industry of the taxpayer.
This research is formalized into a transfer pricing study.
In the case of [NUMBER 1’s] intercompany intangible’s license, the same
intangibles are licensed to third party licensees under similar circumstances
for an ongoing royalty of 4% of revenues. Thus, the transaction has an exact
internal CUT to establish the arm’s length price for [NUMBER 1] Marks. For
this reason, no formal transfer pricing analysis was necessary when the
Marks were contributed from [NUMBER 2] to its subsidiaries and the
intercompany royalty arrangement was established.
The methods described in the facts presented and used to determine the
value of the intangibles and the applicable royalty rate is appropriate.

5. Whether actual cash was exchanged in the relevant transactions.
   The method by which [NUMBER 3] came to own the Marks is described in
   item #2 above and involved a series of transactions. A General Assignment
   Agreement supported the transfer of the Marks to [NUMBER 3] by its
   predecessor, [NUMBER 4]. Because of the nature of this transaction, it was
   not necessary that actual cash be exchanged.
   The Exclusive Licensing, Concept Development and Advertising Services
   Agreement allows [NUMBER 2] to use the Marks in its company owned
   [BUSINESSES] and to sublicense the use of the Marks to its franchisees.
   Under this Agreement, [NUMBER 2’s] company owned restaurants pay
   14

[NUMBER 3] a royalty fee of 4% on the 10th of each month based on based
on the prior month’s sales. [NUMBER 3] charges interest on underpayments.
As a part of the Franchise Agreement, a franchisee agrees to pay royalty fee
equal to 4% of the [BUSINESS’] monthly gross sales, as defined in the
Agreement. This royalty fee compensates [NUMBER 2], the sub licensor, for
the use of the Marks. The royalty fee is due the 10th day of each month and
is based on gross sales for the preceding month and is required to be paid by
electronic transfer.
[NUMBER 3] leases its office space from [LESSOR]. [NUMBER 3] has
Employment Agreements with its three Administrative managers. Wage
policies for these managers are set forth in [NUMBER 3’s] employee manual.
[NUMBER 3] evaluates its overall cash position from all operations including
income from intangibles, restaurant operations and support services and
determines the amount, if any, that will be paid as a dividend to its
shareholder.
Currently, [NUMBER 3’s] excess funds are utilized in
investment activities. However, in the past, dividends have been paid on a
periodic basis. The last dividend payment was made in [YEAR].
The fact that [NUMBER 3] pays dividends to its shareholder is not necessarily
fatal to the issuance of a favorable Letter Ruling as long as the practice is not
used as a systematic means for [NUMBER 3] to transfer funds received for
the licensing of its Marks back to the entity that paid them. The facts
presented show that this is not being done by [NUMBER 3].
The facts presented state that [NUMBER 3] makes loans of excess working
capital to other entities in its affiliated group. Interest rates for these loans are
established by contract at the published LIBOR rate plus 1%. Under the
terms of the loan agreements, borrowers on lines of credit are not required to
make regular cash payments of principal and interest. Interest does accrue
on the unpaid loan balances and the loans are to be paid in no later than
[LOAN DUE DATE].
[NUMBER 3] cannot accept substantial payments for the direct or indirect
licensing of its Marks from [NUMBER 1] and its affiliates and then transfer
funds back to such entities through loans that are not repaid to [NUMBER 3]
by the specified due dates. If this Department were to find that the loans at
issue are not repaid by the specified due date of [LOAN DUE DATE], then
[NUMBER 2] will not be permitted to deduct the payments made to [NUMBER
3] as expenses for licensing the Marks.
There are no exclusivity requirements for [NUMBER 3]’s officers, board
members and employees. Officers, board members and employees of
[NUMBER 3] may be compensated by entities other than [NUMBER 3]. The
fact that officers, board members and employees of [NUMBER 3] may be
compensated by entities other than [NUMBER 3] is not necessarily fatal to the
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issuance of a favorable Letter Ruling. However, it is essential that [NUMBER
3’s] operations be kept separate and completely independent from those of
[NUMBER 1] and its affiliates and that [NUMBER 3’s] officers, board
members and employees are free from influence or interference by [NUMBER
1] and its affiliates when they conduct business on behalf of [NUMBER 3].
From the facts presented, there is no reason to believe that this is not the
case.
[NUMBER 3] is responsible for all expenses that it incurs. Any expenses
incurred on behalf by its affiliates are fully and timely reimbursed.
Assuming that all loans by [NUMBER 3] to [NUMBER 1] and affiliates are
paid by the specified due date of [LOAN DUE DATE], the facts presented
reflect that consideration supporting the legal validity of the licensing of the
Marks, the making of loans, and other transactions did pass between
[NUMBER 3] and the parties involved.

6. Whether the company holding the intangibles has property and payroll in its
   state of domicile.
   [NUMBER 3] is headquartered at [ADDRESS]. It leases this office space from
   [LESSOR] pursuant to a renewable annual lease. The office space is used
   exclusively by [NUMBER 3]. [NUMBER 3] has its own checking account and
   a depository account with [BANK], Delaware.
   [NUMBER 3] has Employment Agreements with its three Administrative
   Managers ([EMPLOYEE 1], [EMPLOYEE 2], and [EMPLOYEE 3]) that are
   dedicated to the day-to-day operations of [NUMBER 3]. Each of these
   employees resides in the Wilmington area. Their duties involve managing the
   day-to-day operations of [NUMBER 3]. All of [NUMBER 3’s] Board of
   Directors meetings are held quarterly in Wilmington, Delaware. [NUMBER 3]
   employees do not provide services to any [NUMBER 1] affiliates. The
   employees in the Wilmington, Delaware office are typically not required to
   work full time to fulfill their job requirements.
   The facts presented establish that [NUMBER 3] leases property and has a
   legitimate operating place of business with paid employees at its domicile in
   Wilmington, Delaware.
7. Whether corporate forms were established with regard to relevant
   transactions and whether the corporate requirements and formalities are
   being met.
   The facts presented establish that [NUMBER 3] meticulously observes all
   corporate formalities and operates separately and independently from
   [NUMBER 1].

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[NUMBER 3] is headquartered at [ADDRESS]. It leases this office space from
[LESSOR] pursuant to a renewable annual lease. The office space is used
exclusively by [NUMBER 3].
[NUMBER 3] has its own Board of Directors, officers and employees.
Employment Agreements are maintained with three Administrative Managers
that are dedicated to the day-to-day operations of [NUMBER 3]. Each of
these employees resides in the Wilmington area. Their duties involve
managing the day-to-day operations of [NUMBER 3]. All of [NUMBER 3’s]
Board of Directors meetings are held quarterly in Wilmington, Delaware.
[NUMBER 3] employees do not provide services to any [NUMBER 1]
affiliates. The employees in the Wilmington, Delaware office are typically not
required to work full time to fulfill their job requirements.
[NUMBER 3] has complete control of the cash that is generated by its
operations and, at the discretion of its management and Board of Directors
uses the proceeds from the licensing of its Marks to fund its operations, pay
dividends, invest in marketable securities, and to make loans to entities in its
affiliated group.
[NUMBER 3] evaluates its overall cash position from all operations including
income from intangibles, restaurant operations and support services and
determines the amount, if any, that will be paid as a dividend to its
shareholder.
Currently, [NUMBER 3’s] excess funds are utilized in
investment activities. However, in the past, dividends have been paid on a
periodic basis. The last dividend payment was made in [YEAR].
The fact that [NUMBER 3] pays dividends to its shareholder is not necessarily
fatal to the issuance of a favorable Letter Ruling as long as the practice is not
used as a systematic means for [NUMBER 3] to transfer funds received for
the licensing of its Marks back to the entity that paid them. The facts
presented show that this is not being done by [NUMBER 3].
The facts presented state that [NUMBER 3] makes loans of excess working
capital to other entities in its affiliated group. Interest rates for these loans are
established by contract at the published LIBOR rate plus 1%. Under the
terms of the loan agreements, borrowers on lines of credit are not required to
make regular cash payments of principal and interest. Interest does accrue
on the unpaid loan balances and the loans are to be paid in no later than
[LOAN DUE DATE].
[NUMBER 3] cannot accept substantial payments for the licensing of its
Marks from [NUMBER 1] and its affiliates and then transfer funds back to
these entities through loans that are not repaid to [NUMBER 3] within a
reasonable time. If this Department were to find that the loans at issue are
not repaid by the specified due date of [LOAN DUE DATE], then [NUMBER 2]
and other subsidiaries and affiliates will not be permitted to deduct the
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payments that they make to [NUMBER 3] as expenses for the licensing of the
Marks.
There are no exclusivity requirements for [NUMBER 3’s] officers, board
members and employees. Officers, board members and employees of RTBD
may be compensated by entities other than [NUMBER 3]. The fact that
officers, board members and employees of [NUMBER 3] may be
compensated by entities other than [NUMBER 3] is not necessarily fatal to the
issuance of a favorable Letter Ruling as long as [NUMBER 3’s] operations are
separate and completely independent from those of [NUMBER 1] and its
affiliates and as long as [NUMBER 3’s] officers, board members and
employees are free from influence or interference by [NUMBER 1] and its
affiliates when they conduct business on behalf of [NUMBER 3]. From the
facts presented, there is no reason to believe that this is not the case.
[NUMBER 3] is responsible for all expenses that it incurs. Any expenses
incurred on behalf by its affiliates are fully and timely reimbursed.

8. Whether there are practical economic effects resulting from the transaction
   aside from tax planning.
   In order to best serve the business of [NUMBER 1], it was determined that the
   Marks should be isolated in their own subsidiary. One of the purposes of
   doing this was to consolidate the Marks so as to better preserve their value;
   to prevent their misuse or misappropriation; and to mitigate possible
   infringement and facilitate investigation of any such claims.
   [NUMBER 3] is responsible for safeguarding the Marks. This includes
   enforcing the terms of its Licensing Agreements and overseeing the rightful
   use and exploitation of the intangible property, as well as managing federal
   and state compliance activities relating to intangibles.
   It is clear from the facts presented that practical economic effects, besides tax
   benefits, resulted from the transactions described.
   The fact that [NUMBER 3] owns interests in pass-through entities that also own
   [NUMBER 1 BUSINESSES] in certain states and the fact that two of [NUMBER 3’s]
   three board members are affiliated with [NUMBER 2] and/or its affiliates is not
   necessarily fatal to the issuance of a favorable Letter Ruling as long as [NUMBER 3’s]
   operations with regard to the holding, maintaining and licensing of the Marks are
   conducted at arms length and are separate and completely independent from those of
   [NUMBER 1] and its affiliates and its board members are free from influence or
   interference by [NUMBER 1] and its affiliates when they conduct business on behalf of
   [NUMBER 3]. From the facts presented, there is no reason to believe that this is not the
   case.

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The facts presented show that [NUMBER 3] is a viable entity in its own right and that its
Board members and its operations and activities are independent from [NUMBER 1]
and its affiliates.
Likewise, the fact that [NUMBER 3] and [NUMBER 1] and affiliates may engage the
same law firms, attorneys, accounting firms and accountants is not necessarily fatal
to the issuance of a favorable Letter Ruling as long as [NUMBER 3’s] operations are
separate and completely independent from those of [NUMBER 1] and its attorneys
and accountants are free from influence or interference by [NUMBER 1] and its
affiliates when they do work for [NUMBER 3]. From the facts presented, there is no
reason to believe that this is not the case.
CONCLUSION
Taken as a whole, and assuming that all loans by [NUMBER 3] to [NUMBER 1] and
affiliates are paid by the specified due date of [LOAN DUE DATE], the facts presented
clearly establish that the [NUMBER 2] meets the guidelines established by the court in
Syms and Sherwin-Williams to be permitted to deduct the payments that it makes to
[NUMBER 3] as expenses for the licensing of intangibles.
The transactions described are not sham transactions. They serve a valid business
purpose aside from generating tax benefits and add value to the Marks owned by
[NUMBER 3]. This justifies the payment of royalties for the use of the intangibles. The
facts presented state that a royalty fee of 4% of restaurant sales was initially established
as a part of Franchise Agreements with third parties. Because the 4.0% royalty fee had
been established as part of the franchising Agreements with third parties, the same rate
was applied to the transactions with the company-owned [BUSINESSES]. [NUMBER 3]
has an exact internal CUT method to establish the arm’s length price for [NUMBER 1]
Marks. For this reason, no formal transfer pricing analysis was necessary when the
Marks were contributed by [NUMBER 2] to its subsidiaries and the intercompany royalty
arrangement was established.
When filing its franchise, excise tax returns with the Department of Revenue on which
intangible license payments are deducted, [NUMBER 2] will need to comply with the
following:

1. Complete the Department’s informational schedule with each return on which the
   expenses are deducted.
2. Attach a copy of this Letter Ruling.
3. Affirm that the facts and circumstances presented in this Letter Ruling have not
   substantially changed since the time the Ruling was requested.

Arnold B. Clapp
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Special Counsel to the Commissioner

APPROVED: Loren L. Chumley, Commissioner

DATE: 9-22-06

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