Can a corporation deduct the royalty payments it makes to a related, commonly-owned intellectual-property-holding affiliate when computing its Tennessee excise tax net earnings, and what factors determine whether that structure is a legitimate business arrangement rather than a tax-avoidance sham?

Subject

Whether royalty payments to a related intellectual-property-holding affiliate are deductible intangible expenses.

Plain-English summary

The Tennessee Department of Revenue ruled that a corporation may deduct the royalty payments it makes to a commonly-owned affiliate for licensing trademarks, trade names, designs, and other intellectual property (IP), concluding the arrangement is a genuine business structure rather than a tax-avoidance sham.

Tennessee requires taxpayers to disclose "intangible expenses" (royalties, license fees, and similar payments) made to affiliates — entities under more than 50% common ownership — on their franchise and excise tax return, or face a negligence penalty and an automatic add-back. Since Tennessee courts hadn't addressed this exact issue, the Department borrowed an eight-factor framework from two influential Massachusetts cases that reached opposite results on materially similar facts: Syms Corp. v. Commissioner of Revenue disallowed royalty deductions where a trademark-holding subsidiary was essentially a shell — one part-time employee, an address rented from the parent's own accounting firm, and royalties that flowed out and back to the parent as a dividend within weeks — finding "no practical economic effect other than the creation of tax benefits." Sherwin-Williams Company v. Commissioner of Revenue upheld similar deductions where the IP-holding subsidiaries were genuine ongoing businesses: independent board members, their own offices and bank accounts, outside legal counsel, arm's-length appraised royalty rates, and licensing to unrelated third parties in addition to the parent.

Applying that framework here, the Department found the IP-holding affiliate looked much more like Sherwin-Williams than Syms: it has its own principal office (outside Tennessee) with its own operating business and dedicated employees (including a Trademark Counselor who is a licensed attorney), holds sole legal title to all the IP with real assignment/license agreements documenting the transfer, sets its royalty rates through independent transfer-pricing studies performed under IRC § 482 methodology by an outside accounting firm, actively files and prosecutes trademark applications, enforces IP rights against infringers and counterfeiters worldwide, and licenses its IP to unrelated third parties as well as to the taxpayer's corporate family. The fact that some officers/employees or the same law/accounting firms also do work for affiliated companies wasn't disqualifying, since the IP entity's operations remained genuinely separate and conducted at arm's length. On balance, the Department concluded the structure has real economic substance — better protection, management, and value-enhancement of the IP — beyond just generating a tax deduction, so the royalty payments qualify as an ordinary and necessary business expense.

What this means for you

Multi-entity corporate groups using IP-holding affiliates

Simply routing royalty payments through a related IP-holding company doesn't automatically create a deductible expense — and doesn't automatically get disallowed either. Tennessee will weigh the same eight factors distilled from Syms and Sherwin-Williams: nature/use of the IP, how it was transferred, whether formal agreements exist, how value/royalty rates were established (ideally independent transfer-pricing studies), whether cash actually changed hands, whether the IP-holder has its own property and payroll in its home state, whether corporate formalities are observed, and whether the structure has practical economic effects beyond tax savings. A thinly staffed shell that just passes royalties back to the parent risks disallowance; a genuinely operating entity with real staff, independent governance, arm's-length pricing, and outside licensees is far more defensible.

Accountants and tax professionals

This ruling is essentially Tennessee's adoption of the Syms/Sherwin-Williams comparative framework as persuasive authority under Tenn. Code Ann. § 67-4-2006(d) — useful any time a client structures IP ownership through a related holding entity. Remember the mandatory compliance mechanics even after a favorable ruling: the taxpayer must still complete the Department's intangible-expense disclosure schedule with each return claiming the deduction, attach a copy of the ruling, and affirm the underlying facts haven't materially changed — failure to disclose triggers an automatic add-back plus a 50% negligence penalty under Tenn. Code Ann. § 67-1-804(b)(2).

Common questions

Q: Are royalty payments to a related IP-holding affiliate automatically deductible in Tennessee?
A: No. Tennessee evaluates the substance of the arrangement using an eight-factor test derived from case law, looking at whether the IP-holder is a genuine operating business or effectively a shell used only for tax benefits.

Q: What made the difference between the disallowed Syms structure and the approved Sherwin-Williams structure?
A: Syms's subsidiary was a near-empty shell with one part-time employee and royalties that circled back to the parent within weeks; Sherwin-Williams's subsidiaries had independent staff, their own offices/bank accounts, arm's-length appraised royalty rates, and licensed IP to unrelated third parties — genuine ongoing businesses.

Q: Does having some shared officers or shared professional advisors between the IP-holder and its affiliates automatically disqualify the deduction?
A: Not by itself, as long as the IP-holding entity's operations remain genuinely separate and its dealings with affiliates are conducted at arm's length.

Q: What must a taxpayer do even after getting a favorable ruling on this issue?
A: Complete the Department's intangible-expense disclosure schedule with every return claiming the deduction, attach a copy of the ruling, and affirm the underlying facts haven't materially changed — failing to disclose triggers an automatic income add-back and a 50% negligence penalty.

Q: Does this ruling apply to other companies' related-party IP licensing arrangements?
A: No. A Tennessee letter ruling binds the Department only for the specific taxpayer and facts addressed and cannot be relied on by others, though the eight-factor analytical framework it adopts is of general use.

Citations and references

Statutes:

• Tenn. Code Ann. § 67-4-2006(d) (intangible expense disclosure requirement for affiliate transactions)
• Tenn. Code Ann. § 67-4-2006(b)(1)(L) (automatic add-back for undisclosed intangible expenses)
• Tenn. Code Ann. § 67-4-2004(1) (definition of "affiliate": more than 50% common ownership)
• Tenn. Code Ann. § 67-4-2004(18)-(20) (definitions of "intangible expense," "intangible income," and "intangible property")
• Tenn. Code Ann. § 67-1-804(b)(2) (50% negligence penalty for failure to disclose)

Cases (persuasive authority from Massachusetts):

• Syms Corp. v. Commissioner of Revenue, 765 N.E.2d 758 (Mass. 2002) (shell-like IP subsidiary; royalty deduction disallowed as a sham)
• Sherwin-Williams Company v. Commissioner of Revenue, 778 N.E.2d 504 (Mass. 2002) (genuine operating IP subsidiaries; royalty and interest deductions upheld)
• Moline Props., Inc. v. Commissioner of Internal Revenue, 63 S.Ct. 1132 (1943) (tax motivation not fatal if entity has economic substance)
• Frank Lyon Co. v. United States, 98 S.Ct. 1291 (1978); Helvering v. Gregory, 69 F.2d 809 (2d Cir. 1934) (genuine reorganizations respected for tax purposes)

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/06-28fe.pdf

Original ruling text

TENNESSEE DEPARTMENT OF REVENUE
LETTER RULING # 06-28

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 [CORPORATION X] may deduct the payments that it makes to
[CORPORATION Y] 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
[CORPORATION X] be permitted to deduct the payments that it makes to
[CORPORATION Y] as expenses for the licensing of intangibles?
RULING
Yes.
ANALYSIS
APPLICABLE TENNESSEE LAW
Effective for tax periods beginning on or after January 1, 2004, Tenn. Code Ann.
§ 67-4-2006(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. § 67-42006(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[.]

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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;
(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

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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.
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:

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1. 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.

2. 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.
3. 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.
4. Royalties amounting to 4% of Syms annual sales were paid to
   SYL. The royalties paid increased from approximately $2.8
   million in 1986 to 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).

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•

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).

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.

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The Commissioner’s position that the royalty payments were not ordinary and
necessary business expenses was upheld and it was noted that:

1. The value of the marks was created entirely by Syms and SYL
   added little or no value to the marks.
2. 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.
3. 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.
4. 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 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:
5. Sherwin-Williams’ transfer of its marks to its Subsidiaries and
   subsequent royalty payments to those Subsidiaries were not
   sham transactions for taxation purposes.
6. Sherwin-Williams’ royalty payments to its Subsidiaries were
   ordinary and necessary business expenses.
7. The royalty payments made by Sherwin-Williams to its
   Subsidiaries were reasonable.

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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 SherwinWilliams 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.
   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. SherwinWilliams’ 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:

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1. Improvement of quality control oversight and increased
efficiencies with regard to the marks by having profit centers
separate from Sherwin-Williams.

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 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:
12. Original board members of each Subsidiary were the comptroller
    of Sherwin-Williams, who also served as chairman, the vicepresident 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

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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.
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.

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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 SherwinWilliams’ 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 SherwinWilliams 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 SherwinWilliams, 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, at 511 (7th Cir. 1997),
    quoting Bass v. Commissioner of Internal Revenue, WL 1442 (1968).

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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:

1. The nature of the intangible property and how it is used.
   The intangible property held by [CORPORATION Y[ is described as
   [CORPORATION Z]® trademarks, trade names, designs, logos,
   domain name rights, copyrights, and nonformula trade secret rights.
   These IPRs are extremely valuable to [CORPORATION A] and its
   subsidiaries and affiliates in the conduct of their business operations
   throughout the United States.
   The intangible assets described and their use by licensees is typical of
   those to which Tenn. Code Ann. § 67-4-2006(d) applies.
2. The method by which the taxpayer transferred its patents, trademarks,
   franchise rights, or other intangibles to its subsidiary.
   As of [DATE], [CORPORATION B] owned and maintained intangibles
   consisting predominately of intellectual property rights related to
   [CORPORATION Z] and its affiliates. [CORPORATION B] consisted of
   two general partners, [CORPORATION C] and [CORPORATION D.]
   On [DATE], [CORPORATION D] assigned its partnership interest to

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[CORPORATION C]. This effectively dissolved the partnership and
resulted in the intangibles being transferred to [CORPORATION C].
On or about the same date, [CORPORATION C] changed its name
to [CORPORATION Y] pursuant to IRC § 368(a)(1)(F).
The filing of new trademark applications including those involving work
marks, logos, composite marks (words and designs together),
packaging design, trade dress and other nontraditional trademarks
anywhere and everywhere in the world are all handled by
[CORPORATION Y], who holds all right, title and interest in such IPRs.
This process is explained more fully in item #3 below.
The facts presented state that [CORPORATION Y] possesses all right,
title and interest in [CORPORATION Z®] brand related IPRs. The
sample License Agreement attached to the request for this Letter
Ruling states that the right, title and interest in such IPRs will at all
times remain in [CORPORATION Y] and that any improvements,
enhancements, derivatives or innovations made by a licensee to the
IPRs will be assigned to [CORPORATION Y].
Of essential importance is the fact that legal title and possession of the
IPRs is not retained by [CORPORATION A] or any of its subsidiaries or
affiliates other than [CORPORATION Y] and that [CORPORATION Y]
retains sole possession, right, interest and legal title to such property.
License Agreements document these facts and make them clear to all
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, [CORPORATION Y] possesses all right, title
   and interest in [CORPORATION Z®] brand related IPRs and any
   improvements, enhancements, derivatives or innovations made by a
   licensee to the IPRs are assigned to [CORPORATION Y].
   Documentation supporting the original transfer of intangibles to
   [CORPORATION Y] includes a Capital Contribution Agreement, a Plan
   of Merger, and Board of Director consents and resolutions.
   The value of the IPRs and the establishment of charges to be made by
   [CORPORATION Y] for their use are documented by various transfer
   pricing studies performed by Deloitte Tax LLP using the comparable
   profits (“CPM”) method. A copy of the most recent such study is for
   the year ended [DATE] and was provided with this Letter Ruling
   request.

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Loans made by [CORPORATION Y] to [CORPORATION Z] are
documented by a Master Promissory Note – Revolving Credit dated
[DATE] covering principal amounts advanced from time to time by
[CORPORATION C] (now [CORPORATION Y]). The Note covers the
applicable terms under which the loans are made, including interest
rates and maturity provisions. A copy of the text of the Master
Promissory Note – Revolving Credit dated [DATE] was attached to the
supplemental facts provided pursuant to this Letter Ruling request.
[CORPORATION Y] licenses its IPRs to the [CORPORATION X] as
well as to unrelated third parties. These transactions are documented
by legal License Agreements, Design Agreements and other
appropriate license contracts between the parties. These license
contracts contain the specific terms under which the license is granted
and details of the transaction, such as limitations on the use of the
IPRs by the licensee, the license fees to be paid and default
provisions.
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.

4. The method by which the value of the intangibles transferred was
   established.
   As previously noted, the value of the IPRs and the charges made by
   [CORPORATION Y] for the use of such IPRs are determined by
   various transfer-pricing studies performed by Deloitte Tax LLP. The
   most recent such study is for the year ended [DATE].
   Deloitte Tax LLP applied the CPM to determine a range of royalty rates
   appropriate for the licensing of intellectual property. This study was
   performed in accordance with IRC § 482 and regulations relevant to
   the application of such method. The CPM evaluates whether the
   amount charged in a controlled transaction is at arm’s length by
   comparing the profitability of the tested party to that of comparable
   companies.
   The methods described in the facts and used to determine the value of
   the intangibles and the applicable royalty rates are appropriate.
5. Whether actual cash was exchanged in the relevant transactions.
   The method by which IPRs were transferred to [CORPORATION Y] is
   described in item #2 above and involved a series of transactions
   supported by such documents as a Capital Contribution Agreement, a

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Plan of Merger, and Board of Director consents and resolutions.
Because of the nature of this transaction, it was not necessary that
actual cash be exchanged.
[CORPORATION
Y’s]
most
significant
IPR
licensee
is
[CORPORATION X], but [CORPORATION Y] also licenses its IPRs to
unrelated third parties. A copy of a License Agreement between
[CORPORATION Y] and a related party is attached to the request for
this Letter Ruling and is represented to be similar in general terms to
licensing agreements entered into with all parties, both related and
unrelated.
The License Agreement requires the licensee to calculate and pay
[CORPORATION Y] license fees on a quarterly basis not later than 45
days after the end of each fiscal quarter and sets forth penalties for
default.
As evidenced in the facts presented and the Master Promissory Note –
Revolving Credit dated [DATE] and attached to the supplemental facts
provided pursuant to this Letter Ruling request, loans made to
[CORPORATION
Z]
and
certain
operating
affiliates
of
[CORPORATION
Z]
and
voluntary
payments
made
by
[CORPORATION Z] to reduce its outstanding principal balance are
made in cash.
The facts presented also state that [CORPORATION Y] pays those
who do work for it and pays its own employees.
The facts presented reflect that consideration supporting the legal
validity of the licensing of the intangibles, loans made, and employees
and others doing work for [CORPORATION Y] did pass between
[CORPORATION Y] and the parties involved.

6. Whether the company holding the intangibles has property and payroll
   in its state of domicile.
   [CORPORATION Y’s] principal offices are located at [ADDRESS –
   NOT IN TENNESSEE].
   It owns and operates [NUMBER
   CORPORATION Z®] locations and has approximately [NUMBER]
   employees dedicated to such operations.
   In addition, [CORPORATION Y] possesses all right, title and interest in
   brand related intellectual property assets. These assets consist of
   trademarks, trade names, designs, logos, domain name rights,
   copyrights and non-formula trade secret rights relating to the
   [CORPORATION Z®] concept.

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[CORPORATION Y] has its own directors, officers and employees who
perform all of the various activities associated with the management
and protection of its intellectual assets and the operation of its
[BUSINESS] in [STATE – NOT TENNESSEE]. In the case of
employees that split their time between [CORPORATION Y] and
[CORPORATION Z, CORPORATION Y] pays the portion of their
salary representative of the time that they spend working for it.
With respect to the management of its IPRs, [CORPORATION Y] has
1 employee located in its [STATE – NOT TENNESSEE] office. This
employee is an attorney licensed in [STATE – NOT TENNESSEE] and
Tennessee and performs the responsibilities of Trademark Counselor.
The facts presented establish that [CORPORATION Y] has property
and a legitimate operating place of business with a paid employee in
its domicile at [CITY, STATE – NOT TENNESSEE].

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 [CORPORATION Y] meticulously
   observes all corporate formalities.
   [CORPORATION Y] operates separately and independently from
   [CORPORATION A] and its other operating affiliates. The facts
   state that the relationship that exists among [CORPORATION Y,
   CORPORATION X, CORPORATION A] and its other affiliates is
   conducted on an arms length basis.
   Transactions by which [CORPORATION Y] came to own all right,
   title and interest in the IRPs is documented by a Capital Contribution
   Agreement, a Plan of Merger and Board of Director consents and
   resolutions. License Agreements and Design Agreements support
   the licensing of rights to use the IPRs. The value of the IPRs and
   the appropriate license fees are determined by transfer-pricing
   studies performed by Deloitte Tax LLP. License fees are paid to
   [CORPORATION Y] on a quarterly basis, or in accordance with
   terms of the applicable License Agreements. Loans made to
   operating affiliates of [CORPORATION A] are evidenced by notes
   containing provisions for interest rates, payments and maturities.
   [CORPORATION Y] has its own officers, board of directors and
   employees who are paid by [CORPORATION Y] for the work that they

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do for it. [CORPORATION Y] retains the services of outside legal
counsel to assist it in connection with its efforts to exploit its IPRs.

8. Whether there are practical economic effects resulting from the
   transaction aside from tax planning.
   It is abundantly clear from the facts presented that practical economic
   effects, besides tax benefits, resulted from the transactions described.
   In order to focus on development and protection of the IPRs,
   [CORPORATION A] choose to house such property in a separate legal
   entity with its own Trademark Counselor to manage and protect them.
   This enables [CORPORATION A] to hold [CORPORATION Y]
   accountable for its performance with regard to development and
   protection of the IPRs. In addition, [CORPORATION A] wanted to
   segregate its IPRs from the liabilities associated with the actual
   production, marketing and sales of [CORPORATION A] and its
   affiliates’ products.
   [CORPORATION Y’s] activities ensure management and protection of
   the tradenames and trademark rights of the [CORPORATION Z®]
   concept. Top-level focus on intellectual property management and
   protection issues is increased and, as a result, the management and
   control of these highly valued IPRs is improved. An additional level of
   liability protection for the IPRs is provided.
   The facts presented list and explain the following specific activities
   performed by [CORPORATION Y], all of which have practical
   economic effects aside from generating tax benefits and all of which
   contribute to better management and the addition of value to the
   intellectual property:
9. The filing of new applications for trademarks, word marks, logos,
   composite marks, packaging design, trade dress and other
   nontraditional trademarks anywhere and everywhere in the world
   where they will be used.
10. Prosecution of pending applications for trademarks and other IPRs.
11. General counseling, which involves such things as clearing rights to
    use certain IPRs, negotiating license agreements, obtaining general
    intellectual property advice on copyright issues, right of publicity
    issues, invasion of privacy issues and transactions.
12. Maintenance of IPR registrations on a state-by-state basis.

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5. Enforcement of IPR rights. This involves protecting the IPRs from
infringement, policing misuse of the IPRs, opposition to
registrations that may infringe on the IPRs, fighting counterfeiting of
products, and protection the rights and integrity of brands by
aggressively pursuing other parties that intermingle counterfeits
and unauthorized products into markets and engage in tax and duty
evasion.

6. The licensing of IPRs to [CORPORATION X] and other affiliates
   and subsidiaries of [CORPORATION A] as well as to unrelated
   parties.
   The fact that [CORPORATION Y] also owns and operates [THE SAME TYPE OF
   BUSINESSES] and the fact that some of [CORPORATION Y’s] officers, board
   members and employees also do work for [CORPORATION Z] is not fatal to
   [CORPORATION X’s] deduction of payments that it makes to [CORPORATION
   Y] as expenses for the licensing of intangibles as long as the relationship that
   exists among [CORPORATION Y], [CORPORATION X] and [CORPORATION A]
   and its other affiliates is kept separate and is conducted at arms length. The
   facts presented show that [CORPORATION Y] is a viable entity in its own right
   and that its operations and activities are independent from [CORPORATION A]
   and its subsidiaries and affiliates.
   For the same reasons, the fact that the law firm of [NAME OF LAW FIRM] does
   work for [CORPORATION Y] and also does work for [CORPORATION Z] and its
   affiliates is not fatal to [CORPORATION X’s] deduction of license fees paid to
   [CORPORATION Y]. This is especially true since the [NAME OF LAW FIRM] is
   the only law firm providing services with respect to the IPRs owned by
   [CORPORATION Y] and it does not do any work for any other [CORPORATION
   A] entity, subsidiary or affiliate.
   Although Deloitte Tax LLP also does tax related work for [CORPORATION Y,
   CORPORATION A] and other [CORPORATION A] affiliates, it does not appear
   that this interferes with the separate and independent operations of
   [CORPORATION Y] or that it results in decisions being made that are adverse to,
   or not in the best interest of, [CORPORATION Y] and the IPRs that it owns and
   manages.
   CONCLUSION
   Taken as a whole, the facts presented clearly establish that the [CORPORATION
   X] meets the guidelines established by the court in Syms and Sherwin-Williams
   to be permitted to deduct the payments that it makes to [CORPORATION Y] 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 IPRs owned by [CORPORATION Y]. This

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justifies the payment of royalties for the use of the IPRs. The value of the lPRs
was determined by third party transfer pricing experts engaged in accordance
with U.S. Treasury Regulations under IRC § 482. There is no doubt that the
royalty payments made by [CORPORATION X] qualify as reasonable ordinary
and necessary business expenses.
When filing its franchise, excise tax returns with the Department of Revenue on
which royalty payments are deducted, [CORPORATION X] 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
Special Counsel to the Commissioner

APPROVED: Loren L. Chumley, Commissioner

DATE: 7-20-06

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