SJC-08516

September 10, 2001. - October 31, 2002.

Present: Marshall, C.J., Greaney, Ireland, Spina, Cowin, Sosman, & Cordy,

JJ.

Taxation, Corporation, Corporate excise, Judicial review. Corporation,

Subsidiary.

APPEAL from a decision of the Appellate Tax Board.

The Supreme Judicial Court on its own initiative transferred the case from

the Appeals Court.

Paul H. Frankel, of New York (Craig B. Fields, of New York, & Maxwell D.

Solet with him) for the taxpayer.

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

Revenue.

William E. Halmkin & Andrew H. Lee, for the Massachusetts Tax Coalition,

amicus curiae, submitted a brief.

CORDY, J.

The Sherwin-Williams Company (Sherwin-Williams) appealed from a decision of

the Appellate Tax Board (board) upholding the denial by the Commissioner of

Revenue (commissioner) of its request to abate $59,445.40 in corporate

excise taxes assessed for tax year 1991 and we transferred the case to this

court on our own motion. The contested assessment was the result of the

commissioner's disallowance of approximately $47 million that

Sherwin-Williams had deducted from its taxable income for royalty payments

to two wholly owned subsidiaries, Sherwin-Williams Investment Management

Company, Inc. (SWIMC), and Dupli-Color Investment Management Company, Inc.

(DIMC) (collectively referred to as the subsidiaries), [FN1] for the use of

certain trade names, trademarks, and service marks (marks), that

Sherwin-Williams had transferred to the subsidiaries and licensed back as

part of a corporate reorganization of its intangible assets in January,

1991. The commissioner also disallowed $80,000 that Sherwin-Williams had

deducted for interest payments to SWIMC, in connection with a $7 million

loan made to it by SWIMC in the fourth quarter of 1991, which was repaid in

the first quarter of 1992.

After a protracted evidentiary hearing, the board found that

Sherwin-Williams had not sustained its burden of establishing its

entitlement to an abatement, and that the commissioner had properly

disallowed the deductions on three alternative grounds: (1) the transfer and

license back of the marks was a sham and could be disregarded under the

"sham transaction doctrine"; (2) the royalty payments were not deductible as

ordinary and necessary business expenses when there was no valid business

purpose justifying the expense; and (3) G.L. c. 63, § 39A, permitted the

commissioner to adjust the taxable income of Sherwin-Williams by eliminating

the royalty payments because they were not made at arm's length and

distorted the actual income of Sherwin- Williams. The board also affirmed

the elimination of the interest expense deduction based on the

commissioner's contention that Sherwin-Williams should never have paid the

royalties that generated both the need to borrow money from SWIMC, and the

source of the funds loaned to it.

We conclude that the board erred when it found that the transfer and

licensing back transactions between Sherwin-Williams and its subsidiaries

were without economic substance and therefore a sham. We also conclude that:

the payment of royalties and interest to SWIMC and DIMC were properly

deductible by Sherwin-Williams because obtaining licenses to use the marks

was necessary to the conduct of its business; even assuming G.L. c. 63, §

39A, empowers the commissioner to eliminate payments made between a foreign

parent corporation and its subsidiaries, it does so only to the extent that

such payments are in excess of fair value, and in light of the substantial

evidence that the royalties paid by Sherwin-Williams reflected fair value,

there is no basis to support the elimination of these payments; and, because

the transactions were not a sham, and the loan between SWIMC and

Sherwin-Williams was genuine, interest was properly chargeable to

Sherwin-Williams when it borrowed the funds and was, accordingly, properly

deductible.

1. Background. From the uncontested evidence presented at the evidentiary

hearing, we set forth the following backdrop to the issues presented for

decision. Sherwin-Williams is a corporation that has manufactured,

distributed, and sold paints and related products for more than 125 years.

It was incorporated under the laws of the State of Ohio, and has its

principal place of business in Cleveland. It manufactures and sells its

products under many brand names, including its own signature brand,

"Sherwin-Williams," and other brands, including "Dutch Boy,"

"Martin-Senour," "Kem-Tone," "Dupli- Color," and "Krylon." Sherwin-Williams

also uses hundreds of marks, including the "Sherwin-Williams" trademark,

several "Dutch Boy" trademarks, and "The Look that Gets the Look" slogan.

In June, 1990, one of Sherwin-Williams's attorneys suggested to Robert E.

McDonald, Sherwin-Williams's senior corporate counsel for patents and

trademarks, the idea of forming two subsidiary companies to hold and manage

the Sherwin-Williams marks and to invest and manage royalty proceeds earned

therefrom. McDonald discussed this idea with other senior corporate

officials, who asked him to evaluate the potential benefits and risks of

establishing such subsidiaries and transferring the Sherwin-Williams marks

to them. After concluding that the potential benefits would be substantial,

McDonald traveled to Delaware, along with another Sherwin-Williams employee,

to meet with individuals who had experience in the management of intangible

asset holding companies there. They met with lawyers, bankers, and

investment managers, including Donald J. Puglisi.

Puglisi was a professor of business and finance at the University of

Delaware, the founder and owner of an investment management and services

firm (Puglisi and Associates), and a member of the board of directors of

many investment companies and Delaware subsidiaries of foreign corporations.

His expertise was principally in business management, portfolio management,

and corporate finance. Puglisi and McDonald discussed how intangible asset

subsidiaries might be created in Delaware to manage and protect

Sherwin-Williams's marks, increase their value, and maximize the investment

of royalty income. They also discussed Puglisi's expertise and interest in

assisting the companies if Sherwin-Williams decided to create the Delaware

subsidiaries.

Delaware was a jurisdiction with which Sherwin-Williams was very familiar,

having previously established a number of corporate subsidiaries there. It

afforded significant legal and tax advantages to corporations that confined

their activities to holding, maintaining, and managing intangible assets. In

particular, under Delaware law, royalties and other income earned by such

corporations were exempt from State taxation. Del.Code Ann. tit. 30, §

1902(b)(8) (1997). These advantages were known and considered by McDonald

and Sherwin-Williams in evaluating the trademark subsidiary plan.

On his return from Delaware, McDonald had further meetings with senior

corporate officials, including Sherwin-Williams's chief financial officer

and its general counsel, to discuss and evaluate the benefits of

transferring the company's marks into separate corporations. McDonald also

assessed the legal risks attendant to the transfer of the marks to ensure

that it could be done without jeopardizing their continued validity. He

further directed an effort to fully identify, catalogue, and document

properly the hundreds of marks that Sherwin-Williams had developed or

acquired during its many years of operation, including common-law trademarks

that had never been recorded with the United States Patent and Trademark

Office. These efforts continued over many months, culminating in the

preparation by McDonald and others of a business plan for consideration by

senior management, and ultimately the Sherwin-Williams board of directors,

in January, 1991.

On January 23, 1991, the Sherwin-Williams board of directors voted to form

SWIMC and DIMC under Delaware law, and to transfer to them all of Sherwin-

Williams's domestic marks. [FN2] The minutes of the January 23, 1991, board

meeting set forth the reasons for the board vote, including:

(1) improvement of quality control oversight and increased efficiencies with

regard to the marks by virtue of having profit centers separate from

Sherwin-Williams;

(2) easier profit analysis of Sherwin-Williams by having profit centers for

the marks that were separate from it;

(3) enhanced ability to enter into third-party licensing arrangements at

advantageous royalty rates;

(4) increased over-all profitability because of the availability of

Delaware's corporate income tax exemption for investment management and

trademark holding companies;

(5) maximized investment returns associated with the marks due to separate

and centralized investment management;

(6) enhanced borrowing capabilities;

(7) subsidiaries could be used in certain instances to acquire businesses;

(8) provided ability to take advantage of the well-developed body of

corporate law and expeditious legal system in Delaware;

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

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

(11) increased liquidity.

Under the board-approved plan, all of the marks affiliated with aerosol

products were assigned to DIMC, and all of the marks affiliated with

nonaerosol products were assigned to SWIMC. [FN3] These assignments were

recorded in the United States Patent and Trademark Office, and SWIMC and

DIMC became the owners of the marks. Sherwin-Williams also contributed

$50,000 and $42,000 respectively to SWIMC and DIMC to help finance the

startup of the companies. In return, Sherwin-Williams and another of its

subsidiaries, Dupli-Color Products Company, received one hundred per cent of

the stock of both subsidiaries, and agreements that licensed most, but not

all, of the marks back to Sherwin-Williams for ten-year terms on a

nonexclusive basis. Under the licensing agreements Sherwin-Williams agreed

to pay royalties to the subsidiaries quarterly, based on a percentage of the

sales of the products bearing those marks. The value of the marks

transferred to the subsidiaries, and fair market royalty rates, were to be

determined by an independent appraisal company.

SWIMC and DIMC were incorporated in Delaware seven days after the January 23

vote. Their boards of directors first met on February 1, 1991, in Delaware.

The original boards of directors of each subsidiary were comprised of the

same three individuals. John Ault, the controller of Sherwin-Williams,

served as chairman of both boards. Conway Ivy, a vice-president and then

treasurer of Sherwin-Williams, served as the second board member. Donald

Puglisi, who was not affiliated with Sherwin-Williams, served as the third

member. Puglisi was elected president and treasurer. Gordon Stewart, a

partner in the Delaware office of Duane, Morris, & Heckscher (who had been

retained as corporate counsel to the subsidiaries), was elected secretary of

both companies. At their second set of board meetings in the spring of 1991,

Stewart was elected to each of the boards of directors as a fourth member.

SWIMC and DIMC each agreed to pay Puglisi a salary of $18,000 annually, and

each agreed to pay Stewart $500 annually. [FN4] The subsidiaries had no

other employees during 1991.

SWIMC and DIMC jointly executed a lease agreement with the Bank of Delaware

for an office that the subsidiaries used to store records. Puglisi conducted

his work as president of the subsidiaries, as well as work in connection

with his other businesses, from his own office in Newark, Delaware. Puglisi

and Associates charged rent to each subsidiary for the use of his office.

The subsidiaries each opened bank accounts with the Bank of Delaware, and

arranged for the bank to take physical custody of the marks on transfer from

Sherwin- Williams. In addition to retaining independent corporate legal

counsel (Stewart), the subsidiaries also retained an independent auditing

firm. Routine accounting work was done by Puglisi and Associates.

The articles of organization of both SWIMC and DIMC provided that their

activities would "be confined to the maintenance and management of its

intangible investments." The articles also placed restrictions and

prohibitions on the subsidiaries, providing that neither SWIMC nor DIMC

could "lease, sell, exchange, transfer, license, assign (except to

affiliates), or dispose of any of the assets of the Corporation (except for

assets having a value under $2,000)," in the absence of approval by the

holder of the majority of shares. In addition, neither subsidiary could

pledge any of its assets without the approval of a majority of stockholders.

These restrictions were reiterated in the bylaws for both corporations. The

articles and bylaws were subsequently amended to eliminate stockholder

approval for the licensing of the marks to conform with the subsidiaries'

practice of entering license agreements without securing stockholder

approval.

Once the subsidiaries had been formed, Sherwin-Williams engaged American

Appraisal Associates (AAA) to appraise the value of the marks that it was

transferring to the subsidiaries in exchange for their stock, and to help

establish an arm's-length royalty rate for the license back of the marks it

intended to use. AAA appraised the value of the marks to be $328,000,000,

and recommended royalty rates ranging from one per cent to four and one-half

per cent for each of Sherwin-Williams's product divisions.

After their formation SWIMC and DIMC operated as ongoing businesses,

entering into nonexclusive licensing agreements with Sherwin-Williams and

other unrelated licensees, receiving substantial royalty payments

(principally from Sherwin-Williams), setting their own investment policies,

investing their royalty income and earning a return on those investments

greater than that earned on comparable funds by their parent, [FN5] paying

taxes, and hiring and paying professionals to audit the companies and to

perform occasional quality control testing on Sherwin-Williams's products.

They also hired and paid their own lawyers to represent them in multiple

trademark proceedings. To assist them with the filings necessary to maintain

the marks, both companies contracted with Sherwin-Williams and paid market

rates on periodic invoices for the services they received. All corporate

formalities were meticulously observed.

Sherwin-Williams's senior management had concerns dating as far back as 1983

regarding the maintenance and effective management of its marks because one

of its marks, the "Canada Paint Company," which was to be used in a Canadian

joint venture had been lost. The corporate official who had been most vocal

in expressing these concerns, Conway Ivy, was put on the boards of SWIMC and

DIMC when they were formed in 1991. The testimony of senior corporate

managers further established that before 1991, the multiple divisions of

Sherwin- Williams, its decentralized management and culture, and the use of

many of the marks across divisions, created uncertain authority and diffuse

decision-making regarding the maintenance and exploitation of the marks,

contributing to their ineffective and inadequate management as a company

asset. Finally, board members of SWIMC and DIMC and Sherwin-Williams's

associate general counsel for patents and trademarks testified that these

concerns had been effectively addressed by the transfer of the marks to the

subsidiaries whose sole focus was on their maintenance and management.

In the proceedings before the board, the commissioner offered evidence from

several experts who testified that the many nontax business reasons

proffered by Sherwin-Williams for the transfer and licensing back of the

marks were either illusory, unrealistic, contradictory, not achievable, or

could have been better achieved by internal business adjustments rather than

by creating subsidiaries and transferring valuable assets to them to be

licensed back. Sherwin-Williams contested the testimony of the

commissioner's experts through the testimony of its own experts. None of the

commissioner's experts contended that the subsidiaries were not ongoing,

profit-making businesses, engaged in business activities including and apart

from the licensing of their marks to Sherwin-Williams, or that the royalty

rates paid by Sherwin-Williams were outside the range of royalties that

would be paid by parties acting at arm's length.

2. Sham transaction. Massachusetts recognizes the "sham transaction

doctrine" that gives the commissioner the authority "to disregard, for

taxing purposes, transactions that have no economic substance or business

purpose other than tax avoidance." Syms Corp. v. Commissioner of Revenue,

436 Mass. 505, 509-510 (2002) (Syms). [FN6] The doctrine generally "works to

prevent taxpayers from claiming the tax benefits of transactions that,

although within the language of the tax code, are not the type of

transactions the law intended to favor with the benefit." Id. at 510, citing

Horn v. Commissioner of Internal Revenue, 968 F.2d 1229, 1236-1237

(D.C.Cir.1992).

"The question whether or not a transaction is a sham for purposes of the

application of the doctrine is, of necessity, primarily a factual one, on

which the taxpayer bears the burden of proof in the abatement process."

Syms, supra at 511. Our review of the board's factual findings is limited to

whether, as a matter of law, the evidence is sufficient to support them.

Olympic & York State St. Co. v. Assessors of Boston, 428 Mass. 236, 240

(1998). If supported by sufficient evidence, we will not reverse a decision

of the board unless it is based on an incorrect application of the law. Koch

v. Commissioner of Revenue, 416 Mass. 540, 555 (1993).

In Syms, we upheld a finding of the board that a transfer and licensing back

of trademarks between a parent and its newly formed subsidiary was a sham

transaction for taxing purposes. There, the evidence that the transaction

was specifically designed as a tax avoidance scheme; royalties were paid to

the subsidiary once a year and quickly returned to the parent company as

dividends; the subsidiary did not do business other than to act as a conduit

for the circular flow of royalty money; and the parent continued to pay all

of the expenses of maintaining and defending the trademarks it had

transferred to the subsidiary, fully supported the board's findings that the

transaction had no practical economic effect other than the creation of a

tax benefit and that tax avoidance was its motivating factor and only

purpose.

The facts of the present case are substantially different. There is no

evidence that the transfer of the marks to the subsidiary corporations and

their licensing back to Sherwin-Williams was specifically devised as a tax

avoidance scheme. The revenue earned by the subsidiaries, including the

proceeds from the royalty payments made by Sherwin-Williams, was not

returned to Sherwin-Williams as a dividend but, rather, was retained and

invested as part of their ongoing business operations, earning significant

additional income. The subsidiaries entered into nonexclusive license

agreements not only with Sherwin-Williams, but also with unrelated parties.

The subsidiaries assumed and paid the expenses of maintaining and defending

their trademark assets. Whether the board properly applied the sham

transaction doctrine to these facts requires a more rigorous analysis of the

origin and purposes of that doctrine than was necessary in Syms.

We start with two principles first articulated by Judge Learned Hand in

Helvering v. Gregory, 69 F.2d 809 (2d Cir.1934), the seminal case

establishing the sham transaction doctrine. The first principle is: "Any one

may so arrange his affairs that his taxes shall be as low as possible; he is

not bound to choose the pattern which will best pay the Treasury; there is

not even a patriotic duty to increase one's taxes." Id. at 810. Or, as

stated by the United States Supreme Court in its affirmance of Judge Hand's

decision: "The legal right of a taxpayer to decrease the amount of what

otherwise would be his taxes, or altogether avoid them, by means which the

law permits, cannot be doubted." Gregory v. Helvering, 293 U.S. 465, 469

(1935) (Gregory ). See Knetsch v. United States, 364 U.S. 361, 365 (1960),

quoting Gregory, supra; Yosha v. Commissioner of Internal Revenue, 861 F.2d

494, 497 (7th Cir.1988) ("There is no rule against taking advantage of

opportunities created by [the Legislature or revenue service] for beating

taxes"). The second principle is that a transaction "does not lose its [tax]

immunity, because it is actuated by a desire to avoid, or, if one chooses,

evade, taxation." Helvering v. Gregory, supra at 810. In other words, our

tax system is a rule-based system, objective in nature, that places

principal importance on what taxpayers do and the economic consequences

attached to those actions, not on what may have subjectively motivated them

to act in the first place.

Based on these two principles, Sherwin-Williams, on initially going into

business, could have organized itself in such a way that its intangible

assets (e.g., its marks) were held in a corporation separate from the

corporations holding its production facilities and sales operations; the

corporation owning the marks could have licensed those marks to its sister

corporations; and this arrangement would have been respected by taxing

authorities even if the structure were motivated entirely by a desire to

minimize Sherwin-Williams's over-all tax burdens. Although motivated by tax

considerations, such a structure would not have been an uncommon way of

doing business nor an artificial construct whose only possible effect was

the avoidance of taxes. Against this backdrop, we decide what an established

business enterprise must prove when it undertakes to reorganize itself to

effectuate a more efficient tax structure in order that the taxing

authorities recognize the reorganization for tax purposes, rather than

disregard it as a sham. [FN7]

The facts and holding in the Gregory decision are instructive on this

question. In that case, the taxpayer owned all the stock of a corporation,

which in turn owned 1,000 shares of a second corporation. Gregory, supra at

467. "For the sole purpose of procuring a transfer of these shares to

herself in order to sell them for her individual profit, and, at the same

time, diminish the amount of income tax which would result from a direct

transfer [of the stock] by way of dividend," the taxpayer sought to bring

about a business "reorganization" under the tax code. Id. To that end, the

corporation set up a subsidiary to which the 1,000 shares of stock were

transferred. All of the stock of the subsidiary were then transferred to the

taxpayer on a tax free basis. Three days later, the taxpayer dissolved the

subsidiary and distributed the 1,000 shares to herself on a reduced tax

basis. Id. As the Supreme Court noted, "[n]o other business was ever

transacted, or intended to be transacted, by [the subsidiary]." Id.

In setting aside the transaction as a sham for taxing purposes, the United

States Court of Appeals for the Second Circuit and subsequently the Supreme

Court disregarded the question of taxpayer's motive, focusing instead on

whether the transactions were a business reorganization as contemplated by

the reorganization statute or "an elaborate and devious form of conveyance

masquerading as a corporate reorganization, and nothing else." Id. at 470.

Both courts concluded that it was the latter. Although the transactions met

the technical requirements of the reorganization statute, the evidence

demonstrated that there was "no business or corporate purpose," and that the

"sole object and accomplishment ... was the consummation of a preconceived

plan, not to reorganize a business or any part of a business, but to

transfer a parcel of corporate shares to the petitioner." Id. at 469.

Consequently, "the transaction upon its face [lay] outside the plain intent

of the [reorganization] statute," and did not qualify for the favorable tax

treatment available to such reorganizations under the statute. Id. at 470.

The Supreme Court further elaborated on the sham transaction doctrine in

Frank Lyon Co. v. United States, 435 U.S. 561 (1978) (Lyon ), in which it

concluded that a sale and leaseback of real property needed to be respected

for tax purposes. In Lyon, a bank sold a building that it was constructing

to the Frank Lyon Company (company), which simultaneously leased the

building back to the bank for its own use. Id. at 566. After the purchase

and completion of construction, the company became liable on the permanent

financing loan for the building, which was secured by an assignment of the

bank's lease. Id. at 568. The company took various tax deductions and

depreciation allowances premised on its ownership of the building. Id. The

Commissioner of Internal Revenue challenged the company's right to those

deductions and allowances, asserting, inter alia, that the bank was the

owner of the building and the sale and leaseback should be disregarded as a

sham for taxing purposes. Id. at 568-569. The Supreme Court concluded that

the sale and leaseback had economic substance and was therefore not a sham

because the obligation to repay the loan fell squarely on the company, and

that "so long as the lessor retains significant and genuine attributes of

the traditional lessor status, the form of the transaction adopted by the

parties governs for tax purposes." Id. at 583-584.

Taken together, the Gregory and Lyon decisions suggest that for a business

reorganization that results in tax advantages to be respected for taxing

purposes, the taxpayer must demonstrate that the reorganization is "real" or

"genuine," and not just form without substance. Stated otherwise, the

taxpayer must demonstrate that the reorganization results in "a viable

business entity," that is one which is "formed for a substantial business

purpose or actually engage[s] in substantive business activity." Northern

Ind. Pub. Serv. Co. v. Commissioner of Internal Revenue, 115 F.3d 506, 511

(7th Cir.1997), quoting Bass v. Commissioner of Internal Revenue, 50 T.C.

595, 600 (1968).

Sham transaction cases most often involve discrete transactions by

businesses or individuals rather than business reorganizations. In

determining whether a transaction is real or just form over substance, a

number of Federal courts have adopted a "two prong" sham transaction

inquiry. Rice's Toyota World, Inc. v. Commissioner of Internal Revenue, 752

F.2d 89 (4th Cir.1985) (Rice's Toyota). The first prong of the inquiry

examines whether the transaction has economic substance other than the

creation of a tax benefit, which has been labeled the "objective" economic

substance test. The second prong examines whether the transaction was

motivated by any business purpose other than obtaining a tax benefit, which

has been labeled the "subjective" business purpose test. [FN8] While often

using similar language, courts have applied this "two prong" inquiry in

different ways. In Rice's Toyota, supra at 91, the court concluded that

"[t]o treat a transaction as a sham, the court must find that the taxpayer

was motivated by no business purposes other than obtaining tax benefits in

entering the transaction, and that the transaction has no economic substance

because no reasonable possibility of a profit exists" (emphasis added).

According to Rice's Toyota and its progeny, if a taxpayer's transaction

satisfies the requirements of either prong of the test it must be respected

for taxing purposes. See Horn v. Commissioner of Internal Revenue, 968 F.2d

1229 (D.C.Cir.1992); United States v. Wexler, 31 F.3d 117 (3d Cir.1994);

Boca Investerings Partnership v. United States, 167 F.Supp.2d 298

(D.D.C.2001).

Other courts have rejected a rigid two-step analysis, opting instead to

treat economic substance and business purpose as "more precise factors to

consider in the application of [the] traditional sham analysis; that is,

whether the transaction had any practical economic effects other than the

creation of income tax losses." Sochin v. Commissioner of Internal Revenue,

843 F.2d 351, 354 (9th Cir.), cert. denied, 488 U.S. 824 (1988). See ACM

Partnership v. Commissioner of Internal Revenue, 157 F.3d 231 (3d Cir.1998);

Casebeer v. Commissioner of Internal Revenue, 909 F.2d 1360, 1363 (9th

Cir.1990); James v. Commissioner of Internal Revenue, 899 F.2d 905 (10th

Cir.1990); Shriver v. Commissioner of Internal Revenue, 899 F.2d 724, 726

(8th Cir.1990); Rose v. Commissioner of Internal Revenue, 868 F.2d 851, 854

(6th Cir.1989). See also Bergman v. United States, 174 F.3d 928, 932 (8th

Cir.1999) ("a transaction must have a purpose, substance, or utility beyond

creating a tax deduction for it to have ... effect").

We agree with those courts that have concluded that whether a transaction

that results in tax benefits is real, such that it ought to be respected for

taxing purposes, depends on whether it has had practical economic effects

beyond the creation of those tax benefits. In the context of a business

reorganization resulting in new corporate entities owning or carrying on a

portion of the business previously held or conducted by the taxpayer, this

requires inquiry into whether the new entities are "viable," that is,

"formed for a substantial business purpose or actually engag[ing] in

substantive business activity." Northern Ind. Pub. Serv. v. Commissioner of

Internal Revenue, supra at 511. In making this inquiry, consideration of the

often interrelated factors of economic substance and business purpose, is

appropriate.

We turn now to the questioned transactions in this case. The board found

that none of the transactions at issue, however defined, had either economic

substance or business purpose other than tax avoidance. The board also found

that, even if the transactions had had a business purpose other than tax

avoidance, their lack of economic substance was fatal to Sherwin-Williams's

claim. We disagree. These transactions (the transfer and license back of

property) are a product and intended part of a business reorganization, and

their economic substance and business purpose must be assessed not in the

narrow confines of the specific transactions between the parent and the

subsidiaries, but in the broader context of the operation of the resultant

businesses. See Northern Ind. Pub. Serv. Co. v. Commissioner of Internal

Revenue, supra at 512 (newly created subsidiary's existence, transactions

with parent, and other economic activities all relevant to sham transaction

analysis). After applying the proper legal standards to the evidence, we

conclude that the reorganization, including the transfer and licensing back

of the marks, had economic substance in that it resulted in the creation of

viable business entities engaging in substantive business activity.

The evidence of economic substance, or substantive business activity, beyond

the creation of tax benefits for Sherwin-Williams, was substantial. Legal

title and physical possession of the marks passed from Sherwin-Williams to

the subsidiaries, as did the benefits and burdens of owning the marks. The

subsidiaries entered into genuine obligations with unrelated third parties

for use of the marks. The subsidiaries received royalties, which they

invested with unrelated third parties to earn additional income for their

businesses. The subsidiaries incurred and paid substantial liabilities to

unrelated third parties and Sherwin-Williams to maintain, manage, and defend

the marks. In sum, the subsidiaries became viable, ongoing business

enterprises within the family of Sherwin-Williams companies, and not

businesses in form only, to be "put to death" after exercising the limited

function of creating a tax benefit. Gregory v. Helvering, 293 U.S. 465, 470

(1935). See Bass v. Commissioner of Internal Revenue, 50 T.C. 595, 600

(1968) (taxpayers' newly formed subsidiary engaged in "substantive business

activity" when it held title to working interests in oil and gas leaseholds;

assumed and paid its share of expenses for the operation of those

leaseholds; collected income from the leaseholds and invested its excess

funds; signed contracts regarding the management of the properties; and

filed income tax returns).

In the face of this substantial evidence, the board rested its finding that

the reorganization and consequent transactions were without economic

substance, principally on subsidiary findings that after the reorganization

(1) Sherwin- Williams owned the stock of, and therefore controlled, the

subsidiaries; (2) Sherwin-Williams (and not the subsidiaries) expended the

money to advertise the products that carried the marks; and (3)

Sherwin-Williams's employees continued to provide the services necessary to

maintain the marks. While these subsidiary findings are supported in the

record, they do not support the board's ultimate finding that the

reorganization was without economic substance or effect and therefore a

sham.

The separate corporate identities of Sherwin-Williams and the subsidiaries

must be respected for tax purposes (where they conduct equivalent of

business activity), see Moline Props. v. Commissioner of Internal Revenue,

319 U.S. 436, 438-439 (1943), regardless of their stock ownership. While

transactions that occur between related companies require close scrutiny to

ensure that they have substance as well as form (and that they are valued at

levels neither artificially inflated nor deflated because of the

interrelated nature of their ownership), the fact that Sherwin-Williams

owned the stock of the subsidiaries does not mean that the reorganization

had no economic substance or effect on its business. It no longer owned the

marks. Instead, it owned stock in the companies that do. It no longer had

the exclusive right to use the marks. Instead, it had nonexclusive and

time-limited licenses to most but not all of them. The new owners of the

marks were free, under their amended bylaws, to enter into licensing

agreements with companies other than Sherwin-Williams without shareholder

approval, and the subsidiaries did so. In addition, Sherwin-Williams

relinquished control over monies it previously retained but now paid to the

subsidiaries as royalties. These monies were not returned to it as

dividends. They were invested (and therefore placed at risk) by the

subsidiaries, under their own investment guidelines and with third parties

outside of Sherwin-Williams's control. These changes resulted from the

reorganization and have legal, practical, and economic effects on Sherwin-

Williams regardless of its stock ownership position. More importantly, they

are ample evidence of a reorganization that has resulted in the creation of

new, viable business enterprises.

Sherwin-Williams incurred advertising expenses to sell its products not to

promote or strengthen the marks. While the marks undoubtedly benefited from

the advertising and sale of Sherwin-Williams products bearing their names,

such benefits are secondary to the principal purpose of the expenditures.

Sherwin- Williams properly expended and expensed these advertising costs

against its sales. In this regard, the board's finding that Sherwin-Williams

and not the subsidiaries incurred the costs of advertising its products is

inconsequential to the ultimate question whether the reorganization was

real.

Finally, that the subsidiaries contracted with Sherwin-Williams for

professional services necessary to maintain the marks bears little

relationship to whether the reorganization had economic substance. What is

relevant is whether the subsidiaries paid the expenses of running their

businesses (with whomever they may have contracted) or whether those

expenses continued to be paid by the parent company, as they were in the

Syms case. Here, those expenses were paid by the subsidiaries to

Sherwin-Williams and, in significantly greater amounts, to other unrelated

professionals. [FN9]

We turn next to the board's assessment of business purpose about which there

was a great deal of contested evidence. Applying our limited scope of review

to the evidence before the board, we conclude that there was sufficient

evidence to support the board's finding that Sherwin-Williams failed to

prove that it undertook the reorganization for any of the reasons adopted by

its board of directors on January 23, 1991, other than reducing its State

tax burden. [FN10] This finding is of course not conclusive on the ultimate

question whether the reorganization was real. Indeed, the board found that,

even if the reorganization and the consequent transfer and licensing

transactions had been motivated by nontax reasons, or served other business

purposes, they would still be a sham because they lacked economic substance

beyond the creation of tax benefits.

We embrace the reasoning of courts that have 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

in a "bald and mischievous fiction." Moline Props. v. Commissioner of

Internal Revenue, supra at 439. See Northern Ind. Pub. Serv. Co. v.

Commissioner of Revenue, 115 F.3d 506, 512 (7th Cir.1997) (public utility's

formation of wholly owned Netherlands subsidiary to borrow money for parent

overseas without triggering Federal withholding tax requirement not a sham,

in spite of tax avoidance motive, where subsidiary engaged in substantive

business activity); Stearns Magnetic Mfg. Co. v. Commissioner of Internal

Revenue, 208 F.2d 849, 852 (7th Cir.1954) (corporate taxpayer who

transferred patents to stockholder partnership as dividend and licensed them

back, may convert form of business as it wishes, even though motive is to

reduce taxes; conversion must be accorded recognition unless it is a change

in form only, without substance); Bass v. Commissioner of Internal Revenue,

50 T.C. 595, 600 (1968) (tax avoidance purpose for reorganizing business

into foreign corporate form irrelevant where form adopted was viable

business entity, i.e., one which "actually engaged in substantive business

activity"). See, e.g., United Parcel Serv. v. Commissioner of Internal

Revenue, 254 F.3d 1014, 1019 (11th Cir.2001) (when dealing with "going

concern," a restructuring has adequate "business purpose" so long "as it

figures in a bona fide, profit-seeking business," regardless of tax

motivation). Because the record in this case establishes that the

reorganization and subsequent transfer and licensing transactions were

genuine, creating viable businesses engaged in substantive economic

activities apart from the creation of tax benefits for Sherwin-Williams,

they cannot be disregarded by the commissioner as a sham regardless of their

tax-motivated purpose.

3. Ordinary and necessary business expenses. General Laws c. 63, § 1 ("[n]et

income"), provides that corporations may take such deductions as are

allowable under the Internal Revenue Code (IRC). See G.L. c. 63, § 1. Under

the IRC, only "ordinary and necessary" business expenses are allowable

deductions. 26 U.S.C. § 162 (2000). The determination whether an expenditure

satisfies the requirements for deductibility under § 162 is a question of

fact. See Commissioner of Internal Revenue v. Heininger, 320 U.S. 467, 475

(1943).

To qualify as an allowable deduction under § 162, a taxpayer must

demonstrate that an expenditure satisfies five requirements: (1) it was paid

or incurred during the taxable year, (2) it was used to carry on a trade or

business, (3) it was an expense, (4) it was a necessary expense, and (5) it

was an ordinary expense. See Commissioner of Internal Revenue v. Lincoln

Sav. & Loan Ass'n, 403 U.S. 345, 352 (1971). The issue here is whether the

royalty payments for the use of the marks were ordinary and necessary

business expenses.

Exactly what constitutes an "ordinary and necessary" business expense has

been the subject of much discussion over the years. In Welch v. Helvering,

290 U.S. 111, 115 (1933), United States Supreme Court Justice Cardozo noted:

"The standard set up by the statute is not a rule of law; it is rather a way

of life. Life in all its fullness must supply the answer to the riddle." In

Deputy v. DuPont, 308 U.S. 488, 495-496 (1940), Justice Douglas emphasized

that "ordinary has the connotation of normal, usual, or customary," and that

each case "turns on its special facts." And in Commissioner of Internal

Revenue v. Tellier, 383 U.S. 687 (1966), Justice Stewart observed: "Our

decisions have consistently construed the term 'necessary' as imposing only

the minimal requirement that the expense be 'appropriate and helpful' for

'the development of the [taxpayer's] business.' " Id. at 689, quoting Welch

v. Helvering, 290 U.S. 111, 113 (1933).

As an alternative ground for the disallowance of Sherwin-Williams's

deduction of royalty payments, the board concluded that Sherwin-Williams's

payment of royalties to its wholly owned subsidiaries was not deductible as

an ordinary and necessary business expense because "the transfer and

license-back transactions between Sherwin-Williams and its subsidiaries

should have been royalty-free." It based this conclusion on its findings

that Sherwin-Williams maintained the value of the marks after the transfer

(by way of advertising and services), and that the subsidiaries "had not

developed the [m]arks in any way, or built any goodwill, or created anything

of value that could be licensed back to the parent."

We disagree with the board's analysis. As noted earlier, advertising costs

were incurred for the purpose of selling products not maintaining the value

of the marks, and any services provided by Sherwin-Williams to maintain the

marks were paid for by the subsidiaries. More fundamentally, however, the

board misconstrues the nature of the reorganization. While Sherwin-Williams

may have voluntarily conveyed the marks to its newly formed subsidiaries, it

received full consideration for the conveyance, i.e., one hundred per cent

of their stock. The relevant question is not who created the value in the

marks, but who had the right to that value, at the time the royalty payments

were made. Once conveyed, Sherwin-Williams had no legal right or claim to

the marks absent licensing agreements. Moreover, the subsidiaries were not

required to add value to what they had acquired from Sherwin-Williams in

order to get fair market royalty rates from it or from the unrelated

third-party licensees with whom they did business. If the subsidiaries had

used some of their stock (or cash) to acquire marks from another company and

in turn licensed them to Sherwin-Williams, there would be no need for them

to "add value" in order properly to demand the payment of royalty fees, and

none is required in these circumstances. As the commissioner's expert,

Professor Alan L. Feld, conceded on cross-examination, "In the corporate

world ... a company does have the right to make a bona fide complete

transfer of a tree ... and then whoever owns the tree, they get the fruit."

Because we have concluded that the reorganization of Sherwin-Williams's

intangible assets was not a sham, the answer to the question who had the

right to the value of the marks, as a matter of law and substance, is the

subsidiaries. The deductibility of the royalty payments between Sherwin-

Williams and the subsidiaries must therefore be treated as the deductibility

of any other expense incurred in a bona fide transaction between related

entities.

The payment of the royalties was a necessary expense because

Sherwin-Williams had "irrevocably divested itself of all title [to the

marks] and had a 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, 853 (7th Cir.1954). Once the marks had been

transferred to the subsidiaries, the royalty payments were necessary so that

Sherwin-Williams could use the marks to advertise and sell its products. One

of the commissioner's experts testified about the importance of the marks:

"I think the trademarks at Sherwin-Williams are very important to its

business.... Their trademarks are very intertwined with the rest of their

business." We agree, and conclude that the royalty payments were "

'appropriate and helpful' for 'the development of [Sherwin-Williams's]

business.' " Commissioner of Internal Revenue v. Tellier, supra at 689,

quoting Welch v. Helvering, supra at 113.

The payment of royalties was also an ordinary expense. "Ordinary has the

connotation of normal, usual, or customary." Deputy v. DuPont, supra at 495.

Although "the transaction which gives rise to [the expense] must be of

common or frequent occurrence in the type of business involved ... the fact

that a particular expense would be an ordinary or common one in the course

of one business and so deductible ... does not necessarily make it such in

connection with another business." Id. In finding that the expense was not

"ordinary," the board credited and relied on the testimony of one of the

commissioner's witnesses who testified in general terms, and without

specifics, that license back arrangements between parent and subsidiary

corporations are quite typically "royalty free." He also testified, however,

that he was personally aware of instances where companies licensed

intangible assets to affiliates and charged them royalties for their use.

Puglisi testified that when Sherwin-Williams once asked him for a

royalty-free license, he turned them down. [FN11] Based on the particular

facts of this case in all their fullness, we conclude that there was not

substantial evidence before the board to support its finding that the

royalty payments were not ordinary expenses.

4. Reasonableness of the royalty payments. Although we have concluded that

the royalty payments that Sherwin-Williams made to the subsidiaries were

ordinary and necessary expenses, we must also consider whether the amount of

the royalty payments was reasonable. "Inherent in section 162(a)'s concept

of 'ordinary and necessary' expenses is the requirement that any payment

asserted to be allowable as a deduction ... be reasonable in relation to its

purpose. 'An expenditure may be, by its nature, ordinary and necessary, but

at the same time it may be unreasonable in amount.' " Audano v. United

States, 428 F.2d 251, 256 (5th Cir.1970), quoting United States v. Haskel

Eng'g & Supply Co., 380 F.2d 786, 788 (9th Cir.1967).

The agreements under which payments are made will be given effect "if the

arrangement is fair and reasonable, judged by the standards of a transaction

entered into by parties dealing at arm's length." Stearns Magnetic Mfg. Co.

v. Commissioner of Internal Revenue, 208 F.2d 849, 852 (7th Cir.1954). See

Audano v. United States, supra at 256 (if agreement was such as "reasonable

men dealing at arm's length" would have made, it should be valid for tax

purposes). A common method for establishing reasonableness is the use of

professional appraisers who can look broadly at related industries and

practices and estimate a proper royalty rate. The AAA report appraised the

value of the marks and recommended royalty rates ranging from one per cent

to four and one-half per cent for each of Sherwin-Williams's product

divisions. We are satisfied from our review of the record that this report

established royalty rates that represented arm's-length transactions, and

the commissioner's experts did not testify otherwise. [FN12]

5. General Laws c. 63, § 39A. General Laws c. 63, § 39A, provides that the

commissioner may determine the "net income of a foreign corporation which is

a subsidiary of another corporation or closely affiliated therewith by stock

ownership" by "eliminating all payments to the parent corporation or

affiliated corporations in excess of fair value." The purpose of the statute

is to give the commissioner the "authority to make adjustments to correct

the effect of less than arm's length transactions," between closely

affiliated companies, Commissioner of Revenue v. AMIWoodbroke, Inc., 418

Mass. 92, 97 (1994), quoting Polaroid Corp. v. Commissioner of Revenue, 393

Mass. 490, 500(198) and thereby address concerns that "tax evasion by means

of intercorporate transactions ... would depress the ... income of

corporations subject to taxation in Massachusetts." Id.

The board found that the transfer and license back of the marks in exchange

for royalty payments were not arm's-length transactions because

Sherwin-Williams controlled the subsidiaries and there was never a question

that the marks would be licensed back to Sherwin-Williams because its

existence depended on their use. It further found that the royalty payments

had no economic purpose because Sherwin-Williams had itself created the

obligation by transferring the marks, and the subsidiaries did nothing to

add value to them which would justify such payments. Consequently, it

concluded that any payments were in excess of fair market value.

Sherwin-Williams contends that § 39A does not apply to it because it is a

parent corporation, not a subsidiary. It also contended that the royalty

payments reflected fair value and arm's-length rates as evidenced by the AAA

appraisal report, the testimony of its own witnesses, and the testimony of

the commissioner's experts. Consequently, there were no payments to

eliminate.

Although we agree with the board that the transactions were not entered into

at arm's length, the relevant inquiries are whether the transfers were bona

fide (which we have concluded they were) and if so, whether the royalty

rates paid were in excess of fair market value (which we have concluded they

were not).

Assuming that § 39A, construed to give effect to its broad remedial purpose,

permits the commissioner to eliminate payments made by a parent to a

subsidiary corporation, it does so only to the extent that those payments

are in excess of fair value. Having concluded that the board was in error in

concluding that the payments were in excess of fair value, we hold that the

commissioner's adjustment to Sherwin-Williams's income could not have been

made pursuant to Section 39A.

6. Interest expense. The commissioner disallowed a deduction for interest

that Sherwin-Williams paid SWIMC in connection with a short-term loan of $7

million. The rationale for the disallowance was that, because the royalty

payments from Sherwin-Williams to SWIMC were unnecessary, the loan back to

Sherwin-Williams and the interest on that loan were also unnecessary. The

board affirmed the disallowance. We reverse. Because we have 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 is no dispute that the loan was actually made, the interest

paid to secure it was deductible. [FN13]

7. Conclusion. The decision of the Appellate Tax Board is reversed.

So ordered.

1. The Sherwin-Williams Company (Sherwin-Williams) owned one hundred per

cent of the stock of Sherwin-Williams Investment Management Company, Inc.

(SWIMC), and eighty-five per cent of the stock of Dupli-Color Investment

Management Company, Inc. (DIMC). The balance of the DIMC stock was owned by

Dupli-Color Products Company, another wholly owned subsidiary of

Sherwin-Williams.

2. The international marks were to remain with Sherwin-Williams under the

management of the company's international division until various legal

impediments had been further explored.

3. The decision to separate the marks in this way was based on Sherwin-

Williams's concerns about the potential for increased legal liability

arising from the aerosol products and their use, and its desire to track and

monitor the sales of those products separately, a task that could be

accomplished through the identification of sales necessary to calculating

the royalties due to the DIMC subsidiary.

4. An assistant secretary also was to be paid $500 annually from each

company.

5. As of December 31, 1991, SWIMC had invested $3,286,798 in short-term

investment instruments and had an outstanding loan due from

Sherwin-Williams, bearing a market interest rate, in the amount of

$7,000,000. By December 31, 1992, SWIMC had $53,361,479 invested in

short-term investment instruments, from which it earned $1,137,156, with no

loans due from Sherwin-Williams. By December 31, 1992, DIMC had $8,791,605

invested in short-term investment instruments, from which it earned

$181,527, with no loans due from Sherwin- Williams.

6. This discussion is confined to transactions alleged to be "shams in

substance," i.e., transactions that really occurred but are alleged to lack

the substance their form represents. We do not discuss transactions that are

alleged to be "shams in fact," i.e., transactions that never occurred.

7. There are other types of transactions that may give rise to a claim of

"sham" by taxing authorities, for example, "tax shelters," see ACM

Partnership v. Commissioner of Internal Revenue, 157 F.3d 231 (3d Cir.1998);

interest paid on contrived loans, see Knetsch v. United States, 364 U.S. 361

(1960); or commodity option straddles unrelated to the conduct of a

business, whose only possible effect is a tax loss or deduction, see Yosha

v. Commissioner of Internal Revenue, 861 F.2d 494 (7th Cir.1988). Those

types of transactions, often disregarded under the sham transaction

doctrine, present a somewhat different set of issues from the reorganization

of an ongoing business. See United Parcel Serv. v. Commissioner of Internal

Revenue, 254 F.3d 1014 (11th Cir.2001).

8. In the context of a reorganization of United Parcel Service, the United

States Court of Appeals for the Eleventh Circuit recently described the

subjective business purpose test in slightly but significantly different

terms, as an inquiry into whether the reorganization "has no business

purpose and its motive is tax avoidance." United Parcel Serv. v.

Commissioner of Internal Revenue, 254 F.3d 1014, 1018 (11th Cir.2001). The

court went on to conclude that the restructuring of an ongoing business has

a "business purpose" so long as "it figures in a bona fide profit-seeking

business," regardless of tax motivation. Id. at 1019.

9. It is not contended by the commissioner that the rates paid to Sherwin-

Williams for professional services were below market rates for the services

performed.

10. We reach this conclusion even if we might have concluded otherwise de

novo. Matter of Segal, 430 Mass. 359, 364 (1999).

11. "In only one instance actually did Sherwin-Williams ask for a

royalty-free license and I did not give it ... they're using my marks, I

expect their consideration for the use of the marks, and I don't believe

that their sale of products using my marks without monetary consideration

would have been fair."

12. One of the commissioner's experts testified: "[I]f [the

Sherwin-Williams's marks] were owned by an independent third party ... a

stranger ... chances are that a very high royalty would be paid." He agreed

that, if the marks were owned by an independent third party, a 2.8 per cent

royalty rate would be "a good deal."

13. There is no dispute that the interest rate was at fair market value.