Skechers USA Inc. vs. USA - Academy of Tax Law

CLICK HERE TO READ THE FULL JUDGMENT Dr Daniel N Erasmus generated this summary, which was also published on his website, www.taxriskmanagement.com.

Case Information

Court: Wisconsin Tax Appeals Commission
Case No: 10-I-171 and 10-I-1721
Applicant: Skechers USA Inc.
Defendant: Wisconsin Department of Revenue
Judgment Date: February 24, 2023

Judgment Summary

The Wisconsin Tax Appeals Commission ruled in favour of the Wisconsin Department of Revenue, affirming its disallowance of royalty deductions claimed by Skechers USA Inc. in relation to intercompany transactions between Skechers and its subsidiary, Skechers USA Inc. II (SKII). The Commission found that the transactions lacked economic substance and were primarily designed to minimize state taxes, deeming them as sham transactions. The decision underscored the importance of economic substance and a valid business purpose for tax-related transactions between related entities.

Key Points of the Judgment

Background

Skechers USA Inc. is a footwear company headquartered in California, with a wholly-owned subsidiary, Skechers USA Inc. II (SKII), incorporated in Delaware. SKII was created in 1999 as part of a tax minimization strategy advised by KPMG, aimed at reducing Skechers’ state tax liability. Skechers transferred its domestic intellectual property (IP) rights to SKII, which licensed it back to Skechers, allowing Skechers to claim royalty deductions on its tax returns for 2000-2003.

The Wisconsin Department of Revenue challenged these deductions, asserting that the intercompany transactions were designed solely for tax avoidance purposes and lacked a valid business purpose or economic substance. Skechers disputed this, leading to the case being heard before the Wisconsin Tax Appeals Commission.

Core Dispute

The core dispute centered around whether the royalty deductions claimed by Skechers in its Wisconsin tax filings were valid. The Department of Revenue argued that the transactions between Skechers and SKII were sham transactions, lacking economic substance and a valid business purpose. Skechers maintained that SKII was a legitimate business entity, and the royalty payments were appropriate and consistent with standard transfer pricing practices.

Court Findings

The Commission found in favour of the Wisconsin Department of Revenue, concluding that:

The transactions between Skechers and SKII were primarily motivated by tax avoidance.
Skechers failed to demonstrate a valid business purpose for the intercompany transactions other than tax minimization.
The transactions lacked economic substance as they did not result in any meaningful changes in business operations, profitability, or risk allocation between Skechers and SKII.

The Commission highlighted the lack of contemporaneous evidence supporting any non-tax-related business benefits for the creation of SKII and the licensing of the IP back to Skechers.

Outcome

The Commission upheld the Department of Revenue’s assessment, disallowing the royalty deductions claimed by Skechers. The decision reaffirmed that tax deductions based on intercompany transactions must have both economic substance and a valid business purpose to be respected for tax purposes.

Transfer Pricing Method

KPMG, acting as Skechers’ advisor, used the Comparable Profits Method (CPM) to determine the royalty rates for the IP licensing transaction between Skechers and SKII. However, the Commission noted that while the CPM methodology might have been followed, the underlying transactions lacked economic substance, thus invalidating the deductions based on them.

Major Issues and Areas of Contention

Economic Substance: The Commission emphasized that the transactions between Skechers and SKII did not result in any real economic change. Despite the creation of SKII, Skechers’ business operations remained unchanged, and the royalty payments were mere journal entries without actual cash flow.
Business Purpose: The primary issue was the lack of a valid business purpose. The Commission found that the creation of SKII and the licensing transactions were primarily designed to reduce state taxes, with no evidence of non-tax-related benefits at the time of the transactions.
Transfer Pricing Validity: While the transfer pricing method (CPM) used to determine the royalty rates was not challenged in its technical aspects, the economic substance of the underlying transactions was deemed insufficient to support the tax deductions.

Was this Decision Expected or Controversial?

The decision was expected based on similar rulings in other cases involving intercompany transactions and tax avoidance. The use of intellectual property (IP) transfers to subsidiaries in low or no-tax jurisdictions has been a common tax minimization strategy for multinational corporations. However, courts and tax authorities have increasingly scrutinized these transactions, especially when there is little or no economic substance beyond tax savings. The decision followed the precedent set by earlier cases, such as Hormel Foods Corp. v. Wisconsin Dept. of Revenue, which also disallowed deductions for transactions that lacked economic substance.

Significance for Multinational Enterprises (MNEs)

This case underscores the importance for MNEs to ensure that intercompany transactions, particularly those involving intellectual property and royalties, have a valid business purpose and economic substance beyond tax minimization. MNEs must be cautious when structuring their operations and ensure that their transfer pricing policies are not solely aimed at reducing taxes, as such transactions are likely to face scrutiny from tax authorities.

Significance for Revenue Services

For revenue authorities, this case highlights the importance of challenging intercompany transactions that appear to be motivated primarily by tax avoidance. The ruling provides a framework for assessing the validity of such transactions, focusing on the need for economic substance and a legitimate business purpose. The decision also reinforces the authority of tax departments to disallow deductions that do not meet these criteria.

Importance of Engaging Transfer Pricing Experts

This case illustrates why it is crucial for MNEs to engage with transfer pricing experts. A robust transfer pricing strategy that complies with both local and international guidelines is essential to avoid disputes with tax authorities. Experts can ensure that intercompany transactions are properly documented, have a valid business purpose, and meet the arm’s length principle. Additionally, experts can help MNEs