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 transactionsIntra-Group Transactions are interactions between entities within the same multinational enterprise (MNE). Such transactions form the backbone of related-party dealings and are essential in managing global operations and aligning business objectives across jurisdictions. Understanding intra-group transactions is critical in international tax and transfer pricing, as they directly impact a company's tax obligations, profitability, and compliance standing. Tax professionals, accountants, lawyers,... 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 liabilityTax liability represents the total amount of tax owed by an individual or business to a tax authority, whether local, national, or international. This obligation arises through various forms of income, profits, or transactions subject to taxation laws and regulations. Understanding tax liability is essential for compliance and efficient financial management for corporations and individuals. It influences how businesses structure.... 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 returnsA Tax Return is a formal statement filed by an individual or entity that details income, expenses, and other pertinent tax information to a tax authority. Its primary purpose is to assess tax liability, determine refunds owed, or highlight outstanding taxes due. Tax returns may include information about earnings, capital gains, allowable deductions, and credits, depending on the tax regulations... for 2000-2003.

The Wisconsin Department of Revenue challenged these deductions, asserting that the intercompany transactionsIntra-Group Transactions are interactions between entities within the same multinational enterprise (MNE). Such transactions form the backbone of related-party dealings and are essential in managing global operations and aligning business objectives across jurisdictions. Understanding intra-group transactions is critical in international tax and transfer pricing, as they directly impact a company's tax obligations, profitability, and compliance standing. Tax professionals, accountants, lawyers,... were designed solely for tax avoidanceTax avoidance refers to the practice of legally structuring financial activities to minimise tax liability, reducing the amount of tax owed without violating laws. Unlike tax evasion, which is illegal and involves concealing income or misreporting, tax avoidance operates within the framework of the law. Multinational enterprises (MNEs) and individuals often engage in tax planning strategies that reduce tax liabilities... 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 filingsA Tax Return is a formal statement filed by an individual or entity that details income, expenses, and other pertinent tax information to a tax authority. Its primary purpose is to assess tax liability, determine refunds owed, or highlight outstanding taxes due. Tax returns may include information about earnings, capital gains, allowable deductions, and credits, depending on the tax regulations... 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 pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... 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 avoidanceTax avoidance refers to the practice of legally structuring financial activities to minimise tax liability, reducing the amount of tax owed without violating laws. Unlike tax evasion, which is illegal and involves concealing income or misreporting, tax avoidance operates within the framework of the law. Multinational enterprises (MNEs) and individuals often engage in tax planning strategies that reduce tax liabilities....
Skechers failed to demonstrate a valid business purpose for the intercompany transactionsIntra-Group Transactions are interactions between entities within the same multinational enterprise (MNE). Such transactions form the backbone of related-party dealings and are essential in managing global operations and aligning business objectives across jurisdictions. Understanding intra-group transactions is critical in international tax and transfer pricing, as they directly impact a company's tax obligations, profitability, and compliance standing. Tax professionals, accountants, lawyers,... 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 transactionsIntra-Group Transactions are interactions between entities within the same multinational enterprise (MNE). Such transactions form the backbone of related-party dealings and are essential in managing global operations and aligning business objectives across jurisdictions. Understanding intra-group transactions is critical in international tax and transfer pricing, as they directly impact a company's tax obligations, profitability, and compliance standing. Tax professionals, accountants, lawyers,... 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 PricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... Validity: While the transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... 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 transactionsIntra-Group Transactions are interactions between entities within the same multinational enterprise (MNE). Such transactions form the backbone of related-party dealings and are essential in managing global operations and aligning business objectives across jurisdictions. Understanding intra-group transactions is critical in international tax and transfer pricing, as they directly impact a company's tax obligations, profitability, and compliance standing. Tax professionals, accountants, lawyers,... and tax avoidanceTax avoidance refers to the practice of legally structuring financial activities to minimise tax liability, reducing the amount of tax owed without violating laws. Unlike tax evasion, which is illegal and involves concealing income or misreporting, tax avoidance operates within the framework of the law. Multinational enterprises (MNEs) and individuals often engage in tax planning strategies that reduce tax liabilities.... 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 MNEsWhat are Multinational Enterprises (MNEs)? Multinational Enterprises, commonly referred to as MNEs, are corporations that operate in multiple countries through various subsidiaries, branches, or affiliates. These entities maintain a central management structure while leveraging diverse resources, labour markets, and customer bases across borders. The fundamental aspect that distinguishes MNEs from other corporate forms is their cross-border activity, which can include... to ensure that intercompany transactionsIntra-Group Transactions are interactions between entities within the same multinational enterprise (MNE). Such transactions form the backbone of related-party dealings and are essential in managing global operations and aligning business objectives across jurisdictions. Understanding intra-group transactions is critical in international tax and transfer pricing, as they directly impact a company's tax obligations, profitability, and compliance standing. Tax professionals, accountants, lawyers,..., particularly those involving intellectual property and royalties, have a valid business purpose and economic substance beyond tax minimization. MNEsWhat are Multinational Enterprises (MNEs)? Multinational Enterprises, commonly referred to as MNEs, are corporations that operate in multiple countries through various subsidiaries, branches, or affiliates. These entities maintain a central management structure while leveraging diverse resources, labour markets, and customer bases across borders. The fundamental aspect that distinguishes MNEs from other corporate forms is their cross-border activity, which can include... must be cautious when structuring their operations and ensure that their transfer pricing policiesTransfer Pricing Policies refer to the rules and methods established by multinational enterprises (MNEs) to determine the pricing of transactions between related parties, such as subsidiaries or divisions of the same company. These transactions may involve the transfer of goods, services, intellectual property, or financial arrangements. Transfer pricing policies are essential for ensuring that intercompany transactions adhere to the arm’s... 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 transactionsIntra-Group Transactions are interactions between entities within the same multinational enterprise (MNE). Such transactions form the backbone of related-party dealings and are essential in managing global operations and aligning business objectives across jurisdictions. Understanding intra-group transactions is critical in international tax and transfer pricing, as they directly impact a company's tax obligations, profitability, and compliance standing. Tax professionals, accountants, lawyers,... that appear to be motivated primarily by tax avoidanceTax avoidance refers to the practice of legally structuring financial activities to minimise tax liability, reducing the amount of tax owed without violating laws. Unlike tax evasion, which is illegal and involves concealing income or misreporting, tax avoidance operates within the framework of the law. Multinational enterprises (MNEs) and individuals often engage in tax planning strategies that reduce tax liabilities.... 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 MNEsWhat are Multinational Enterprises (MNEs)? Multinational Enterprises, commonly referred to as MNEs, are corporations that operate in multiple countries through various subsidiaries, branches, or affiliates. These entities maintain a central management structure while leveraging diverse resources, labour markets, and customer bases across borders. The fundamental aspect that distinguishes MNEs from other corporate forms is their cross-border activity, which can include... to engage with transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... experts. A robust transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... strategy that complies with both local and international guidelines is essential to avoid disputes with tax authorities. Experts can ensure that intercompany transactionsIntra-Group Transactions are interactions between entities within the same multinational enterprise (MNE). Such transactions form the backbone of related-party dealings and are essential in managing global operations and aligning business objectives across jurisdictions. Understanding intra-group transactions is critical in international tax and transfer pricing, as they directly impact a company's tax obligations, profitability, and compliance standing. Tax professionals, accountants, lawyers,... are properly documented, have a valid business purpose, and meet the arm’s length principleThe Arm’s Length Principle (ALP) is a cornerstone concept in international taxation and transfer pricing. It requires that transactions between related parties, such as subsidiaries or affiliates within a multinational enterprise (MNE), mirror those that would occur between independent entities under similar circumstances. This principle ensures that each entity within an MNE is compensated fairly and transparently, based on the.... Additionally, experts can help MNEsWhat are Multinational Enterprises (MNEs)? Multinational Enterprises, commonly referred to as MNEs, are corporations that operate in multiple countries through various subsidiaries, branches, or affiliates. These entities maintain a central management structure while leveraging diverse resources, labour markets, and customer bases across borders. The fundamental aspect that distinguishes MNEs from other corporate forms is their cross-border activity, which can include...