United States: Wisconsin Tax Appeals Commission Finds Intangible Holding Company Has No Liability, But Reserves Right To Assess Operating Company

The Wisconsin Tax Appeals Commission (WTAC) recently concluded that an out-of-state intangible holding company did not have a Wisconsin corporation income or franchise tax liability.1 Under the law in effect during the tax periods at issue, the taxpayer's incomeproducing activity occurred completely outside Wisconsin, resulting in a sales factor of zero. Based on this conclusion, the WTAC did not reach the issue of whether imposition of the tax on the intangible holding company violated either the Due Process or Commerce Clauses of the United States Constitution. However, a separate tax assessment against the holding company's parent operating company for the same period remains outstanding.


The taxpayer was formed as a wholly-owned subsidiary of a California-based operating company in 1999. Upon its formation, the parent contributed all of its existing domestic intellectual property, including trademarks, patents, and copyrights, to the taxpayer. The taxpayer licensed the intellectual property to its parent and to unrelated licensees, with the amount of the charged license fees established by a transfer pricing study prepared by the taxpayer's accounting firm.

For the 2000-2003 tax years, the taxpayer did not file Wisconsin corporate income / franchise tax returns. During that period, the taxpayer had no offices, employees, or representatives in Wisconsin and owned no real or tangible personal property in the state. Its parent sold tangible personal property bearing and incorporating its licensed intellectual property to Wisconsin customers. Pursuant to the terms of the licensing agreement, the parent, not the taxpayer, controlled how and where the domestic intellectual property was used.2

In December 2008, the Wisconsin Department of Revenue issued a Notice of Field Audit Action to the taxpayer reflecting an assessment for corporate franchise tax due in the amount of $2,402,930 for the 2000-2003 calendar years. The assessment was issued "in the alternative" to two separate corporate franchise tax assessments issued to the parent and denying its deductions for royalty payments made to the taxpayer (the assessments issued to the parent were held in abeyance pending a determination in this matter). The assessment asserted that the taxpayer had corporate franchise tax nexus with Wisconsin based on the fact that it licensed intellectual property to its parent company for use in Wisconsin. The taxpayer filed a Petition for Redetermination, which was ultimately denied, resulting in the WTAC hearing.

Income Tax Liability

The issues in this matter included: (i) whether the Department had the statutory authority to impose Wisconsin income or franchise tax on the taxpayer; (ii) whether all "incomeproducing activities" relating to the taxpayer's licensing of intangible property during the period at issue occurred outside Wisconsin, thereby resulting in the apportionment of none of the taxpayer's income to the state; (iii) whether the Department wrongly excluded the taxpayer's property and payroll factors from the otherwise applicable three-factor statutory apportionment formula; and (iv) whether the imposition of Wisconsin income or franchise tax on the taxpayer violated the Due Process Clause and/or Commerce Clause of the United States Constitution.

Nexus and Apportionment Law for Years at Issue

Corporations engaged in multistate business are subject to franchise tax in Wisconsin based on apportionable income.3 For the 2000-2003 tax years, Wisconsin taxable income was reportable on a separate entity basis and based on an apportionment fraction composed of a double-weighted sales factor, a property factor, and a payroll factor.4 To compute the sales factor, sales of items other than tangible personal property were sourced to Wisconsin if the income-producing activity was performed in Wisconsin. If the income-producing activity was performed both in and outside Wisconsin, the sales were divided in proportion to the direct costs of performance incurred in each such state in rendering the service (a pro rata approach).5 Specifically, the term "income producing activity" was defined as "the act or acts directly engaged in by the taxpayer for the ultimate purpose of obtaining gains or profit. This activity does not include activities performed on behalf of a taxpayer such as those conducted on its behalf by an independent contractor."6 In the years following the audit period, Wisconsin made a variety of changes to its corporation income tax system.7

Income-Producing Activity

The taxpayer argued that, for the tax years at issue, it engaged in no income-producing activities in Wisconsin, so none of its royalty income should be included in the numerator of its Wisconsin sales factor. The Department, in contrast, asserted that because the taxpayer's royalty income was generated by the sale of tangible property in Wisconsin which bore the licensed trademarks owned by the taxpayer, the relevant income-producing activity was the sale of the items. Thus, the Department contended, the royalties related to the sales of tangible property in Wisconsin by the parent should be included in the numerator of the sales factor and the royalties from the sale of tangible property everywhere by the licensee should be included in the denominator.

In support of its position, the Department cited a case involving a Delaware corporation which sold local and national advertising placed in telephone directories distributed in Wisconsin during the years 1994 through 1996.8 In that instance, the income-producing activity was found to be the distribution of the directories to Wisconsin residents, not the ancillary activities performed in other states.

In considering the Department's position, the WTAC relied upon a prior decision with similar facts involving the sourcing of revenue from media advertising time.9 The Commission had considered whether the revenue earned by a taxpayer from the sale of network and national advertising time in Wisconsin was properly includable in the numerator of the sales factor of its Wisconsin apportionment formula. The taxpayer had derived advertising revenue in Wisconsin from both local advertising, solicited by a Wisconsin sales staff, and national advertising, placed by national sales representatives located outside the state. The Commission found that the network and national advertising revenues were based upon the showing or broadcasting of the advertisements. Thus, the income-producing activity was the actual broadcasting of the programming desired by the advertiser and the commercial spots during that programming, which was located in Wisconsin.

To identify the income-producing activity engaged in by the taxpayer in the current case, the WTAC focused on the terms of the licensing contract. Also, the WTAC relied upon the Department's long-standing rule for the tax period at issue, which stated that "income producing activity" means "the act or acts directly engaged in by the taxpayer for the ultimate purposes of obtaining gains or profits."10 The only activity directly engaged in by the taxpayer was the licensing of the domestic intellectual property. To the extent design, development, and marketing activities related to the intellectual property might have aided in these sales, the activities took place outside Wisconsin. Thus, the taxpayer engaged in no income-producing activities in Wisconsin during the tax period at issue, resulting in a Wisconsin sales factor of zero.

Distinguishing between the cases cited as supportive of the Department's position, the WTAC noted that those taxpayers had employees, property, and direct activities in Wisconsin. By contrast, the taxpayer had no employees or property in Wisconsin and did not directly engage in any activities in the state. As a result, it had no "income-producing activities" in Wisconsin and no part of its royalty income was includable in the numerator of its Wisconsin sales factor. While the sale of tangible property bearing the trademark owned by the taxpayer is certainly an income-producing activity, the WTAC found, "it is an activity of the taxpayer's parent corporation, not the taxpayer. To reach a different conclusion and impose a market-based sourcing rule like the one adopted by the Wisconsin legislature in 2009 would be contrary to the express language of the statutes and regulations in effect during the tax periods at issue, as well as the legislative history leading up to the 2009 statutory change."

Because the WTAC concluded that the taxpayer had a zero apportionment factor for Wisconsin franchise tax purposes, it did not consider whether the Department had the statutory or constitutional authority to impose the tax, nor whether the Department erred in excluding the taxpayer's property and payroll factors, which were zero, in its computation of taxable income.


The statutory changes enacted by Wisconsin effective for dates after the tax period at issue were adopted in part to address intellectual property affiliate structures which allowed certain companies to reduce taxes in separate reporting states. The adoption of sales factor sourcing rules for income from intangible assets based on where the intangible assets are used more closely mirrors destination-based sourcing rules long used to source income from sales of tangible personal property. Finally, the changes to the sales factor sourcing rules render the identification of an "income-producing activity," the very crux of this decision, unnecessary.

Wisconsin, like many other states, has denied operating companies a deduction for royalty payments made to intellectual property companies. Such claims have been sustained for a multitude of reasons, including that the primary purpose to form the intellectual property affiliate was tax avoidance and that such formation otherwise lacked a valid business purpose.11 Other arguments sustained in various jurisdictions include that the intellectual property affiliate lacked economic substance, the organization of the intellectual property affiliate was a sham transaction, and/or the denial of the deduction for the royalty payments was necessary to more clearly reflect income pursuant to the state's version of Internal Revenue Code Sec. 482. In Wisconsin, the WTAC has upheld the Department's denial of deductions for royalties paid to a related entity based on the fact that the primary purpose for the creation of the affiliate and payment of royalties was tax avoidance, and that payment of the royalties otherwise had no economic substance or business purpose.12

Held in abeyance are franchise tax assessments against the taxpayer's parent company, which deny the deductions taken by that entity related to the royalty payments made to the taxpayer. No specific details were provided regarding the decision to move forward with this proceeding first, rather than proceeding with the seemingly more common approach of first addressing the assessments against the parent company. Perhaps the tax liability at issue in this case was greater than the assessments against the parent, or the taxpayer was more confident of its abilities to succeed in this argument. As no other case involving royalty payments to an intellectual property affiliate has gone to trial in Wisconsin since Hormel, it appears that the taxpayer's parent will likely face additional action if the taxpayer's matter is not appealed by the Department.13 Time will tell whether that case reaches the WTAC or whether the parties decide it more prudent to settle the issue.

1 Skechers USA, Inc. II v. Wisconsin Department of Revenue, Wisconsin Tax Appeals Commission, No. 10-1-173, July 31, 2015.

2 Importantly, the licensing agreement between the taxpayer and its parent was negotiated and executed outside Wisconsin. In addition, all activity engaged in by the taxpayer relating to the designing, developing, and marketing of its intellectual property, as well as all work to increase the number of its patents and trademarks, took place outside Wisconsin.

3 WIS. STATS. § 71.25 (5) (prior law).

4 WIS. STATS. § 71.25 (9)(d) (prior law).

5 WIS. STATS. § 71.25 (9)(e) (prior law).

6 WIS. ADMIN. CODE § 2.39(6) (prior law).

7 Wisconsin enacted legislation to phase in a single sales factor apportionment formula, which became fully implemented for taxable years beginning after December 31, 2007. Act 37 (S.B. 197), Laws 2003. Wisconsin also changed the rules for sourcing sales of services and intangible property. Act 25 (A.B. 100), Laws 2005; Act 2 (S.B. 62), Laws 2009. The new method of sourcing sales, other than sales of tangible personal property, generally assigns receipts from royalty income based on a market-sourcing approach. Specifically, for taxable years beginning on or after January 1, 2009, gross royalties and other gross receipts received for the use or license of intangible property, are sourced to Wisconsin if the purchaser or licensee uses the intangible property in the operation of a trade or business at a location in Wisconsin. If the purchaser or licensee uses the intangible property in more than one state, the royalties from the use of the intangible property are divided in proportion to the use of the intangible property in those states. WIS. STATS. § 71.25(9)(dj), adopted by Act 2 (S.B. 62), Laws 2009. A listing of intangible property receiving such treatment includes patents, copyrights, trademarks, trade names, services names, franchises, licenses, specifications, blueprints, processes, techniques, formulas, designs, layouts, patterns, drawings, manuals, technical know-how, contracts, and customer lists. Finally, for tax years beginning on or after January 1, 2009, Wisconsin adopted mandatory combined reporting. Act 2 (S.B. 62), Laws 2009.

8 Ameritech Publishing, Inc. v. Wisconsin Department of Revenue, 788 N.W.2d 383 (Wis. Ct. App. 2010).

9 The Hearst Corp. v. Wisconsin Department of Revenue, Wisconsin Tax Appeals Commission, No. 01-I- 227 (P-II), Jan. 22, 2008.

10 WIS. ADMIN. CODE § 2.39(6) (prior law) (emphasis added).

11 Wisconsin was the first state to codify an economic substance requirement. WIS. STATS. §§ 71.10(1m) and 71.30(2m), as adopted by Act 2 (S.B. 62), Laws 2009. For tax years beginning on or after January 1, 2009, transactions considered to lack economic substance are statutorily disallowed. Wisconsin had followed a similar administrative policy prior to codification. See, for example, Hormel Foods Corp. v. Department of Revenue, Wisconsin Tax Appeals Commission, No. 7-I-17, Mar. 29, 2010. In that instance, the WTAC applied general economic substance principles to a period prior to adoption of the statute.

12 Hormel Foods Corp. v. Department of Revenue, Wisconsin Tax Appeals Commission, No. 7-I-17, Mar. 29, 2010.

13 Although Hormel appealed the WTAC decision to the Circuit Court, the case was ultimately settled prior to hearing.

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