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Sweet Result in Utah State Tax Commission v. See’s Candies, Inc.

Tax Development Nov 08, 2018

Properly Implemented Business Planning Leads to a Sweet Result in Utah State Tax Commission v. See’s Candies, Inc.

Berkshire Hathaway Inc. (“Berkshire”) is the parent holding company of a variety of business interests. At its helm is arguably one of the best business minds in the world, Warren Buffett. Berkshire invests in a variety of industries, including freight transportation, finance, utilities, insurance companies, consumer retail, food, building materials, and numerous other interests. Operating decisions for the various Berkshire companies are made by the managers of those businesses, while investment and capital deployment decisions are made at the holding company level. 

In 1997, one of Berkshire’s insurance subsidiaries, Columbia Insurance Company (“Columbia”) offered to purchase intellectual property (IP) from See’s Candies, Inc. (“See’s”) and other Berkshire-operating companies. The sale was executed as a tax-free exchange of stock for assets under Internal Revenue Code (IRC) § 351; See’s transferred its IP in exchange for preferred stock in Columbia equal to the fair market value of the IP. 

When Columbia decided to embark upon this strategy, it increased its staff levels from one full-time attorney, who spent about 75% of his time on IP, to three full-time IP attorneys. The Columbia IP attorneys kept the trademarks in force and prosecuted infringement. They also visited and trained operating company employees regarding updates in IP law and best practices. They evaluated IP procedures and quality of the branded product to ensure enhancement of the IP. See’s and the other operating companies could then focus on their core businesses (e.g., the making of candy). Berkshire would also be able to measure the operating companies on their cost of capital by removing the value of the IP from the operating profit.  

The transfer is one that would be seen between unrelated business entities. The intellectual property of See’s would be managed by a company with IP expertise—Columbia, and Columbia would have additional cash reserves that could be used to grow its business. A portion of the increased value of Columbia would inure with See’s through its preferred shareholdings in Columbia.

An agreement between See’s and Columbia allowed See’s to use the IP. The royalty set for the use of the IP was meticulously developed by an independent transfer pricing study. That study was used not only to set the royalty rate, but also the value for which the IP was transferred to Columbia. The pricing set by the study ensured that See’s received stock in Columbia equal to the value of the intangibles transferred. The royalty for using the IP was adjusted for expenses incurred by See’s to maintain the IP through advertising, managing customer subscription lists, and other activities. In a separate agreement, any additional IP created by See’s would be on Columbia’s behalf and would be owned by Columbia and licensed to See’s. Columbia would reimburse See’s for its development expenses on a percentage rate of domestic sales. All financial exchanges between See’s and Columbia were set by this independent transfer pricing study and were reevaluated and renewed on a periodic basis. Under the agreement, Columbia did not return to See’s any part of the royalties it received as payments, nor did it provide See’s loans, dividends, or other compensation. 

This transaction was first audited by the Multistate Tax Commission (MTC), for years 1995 to 1998. MTC ultimately recommended that the royalty be lowered by 10%, which took the royalty down to the bottom end of the acceptable royalty range established by the transfer pricing study. MTC initiated another audit of See’s for the years 1999 through 2007. For those years, the Utah State Tax Commission (“the Commission”) disallowed the royalty deductions in their entirety under its authority under Utah Code Annotated § 59-7-113. The Commission’s position is that the income of See’s is not fairly reflective of its taxable income due to the royalty deductions. That audit is the subject of the recently decided Utah Supreme Court case.1 

The Utah District Court, the trial court, noted in its opinion that experts for See’s were able to support and maintain the business purpose behind the transaction, while the Commission’s experts were not able to rebut the business purpose of the transactions with any credible witness. One of the witnesses for See’s confirmed that the IP transfer was common, and both parties benefited from the transaction. That expert testified that he would not have recommended that See’s undertake the transaction solely for the tax benefits. 

With the business purpose of the transaction being recognized and sustained by the Court, the gist of the case was whether the Commission had an unlimited ability to reallocate income under Utah Code Ann. § 59-7-113 or whether the Commission was limited to adjustments allowed under IRC § 482. The District Court found that the Commission did not have unfettered discretion, which led to its appeal to the Utah Supreme Court.

The Utah Supreme Court looked at the history of IRC § 482. Its review dates to the Revenue Act of 1921, when Congress adopted the earliest predecessor of § 482. The section was enacted to allow the Commissioner to require companies to file consolidated returns to properly reflect income. In 1928, Congress modified this approach to correcting the distortion that could be created by intercompany transactions in IRC § 45. Congress gave the Internal Revenue Service (IRS) the authority to allocate income and expenses between related entities to clearly reflect its true income. “[T]his history confirms that Congress intended section 45 to provide the IRS with a tool to address transfer pricing manipulation.” The IRS had interpreted this authority2 as the ability to recast transactions into those in which unaffiliated parties would enter into at an arm’s length.

The Court then addressed the history of Utah’s code § 113. The predecessor to the Utah section was enacted in 1931 as § 20 of the Corporation Franchise Tax Act, 1931 Utah Laws 87. Section 20 was enacted verbatim from IRC § 45. The Court found that when the Legislature adopts similar language to a federal statute, “that use…indicates a legislative intent to adopt not just the language of a federal statute, but also its accompanying ‘cluster of ideas’….[W]hen our legislature copies a federal statute, federal interpretations of the statute constitute persuasive authority as to the statute’s meaning.” The Court found that since Utah § 113 contains the same language as IRC § 45, the federal interpretation of the phrase “necessary to clearly reflect income” in Utah § 113 has the same meaning as IRC § 45, “that allocation is ‘necessary’ in circumstances when related companies enter into transactions that do not resemble what unrelated companies dealing at arm’s length would agree to do.” 

The Supreme Court found that the District Court had concluded that the See’s-Columbia transaction was at an arm’s length, justifying the royalty deduction. The Supreme Court rejected the Commission’s arguments that other states have chosen to tax insurance companies differently or that the application of § 482 at the federal level was irrelevant because federal taxes were not affected by the transaction. The Court upheld the transaction as reflecting an arm’s length arrangement that unrelated companies would enter into for legitimate business purposes and upheld the District Court’s ruling. Sound business planning, accompanied by accurate and meticulously followed execution, wins the day in this “sweet” decision.   

1 Utah State Tax Commission v. See’s Candies, Inc., 2018 UT 57, October 5, 2018. 
2 Pub. L. No. 70-561, 45 Stat. 791, 806 (1928).

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