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									                                                                                            MARCH 2002

A FOLEY & LARDNER TAX, VALUATION AND FIDUCIARY LITIGATION PUBLICATION




IP HOLDING COMPANIES UNDER ATTACK
                                                                    MORE NEWS
A Report from a Key State Income Tax Battleground
                                                                    Continuing Update on Tax Shelters
The States have launched a full scale attack against intellectual
property holding companies (“IP Holding Companies”). Dozens         Following up on our February
                                                                    issue focusing on developments in
of cases are in litigation across the country, and widely varying
                                                                    the Tax Shelter area, there are
results have been reported from State to State. In this month’s
                                                                    more developments this month.
newsletter, we will review recent developments and offer some
thoughts on where IP Holding Company litigation is headed           First, the IRS has announced that
and what tax managers should do to strengthen the defenses          its Penalty Waiver Program has
of their IP Holding Companies.                                      been a great success with almost
                                                                    80 taxpayers making submissions
One of the States’ key lines of attack is to assert expansive       to the IRS by early March. Larry
theories of nexus against IP Holding Companies whose only           Langdon, Commissioner of the
presence in the taxing State is the use of their intangible         IRS’s Large and Mid-Sized
assets. The States have scored significant nexus victories in       Business Division was quoted as
cases such as Geoffrey in South Carolina and Kmart Properties       stating about the program: “We’re
in New Mexico, but have also suffered defeats, notably in the       learning about abusive shelter
SYL, Crown Cork & Seal and MCI International                        techniques that even people from
                                                                    [the private sector] didn’t know
Telecommunications cases in Maryland.
                                                                    about. We’re learning about
The States have also attacked the deductions for royalties paid     promoters we didn’t know about.”
to an IP Holding Company by its affiliated group of operating       As a condition to participation in
companies (“Operating Group”). The States’ legal ammunition         the program, taxpayers are
                                                                    required to provide the IRS with
for this offensive includes:
                                                                    full documentation of the shelter
•   attacks upon the separate existence of IP Holding               and the name of the promoter. As
    Companies under “business purpose,” “economic                   a result, the IRS is likely to
                                                                    demand that the promoters
    substance” or “sham transaction” doctrines, which
                                                                    disclose the name of all other
    traditionally have been associated with the federal income
                                                                    taxpayers who used the shelter
    tax                                                             technique.
•   denial or adjustment of deductions for royalties paid to IP
                                                                    In addition, the IRS has
    Holding Companies under State law authority similar to
                                                                    announced the formation of
    federal Section 482 of the Internal Revenue Code
                                                                    transaction specific task forces
•   assertion of statutory forced combination of distinct           involving revenue agents,
    corporate entities                                              attorneys from the Chief
•   imposing alternative apportionment formulae where the           Counsel’s office, the Treasury
    statutory scheme does not “fairly represent” income earned      Department and the Office of Tax
                                                                    Shelter Analysis.
    within the State.



                                          continued on next page
                                                                      PAGE 2                     MARCH 2002




IP Holding Companies which have significant business activity,         Continuing Update on Tax
apart from licensing intellectual property back to the Operating       Shelters, continued
Group, should survive State attacks based upon economic
substance, business purpose or sham transaction arguments.             Part of the function of the task
                                                                       forces will be early identification
In particular, patent management and trademark licensing
                                                                       of new abusive shelters and early
companies with significant licensing to third parties outside their
                                                                       public notice challenging the
affiliated Operating Group should not be susceptible to these
                                                                       shelters.
attacks. Nevertheless, we expect that some States will
continue to attack even the most substantial IP Holding                On the legislative front, on March
Companies utilizing expansive nexus theories, alternative              21, the Senate Finance
apportionment formulae or outright denial of deductions on a           Committee held hearings on
variety of grounds.                                                    corporate tax shelters and
                                                                       several senators indicated that
On the other hand, many IP Holding Companies formed in the             they would be introducing new
1990s acquired trademarks or similar intangibles solely for the        legislation to address abusive
purpose of licensing back to the Operating Group, without              shelters in the near future. In
hiring any employees, acquiring any significant tangible               connection with the hearings, the
property or engaging in other business activity. These “paper          Joint Committee on Taxation
companies” are most susceptible to attack by the States on all         released a detailed report on the
                                                                       current shelter situation.
of the theories listed above, and tax managers should consider
ways to add significant business activity to these paper
companies to withstand attack by State auditors.
What is an IP Holding Company?                                         Illinois Proposes Rules for
The structure of the typical IP Holding Company is fairly simple.      Financial Organization
The Operating Group creates the IP Holding Company as a                Apportionment, 2 nd Tier
corporate subsidiary in a State where there is no corporate            Partnerships
income tax (e.g., Delaware, for holding companies, or Nevada),
                                                                       The Illinois Department of
or a State where receipt of royalty payments will not result in
                                                                       Revenue issued two important
additional State tax (often the State of corporate domicile of the
                                                                       sets of proposed income tax
Operating Group). The Operating Group transfers intellectual           regulations in March. The first
property or other intangible assets, including patents,                proposed regulation provides
trademarks, trade names, service marks and copyrights, to the          guidance for the apportionment of
IP Holding Company. The IP Holding Company then enters                 business income of financial
into a license agreement, under which the Operating Group              organizations, which in general
agrees to pay the IP Holding Company a royalty in exchange             include banks, investment
for the exclusive or nonexclusive right to use the intellectual        companies, sales finance
property or intangible assets.                                         companies and similar entities.
                                                                       The proposed regulation would
This structure is designed to create deductions for royalties          codify the position that dividends
paid to the IP Holding Company, reducing the Operating                 and interest will be “received”
Group’s income or franchise tax liability in States where it           outside of Illinois if received in a
operates. The IP Holding Company receives the royalties in a


                                           continued on next page
                                                                     PAGE 3                         March 2002




tax-free or tax-neutral jurisdiction. The IP Holding Company          Illinois Proposes Rules for
typically can distribute tax-free dividends to its parent in the      Financial Organization
amount of the royalties paid, or loan its accumulated cash to
                                                                      Apportionment, 2 nd Tier
the Operating Group.
                                                                      Partnerships, continued
The IP Holding Company may license the intellectual property          lockbox located outside Illinois or
to independent third parties, and, indeed, some patents and           by wire transfer to an account
other intangible assets may generate revenues exclusively             located outside Illinois. This
from third party licensing. IP Holding Companies may                  proposed regulation will facilitate
undertake the task of preventing infringement of the intellectual     tax planning through the formation
property, and, in some cases, may be used as a financing              of sales finance company
vehicle or carry out other business activities apart from             subsidiaries, which can be
licensing the intellectual property back to the Operating Group.      separated from an otherwise
                                                                      unitary business group. Prop.
IP Holding Companies are most effective to reduce income              Reg. 100.3400.
taxes in States which tax corporations on a separate basis. In        The second proposed regulation
States which require combined or consolidated reporting by the        would amend the Illinois rule which
Operating Group and the IP Holding Company, the deduction             requires corporate partners to
for royalty payments typically disappears as an intercompany          include their proportionate share of
elimination. In those “combined States,” an additional                income and apportionment factors
challenge is to structure the IP Holding Company to be                of first-tier partnerships, but not
separate from the unitary business group or consolidated              lower-tier partnerships, in their
group.                                                                combined income and factors.
                                                                      The proposed regulation would
Direct Attacks on IP Holding Companies: State Attempts                require a flow-up of income and
to Assert “Nexus” Without Physical Presence                           factors of second-tier partnerships,
Some States attack the IP Holding Company structure by                but apparently not lower-tier
seeking to tax the IP Holding Company directly, and for these         partnerships. Prop. Reg.
States, the threshold issue is “nexus” or jurisdiction to tax. For    100.3380(d).
nexus to exist, the taxpayer’s connection to the taxing State         Numerous two-tier partnership
must satisfy both (1) a relatively low “minimum contacts”             structures have been set up in
threshold required by the Due Process Clause, which requires          recent years to effectively
only that the taxpayer purposefully directs its activities toward     separate businesses from a
the State’s economic forum, with or without physical presence         unitary business group for Illinois
there, and (2) a more exacting “substantial nexus” test required      combined reporting purposes.
by the Commerce Clause, which is the source of current                The proposed regulations appear
litigation controversy over whether some physical presence in         to prevent this technique, although
                                                                      third-tier partnerships might still be
the taxing State is required.
                                                                      separated from the unitary
It has been clear since Geoffrey, Inc. v. South Carolina, 437         business group. The intended
S.E.2d 13 (S.C. 1993), cert. denied, 510 U.S. 992 (1993), that        effective date of the regulation is
captive trademark companies established by retailers may be           not yet clear.
susceptible to nexus challenges by the States where the


                                           continued on next page
                                                                     PAGE 4                         March 2002




affiliated retailer uses the trademark on a widespread basis,         Illinois Proposes Rules for
even though the IP Holding Company itself has no physical             Financial Organization
presence in the taxing State. However, the Geoffrey decision
is controversial, and State courts remain divided on whether          Apportionment, 2 nd Tier
some physical presence is required by the “substantial nexus”         Partnerships, continued
requirement of the Commerce Clause, as interpreted in Quill           The existing Illinois partnership
Corp. v. North Dakota, 504 U.S. 298 (1992).                           regulation is the subject of
                                                                      litigation pending in the Illinois
States in which nexus is the key inquiry – generally States           Appellate Court, in which Foley &
which apportion royalty income by place of use of the intangible      Lardner represents the taxpayers.
– have refined their nexus arguments and currently advocate           BP Oil Pipeline Co. v. Department
both direct and “representative” nexus theories in litigation.        of Revenue, No. 01-2364, and
The development of State nexus attacks on trademark                   Unocal Pipeline Co. v. Department
companies over the past decade is illustrated by comparing            of Revenue, No. 01-2365.
Geoffrey with the recently decided case of Kmart Properties,
Inc. v. Taxation and Revenue Department, Dkt. No. 21,140
(N.M. Ct. App., Nov. 28, 2001), appeal granted (Jan. 9, 2002).
The Geoffrey Case. In Geoffrey, the taxpayer was a second-            UPCOMING EVENT
tier subsidiary of Toys R Us which owned trademarks and trade
names which it licensed to the Toys R Us Operating Group.             2002 National Directors Institute
The taxpayer did not have any physical presence in South              May 9, 2002 • Chicago, IL
Carolina, but also appeared to engage in little if any business       The fall-out from the Enron
activity, after its original license, in its domicile of Delaware.    collapse continues to prompt
The South Carolina Supreme Court first held that the IP               increasing SEC and public scrutiny
Holding Company had sufficient “minimum contacts” with South          of the roles, duties and actions of
Carolina to satisfy the low Due Process Clause threshold,             boards of directors and audit
without any physical presence in the State, because it                committees. These circumstances
“purposefully directed its activities toward South Carolina’s         have caused directors to become
economic forum... by licensing intangibles for use in South           increasingly concerned about their
Carolina and receiving income in exchange for their use.”             responsibilities and potential
                                                                      liability.
The South Carolina Supreme Court then concluded that the
U.S. Supreme Court’s Commerce Clause analysis of                      To help directors, officers,
                                                                      corporate counsel and other
“substantial nexus” in Quill does not require physical presence
                                                                      boardroom advisors better
in the taxing State, except in the case of sales and use taxes at
                                                                      understand and address these
issue in Quill. Although the Court recognized the “substantial
                                                                      difficult issues, Foley & Lardner is
nexus” prong of Commerce Clause analysis, citing Complete             sponsoring a National Directors
Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the Court           Institute.
nevertheless concluded that “substantial nexus” could be
satisfied merely by “licensing intangibles for use in this State
and deriving income from their use here.”



                                          continued on next page
                                                                    PAGE 5                       March 2002




In effect, the South Carolina Supreme Court – without explicitly     2002 National Directors Institute,
stating as much – extended the lower Due Process threshold of        continued
“purposeful direction of activity” toward the taxing State to its
Commerce Clause analysis, and decided that the IP Holding            The Institute will include
Company met that lower threshold for nexus by the exclusive          presentations and interactive
licensing of the Toys R Us trademarks, trade names and               panel discussions, featuring Arthur
service marks to the Toys R Us Operating Group in South              Levitt, Former Chairman of the
Carolina. The Geoffrey Court also rejected the taxpayer’s            Securities and Exchange
contention, based on the outdated doctrine of mobilia                Commission; Sarah Teslik,
                                                                     Counsel of Institutional Investors;
sequuntur personam, that its intangibles must be sited solely to
                                                                     among others.
its corporate domicile in Delaware.
                                                                     For more information, please send
The Kmart Properties Case. Like the Geoffrey case decided            an email—including your contact
eight years earlier, Kmart Properties involved a captive             information—to
trademark subsidiary and illustrates the refinements in the          fed.state.tax.news@foleylaw.com
States’ direct nexus attack on IP Holding Companies. Kmart
established its trademark subsidiary, Kmart Properties, as a
Michigan corporation, with separate offices leased in its own
name near Kmart’s headquarters and a separate payroll of five
employees, including two intellectual property attorneys and
support staff. Accordingly, the IP Holding Company was more
than a mere paper corporation and apparently engaged in
some trademark protection activity, although it licensed the
trademarks to Kmart exclusively, for a royalty of 1.1 percent of
sales, and apparently had no unaffiliated third-party licensees.
The New Mexico Court of Appeals adopted the Geoffrey
Court’s Commerce Clause analysis, stating that the
“overarching substantial nexus test announced in Complete
Auto Transit” does not require physical presence in the taxing
State, and limited Quill’s precedential reach to sales and use
taxes. In the Court’s view, the “use of Kmart Properties’ marks
within New Mexico’s economic forum for the purpose of
generating substantial income” was enough to provide
“substantial nexus.”
But the New Mexico Court of Appeals went further, and
focused on the legal concept that a trademark and its goodwill
are inseparable property rights that, as a practical matter, are
bound to the business that generates the goodwill. The Court
concluded that the value of the Kmart trademarks was
inextricably tied to the operations of the Kmart retail stores in
the State, and that Kmart Properties had established a physical


                                          continued on next page
                                                                     PAGE 6                      March 2002




presence in New Mexico through the activities of the Kmart stores and employees located there,
relying in part on the “representational” nexus cases of Tyler Pipe Industries v. Washington, 483 U.S.
232 (1987), and Scripto v. Carson, 362 U.S. 207 (1960).
The New Mexico Court in Kmart Properties also upheld the State’s imposition of an alternative
apportionment formula in order to tax the IP Holding Company. New Mexico’s three factor formula
based upon payroll, tangible personal property and sales in New Mexico would not have apportioned
any of the trademark company’s income to New Mexico. The Court upheld the revenue department’s
use of a single gross receipts factor based upon the source of the royalties (i.e., the sales which gave
rise to the royalty payments) under the UDITPA provision which permits alternative apportionment
where the statutory formula does not “fairly represent” the income earned in the State. The Michigan-
based payroll and property factors were excluded as de minimis, as they purportedly “played little or no
role in how Kmart Properties generated its income.”
The New Mexico Supreme Court has granted Kmart Properties’ appeal and may rein in the lower
Court’s expansive reading of nexus, or it may recognize that the IP Holding Company’s legitimate
business activity in Michigan should not have been excluded from the apportionment formula. The
New Mexico Court of Appeals decision, if allowed to stand, provides a detailed roadmap to the States
to argue that virtually all trademark licensing companies have nexus with the States in which the
trademarks are used.
Nexus Decisions in Maryland and Tennessee. To be sure, not all State courts agree with the
conclusion in Geoffrey and Kmart Properties that there is no requirement of physical presence in the
substantial nexus prong of the Commerce Clause, outside of the context of sales and use taxes
considered in Quill. In a trio of decisions, the Maryland Tax Court declined to rule directly on whether
the Commerce Clause requires “physical presence,” but then concluded that, absent physical
presence, nexus did not exist to tax a trademark holding subsidiary, a trademark and patent holding
subsidiary and a subsidiary which conducted MCI’s international calling functions through service
agreements with its Operating Group. SYL, Inc. v. Comptroller, No. 24-C-99-002388 (Md. Cir. Ct.,
Mar. 17, 2000); Crown Cork & Seal (Delaware) Inc. v. Comptroller, No. 24-C-99-002389 (Md. Cir. Ct.,
Mar. 17, 2000); MCI Int’l Telecom. Corp. v. Comptroller, No. 24-C-99-002387 (Md. Cir. Ct., Mar. 17,
2000). The Maryland Circuit Court affirmed the Maryland Tax Court’s finding that these corporations
were not “phantom entities” with no substance, and accordingly that nexus could not be attributed to
them by reason of their relationship to their Operating Groups.
The Tennessee Courts also have rejected the Geoffrey rationale in cases involving banking and
internet “presence” within the State. In JC Penney National Bank v. Johnson, 19 S.W.3d 831 (Tenn.
Ct. App. 1999), the Tennessee Appellate Court concluded that some physical presence is necessary
to establish nexus and declined to find nexus where the bank’s only property within the State was
thousands of credit cards held by its customers. In America Online Inc. v. Johnson, No. 97-3786-III
(Tenn. Ch. Ct., Mar. 13, 2001), a lower court followed this reasoning and declined to impose nexus
upon America Online, despite its widespread distribution of software diskettes within the State.



                                          continued on next page
                                                                     PAGE 7                       March 2002




Despite these taxpayer victories, States will continue to attack trademark companies using the
expanded nexus theories embraced by Kmart Properties. Trademark holding companies with
substantial third-party licensing activities are better positioned than purely captive trademark
companies to defend against nexus attacks and to prove that their business activity is in their
headquarters State and not in the market States. Other types of IP Holding Companies, e.g., patent
management companies where nexus or use in market States will be more difficult for the States to
identify and prove, have even better defenses against nexus attacks than the active trademark
companies. Nevertheless, the States will likely attempt to extend their nexus victories to all types of IP
Holding Companies until the boundaries of nexus are more clearly drawn by litigation or by federal
legislation.
Indirect Attacks on IP Holding Companies:
Deny the Royalty Deduction or Tax the Operating Group
Several States have attempted to attack the corporate structure of IP Holding Companies through a
growing variety of arguments, all focused on denying an Operating Group’s deduction for royalties paid
to its IP Holding Company. Leading the States’ charge are two decisions of the Massachusetts
Appellate Tax Board which illustrate the use of business purpose, economic substance, form over
substance and sham transaction attacks upon the IP Holding Company structure. Syms Corp. v.
Commissioner of Revenue, F215484 and F228324 (Mass. App. Tax Bd., Sept. 14, 2000); The
Sherwin-Williams Co. v. Commissioner of Revenue, F23560 (Mass. App. Tax Bd., July 19, 2000).
In Syms Corp., a well-known clothing retailer transferred trademarks to a Delaware subsidiary, SYL,
Inc. (“SYL”), based upon the advice of outside professionals who presented Syms with a prepackaged
plan to reduce State income taxes. Syms paid SYL a royalty of four percent of sales for the use of the
trademarks. SYL conducted no other business, although it purportedly had one part-time employee
who administered several hundred similar special purpose corporations and was paid an annual salary
of $1,200. Royalty payments of over $10 million per year paid to SYL were almost immediately
distributed back to Syms as a dividend, and Syms continued to undertake and fund all of the
trademark protection functions after the transfer to SYL. Syms did not help its case by claiming royalty
deductions on its Massachusetts tax returns for periods beginning three months before SYL was
formed in Delaware and almost one year prior to the recordation of the assignment of the trademarks
at the U.S. Patent and Trademark Office.
The Massachusetts Appellate Tax Board, following federal case law, disallowed the royalty deductions
on grounds that the transfer and license-back of the trademarks and the associated royalty payments
should be disregarded as sham transactions which had no business purposes and no economic
substance apart from tax avoidance. Syms attempted to counter this attack by contending that it had
numerous business purposes for establishing the trademark subsidiary, including: better legal
protection of the marks; isolation of the marks from potential hostile takeover bids; better management
of the marks; protection of the Syms’ employees from legal dispute over the marks; enhanced ability to
borrow funds; facilitation of corporate acquisitions, benefits of Delaware corporate law and judicial
system; simplification of corporate accounting; and enhanced ability to enter into third-party franchising
and licensing agreements for the use of the marks.


                                          continued on next page
                                                                     PAGE 8                       March 2002




The Appellate Tax Board, however, upheld the Commissioner’s findings that these purported business
purposes were not supported by the evidence, that Syms retained control over the marks and that the
transaction was a “contrived mechanism” that lacked economic substance and should be treated “as if
no transaction ever occurred.” For good measure, the Board found that the deduction should be
disallowed on alternative grounds that the royalties were not ordinary and necessary business
expenses as defined in Section 162 of the Internal Revenue Code, and that the Commissioner could
adjust the royalty payments since they were in excess of fair value under Section 39A of the State
revenue code, which is similar to federal Section 482.
The Sherwin-Williams decision is similar, although in that case the trademark company engaged in a
limited amount of licensing to third parties (less than one percent of its revenues), which the
Massachusetts Appellate Tax Board found to be inconsequential.
Syms is a spectacular taxpayer defeat, but presented a spectacularly bad set of facts – a truly “paper”
trademark subsidiary with no provable business activity apart from the paper licensing of its
trademarks back to the parent. The Syms decision, when contrasted with the Maryland decision in
Sherwin-Williams described above, illustrates how State law doctrines vary widely and litigation
outcomes depend upon State-specific precedent.
IP Holding Companies which have significant business activity, particularly significant licensing to third
parties, should be able to survive State attacks based upon economic substance, business purpose or
sham corporation arguments, perhaps even from States such as Massachusetts that apply these
doctrines aggressively.
Requirement to File Combined or Consolidated Returns
New York Forced Combination. New York State and New York City have taken a different line of
attack on IP Holding Companies by invoking statutory requirements for forced combination of affiliated
corporations. Under New York law, where there are substantial inter-corporate transactions, a
rebuttable presumption of distortion of income on separate franchise tax returns arises, and taxpayers
are forced to file a combined return. However, taxpayers who rebut the presumption of distortion of
income by showing that the inter-corporate transactions were at arm’s length are entitled to file
separate returns, and the burden of proof of actual distortion shifts to the State. In a series of highly
detailed factual cases before the New York State Division of Tax Appeals and the New York City Tax
Appeals Tribunal, corporate taxpayers have been successful in rebutting the presumption of distortion
of income and thereby preventing forced combination. In re Sherwin-Williams Co., DTA No. 816712
(NYS Div. Tax App., Jun. 7, 2001); In re Toys “R” Us-NYTEX Inc., TAT 93-1039(GC) (NYC Tax App.
Trib., ALJ Div., Aug. 4, 1999; In re Express, Inc., DTA Nos. 812330-812332 (NYS Div. Tax App., Sep.
14, 1995).
The key to these taxpayer victories was the taxpayers’ ability to prove that the licensing agreements
were at arm’s length and did not distort the income of the Operating Group. However, in one case the
taxpayer was unable to prove that the transactions were at arms’ length and succumbed to forced
combination. In re Burnham Corp., DTA No. 814531 (NYS Div. Tax App., July 10, 1997).


                                          continued on next page
                                                                     PAGE 9                      March 2002




Note that the Sherwin-Williams case in New York was decided on facts essentially the same as the
Massachusetts Sherwin-Williams case, again illustrating the wide variance of State statutory law and
judicial doctrines which confront both taxpayers and the States when defending or attacking IP Holding
Companies.
Illinois Combination for Unitary Business Groups. Illinois requires combined reporting by unitary
business groups as a general rule, whether or not distortion of income is present. As a result, IP
Holding Companies ordinarily can reduce Illinois income taxes for the Operating Group only if the IP
Holding Company can be separated from the rest of the unitary business group.
In Zebra Technologies Corp. v. Topinka, No. 98 L 50479 (Cir. Ct. Cook County, July 23, 2001), appeal
pending, the taxpayer transferred patent rights to a Delaware subsidiary corporation which maintained
an office, a part-time employee with no apparent expertise in patent administration, and a personal
computer in Hamilton, Bermuda. The Bermuda office was established to satisfy the Illinois “80/20
rule,” which excludes a corporation from the Illinois combined group if eighty percent of its payroll and
property is located outside the United States.
The Illinois Circuit Court concluded that most of the activity of protecting the value of the patent and
trademark rights was performed by the parent company’s employees in Illinois and, without significant
analysis of the payroll and property factors and whether the 80/20 rule was technically satisfied,
rejected the taxpayer’s position by stating that “Zebra did not meet its burden of proof by showing that
80% or more of its business activities took place outside of the United States.” Although the Court did
not expressly invoke the business purpose doctrine, which has not yet been adopted by the Illinois
Appellate Courts, in another portion of its opinion, the Court found that a foreign sales corporation
chartered in the Virgin Islands did not meet the 80/20 test and “served no valid business purpose, only
tax avoidance.”

The Zebra Technologies case is on appeal, and the ultimate decision will reveal whether or not the
Illinois Appellate Courts will embrace business purpose or substance over form doctrines. Whatever
the outcome, taxpayers should consider alternative methods of separating an IP Holding Company
from the Illinois combined group, such as combining the IP Holding Company functions with a
“financial organization” as defined in Illinois law.

Concluding Thoughts
Despite the fact that many States have attacked IP Holding Companies as abusive tax shelters, IP
Holding Companies with real business purposes and activity should withstand most of the States’ legal
challenges. On the other hand, it is doubtful that pre-packaged “paper” IP Holding Companies can
withstand attack in many States, and litigation of these difficult cases could create precedent that is
detrimental to IP Holding Companies with real business activity.

Companies that have established IP Holding Companies should review their operations to determine
whether there is sufficient business substance to protect against attacks on business purpose,
economic substance, or sham transaction grounds. To withstand attack, IP Holding Companies should



                                            continued on next page
                                                                                           PAGE 10                           March 2002




have property, business activity, employees with substantial                                For More Information
business functions and, if possible, significant licensing to
unrelated parties. IP Holding Companies without significant                                 To learn more about our Federal and
business activity, apart from licensing intellectual property back                          State Tax Controversy services, please
to the Operating Group, should consider moving trademark or                                 call your Foley & Lardner attorney or
patent maintenance and protection functions or other business                               feel free to contact one of the individuals
activities into the IP Holding Company. In addition, inter-                                 listed below.
company licensing agreements should be reviewed periodically                                Fred Ackerson
and royalty rates should be compared to market rates and                                    fackerson@foleylaw.com
substantiated by appraisal.                                                                 312-755-2692
The battle over IP Holding Companies will continue to be
                                                                                            John Palmer
fought State by State. Taxpayers can win the battle by
                                                                                            jpalmer@foleylaw.com
understanding the emerging legal doctrines and adjusting the                                312-558-6787
business activity and substance of their IP Holding Companies
to satisfy the requirements of the States in which they operate.                            Maureen McGinnity
                                                                                            mmcginnity@foleylaw.com
                                                                                            414-297-5510

                                                                                            Mike Woolever
                                                                                            mwoolever@foleylaw.com
                                                                                            312-558-6647

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