Originally published on Forbes.com.
Saying it is all about the brand to minimize state income taxes, is probably the main theme of Target Brands Inc v Brohl, which was recently decided in the District Court for the City and County of Denver. Target Brands Inc, where all Target’s intellectual property is parked took the position that it did not have to file in Colorado, despite receiving over $400 million in royalties on sales in Target’s Colorado stores. The Colorado Department of Revenue, as you might expect, views it differently. There were eleven years at issue (1999-2009).
Hard To Root For Target On This One
The decision mostly went for the state. My rule is to always root for the taxpayers, except when they are being lame. You could not characterize Target’s behavior here as lame, but I really could not root for them. And it is really not about Target. I think the techniques used are pretty common. The decision, which unfortunately I cannot find a free link to, explains how it is done, which is why I find it of interest.
Importance Of The Brands
Target makes it very clear that its brand is of great importance. You can read in its 10-k:
Our brand image is a critical element of our business strategy. Our principal trademarks, including Target, SuperTarget and our “Bullseye Design,” have been registered with the U.S. Patent and Trademark Office. We also seek to obtain and preserve intellectual property protection for our owned brands.
I probably don’t get out enough or something because I don’t recognize any of the brands for various lines of products that Target supports. I had fun guessing what some of them might be. Boots & Barkley sounded like something outdoorsy. It’s actually stuff for your pets, which makes sense when I think about it. I had no idea what Xhilaratation might be, which you will see is a good thing if you check the link. Fieldcrest also sounded outdoorsy, but it is towels.
My covivant, who is more attuned to these things also did not recognize any of the thirty Target “Owned” and “Exclusive” brands mentioned. Maybe it is just us, but when you consider that the Target Corporation pays Target Brands Inc billions of dollars to promote and protect them along with the core Target brand, you would think they would be doing a little better.
A Subsidiary
Of course, Target Brands Inc is a wholly-owned subsidiary of Target Corporation. According to the decision, the way the arrangement works is that whatever Target Corporation pays TBI is immediately loaned back to the parent. Interest would be paid every once in a while, which would also be loaned back. Occasionally, the loan was paid down which led to TBI paying a dividend to its parent.
So what was TBI all about?
There were business risks and negative consequences to Target’s failure to have centralized resources dedicated to the management, protection, and enhancement of its IP, particularly with respect to its Target stores and related private-label brands. For example, prior to TBI’s existence, valuable trademarks such as Archer Farms were not even registered. In addition, Target lost its ability to expand into Australia because, prior to TBI’s existence, an unaffiliated copycat retailer named “Target Australia” had established operations using many of Target’s trademarks (such as the Bullseye).
The formation of TBI was motivated by, and served, legitimate business purposes aside from providing tax benefits. TBI’s legitimate business purposes included having a dedicated group of people and resources who could focus on brand management, protection, enforcement, compliance, training, and expansion of TBI’s IP portfolio. Those purposes also included, as discussed above, ensuring that TBI held rights in its IP in international jurisdictions to prevent any other Target Australia-type situations.
Of course, there could have just been a division or something created in the home office to take care of all this. Instead, they set up a separate company. Now why did they do that?
Why A Separate Company?
Well, even though the three or four per cent of sales that TBI receives in royalties and that loan money going back and forth gets eliminated in the consolidated financial statements, TBI files a separate tax return. So all those eliminated transactions are real for income tax purposes. TBI is a separate company.
Maybe three or four percent does not sound like a lot to you. Well you need to remember that it is three or four percent of sales. In 2009, for example, Target had sales of over $60 billion, but all those towels and pet supplies and whatever have to be paid for, which costs over $40 billion. So the $2 billion or so in royalties moves a lot of the of the $3.9 billion in pretax earnings off the consolidated tax return. The court picked 2002 as a year in which things got extreme.
The removal of TBI’s income from Target’s combined return created a substantial tax benefit for Target, as demonstrated by Target’s taxes for tax year 2002. At the federal level, Target Corporation and all of its subsidiaries had $1,588,215,074 in federal taxable income. To calculate Colorado net income, the income from certain companies that could not be included in the Colorado combined return was excluded. ) These exclusions reduced the income that could be subject to apportionment from $1,588,215,074 to a loss of $248,288,779. Because Target experienced a loss, it owed no Colorado income tax for tax year 2002. TBI (under its former name, Dayton Hudson Brands, Inc.) was one of those excluded companies. TBI had federal taxable income of $1,334,721,287 for that year. . Had TBI been included in Target’s combined return, the amount of Target’s income subject to apportionment would have been $1,079,549,142 instead of negative $255,172,145. This would have resulted in positive income of $24,455,026.71 being apportioned to Colorado instead of a loss of $5,780,303. After applying Colorado’s corporate income tax rate, Target would have owed $1,132,267.74 to Colorado.
You might think that other states picked up what Colorado lost, but maybe not so much. Even though Target’s stores are in the United States, TBI’s branding operations are all over the world.
TBI’s employees were located in: Minneapolis, Minnesota; Kowloon, Hong Kong; Florence, Italy; Guangzhou, China; Shanghai, China; Guatemala City, Guatemala; Taipei, Taiwan; Singapore; New Delhi, India; and Mexico City, Mexico. None of TBI’s employees were located in Colorado. Ms. Street testified TBI had to be structured so that at least 80 percent of its assets were located outside of the United States in order to receive certain tax benefits. She was responsible for creating yearly budgets for TBI to ensure that TBI always had at least 80 percent of its assets outside of the United States.
They Have To Pay Something
TBI claimed that Colorado income tax could not be applied because it was not “doing business” in Colorado and that Colorado assertion of tax authority violated the Commerce Clause of the United States Constitution.
The court was not buying TBI’s argument.
Even if “doing business in Colorado” is not co-extensive with the constitutional tests, nor specifically defined by regulation for intangible property, the Court concludes that TBI was doing business in Colorado. TBI chose to license its IP for use by Target in Colorado. TBI chose to base the royalties it would receive under that license on Target’s sales both in Colorado and nationwide. TBI relied on Target to present TBI’s IP—its central asset—in the best possible light in Colorado, and, to some extent, directed those efforts. Finally, TBI received hundreds of millions of dollars in income related to the use of its IP in Colorado. The Court concludes that even if “doing business in Colorado” is not necessarily co-extensive with the constitutional tests, TBI was doing business in Colorado.
There was also a sort of version of Elizabeth Warren’s “You didn’t build that speech”.
The Court finds that there is a fair relationship between the taxes assessed against TBI and the benefits Colorado provides. The undisputed evidence is that ]without the benefits Colorado provides, Target would have no inventory to sell at its stores, no employees to make those sales, and no customers to buy Target’s products —all of which would mean that TBI would receive no royalty income from Colorado.
To the extent Colorado provides additional services to Target that allow Target to operate its stores here, those services similarly benefit TBI. Those other services include police, fire department, and 911 services, all of which Target’s store policies indicate an intent to use. Therefore, the Court concludes that TBI benefits from the services Colorado provides and that the tax is fairly related to these benefits because these services make the generation of TBI’s royalty income possible.
Conceptually, I have a lot of difficulty with the idea that a retail operation can detach the value of its brand from its operation. The public-facing employees and the atmosphere in the tangible location have a lot to do with the perception of the brand. Were it not for the tax benefits, there probably would not be any incentive to to set up a separate legal entity, particularly one that in some years could turn a profit into a loss.
Other Coverage
Vidya Kauri wrote “Target Unit Found Liable For Colo. Corporate Income Tax” on Law 360 noting that the case was not a total win for Colorado.
But the court also handed the Colorado Department of Revenue a disappointment when it cast away its formula for calculating TBI’s taxable income that eliminated all of TBI’s payroll, property and sales factors, and instead relied on the sales factor of its parent, Target.
Wolters Kluwer also had a summary as did PWC.