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STATE OF NEW YORK DIVISION OF TAX APPEALS ________________________________________________ In the Matter of the Petition of LOWE'S
HOME CENTERS, INC.
DETERMINATION Petitioner, Lowe's Home Centers, Inc., P.O. Box 1111, North Wilkesboro, North Carolina 28656, filed a petition for redetermination of a deficiency or for refund of corporation franchise tax under Article 9-A of the Tax Law for the fiscal years ending January 31, 1997 and January 30, 1998. A hearing was held before Gary R. Palmer, Administrative Law Judge, at the offices of the Division of Tax Appeals, 641 Lexington Avenue, New York, New York commencing on March 13, 2002 and continuing on March 14 and June 10 through June 14, 2002. The matter was thereafter continued at the offices of the Division of Tax Appeals, 500 Federal Street, Troy, New York on August 14 and 15, and August 28 through 30, September 4 through 6, 11 and 12, 2002. The hearing concluded in Troy, New York on November 4 through November 7, 2002, with all briefs to be submitted December 31, 2003, which date began the six-month period for the issuance of this determination. The six-month period was extended for an additional three months pursuant to 20 NYCRR 3000.15(e)(1). Petitioner appeared by Phillips, Lytle, Hitchcock, Blaine & Huber, LLP (Edward M. Griffith, Jr., Esq. and Gary J. Gleba, Esq., of counsel), and by Morrison & Foerster, LLP (Craig B. Fields, Esq., of counsel). The Division of Taxation appeared by Mark F. Volk, Esq. (Nicholas A. Behuniak, Esq. and Clifford M. Peterson, Esq., of counsel). ISSUE Whether the Division may require petitioner to file its franchise tax report on a combined basis with its sister corporation, LF Corporation. FINDINGS OF FACT 1. Pursuant to section 3000.15(d)(6) of the Rules of Practice and Procedure of the Tax Appeals Tribunal and section 307(1) of the State Administrative Procedure Act, both parties submitted proposed findings of fact. Petitioner has submitted 126 proposed findings of fact, and the Division has submitted 360 proposed findings of fact. The proposed findings of fact have been substantially incorporated into this determination with the exception of those noted in the final two findings of fact. 2. Petitioner, Lowe's Home Centers, Inc. ("LHC"), a North Carolina corporation, is a retailer of home improvement products and a wholly-owned subsidiary of Lowe's Companies, Inc. ("LCI"), which is also a North Carolina corporation. 3. LF Corporation ("LF") is a Delaware corporation and a wholly-owned subsidiary of LCI. LF's office is located in Wilmington, Delaware. LF was incorporated in Delaware on July 6, 1989 for purposes that include the ownership of certain trade names and trademarks formerly owned by LCI. LF did not operate any home improvement stores, sell any products or operate any distribution centers during the tax years at issue. 4. As a result of a corporation franchise tax field audit, the Division of Taxation ("Division") on December 26, 2000 issued a Notice of Deficiency to LHC asserting additional corporation franchise tax due in the sum of $45,859.00 plus penalty and interest for the fiscal year ending January 31, 1997 ("tax year 1996") and tax in the sum of $300,553.00 plus penalty and interest for the fiscal year ending January 30, 1998 ("tax year 1997"). 5. LHC filed a timely petition with the Division of Tax Appeals challenging the imposition of the additional corporation franchise tax. Petitioner alleges that the Division erroneously required petitioner to file combined corporation franchise tax reports with LF for tax years 1996 and 1997. 6. During tax years 1996 and 1997 petitioner exclusively operated all Lowe's retail stores except those located in North Carolina and Ohio. Petitioner also owned four regional distribution centers during this period. During this same time period petitioner was building and opening between 70 and 80 new stores each year. By late 1997 petitioner was operating all Lowe's stores, which then numbered over 400. As of 2002, about 70 percent of the Lowe's stores were owned by petitioner, with the remaining 30 percent being leased. Petitioner had about 50,000 employees during the tax years at issue. 7. For a portion of tax years 1996 and 1997 LCI operated the retail stores in North Carolina and Ohio. During tax year 1996 LCI transferred by merger the Ohio stores to petitioner, and during tax year 1997 it transferred the North Carolina stores to petitioner. LCI continued to serve as the centralized corporate management arm of the Lowe's group and the provider of executive management services to LHC. For these services LHC paid to LCI an annual management fee. For tax year 1996 this management fee was $24,963,568.00. For tax year 1997 this fee was $31,022,870.00. LCI employed about 10,000 persons during this period. LF had one employee during the tax years at issue. It did not pay any management fees to LCI during this period. 8. LCI and its subsidiaries were reorganized in 1989. Before the reorganization LCI had about 24 wholly-owned subsidiaries. Each subsidiary operated all the stores in a particular state under the style, Lowe's of Alabama, etc. Pursuant to the 1989 reorganization these subsidiaries, with the exception of those owning the stores in Ohio and North Carolina, were merged into Lowe's Investment Company ("LIC"), whose corporate name was later changed to Lowe's Home Centers, Inc. LIC, which became LHC, owned all the store real estate and was qualified to do business in each state where the retail stores were located. 9. Before the 1989 reorganization and the formation of LF, LCI owned the marks and permitted their use, including the trade name, Lowe's, by the various subsidiaries at all their retail locations. There were no written licensing agreements, no provision for the payment of royalties, no quality control standards and no formal monitoring of the use of the marks by either LCI or the various subsidiaries. 10. Gaither Keener, Esq., and Paul B. Bell, Esq., were intellectual property attorneys retained by LCI in the mid-1980s. Each testified on behalf of petitioner that abandonment could be asserted as a defense to a claim for the unauthorized use of the marks by third parties because of the failure of LCI to exercise quality control over the marks. 11. During the period from 1988 through 1990 LCI developed a vision statement for the Lowe's group in response to Home Depot's having overtaken Lowe's as the largest home improvement retailer in the country. The thrust of the vision statement was that Lowe's must become more centralized on all levels so as to be perceived as one organization rather than a group of different stores acting independently of one another. 12. At the time LF was incorporated in 1989 petitioner had no stores in New York State and had no plans to establish stores in the State. Petitioner opened its first store in New York State, on October 24, 1996, in Vestal. Petitioner opened four additional stores in New York State in the latter part of 1997. These stores were located in Utica, Big Flats, Kingston and Auburn. 13. In January 1989 Arthur Andersen, LLP ("AA") completed a state tax study to determine how best to restructure the intercorporate relationship of LCI and its subsidiaries to identify tax minimization opportunities, particularly how to take advantage of state net operating loss carryovers. In its study AA "strongly" recommended the creation of a separate finance and trademark company in a "tax haven state" for the purpose of producing substantial state tax savings. The study identified Delaware, Nevada, New York and Texas as tax haven states, but focused on Delaware as the state first considered by businesses that utilize the affiliated finance company concept because, by statute, Delaware specifically provides that corporations whose activities within the state are confined to the maintenance and management of their intangible investments and the collection and distribution of income from such investments are exempt from income taxation. The purpose of the investment holding company was to acquire and hold LCI's intangible assets including the Lowe's trade names, trademarks and service marks. Under the proposal the Delaware holding company owning the marks would then license the use of the trade name and trademarks to the various store locations in return for an arm's-length royalty. As long as the holding company confined its operations to Delaware, it would not be taxed on its receipt of the royalties and the operating affiliates paying the royalties would be entitled to a deduction for state and local tax purposes. 14. The AA study noted the existence of certain risks to the success of the proposed tax saving measures, including a finding by a state agency that the royalty payments are not arm's length and the requirement by the state that the holding company's income be combined with that of the local affiliate for reporting purposes. 15. The proposed transfer of the trade names, trademarks and service marks owned by LCI to a Delaware financial subsidiary and license-back arrangement underlying the AA study was reviewed by Mr. Bell, at the request of LCI's general counsel, to determine whether the proposed transfer might jeopardize the Lowe's trade name and trademark rights. In his testimony Mr. Bell addressed areas of the Lowe's operation, as it existed in 1989, that he felt needed attention. He expressed concern with the fact that the individual stores were operating on their own with little, if any, oversight from the parent company. In his 1989 letter to LCI's general counsel, Mr. Bell stated that the public policy purpose of the law of trademarks and unfair competition was to protect the public from confusion and deception relating to the origin of products and services, and to avoid the abandonment of a registered trademark through the separation of the mark from its associated goodwill. Mr. Bell concluded that because the transfer was to be between corporations in the parent/subsidiary relationship with common officers and directors, and because the element of control was present together with a sound business purpose, these factors would serve to prevent any diminution of trademark or trade name rights. According to Mr. Bell, a further advantage of the proposed transfer of Lowe's marks to a corporation that did not carry the Lowe's name was to render it less likely that an infringer in search of a defense, such as abandonment of a mark, would look behind the new corporate owner to discover a deficiency in quality control standards maintained for the marks by their former owner. 16. On June 9, 1989 the board of directors of LCI adopted a resolution approving the formation of LF, which was incorporated in Delaware on July 6, 1989 as an investment and trademark holding corporation exempt from state income taxation under Delaware Code § 1902(b)(8). The resolution did not specify any preexisting problems with the manner in which LCI or LHC used or controlled the marks. The specific corporate purpose, as stated in the LF certificate of incorporation, was to maintain and manage its intangible investments and the collection and distribution of the related income. 17. By subscription agreement dated August 1, 1989, LCI acquired rights to 582 shares of LF's common stock to be issued on August 31, 1989 in exchange for the transfer by it to LF of all its right, title and interest in and to certain trademarks together with the associated goodwill of its business symbolized by the trademarks, along with applicable trademark registrations and applications therefore. Also assigned to LF in return for the shares of common stock was a promissory note to be dated September 1, 1989, evidencing an obligation of petitioner to LCI in the sum of $313,952,171.81. The assignment of the marks and the United States trademark/service mark registrations and applications to LF was recorded with the United States Patent and Trademark Office on or about September 1, 1989. 18. By separate license agreements, both dated August 31, 1989, LF, as "licensor," outlined the terms and conditions whereby it granted a nonexclusive, nontransferable personal right and license to the use of the name "Lowe's" and all other trade names, trademarks and service marks owned by LF to LCI and LHC as "licensees." Under the terms of the license agreements the licensor assumed the responsibility to maintain the licensed marks in full force and effect by filing renewals and such other documents as may be required by law to keep the marks in active status. 19. The license agreements of August 31, 1989, by their terms, provided that a reasonable and fair royalty for the use of the licensed marks is 3.4 percent of the gross sales by the licensees at each of their retail establishments. The license agreements further imposed upon the licensees the obligation, as the representatives of the licensor, to preserve the high standards and goodwill of the licensed marks and to exercise such supervision and control with respect to all of their retail merchandising establishments as to preserve and enhance the goodwill of the marks. The licensor reserved the right to inspect all retail facilities, review licensed services and approve samples of licensed products as well as advertising and promotional materials using the licensed marks. 20. By amendment number 1 to each of the license agreements dated August 31, 1989, LF and LHC in the one instance, and LF and LCI in the other instance, agreed that effective September 1, 1991 the royalty rate would be reduced to 2.5 percent of gross sales. 21. LCI and LF entered into an amended and restated license agreement effective January 31, 1998 covering the period immediately following the fiscal years at issue, which agreement provided that the "license granted hereunder shall be non-royalty bearing." 22. LF leased an office in Wilmington, Delaware for the fiscal years ending January 31, 1997 and January 30, 1998 under a one-year renewable lease providing for annual rent in the sums of $10,325.00 and $10,413.00, respectively. The office consisted of four rooms plus kitchen and bath and was not shared with any other entities. 23. In 1989 LCI retained Valuation Engineering Associates, an affiliate of Touche Ross, to conduct an appraisal of the Lowe's trade name. Its report, dated August 17, 1989, noted that intangible assets exist at all phases of the business operation, generally produce value in excess of their costs, and enhance the value of the firm by either increasing revenue or reducing costs. Using the cost approach, it was determined that the fair market value of the Lowe's trade name as of June 30, 1989 was $266,500,000.00, and the recommended pretax royalty rate was 3.4 percent of sales. The cost approach determines the value of a trade name or trademark as the cost required to recreate the current level of brand loyalty, consumer awareness or product recognition enjoyed by the firm. A determination was also made in the underlying report that the remaining economic life of the Lowe's trade name was five years. 24. In 1991 AA was retained by LF to estimate the fair royalty rate value of the trademarks and trade names. For the purpose of its valuation, AA defined the term "fair royalty rate" as the "royalty rate at which the property under consideration would be licensed in an arm's-length transaction between a willing licensee and a willing licensor, each informed but neither under any compulsion to act." AA determined that effective July 31, 1991 the fair royalty rate value was 2.5 percent of net sales which was based on historical operating margins, the industry's cost of capital, and royalty rates paid by what it claimed were comparable companies engaged in the same or similar lines of business. The cost of capital was used to estimate the appropriate discount rate to apply to the various royalty rates paid by the companies analyzed. This discount rate was based on the weighted average cost of capital of petitioner and the industry. The factors considered in determining the royalty rate included profitability, market recognition, market share, barriers to entry, product loyalty and business risk. AA's research revealed that the rates charged for licensing what it claimed were comparable products in comparable industries ranged from .5 percent to 2.5 percent of net sales. The work papers in support of the 1991 AA report do not indicate why the Lowe's trademark belonged at the high end of this range, nor do they identify the actual companies claimed to be comparable to Lowe's or the products or services licensed. The arithmetic mean of the royalty rates listed in the summary table to the 1991 AA analysis (Exh S-1) was 2 percent, but listed as 2.1 percent. The 2.5 percent concluded royalty rate exceeded that mean. The 2.5 percent royalty rate paid by petitioner to LF during tax years 1996 and 1997 was based, in part, on the 1991 AA report. 25. In 1997 AA was again engaged to estimate the fair market royalty rate to be charged for the use of the Lowe's trade name and that of another LCI subsidiary, The Contractor Yard, Inc., which was formed in 1994 to serve the professional contractor market. Because of the emergence in the 1990s of Home Depot and Lowe's as the dominant "big box" home centers, which in February of 1997 had a combined market share of 15 percent, small independent and regional chain home centers were forced to merge or go out of business. Home Depot had home centers in the United States and Canada during the years at issue. Among the factors considered by AA in its 1997 analysis to determine an arm's length royalty rate were Lowe's name recognition, market share, and barriers to entry. AA attempted to apply the "best method rule" of Treasury Regulation § 1.482-1(c) whereby it determined that the best method to use to estimate the arm's-length royalty rate to be paid by petitioner for its use of the Lowe's trade name was the comparable uncontrolled transaction ("CUT") method of Treasury Regulation § 1.482-4(c). Under the CUT methodology the appraiser had to identify comparable uncontrolled companies in the retail home improvement industry. AA selected six purported comparable companies for use in its analysis. The six companies were Home Depot; BMC West Corporation; Wolohan Lumber; DIY Home Warehouse, Inc.; Wickes Lumber Company and Eagle Hardware & Garden, Inc. AA examined the profit margins of the six companies and determined that the average profit margin of the six companies for the latest fiscal year was 6 percent while Lowe's profit margin for the same period was 8.1 percent, ranking Lowe's in second place behind Home Depot. AA observed that the fact that Lowe's profit margin was higher than all but one of the six companies supported the use of a higher than the average royalty rate for the Lowe's trade name. AA eliminated Home Depot and Wickes Lumber Company as comparable companies to petitioner in its 1997 study. Home Depot was eliminated because it owned valuable intangible assets and Wickes was eliminated because it had significant manufacturing operations. In applying the CUT method AA determined that the royalty rate range of the remaining four companies was from 1 percent to 5 percent, and that based on Lowe's comparative size, market position, profitability and registered trademark status, it concluded that a 3 percent of sales royalty rate was appropriate for the Lowe's trade name. There was no showing by AA that the intangible assets owned by the four uncontrolled companies had a similar profit potential to that of petitioner's intangible assets. The 1997 AA report attributed a large part of the residual intangible asset value to the trademarks and trade names, as opposed to petitioner's other intangible assets. 26. During the years at issue Homer TLC, Inc. ("Homer"), a wholly-owned indirect subsidiary of Home Depot, owned certain trademarks, including the name "The Home Depot." Homer licensed the use of these trademarks to Home Depot's operating subsidiaries. 27. In 2000 AA was engaged to again examine the royalty rate paid by LHC to LF for the intercompany licensing of the marks. The transfer pricing report it issued, dated March 2, 2000, was not prepared in anticipation of litigation and did not focus specifically on the tax years at issue. In applying the CUT method, AA identified what it considered to be two comparable uncontrolled transactions with license agreements that involved the transfer of similar intangible property under circumstances it considered to be substantially the same as the LHC-LF controlled transaction. The requirement of the CUT method that the profit potential of the intangible property involved in the uncontrolled transaction be similar to the profit potential of the intangible property involved in the controlled transaction was not complied with by AA as required by section 1.482-4(c)(2)(iii)(B)(1)(ii) of the Treasury Regulations. The first such license agreement licensed the use of the Century 21 trade name and trademark from Century 21 Real Estate Corporation ("Century 21") to American Remodeling, Inc. ("AMRE"). This agreement, dated October 7, 1995, entitled AMRE to use the Century 21 trade name and logo in its sale of home improvement products and services in return for a royalty payable to Century 21 of three percent of net sales plus an additional annual payment of $10 million to the Century 21 National Advertising Fund to promote the Century 21 trade name and the products sold by AMRE under that name. 28. The second purported comparable agreement was a franchise agreement for the franchise of Ace Hardware Stores marks providing for a royalty of 2 percent of net sales plus an advertising fee of 1.3 percent of net sales, for a total of 3.3 percent. Because retail franchise agreements provide franchisees with intangible property related to the operation of the franchised stores in addition to the use of trade names and trademarks, AA determined that the Century 21-AMRE agreement was a more reliable comparable uncontrolled transaction which supported an arm's-length royalty rate of three percent of net sales. 29. A comparable profits method ("CPM") analysis was employed in 2000 by AA to confirm its findings under the CUT method that three percent of net sales was an arm's-length royalty rate. This method compares the profitability of the tested party, which was Lowe's consolidated companies, as measured by a profit level indicator, to the profitability of uncontrolled taxpayers in similar circumstances. In this analysis AA obtained income statement and balance sheet data from six uncontrolled home improvement retailers, five of whom it considered to be comparable to LHC. After excluding Home Depot from this group of six, AA proceeded to calculate separate operating margins for 1996, 1997 and 1998 for each of the remaining five entities, who are: Building Materials Holding Corp.; DIY Home Warehouse, Inc.; Homebase, Inc.; White Cap Industries, Inc.; and Wolohan Lumber Co. The highest and the lowest operating margin in the range of operating margins for each of the three years was excluded to create an interquartile range. This interquartile range of operating margins was compared to the operating margin earned by Lowe's consolidated companies in each of the fiscal years ending January 1997, 1998 and 1999. These operating margins in the 2000 CPM study were obtained from financial information derived from the Lowe's consolidated companies, including LCI, LHC, LF and other subsidiaries of LCI. The direct source of this information was a Compustat electronic financial database. 30. During the years at issue LF had one employee, Gisela Eubanks, who, at the time of her testimony, held the titles of assistant secretary and comptroller of LF. She has worked for LF since June 1995. Ms. Eubanks is a certified public accountant who worked on both trademark and investment matters. Ms. Eubanks conducted LF's day-to-day operations, including the payment of expenses, collection of revenues, maintenance of books and records, issuance of her own payroll checks, and the maintenance of checking and investment accounts. In addition, Ms. Eubanks worked with Wilmington Trust Company representatives relating to investments, outside accountants relating to financial statements and preparation of state tax returns, the LCI internal audit group relating to quality control audits, and outside legal counsel relating to general legal matters. Ms. Eubanks attended LF board of directors meetings at which she would report on financial matters and take minutes. Her corporate check signing authority was limited to $2,000.00. Prior to Ms. Eubank's employment with LF in 1995, her duties were performed by Delaware Corporate Management, Inc., which provided office space, part-time clerical support, accounting and related services. 31. During the tax years at issue LF had an investment management agreement and a custodial agreement with Wilmington Trust Company. Wilmington Trust invested funds on behalf of LF pursuant to investment guidelines established by LF's board of directors. A Wilmington Trust representative reported investment portfolio performance orally and in writing to LF's board of directors at its quarterly meetings. The investment portfolio was worth about $50 million during the tax years at issue. In recent years LF's investments have produced a higher rate of return than the short-term investment portfolio maintained by LCI. 32. During the tax years at issue Alston & Bird handled all trademark matters for LF and LCI, including filing registrations for and renewing trademarks, filing registrations and renewals of internet domain names, monitoring third-party trademark applications for possible infringement issues and addressing such issues as they arose, maintaining a database of LF's marks and overseeing foreign trademark registrations. A Wilmington, Delaware law firm, Stewart & Associates, handled LF's general legal matters including reviewing leases, loan agreements and license agreements. 33. On August 31, 1993 the Internal Audit Department of LCI was engaged by LF Corporation to perform quality control audits of Lowe's retail facilities in accordance with the Standards of Quality for Licensees promulgated by LF Corporation. These store audits were conducted during the fiscal years under review with the results compiled in an annual report to the LF board of directors. The Standards of Quality for Licensees required the review of such matters as the cleanliness and appearance of the stores, parking lots and the landscaping; the appearance and state of repair of vehicles; the uniformity and quality of forms, letterheads and packaging bearing the licensed marks; and the appearance, attitude and training of employees. The Internal Audit Department may perform a full store audit, which takes two employees two weeks to complete, or a mini-audit, which can be completed by one employee in a day and a half. In tax year 1996, the Internal Audit Department completed 89 full store audits and 344 mini-audits. LF paid LCI's internal audit group for its services based on an hourly rate established at the beginning of each fiscal year, which rate included direct personnel costs as well as administrative and overhead costs. LF's share of the total cost of each audit was based on 10 man-hours for a full store audit and one man-hour for a mini-audit. For tax year 1996, LF paid to LCI $33,850.00 for the services of its Internal Audit Department. For tax year 1997 LF paid $42,150.00 for these services. The Internal Audit Department reported the results of its audits to LF on an annual basis, unless a store was deficient in meeting its quality control standards. In such cases, LF was notified immediately. When LCI notified LF that a store was in violation of the Standards of Quality for Licensees, LF sent a letter to LCI's chief operating officer notifying him of the violation. The record does not indicate any follow-up on the part of LF after it sent the letter to LCI regarding a violation. 34. During the tax years at issue LF paid fees for membership in the Geoffrey Coalition, a group formed by Price Waterhouse to monitor state tax developments on behalf of its members. 35. During the tax years at issue LF filed state tax returns and paid taxes to several states, including North Carolina and South Carolina. It also reimbursed LCI for its share of the consolidated Federal tax liability. 36. During the tax years at issue LF borrowed funds under an arrangement with a Citibank subsidiary ("CAFCO"). Under this arrangement LHC and LCI assigned a security interest in their receivables to LF which, in turn, assigned the security interests to CAFCO. CAFCO then sold commercial paper secured by the receivables. The funds generated by these sales were loaned by CAFCO to LF. Upon its receipt of the funds, LF transferred the funds to LCI at the same interest rate plus a spread of 7½ basis points (.075%). LCI in turn loaned these funds to LHC for capital expansion. LHC made payments of interest only to LF with no payments of principal. LHC's interest payments were claimed as a deduction on its state tax returns. In tax year 1996 LHC made interest payments to LF in the sum of $113,848,561.00 and in tax year 1997 LHC's interest payments to LF totaled $115,965,787.00. LF paid no state tax on its interest income from LHC. Any out-of-pocket expenses incurred by LF in connection with the arrangement were reimbursed by LCI. Ms. Eubanks determined the maturity of the commercial paper sold by CAFCO. 37. During the tax years at issue LF's board of directors held quarterly meetings at the law offices of Stewart & Associates in Wilmington, Delaware. Before each meeting an agenda was provided to the directors together with copies of reports and other documents that were to be discussed at the meeting. LF also held annual shareholder's meetings in Delaware. All of LF's issued shares were owned by LCI. 38. Among the matters discussed at the LF board meetings during the tax years at issue were trademark matters including new trademarks to be accepted by the board, foreign trademark registrations, and third-party requests to use LF's trademarks. Other matters discussed at the board meetings included LF's quarterly financial statements and the status of state tax audits. Investment matters discussed at the LF board meetings included the performance of its investment portfolio, changes to the investment guidelines and the current status of the CAFCO arrangement. The LCI vice-president in charge of the Internal Audit Department made an annual presentation to the LF board regarding the number of store audits and an overview of their results. 39. New trademarks and service marks are developed by the LCI marketing team. If requested, an investigation is then conducted by the patent and trademark attorneys to determine if the proposed new mark is registerable, i.e., whether or not it infringes the rights of third parties. If the mark is viable, then the attorneys may be asked to file an application for registration with the United States Patent and Trademark Office. There are no instances in LF's board minutes where the LF board directed that the attorneys be asked to file such applications. 40. Since 1989 the Lowe's store base has been transformed from a chain of small hardware and building materials stores into a chain of home improvement warehouse superstores. During tax year 1996 Lowe's large stores, defined as those with more than 80,000 square feet, generated 61 percent of total sales, while during tax year 1997, such stores generated 70 percent of total sales. By the end of tax year 1997 Lowe's had more than 446 stores located in 25 states. Between May of 1996 and May of 1997 sales rose by 26 percent. The shift to newer and larger stores permits a broader merchandise mix which translates into higher profit margins. In 1997, 86 percent of Lowe's total retail square footage was new since 1991 and 75 percent of its retail square footage was less than 4 years old. The broad product mix found in Lowe's stores and the well trained, knowledgeable employees who work there are key to Lowe's continued growth in sales. 41. Historically Lowe's had emphasized the needs of professional contractors in its retail operations. Beginning in 1989 that emphasis began to change whereby during the tax years at issue Lowe's focus was on the needs of the do-it-yourself homeowner. 42. Professor Richard D. Pomp testified on petitioner's behalf and his written report was received into evidence. Professor Pomp is a professor of law at the University of Connecticut School of Law and an adjunct professor at both the New York University School of Law and Columbia Law School. He is the author, with Oliver Oldman, of a casebook, State and Local Taxation, that is used by law schools, accounting firms and corporations. He was the director of the New York State Tax Study Commission from 1982 to 1987. Professor Pomp has been retained as a consultant by the U.S. Department of Justice, U.S. Treasury Department, the Internal Revenue Service, the Multistate Tax Commission and various states including New York, New Jersey, Connecticut, Delaware and California. He was accepted and testified as an expert on Federal and state tax policy. 43. Before rendering his report and giving testimony, Professor Pomp reviewed certain documents along with transcripts of previous testimony. In addition, he conferred with certain LCI and LF directors, officers and employees as well as trademark counsel. 44. In his testimony Professor Pomp discussed the business purposes for which LF was formed in support of his position that it was not a shell corporation. He expressed his opinion that LF's business is a service business and that many service businesses, like LF, have high income and low expenses, and further, that the only policy significance to the commissioning by LF of four transfer pricing studies was to show that LF was trying to do the right thing. 45. Steve L. Snyder, a senior manager in the transfer pricing group of Deloitte Touche, was qualified and accepted by consent as an expert in transfer pricing. Mr. Snyder had been employed by AA from November 1999 to May 2002, and before that for 4½ years with Ernst & Young. He is a graduate of Vanderbilt University where he received an MBA. Of the approximately 150 transfer pricing studies Mr. Snyder had performed, 30 to 40 involved intangible assets and approximately two-thirds of that number involved state, as opposed to Federal, tax matters. His experience includes eight studies involving the licensing of intangible assets in the retail industry. Mr. Snyder, with other AA employees, performed the analyses for the 2000 and 2002 AA studies to determine the arm's length range of the royalty rates to be paid by the LHC to LF. During the period when the 2000 AA transfer pricing study was being prepared, Mr. Snyder received an e-mail dated March 3, 2000 from a co-worker, Mr. Fijol, seeking direction in the preparation of the study. Mr. Fijol noted, with regard to the licensing company (LF), that the "functional analysis is thin" and "the licensing company doesn't currently have many functions to discuss." 46. Mr. Snyder described the methodologies he used and the conclusions he reached in both of the AA March 2, 2000 transfer pricing studies, as well as the two January 2002 studies he conducted. A CUT method and a CPM study was performed by Mr. Snyder for each year. AA had previously performed royalty rate studies on behalf of LF dated October 2, 1991 and November 14, 1997. Mr. Snyder reviewed the 1991 and the 1997 studies in his testimony, and discussed the details of the 2000 study that he authored. His information source for the 2000 CPM was financial information derived from the Lowe's consolidated companies filings that Mr. Snyder obtained from a Compustat electronic financial database. He prepared the 2002 transfer pricing CUT and CPM studies as supplements to his 2000 studies, and therefore omitted from the 2002 CUT and CPM the best method analysis he performed in conjunction with the 2000 studies. 47. In preparing for his 2002 transfer pricing studies, Mr. Snyder examined unaudited segmented income statements and balance sheets pertaining to LHC. He also examined annual reports and Security Exchange Commission Forms 10-K for other companies in the home improvement industry. 48. In his 2002 CUT analysis, Mr. Snyder initially tried to identify internal comparable transactions involving either the licensing of LF's marks to an unrelated party in an industry similar to that of LHC, or to determine if LHC licensed similar marks from an unrelated party. He found what at first appeared to be a CUT involving a licensing agreement between an advertising affiliate of LHC and LF and an entity named Sports Marketing Enterprises which licensed the use of LF's marks in connection with the marketing of NASCAR racing apparel and souvenirs. Mr. Snyder rejected this licensing agreement because the sale of apparel and souvenirs represented a different profit potential than the sale of home improvement products. 49. Mr. Snyder next conducted a search of the Compact Disclosure database and the RoyaltySource Intellectual Property database in an effort to find licensing agreements between home improvement retailers and third parties comparable to the licensing agreement between LF and LHC. This search identified two potential comparable agreements that he determined to be CUTs. The first such agreement was between Century 21 and AMRE and the second agreement involved Sears, Roebuck and Company and AMRE. In 2002 Mr. Snyder rejected as a CUT the same Ace Hardware franchise agreement that he had relied on as a CUT in the AA 2000 transfer pricing study. 50. Under the Century 21-AMRE agreement AMRE was granted the use of the Century 21 home improvement trademarks within the United States in the marketing, selling and installation of home improvement products. The agreement provided that AMRE would pay to Century 21 a royalty equal to the greater of earned royalties or minimum royalties where earned royalties were equal to three percent of AMRE contract revenue, and minimum royalties ranged from $11 million in 1996 to $27.9 million in 2005. In addition to the royalty payments, AMRE was required to pay $10 million annually to the Century 21 National Advertising Fund. In 1996 AMRE paid the minimum royalty in the sum of $11 million plus the $10 million to the advertising fund. Petitioner maintains that by excluding the advertising expense as an adjustment and considering only the $11 million royalty payment, the royalty amounted to 4.4 percent of net sales. 51. Under the Sears/AMRE agreement, AMRE was granted the right to use the Sears trade name in connection with its sales and installation of certain home improvement products. For this privilege AMRE was obligated to pay Sears a royalty equal to 12 percent of gross revenues until it paid $320 million, then 9.5 percent until it paid $335 million and 8 percent thereafter. In addition the agreement required AMRE to actively advertise and promote the products it sold and installed under the agreement. Mr. Snyder made a sales volume adjustment to account for LHC's higher level of sales compared to those of AMRE, which he determined resulted in a royalty rate of 8 percent of net sales. This 8 percent rate included the provision to AMRE by Sears of certain unspecified support services. 52. It is Mr. Snyder's position that the royalty rates agreed to in the Century 21-AMRE and the Sears Roebuck-AMRE licensing agreements support his contention that the 2.5 percent royalty rate used by LHC and LF in their licensing agreement is arm's-length. As with the CUT method employed in the AA 2000 transfer pricing study, there was in the 2002 study a failure to comply with the Treasury Regulation requirement that the intangible property involved in the controlled transaction be comparable to the intangible property involved in the uncontrolled transaction by demonstrating that both sets of intangibles have similar profit potential through the direct calculation of the net present value of the benefits to be realized through the use of the intangible property. 53. In order to confirm the results of its 2000 and 2002 CUT analyses, AA conducted two CPM analyses, one in the year 2000 with the Lowe's consolidated companies as the tested party, and the second in 2002 with LHC as the tested party. In its 2000 CPM study, it sought to identify comparable retailers by searching 15 Standard Industrial Classification ("SIC") Codes in three electronic databases, which resulted in a pool of 176 companies. Following a review of short business descriptions of each company, AA eliminated 116 companies for various stated reasons, leaving 60 companies for a detailed examination of their Forms 10-K. Upon completing this review, AA selected five companies whose functions and risks it considered to be comparable to the Lowe's consolidated companies. The five companies were Building Materials Holding Corp.; Do-it-Yourself Home Warehouse, Inc.; Homebase, Inc.; White Cap Industries, Inc.; and Wolohan Lumber Co. Fiscal year 1996 through 1998 income statement and balance sheet information for the five companies was used to compute what Mr. Snyder found to be an arm's-length range of operating profit margins, which range was then adjusted to the working capital levels of Lowe's operating companies. This range of working capital adjusted operating margins was compared to the actual operating margins earned by the Lowe's consolidated companies after payment of the royalty to LF, and used to determine, according to Mr. Snyder, a range of arm's-length royalty rates to be paid to LF. 54. In the AA January 2002 CPM transfer pricing report, Mr. Snyder explained that he selected the CPM due to the availability and reliability of data from unrelated companies performing functions, bearing risks and owning routine intangible assets similar to those of LHC. He explained that he selected the operating profit margin as the profit level indicator ("PLI") because this PLI is often used where the tested party engages in the sale of products to end-users. Mr. Snyder omitted a best method analysis in this CPM study. Mr. Snyder conducted three searches to identify uncontrolled retailers that performed functions, faced risks and owned routine intangible assets similar to those of LHC. The three searches covered published data for the years 1990, 1995 and 1999, respectively. 55. In his search of the 1990 data, Mr. Snyder searched a total of 155 companies in 15 SIC codes to identify potential comparable companies. This group was reduced to 26 companies through his application of certain rejection criteria, which excluded companies that engaged in substantial design and development activities, companies that operated in an industry other than home improvement retailing and those having substantial operations outside the United States. Mr. Snyder then examined the annual reports and Forms 10-K of these 26 companies, resulting in the identification of five companies whose functions, risks and routine intangible assets he considered to be comparable to those of LHC. 56. The search of the 1995 data made use of the Compact Disclosure electronic database and the same primary SIC codes used in the 1990 search. Of the 172 companies identified by Mr. Snyder for further evaluation, 148 were eliminated through the application of the same rejection criteria used in the 1990 search. A detailed examination of the annual reports and Forms 10-K of the remaining 24 companies brought about the elimination of 16 companies, leaving 8 companies he identified as performing functions, assuming risks and owning routine intangible assets similar to LHC. 57. The third search, that of the 1999 data, proceeded in a similar vein wherein eight companies were ultimately identified by Mr. Snyder as performing functions, assuming risks and owning routine intangible assets comparable to LHC. After eliminating the duplicates between the three searches, along with companies in financial distress and one company with incomplete financial data, Mr. Snyder was left with 11 companies which he subjected to financial analysis. The 11 companies were Building Materials Holding Corp. ("Building Materials"); DIY Home Warehouse, Inc. ("DIY"); Eagle Hardware and Garden, Inc. ("Eagle"); Hechinger Co. ("Hechinger"); Homebase, Inc. ("Homebase"); National Home Centers, Inc. ("National"); Orchard Supply Hardware Corp. ("Orchard"); Payless Cashways, Inc. ("Payless"); Strober Organization, Inc. ("Strober"); White Cap Industries, Inc. ("White Cap"); and Wolohan Lumber Co. ("Wolohan"). 58. Building Materials sold retail building materials primarily to professional contractors as well as to project oriented consumers. As of December 31, 1997 it operated 55 building materials centers in the western United States. Most of its stores feature value-added operations, which include the fabrication of roof trusses, pre-hung doors and pre-assembled windows. Its sales for the year ending December 1997 were $728 million. 59. DIY operated 16 warehouse format home improvement centers that sell primarily to do-it-yourself customers. Its stores are located in northeast Ohio with each store in the size range of 66,000 to 109,000 square feet. Most of its stores are leased. DIY offers a high level of customer service. DIY's sales for the fiscal year ending January 3, 1998 were $210 million. 60. Eagle operated 30 home improvement warehouse style stores in the western United States primarily serving do-it-yourself customers as well as professional contractors. Its stores averaged 125,000 square feet, about half of which are leased. It maintained one 214,000 square foot distribution center which handled about 20 percent of its merchandise. Eagle's sales for the fiscal year ended January 30, 1998 were $971 million. 61. Hechinger sells products for home and garden at retail primarily to do-it-yourselfers. Through subsidiaries it operated 64 stores under the Hechinger name, 52 stores using the name "Home Quarters Warehouse" and one store in Albany, New York under the name "Better Spaces." All but 22 stores were leased. These stores are located in the eastern and central states and average 70,000 square feet. Its sales for the 34-week period ending September 27, 1997 were $1.36 billion, and for the 53-week period ending October 3, 1998 its sales totaled $3.44 billion. Hechinger posted net losses throughout the period from January 1995 to October 1998. 62. Homebase is the second largest operator of home improvement warehouse stores in the western United States selling at retail to do-it-yourself and professional contractor customers. In January 1999 it operated 84 stores in 10 states averaging about 103,000 square feet in size. All but 19 of its stores were leased. Its sales for the fiscal year ending January 31, 1998 were $1.5 billion. 63. National operated nine home center stores in Arkansas selling to do-it-yourself and professional contractor customers. Of the nine stores, five were leased. The stores average 125,000 square feet in size. It operates value-added production facilities wherein it manufactures countertops, pre-hung doors and window units. National's sales for the fiscal year ending January 31, 1998 were $151 million. It posted losses during its fiscal years ending January 1997 and January 1998. 64. Orchard operated 60 hardware stores in northern and central California catering to the "fix-it" homeowner, filling the niche between small hardware stores and large home improvement warehouses. Forty-nine of its stores are leased. Its stores averaged around 40,000 square feet in size. Orchard's most recent sales figures in the record are taken from its Form 10-Q for the quarter ending July 28, 1996, where sales for the six-month period ending July 28, 1996 were $303 million. 65. Payless operated 164 retail stores in 20 states selling to both do-it-yourself and professional contractor customers. Lumber accounted for about 50 percent of its sales. The retail locations were served by its eight distribution centers. Its sales for the fiscal year ending November 29, 1997 were $2.3 billion. Payless filed under Chapter 11 of the Bankruptcy Code on July 21, 1997. 66. Strober sold building materials primarily to professional contractors from its 11 building supply centers located in New York, New Jersey, Pennsylvania and Connecticut. Its stores averaged about 40,000 square feet. About one-half of its stores are leased. The most recent Form 10-K in the record reveals that its sales for the year ending December 31, 1995 were $126 million. 67. White Cap marketed its tools and materials primarily to professional contractors from its 40 branch locations in the western United States. All of its facilities are leased. It also markets its products through an outside sales force, catalogue orders and a centralized "fulfillment center." White Cap's sales for the fiscal year ending March 31, 1998 were $187 million. 68. Wolohan maintained 50 building material stores in Illinois, Indiana, Kentucky, Michigan and Ohio catering to builders, remodelers and do-it-yourself customers. Its sales for the year ending December 31, 1997 were $425 million.(1) 69. AA obtained financial data for LHC and the foregoing selected companies for the period 1992 through 1999. The financial data for LHC that Mr. Snyder used in the 2002 CPM study was limited to unaudited internal data from the LHC income statements and balance sheets, along with trial balance information. 70. The market to book value ratio ("M/Bvr") is a measure of value, created or destroyed, that is equal to the present value in dollars an investor receives for each dollar invested. The M/Bvr depicts a rank ordering of economic performance which correlates with the excess returns the company is earning or not earning, as the case may be. A M/Bvr greater than one indicates the company is expected to earn excess returns on invested capital, while a M/Bvr that is less than one indicates that such earnings will be sub-par. The following chart sets forth the M/Bvr for 1996, 1997 and 1998, as determined by Dr. Alan C. Shapiro, the Division's witness, in his report (exhs. 15, 15.1), relating to Home Depot, Lowe's and 9 of the 11 proposed comparable companies investigated by AA in connection with its 2002 CPM study, and for which data was available to Dr. Shapiro.
71. American Appraisal Associates ("AAA") was retained to prepare a transfer pricing study to determine whether the royalty paid under the license of the marks by LF to LHC and LCI was within an arm's-length range under section 1.482 of the Treasury Regulations. 72. Richard J. Billovits, a vice president and principal of AAA, conducted the study. He holds an MBA in finance from St. John's University. He has about 12 years experience in the valuation of intangible property, including trademarks, and has worked on transfer pricing studies relating to trademarks and other intangible property. Mr. Billovits was accepted as an expert in the valuation of intangible assets and in transfer pricing, but was not offered or received as an expert in IRC § 482 matters. 73. Mr. Billovits gave testimony regarding the methods used and conclusions reached in the study. His report, dated as of January 31, 1997 and January 31, 1998, was received in evidence. In the course of preparing to conduct the study, Mr. Billovits reviewed various financial and other documents regarding the operations of LHC and LF. He visited LCI's headquarters in Wilkesboro, North Carolina; LF's office in Wilmington, Delaware, and three stores located in New York, New Jersey and North Carolina. Mr. Billovits also spoke with certain executives of LCI and LF. He determined that the CUT method was the best method to use to determine the appropriate range of arm's length royalty rates. 74. In order to find comparable license agreements entered into by uncontrolled parties, Mr. Billovits looked to various sources including Intellectual Property Research Associates, the RoyaltySource Intellectual Property Database, Home Improvement Research Institute, and Bonds Franchise Guide 1999. He also reviewed various Forms 10-K filed by companies in the home improvement industry. 75. Mr. Billovits found two license agreements that he considered to be comparable. One such agreement was the October 17, 1995 agreement whereby AMRE was granted the use of the Century 21 trademarks. This is the same agreement selected by AA as a CUT which is referenced in Finding of Fact "27". The second agreement determined by AAA to be comparable was the Ace Hardware Corp. ("Ace") franchise agreement, as reported in Bond's Franchise Guide 1999, which granted franchise rights to various franchisees. This is the same franchise agreement referred to in Finding of Fact "28", which agreement was relied upon by AA in its 2000 transfer pricing report, and then rejected by AA as a CUT in its 2002 study referenced in Finding of Fact "49". In return for these rights, the franchisee would pay Ace a 2 percent of gross sales royalty plus an advertising fee of 1.3 percent, all in addition to an initial non-refundable franchise fee of $25,000.00 for the first store and $15,000.00 for each additional store. 76. Based on these CUTs, AAA determined the arm's-length royalty rate range to be from 2 to 3 percent. In order to test its findings under the CUT method, AAA next employed a CPM analysis. Under this method and using the Lowe's consolidated companies as the tested party, AAA searched 15 SIC codes in various sources and data bases, which search yielded 104 companies. An examination of short business profiles of the 104 companies to compare their business operations with those of LHC served to reduce the list of potential comparable companies to 14. 77. AAA next screened the 14 companies based on a number of factors intended to exclude companies that, among other things, owned valuable trademarks or engaged in major manufacturing activities or were not United States companies conducting business primarily in the United States or were in financial distress or did not derive most of their revenue from the sale of home improvement products. This screening process reduced AAA's list of potential comparable companies to seven, including six of the companies selected as comparable companies by the AA analysis (Building Materials, DIY, Homebase, National, Wolohan and White Cap) plus Wickes, Inc. ("Wickes"). Homebase had changed its name to House-2-Home, Inc. since the AA study. Mr. Billovits advised that Home Depot was excluded because it owned valuable trademarks. 78. AAA next determined the operating margin and the rate of return on operating assets of each company in this group of seven and then made adjustments for differences in inventory valuation methods as well as nonrecurring and nonoperating items. Using Lowe's audited consolidated numbers, AAA adopted the Lowe's operating margin as the profit level indicator and used the rate of return on operating assets for confirmation. 79. According to Mr. Billovits, by assuming the payment to LF by LHC of a three percent royalty rate, and comparing LHC's operating margins and rates of return on operating assets with the interquartile range of these results for the seven companies for the years 1996, 1997 and 1998, LHC's operating margins and rates of return on operating assets were within or higher than the interquartile range of each measurement in each year. Based on its CPM study, AAA concluded that LHC could pay a 3 percent royalty to LF for its use of the marks and remain within or above the interquartile range of the seven companies, which, in turn, demonstrates that a 3 percent royalty rate would be arm's length. Thus, according to Mr. Billovits, if a 3 percent royalty rate is arm's-length, then, of necessity, so is the 2.5 percent royalty that LHC was actually paying to LF during this period. 80. In conducting its CUT study, AAA failed to comply with the Treasury Regulation requirement that the intangible property involved in the controlled transaction be comparable to the intangible property involved in each of the uncontrolled transactions by demonstrating that both sets of intangibles have a similar profit potential through the direct calculation of the net present value of the benefits to be realized through the use of the intangible property. 81. The Division presented the testimony of Alan C. Shapiro, Ph.D., whose written report, dated June 3, 2002, was received in evidence. Dr. Shapiro has a Ph.D. in economics from Carnegie Mellon University and has taught economics and finance for more than 25 years. He is the Ivadelle and Theodore Johnson Professor of Banking and Finance at the Marshall School of Business of the University of Southern California ("USC"). At USC he served as chairman of the Department of Finance and Business Economics. Dr. Shapiro was accepted as an expert in economics, corporate finance, valuation of intangibles and transfer pricing. He did not purport to be and was not offered as an expert in IRC § 482 principles. 82. Dr. Shapiro, in his testimony and report, criticized the AA and AAA royalty rate studies and concluded that LF's trademarks had little intrinsic value and could be replaced at relatively low cost. He asserted that the AA and the AAA CUTs were not comparable to the LHC/LF licensing agreement; the royalties paid by LHC extracted too great a portion of its operating income for the period 1991 through 2000 and prevented LHC from earning its cost of capital on its tangible and intangible assets; that contrary to the positions of AA and AAA, LHC did own unique and valuable intangible assets, without which the marks owned by LF would be all but worthless; and the CPM analyses ignore the fact that LHC was operating in an industry in transition with few winners (Lowe's and Home Depot) and many losers. Dr. Shapiro explained that not all excess returns a company may earn are attributable to its trade names. He discussed competitive advantages that earn excess returns and take the form of either cost based advantages or product differentiation. In his report, Dr. Shapiro also discussed barriers to entry by competitors, the ability to innovate, the role of trademarks as a signal to consumers, and the tendency of a trademark to become stale and to require frequent ref |