TOYS "R" US-NYTEX, INC. – DETERMINATION – 08/04/99 In the Matter of TOYS "R" US-NYTEX, INC. TAT(H) 93-1039(GC) – DETERMINATION NEW YORK CITY TAX APPEALS TRIBUNAL ADMINISTRATIVE LAW JUDGE DIVISION GENERAL CORPORATION TAX - THE COMMISSIONER OF FINANCE COULD NOT REQUIRE PETITIONER, WHICH OWNED AND OPERATED STORES IN NEW YORK, TO FILE A COMBINED GENERAL CORPORATION TAX RETURN WITH RELATED FOREIGN CORPORATIONS WHICH HELD INTANGIBLE PROPERTY INCLUDING TRADEMARKS, MORTGAGES AND LOANS/PETITIONER REBUTTED THE REGULATORY PRESUMPTION OF DISTORTION BY ESTABLISHING, THROUGH UNCHALLENGED EXPERT TESTIMONY, THAT ITS SUBSTANTIAL INTERCORPORATE TRANSACTIONS WITH RELATED CORPORATIONS WERE EITHER AT ARMS LENGTH OR ON SUCH TERMS THAT REPORTING ON A COMBINED BASIS WAS NOT REQUIRED TO ELIMINATE DISTORTION AS THE NON-ARM'S LENGTH PRICING INCREASED THE CITY GENERAL CORPORATION TAX LIABILITY OR WAS DE MINIMUS/THE CORPORATIONS WHICH HELD THE INTANGIBLES HAD ECONOMIC SUBSTANCE AND THEIR FORM COULD NOT BE DISREGARDED/THE ORIGINAL TRANSFER OF TRADEMARKS, TRADENAMES AND OTHER PROPERTY COULD NOT BE DISREGARDED FOR TAX PURPOSES AS THEY WERE VALID TRANSFERS WHICH HAD ECONOMIC SUBSTANCE AND GENUINE BUSINESS PURPOSES AND WERE NOT ENTERED INTO SOLELY FOR TAX AVOIDANCE PURPOSES. AUGUST 4, 1999

NEW YORK CITY TAX APPEALS TRIBUNAL ADMINISTRATIVE LAW JUDGE DIVISION_ : In the Matter of the Petition : : : DETERMINATION of : : TAT(H) 93-1039(GC) TOYS “R” US-NYTEX, INC. : : __________________________________:

Murphy, A.L.J.:

Petitioner, Toys “R” Us-NYTEX, Inc., filed a Petition

with the Commissioner (the “Commissioner” or “Respondent”)

of the New York City (“City”) Department of Finance (the

“Department”) requesting redetermination of a deficiency of

General Corporation Tax (“GCT”) under Chapter 6 of Title 11

of the Administrative Code (the “Code”) of the City of New

York (the “City”) for the tax years ended February 2, 1986,

February 1, 1987 and January 31, 1988 (the “Tax Years”).

Pursuant to the provisions of sections 168 through 172

of the City Charter as amended by act of the New York State

Legislature on June 28, 1992, Ch. 808, Laws 1992, section

140, this case, which was pending before the Hearings Bureau

on October 1, 1992, was transferred to the City Tax Appeals

Tribunal for determination.

A formal hearing was held before the undersigned on

July 22, 1997, July 23, 1997 and July 24, 1997, at which

time evidence was admitted and testimony was taken.

Petitioner was represented by Paul H. Frankel, Esq., Hollis

J. Hyans, Esq., and Irwin M. Slomka, Esq. of Morrison &

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Foerster LLP. Robert J. Firestone, Esq., Frances J. Henn,

Esq. and Martin Nussbaum, Esq., Assistant Corporation

Counsels, represented the Respondent.

The parties entered into a Stipulation of Facts and

Exhibits (the “Stipulation”) dated July 16, 1997, which was

admitted into evidence at the formal hearing. The

stipulated facts have been substantially incorporated in the

Findings of Fact below.

Following the hearing, the representatives submitted

briefs in support of their positions.1 Petitioner’s initial

Brief was filed on January 9, 1998. Respondent filed a

Reply Brief on July 15, 1998. On November 2, 1998

Petitioner filed its Reply Brief, and on December 23, 1998

Respondent filed his Sur Reply Brief.

ISSUE

Whether, pursuant to Code §11-605.4, Respondent may

require Petitioner to file its City GCT reports for the Tax

Years on a combined basis with certain related corporations

because the substantial intercompany transactions which were

the predicate for requiring such combination: (1) were not

made on an arm’s length basis; or (2) must be “integrated”

with the earlier 1984 transfers of underlying property to

those related corporations and therefore disregarded for GCT

purposes.

1 The representatives also entered into a “Stipulation as to the

Transcript of Hearing” on October 22, 1998, agreeing to certain changes in the transcript.

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FINDINGS OF FACT

1. Petitioner, Toys “R” Us-NYTEX, Inc., is a New York

State (“State”) corporation which operates retail toy and

children’s clothing stores in the State and in Texas.

Petitioner was formed on January 30, 1984, and is a wholly-

owned subsidiary of Toys “R” Us, Inc. (“Toys Inc.”). During

the Tax Years Petitioner operated six stores in the State.

2. Toys Inc., a Delaware corporation with principal

offices located in Rochelle Park, New Jersey, is the parent

corporation of: Petitioner, Toys “R” Us-Penn (“Toys-Penn”),

Toys “R” Us-Mass (“Toys-Mass”), and Toys “R” Us-NJ (“Toys-

NJ”) (collectively referred to as the “Operating Com-

panies”). Toys Inc. is also the parent corporation of TRU,

Inc. (“TRU”) and certain international subsidiaries. In

addition to holding the stock of subsidiaries, Toys Inc.

operates retail toy and children’s clothing stores outside

the State. Toys Inc. maintains warehouse and distribution

centers, and owns and operates its own fleet of trucks.

Corporate History

3. Charles Lazarus founded the first Toys “R” Us store

in 1957. The store was organized on principles of

supermarket retailing. In 1966, in an effort to secure

capital to expand his business, Mr. Lazarus sold his four

stores to Interstate Department Stores, Inc. (“Interstate”),

a conglomerate comprised of retail businesses.

4. In 1974, Interstate declared bankruptcy. The

bankruptcy court permitted Mr. Lazarus to continue to run

the operations of Interstate. He restructured the company

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with an emphasis on the toy business, selling many of the

non-toy operations. Interstate emerged from bankruptcy in

1978 with sixty stores nationwide. Interstate was

subsequently reorganized under the corporate name Toys “R”

Us, Inc.2

5. During the 1980s, the business of Toys “R” Us

continued to expand. From 1980 to 1990, Toys “R” Us grew

from 85 stores in 13 states to 404 stores in 41 states and

Puerto Rico with a 22% market share. During this time, Toys

“R” Us opened stores in other countries, and broadened its

merchandise offerings to include children’s clothing.

Eventually, separate children’s clothing stores were opened

under the Kids “R” Us name.

6. Prior to the Tax Years, Toys Inc. conducted all the

operations of the business of Toys “R” Us. At that time,

TRU Realty, Inc. (“Realty”), a wholly-owned subsidiary of

Toys Inc., held title to all real property owned and used by

the business.

The Group as Reorganized

7. In 1984, Toys Inc. substantially reorganized its

corporate structure. Several new corporations were formed

and the functions of the existing corporations were changed.

Toys Inc. remained the parent corporation, holding the stock

of Petitioner and the other Operating Companies, as well as

the stock of TRU, certain international subsidiaries and

alien corporations. TRU held the stock of Geoffrey, Inc.

(“Geoffrey”), ABG, Inc. (“ABG”), Toys “R” Us-UK Inc. (“Toys-

2 According to the organizational chart, reproduced infra at page

5, and the Exhibits to the Stipulation, Interstate maintained an active

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UK”), Interstate, and certain international subsidiaries.

The following organizational chart reflects the corporate

structure as of April 1985:

The corporations shown above comprised the Toys “R” Us Group

(the “Group”) during the Tax Years.

8. As Michael Goldstein, the present Chief Executive

Officer of Toys Inc.,3 credibly testified at hearing with

respect to the bases for the 1984 restructuring, Geoffrey,

ABG and TRU (the “Related Corporations”) were formed to

protect the Group from hostile takeovers and other potential

litigation, as well as for tax-planning reasons; and

Geoffrey was specifically formed for the purposes of

holding, protecting and creating trademarks and trade names.

corporate existence as a subsidiary of Toys Inc. after the restructuring in the 1980s. See, generally, Stip. Ex. 34-36.

3 Mr. Goldstein joined the Toys “R” Us organization in 1983 as its

senior vice president and chief financial officer. During the course of his association with Toys Inc., he has variously held the positions of senior vice president, executive vice president and chief financial officer. During the Tax Years Mr. Goldstein was an officer and member of the Board of Directors of several corporations in the Group, including the Related Corporations.

TOYS INC.

TOYS-NJ TOYS-MASS TOYS-PENN PETITIONER INT’L SUBS

TRU

GEOFFREY ABG TOYS-UK INTERSTATE INT’L SUBS

UK SUBS

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9. Toys-NJ is a New Jersey corporation which operates

retail toy and children’s clothing stores in New Jersey.

Toys-NJ also provides management and financial services to

the Related Corporations pursuant to separate agreements

with the other corporations; i.e., the “Geoffrey Service

Agreement,” the “ABG Service Agreement,” and the “TRU

Service Agreement” (collectively, the “Agreements”). The

Agreements also provide that Toys-NJ will “advanc[e]

sufficient working capital for the conduct of the business”

of the Related Corporations.

During the Tax Years, Toys–NJ was responsible for

performing centralized operational functions for the Group,

including purchasing, pricing, staffing of the stores, and

providing other services such as managerial, tax, accounting

and legal services. Toys-NJ also determined store site

locations, layout, merchandise selection, and pricing for

the regional Operating Companies. Toys-NJ administered the

Group’s advertising, although actual advertisement placement

was the responsibility of the Operating Companies. The

costs of many of the services performed by Toys-NJ were

allocated to the Operating Companies according to those

companies’ sales. Services which Toys-NJ provided the

Related Corporations were separately charged, pursuant to

the Agreements. Toys-NJ maintained an in-house legal staff,

which included between five and ten attorneys during the Tax

Years.4

10. Toys-Penn and Toys-Mass operate retail toy and

children’s clothing stores in Pennsylvania and

Massachusetts, respectively.

4 All Operating Companies, including Toys-NJ, had a division which

operated the Kids “R” Us stores.

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11. Toys-UK is a wholly-owned subsidiary of TRU.

Toys-UK is affiliated with other Toys “R” Us corporations

doing business in the United Kingdom (the UK Subs), as well

as with TRU(UK) Inc., the United Kingdom subsidiary of TRU.

12. Geoffrey, a Delaware corporation, was formed on

January 24, 1984 as a wholly-owned subsidiary of Toys Inc.

Since 1985, Geoffrey has been a wholly-owned subsidiary of

TRU. Geoffrey licensed the Toys “R” Us and Kids “R” Us

trademarks and tradenames to members of the Group as well as

to unrelated corporations.

13. ABG, a Nevada corporation, was formed on January

24, 1984. Since 1985, ABG has also been wholly owned by

TRU. During the Tax Years, ABG provided the Group with

mortgage financing so that the Operating Companies could

finance their real estate development.5

14. TRU, a Delaware corporation formed on January 12,

1984, is a wholly-owned subsidiary of Toys Inc. During the

Tax Years, TRU held the stock of foreign and domestic

affiliated companies, including Geoffrey and ABG. TRU

invested assets of affiliated corporations and made loans to

Toys Inc. and other Group corporations.

15. For purposes of this proceeding only, Petitioner

agrees that it was engaged in a unitary business with the

Related Corporations within the meaning and intent of §11-

91(e)(2) of the Rules and Regulations of the City of New

York (“RCNY”).

5 Michael Goldstein testified that ABG was also engaged in

developing parcels of property with unrelated developers which would be occupied by unrelated corporations as well as by Toys “R” Us stores. Tr. at 296-7.

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16. Simon, Master & Sidlow (the “Simon firm”), an

unrelated accounting firm located in Wilmington, Delaware,

performed accounting and financial services for Geoffrey and

TRU during the Tax Years. The Simon firm provided one

employee to serve as a part-time employee of TRU and

Geoffrey. The firm billed fees which covered the employee’s

salary and “audit and advisory fees.” The firm usually

billed these fees to TRU and Geoffrey separately. Stip. Ex.

13, 29. Two of the firm’s principals, Howard H. Simon and

William H. Master, also served as officers and directors of

affiliated Group corporations.

Geoffrey

17. Prior to the reorganization, Toys Inc. performed all

tasks involving the various Toys “R” Us trademarks and trade

names. Mr. Goldstein testified that during this earlier

period, the corporation was not particularly diligent in

trademark protection and there were infringements which were

not addressed. Tr. at 328-9.

18. Effective August 1, 1984, Toys Inc. assigned

various Toys “R” Us and Kids “R” Us trademarks and trade

names to Geoffrey.6 According to the assignment agreement,

Toys Inc.: (a) transferred to Geoffrey “the entire right

title and interest in and to the [listed] marks . . .

together with the goodwill of the business symbolized by

6 As part of the 1984 reorganization, Toys Inc. transferred to

Geoffrey the following intangible assets: the Toys “R” Us trademark to identify a line of children’s goods, including toys; the Toys “R” Us service mark; the Kids “R” Us trademark for wearing apparel; the Kids “R” Us service mark; the “term” Toys “R” Us; U.S. and foreign registration of the marks ‘Toys “R” Us,’ ‘Kids “R” Us,’ and other registrations terminating in “R” Us. Toys Inc., however, did not transfer merchandising skills, techniques and expertise. Ex. 2, vol. 1, Ernst & Young “Toys “R” Us Transfer Pricing Analysis” (the “E&Y Report”), pp. 28-9.

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said marks, and the respective registrations and appli-

cations for registration thereof;” and (b) assigned to

Geoffrey:

. . . any and all causes of action, claims, demands, or other rights occasioned from or because of any and all past infringements . . . together with the right . . . to sue and recover therefore including the right to bring suit in its own name and to receive, retain, hold and enjoy for its own use and behalf . . . any and all damages, profits or other recov- eries . . . .

At the end of 1985, Toys Inc. transferred the stock of

Geoffrey to TRU.

19. Geoffrey is registered with the United States

Patent and Trademark Office as the owner of the Toys “R” Us

and Kids “R” Us trademarks, service marks and trade names,

including those transferred on August 1, 1984 and those

subsequently developed.

20. Geoffrey licensed the Toys “R” Us and Kids “R” Us

marks and names to affiliated domestic and foreign operating

companies, joint ventures and franchise partners, pursuant

to written licensing agreements.7 In such agreements, Geof-

frey granted the licensee (e.g., the operating companies and

Toys Inc.): “a non-exclusive right and license to use the

mark(s) . . . for the products and services listed . . .

and as a trade name to identify the licensee’s business, and

to use said Licensed Mark in advertisements and promotional

materials relating thereto.” The licensees were granted “a

non-exclusive right and license to use the Licensor’s

7 Mr. Goldstein testified that agreements with foreign affiliates

or partners included a component for licensing of the marks, and a component for “knowhow.” Tr. at 288-90.

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merchandising skills, techniques and know-how . . . in the

operations of the Licensee’s business.” The agreements

identified the marks and placed certain geographical

limitations on their use. The agreements with affiliates

have a term of twenty years, with five-year renewal

provisions. See, e.g., Stip. Ex. 9.

21. Each licensing agreement provides for “Quality

Control” whereby the licensee agrees that the products and

services to which the marks are applied will be of “high

standard and of such quality, workmanship, style and

appearance as shall, in the sole judgement of the Licensor,

be reasonably adequate and suited to their exploitation to

the best advantage and to the protection and enhancement of

the Licensed Mark and Licensed trade name, and the goodwill

pertaining thereto.” Each agreement also provides for

enforcing quality control; for example, by requiring the

licensee to submit samples of the products and services

using the marks to Geoffrey for approval. See, Stip. Ex. 6,

Art. VI – “Quality Control.”

22. Geoffrey charged Petitioner, the other Operating

Companies, and Toys Inc. a royalty for the non-exclusive use

of the trade names and other intangibles pursuant to the

separate licensing agreements. During the Tax Years,

Geoffrey charged the Operating Companies a royalty at a rate

of one percent (1%) of their net sales. Geoffrey also

licensed the right for specific products and services and

the right to use the marks in promotional materials to the

Operating Companies. Advertising expenses were borne by the

licensees.

23. The royalty rate Geoffrey charged the Operating

Companies was determined after an internal review of rates

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charged by other unrelated corporations,8 as well as a

review of certain agreements Toys “R” Us had with an

unaffiliated corporation. Geoffrey’s Board of Directors

approved the royalty rate at their November 30, 1984

meeting.

24. During the Tax Years, Geoffrey maintained an office

in Delaware. The corporation had no full-time employees,

but had one part-time employee who was responsible for

keeping the corporation’s books and paying its bills. The

Simon firm performed accounting and financial services for

Geoffrey.

25. The law firm of McAulay, Fields, Fisher, Goldstein

& Nissen (the “McAuley firm”) provided Geoffrey with legal

services during the Tax Years, primarily in the areas of

trademark and trade name protection and related litigation.

Paul Fields generally performed these services, and Geoffrey

paid the McAulay firm for this work. Mr. Goldstein

testified that outside counsel fees charged by the McAulay

firm for work for Geoffrey exceeded $100,000 per year during

the Tax Years. Tr. 291.

26. Geoffrey’s principal expenses during the Tax Years

were the fees it paid Toys-NJ and the McAulay firm. Other

expenses related to trademarks and trade names, such as

advertising, were borne by the individual licensees.

8 After the Tax Years, the royalty rates charged to affiliates

were increased to three percent (3%) for Toys “R” Us marks and names, and two percent (2%) for Kids “R” Us marks and names. Mr. Goldstein testified that Toys Inc. commissioned a study by a national accounting and consulting firm to review royalty rates charged for use of trademarks and trade names. Tr. at 287. See, also, Finding of Fact 30, infra, concerning the advance pricing arrangement between Toys Inc. and the Internal Revenue Service (“IRS”).

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27. In 1982, Toys Inc. entered into an agreement with

an unrelated company located in Kuwait. The agreement

provided for the licensing of the Toys “R” Us trademarks and

the furnishing of technical advice and assistance. Pursuant

to the agreement, the Kuwaiti corporation paid Toys Inc. a

fee of three percent (3%) of its net sales for a term of

five years with a 2-year renewal provision. That fee

represented a one percent (1%) payment for specific uses of

the trademarks and a two percent (2%) payment for the

furnishing of technical services. In 1984, after the

trademarks were transferred to Geoffrey, Geoffrey received

the allocable portion of the fee attributed to the license

of the trademarks to the Kuwaiti corporation, while the

Operating Companies received the portion of the fee

allocated to the furnishing of technical services.

28. Prior to 1984, Toys Inc. licensed the Toys “R” Us

trademarks to two unrelated companies which operated their

businesses within Toys “R” Us stores: an unrelated shoe

manufacturer and an unrelated portraiture corporation. The

subsequent licensing agreements between Geoffrey and the

Operating Companies were based on the form of these third-

party agreements and were considered when Toys Inc.

established the 1% royalty rate which Geoffrey charged the

Operating Companies. Stip. Ex. 10 (“Minutes of the Special

Meeting of the Board of Directors of Geoffrey, Inc. held on

November 30, 1984”).

29. During the Tax Years, Geoffrey received royalty

income from Toys Inc. at a rate of one per cent of the sales

of Toys Inc.’s operating affiliates. Geoffrey received

royalty income from Toys Inc.’s “domestic sources” in the

following amounts: $18,893,974 in 1986; $23,048,528 in

1987; and $28,829,148 in 1988. Geoffrey also received

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royalty income from Toys Inc.’s “foreign sources,” in the

following amounts: $287,276 in 1986; $679,066 in 1987; and

$1,561,144 in 1988. E&Y Report Ex. 21.

30. Subsequent to the Tax Years, Toys Inc. entered

into an advance pricing arrangement with the IRS which set

the Geoffrey royalty rate at 3% for the licensing of the

Toys “R” Us trademarks and trade names and 2% for the

licensing of the Kids “R” Us trademarks and trade names.

31. On November 30, 1984, Geoffrey and Toys-NJ entered

into the Geoffrey Service Agreement. Toys-NJ agreed to

provide Geoffrey with certain legal, administrative, and

financial services. In exchange, Geoffrey agreed to pay

Toys-NJ an annual fee of $50,000, which represented an

estimate of the cost of the time which Toys-NJ employees

would spend working for Geoffrey. Toys-NJ also agreed to

advance working capital to Geoffrey as necessary. Geoffrey

paid Toys-NJ the $50,000 annual fee during each of the Tax

Years.

32. Toys-NJ coordinated information which it received

from employees of Group affiliates concerning licensing and

trademark infringement with the McAulay firm. Toys-NJ also

prepared the monthly calculations of royalties due Geoffrey

from affiliates and performed a limited cash management

function for Geoffrey involving arranging intercompany loans

and short-term investments.

33. Until November 15, 1985, Lario M. Marini was

President of Geoffrey, David P. Fontello was its Vice

President/Treasurer, and Emmett R. Harmon was its Assistant

Secretary. After that time, Howard H. Simon was Geoffrey’s

President and William H. Master was its Vice

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President/Treasurer. Michael Goldstein was Geoffrey’s

Secretary during the Tax Years. These officers were also

Directors of Geoffrey.

34. Geoffrey had an office in Wilmington, Delaware

and, during the Tax Years, employed first Charles Campbell

and then Sherri L. Bednash.

ABG

35. Prior to the 1984 reorganization, Toys Inc. loaned

funds to Realty on an interest-free basis to allow Realty to

acquire real property and/or construct buildings thereon.

Realty charged Toys Inc. rent for the use and occupancy of

the real property. These transactions were accounted for

through an “open accounts receivable” from Realty which

reflected a net amount owed by Realty to Toys Inc.

36. As of January 29, 1984, Realty transferred to

Petitioner and the other Operating Companies, real property

located in the states in which those entities conducted

their operations.

37. As of February 24, 1984, Realty mortgaged its real

property holdings to Toys Inc. as security for the accounts

receivable. Petitioner and the other Operating Companies

also mortgaged their property holdings as security for the

accounts receivable. On that same date, Toys Inc. began to

charge interest on the outstanding loan balances.

38. Effective February 28, 1984, Toys Inc. made a

capital contribution to ABG of mortgage notes in the amount

of approximately $136 million. The mortgage notes were

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issued for a term of thirty years and bore an interest rate

of 12%.

39. On March 1, 1984, Realty was merged into Toys Inc.

40. During the Tax Years, ABG held 112 mortgages on

real property owned by Petitioner, Toys Inc. and the other

Operating Companies. Of these mortgages, 83 had been

transferred to ABG by Toys Inc. in 1984. The remaining 29

mortgages were made by ABG directly. The mortgages were

made from ABG to Toys Inc. and totaled in excess of $222

million. All mortgage loans were for a 30-year term.

41. The interest rates charged by ABG on mortgage

loans to affiliates during the Tax Years ranged from 9.5% to

12%, with the average interest rate being 11.9%. The rates

were determined following consultation with real estate

professionals and developers and were similar to rates

charged between unrelated parties.

42. ABG received the following interest income during

the Tax Years: $18,636,124 in 1986; $20,765,835 in 1987; and

$21,466,716 in 1988. E&Y Report Ex. 23.

43. On January 24, 1985, ABG and Toys-NJ entered into

the “ABG Service Agreement.” Toys-NJ agreed to provide

services to ABG in exchange for an annual fee of one half of

one percent (.5%) of ABG’s gross annual interest income for

the preceding fiscal year. Pursuant to the ABG Service

Agreement, Toys-NJ provided ABG accounting, administrative

and financial services, as well as specific real estate

services (e.g., insurance placement). Toys-NJ also agreed

to provide “financing advice,” to assist in formulating

mortgage policy, and to provide minimal cash management for

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ABG. The ABG Service Agreement provided, as did the

Geoffrey Service Agreement, that Toys-NJ would advance

working capital to ABG as necessary.

44. Individuals in the Toys-NJ real estate group

assisted ABG in preparing the documentation for the

refinancing of Toys Inc.’s properties and were responsible

for “the movement of cash,” including the payment of

interest, between Toys Inc. and ABG. E&Y Report, p. 90.

45. During the Tax Years ABG paid the following fees

to Toys-NJ: $93,181 in 1986; $103,829 in 1987; and $107,344

in 1988. E&Y Report Ex. 23, 35.

46. ABG rented an office in Nevada.

47. Kafoury, Armstrong & Company (the “Kafoury firm”),

an unrelated Nevada accounting firm, provided general

accounting services to ABG during the Tax Years,

particularly in the area of real estate transactions.

48. An associate of the Kafoury firm was a part-time

employee of ABG, and two partners of the firm, Thomas L.

Booker and Wayne Mark Stewart, were directors of ABG.

During the Tax Years, Mr. Brooker was President of ABG.

Steven J. Meyer was ABG’s Vice President/Treasurer until

August 29, 1985. Thereafter, Mr. Stewart was its Vice

President/Treasurer. Mr. Meyers an was employee of ABG for

the calendar year 1985 and Mr. Stewart was an employee of

ABG for the calendar year 1986. Michael Goldstein was ABG’s

Secretary during the Tax Years.

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49. Principal and interest payments on mortgages held

by ABG were required to be paid on a quarterly basis. The

interest income paid by Toys Inc. was used to refinance

other Group properties. Toys-NJ was responsible for

transferring funds for mortgage refinancing to Toys Inc. and

interest payments to ABG.

TRU

50. TRU was formed in 1984 as a wholly-owned

subsidiary of Toys Inc. to hold the stock of subsidiaries,

to make loans to Group affiliates, and to oversee and manage

Group investments.

51. In December 1985, the stock of Geoffrey and ABG

were contributed to TRU.

52. Toys Inc. funded TRU with an initial contribution

of approximately $150 million of investment assets, in

exchange for which Toys Inc. received all the stock of TRU.

During the period in issue, TRU had common stock and paid-in

capital worth between $295 million and $400 million. This

amount was the principal source for loans which TRU made to

Toys Inc. for the working capital needs of the Operating

Companies, as well as loans to other Toys “R” Us

affiliates.9

53. Initially, TRU chose the Wilmington Trust Company

as the depository for its moneys and investments and as

trustee to manage its investments. In 1984, TRU’s Board of

9 The minutes of the June 6, 1986 meeting of TRU’s Board of

Directors state that TRU also made loans directly to Toys-UK and to the Toys “R” Us affiliate in Canada. Stip. Ex. 26.

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Directors established extensive guidelines for investing,

which were revised periodically. See, Stip. Ex. 26.

54. TRU periodically10 received funds from Group

affiliates. TRU’s subsidiaries (including Geoffrey) also

transferred their excess funds to TRU in the form of

dividends. The cash balance in TRU’s accounts would

fluctuate accordingly. When affiliates required working

capital, TRU made short-term loans to Toys Inc., which were

accounted for as intercompany loans.

55. Any excess funds which TRU did not lend to Toys

Inc. were usually fully invested in short-term instruments.

Establishing TRU as a separate investment affiliate

benefited the Group by, among other advantages, maximizing

foreign tax credits.

56. TRU received income for the Tax Years from two

sources: interest on loans and income from investments. For

1986, TRU received taxable interest income of $11,455,214;

federal tax exempt income of $1,559,588; and dividend income

of $1,886,434. For 1987, TRU received taxable interest

income of $13,293,020; federal tax exempt interest income of

$618,023; dividend income from unrelated sources of

$430,551; and dividend income from Geoffrey of $6,500,000.

For 1988, TRU received federal taxable interest income of

$15,711,598; federal tax exempt interest income of $583,041;

dividend income from unrelated sources of $138,398; and

dividend income from Geoffrey of $15,711,598. E&Y Report

Ex. 17.

10 The Operating Companies generally earned almost half of their

annual sales income in the fourth quarter, from November through January. Mr. Goldstein testified that after January, “cash balances decline as [the Group affiliates] build up inventory and construct new stores.” Tr. at 347.

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57. Toys-NJ entered into the TRU Service Agreement on

April 27, 1984 and the agreement was retroactive to January

30, 1984. Toys-NJ agreed to provide TRU with basic

accounting, insurance and incidental services. Toys-NJ also

agreed to provide TRU with investment advice and to act as

TRU’s agent in purchasing securities, including obligations

of affiliates. Toys-NJ’s asset management group and its

accounting group performed these activities and employees of

Toys-NJ administered the intercompany loans.

58. TRU agreed to pay Toys-NJ one half of one percent

(.5%) of its “gross annual investment income” pursuant to

the TRU Service Agreement. Gross annual investment income

was not defined in the TRU Service Agreement. However, the

E&Y Report states that “based on a management fee

calculation . . . gross annual investment income would

include capital gains, all interest income, and dividend

income from unrelated parties.” E&Y Report, p. 73, fn. 37.

59. During the Tax Years, TRU paid Toys-NJ the

following fees: $74,506 in 1986; $71,540 in 1987; and

$82,165 in 1988. E&Y Report Ex. 17.

60. The chairman and president of Toys, Inc., and the

officers and directors of some of its subsidiaries, were

responsible for TRU’s investment decisions, which were made

pursuant to investment guidelines adopted by TRU’s Board of

Directors. Stip. Ex. 11, 26.

61. From 1985 forward, the Simon firm also performed

accounting services for TRU. The firm billed TRU directly,

at a rate of approximately $110 to $250 per month.

20

62. From April 1984 until November 15, 1985, Lario M.

Marini was TRU’s President, David P. Fontello was its Vice

President/Treasurer, and Emmett R. Harmon was its Assistant

Secretary. After that time, Howard H. Simon was TRU’s

President and William H. Master was its Vice-President-

Treasurer. Michael Goldstein was TRU’s Secretary during the

Tax Years. These officers of TRU were also its Directors.

63. During the Tax Years, TRU maintained an office in

Wilmington, Delaware. Mr. Campbell and Ms. Bednash were

part-time employees of TRU in 1985, 1986 and 1987, primarily

performing accounting services for the corporation.

Petitioner’s Filings and The City GCT Audit

64. Petitioner filed City GCT returns for the Tax

Years, reporting on a separate basis, and paid GCT in the

amounts of: $247,745 for the period ended February 2, 1986;

$342,782 for the period ended February 1, 1987; and $465,317

for the period ended January 31, 1988.

65. In 1991 and 1992, Respondent conducted a GCT field

audit of Petitioner’s books and records for the Tax Years.

The audit was performed by Leopold C. de la Torre, an

auditor with the Department.

66. On February 24, 1992, Respondent issued to

Petitioner a Notice of Determination (the “Notice”) of GCT

due for the Tax Years, in the following amounts (with

interest computed to February 28, 1992):

21

TAX PERIOD PRINCIPAL INTEREST PENALTY TOTAL FYE 2/2/86

FYE 2/1/87

FYE /31/88

TOTAL

$ 50,768.73

48,574.31

71,258.23

$170,601.27

$37,949.69

28,260.80

33,140.65

$99,351.14

$ 5,077.00

4,857.00

7,126.00

$17,060.00

$ 93,795.42

81,692.11

11,524.88

$287,012.42

67. The Notice included several specific audit

adjustments which are not at issue in this proceeding.11 In

response to the Notice, Petitioner paid approximately

$27,000. At that time, Respondent did not assert that

Petitioner be required to file its GCT returns on a combined

basis with any affiliated corporations.12 Mr. de la Torre

testified, however, that during the course of his audit he

reviewed spreadsheets which were filed with the federal

consolidated return for Toys Inc., Petitioner’s parent. Tr.

at 547, 556, and 558.

68. On May 18, 1992, Petitioner timely filed a

Petition for Hearing with the Department of Finance,

protesting the specific audit adjustments.

69. On April 30, 1992, as required by 19 RCNY §11-

91(g)(6), Petitioner timely informed Respondent of State

changes made to its reported State entire net income and

11 These adjustments include: (1) increasing the add-back to

entire net income of interest paid to more than five percent shareholders; (2) imputing interest income on certain Industrial Revenue Bond receivables; (3) disallowing of certain partnership losses; (4) increasing the add-back for ACRS depreciation; and (5) adjusting Petitioner’s reported business allocation percentage.

12 The City Audit Comments specifically state that Toys Inc. “does

not have intercompany sales with [Petitioner]. The issue of combination is therefore not applicable in this audit.” Stip. Ex. 2. Mr. de la Torre confirmed this audit determination at hearing. Tr. at 555.

22

State corporation franchise tax liability (the “State

Changes”). The State Changes reflected the requirement that

Petitioner file its State franchise tax reports on a

combined basis with certain affiliated corporations for the

periods ended January 31, 1984, January 31, 1985 and

February 2, 1986.

70. For the period ended February 2, 1986, which

period is at issue in this proceeding, the State required

Petitioner to file on a combined basis with Toys Inc., Toys-

NJ, Toys-Penn, Toys-Mass, Toys-UK and the Related

Corporations.

71. The State did not issue a determination to

Petitioner with respect to the period ended February 1,

1987, which period is at issue in this proceeding, as the

statute of limitations on State corporation franchise tax

assessment had expired.

72. For the period ended January 31, 1988, which

period is also at issue in this proceeding, Petitioner filed

its State corporation franchise tax report on a combined

basis with Toys Inc., Toys-NJ, Toys-Penn, Toys-Mass, Toys-UK

and the Related Corporations.

73. Petitioner filed City GCT returns for the Tax Years

on a separate reporting basis.

74. Based on the reported State changes, Respondent

performed a re-audit of Petitioner in 1995. On August 10,

1995, Respondent issued to Petitioner a Consent to Audit

Adjustment, setting forth a revised deficiency which

reflected the Commissioner’s determination that Petitioner

should be required to file its GCT returns for the Tax Years

23

on a combined reporting basis with certain affiliated

corporations (the “Revised Deficiency”). The Revised

Deficiency asserted that the following GCT and interest

(computed through September 30, 1995) were due from

Petitioner for the Tax Years:

Tax Year Ended GCT Interest

2/2/86 $44,051.67 $58,828.04

2/1/87 49,672.44 56,088.32

1/31/88 43,554.65 42,316.58

With respect to the period ended February 1, 1987,

Respondent limited the amount of the revised deficiency to

the principal GCT amount originally asserted in the Notice,

$48,574.31, to avoid having to bear the burden of proof on a

greater deficiency asserted after the Notice was issued and

the petition was filed. See, Code §11-680(5)(c). Respondent

does not assert any penalties with respect to this revised

determination and has abated all penalties asserted in the

Notice.

75. During the course of pre-hearing proceedings, I

requested Respondent’s representative to articulate

Respondent’s basis for the Revised Deficiency. On January

11, 1996, Respondent’s representative wrote Petitioner’s

representative, explaining that audit adjustments relating

to interest to stockholders, interest income imputed from

IRB receivables, and the disallowance of partnership losses

were no longer being asserted. Respondent’s representative

noted that Petitioner would be required to file a combined

report for the Tax Years which would include the following

related corporations: Toys Inc., Toys-Penn, Toys-NJ, Toys-

Mass, Toys-UK (for the 1988 Tax Year only), and the Related

Corporations, stating:

24

During the three years ending in 1989, 1990 and 1991, Petitioner filed combined New York State Corporation franchise tax reports with those cor- porations required, in the prior New York State audit, to file combined returns with petitioner. Petitioner did not however, file combined New York City general corporation tax returns for that same period. Petitioner has not indicated any change in the facts material to the issue of combina- tion, between the period covered by the prior New York State audit and the subsequent period in which petitioner filed combined New York State returns. Thus, in addition to the findings of the New York State audit, petitioner’s own signed New York State tax returns provides [sic] further support for the reasonableness of the Combined Deficiency. Stip. Ex. 5.

76. For purposes of this proceeding only, Petitioner

does not contest Respondent’s proposed adjustment to the

extent that it requires Petitioner to file its City GCT

returns for the Tax Years on a combined reporting basis with

Toys, Inc., the Operating Companies, Toys-NJ, Toys-Penn,

Toys-Mass and Toys-UK (for Tax Year 1988 only).

77. Petitioner’s capital stock and the capital stock of

the Related Corporations and other Operating Company

subsidiaries are owned or controlled, directly or indirectly

by Toys Inc. within the meaning and intent of 19 RCNY §11-

91(e)(1).

The South Carolina Geoffrey Case

78. On April 7, 1993, the Supreme Court of South

Carolina issued Geoffrey, Inc. v. South Carolina Tax

Commission, 313 S.C. 15, 437 S.E.2d 13; 1993 S.C. LEXIS 134

(1993). The issue in that case was whether Geoffrey had

nexus with the State of South Carolina sufficient to subject

its royalty income to the South Carolina income tax on

25

corporations and business license fees pursuant to South

Carolina Code Annotated §12-7-230 (Supp. 1992). The periods

in issue in that proceeding were the fiscal years ending

January 1986 and January 1987. During the course of those

proceedings, the testimony of Mr. Louis Lipschitz, Vice

President of Finance and Treasurer of Toys Inc., was

offered. A copy of the transcript of that testimony was

made a part of the record of this proceeding.

Generally, Mr. Lipschitz’s testimony in the South

Carolina proceeding concerned the business of Toys Inc. in

South Carolina, the incorporation of Geoffrey, the ownership

of Geoffrey, Geoffrey’s corporate activities (including

activities performed on behalf of Geoffrey to enforce and

protect the Toys “R” Us marks), and the licensing agreement

between Geoffrey and Toys Inc. That testimony was offered

in the context of the Toys Inc.-Geoffrey agreement as it

affected Geoffrey’s South Carolina tax liability.13 The

South Carolina Supreme Court found that Geoffrey had

sufficient nexus with South Carolina, through the presence

in that state of intangible property (trademarks, et al.),

so that the tax imposed upon Geoffrey did not violate

requirements of the Due Process Clause and the Commerce

Clause of the United States Constitution.

Transfer Pricing Analyses

79. Petitioner offered the testimony of Dr. Irving H.

Plotkin of Arthur D. Little, Inc. and submitted into

evidence a report prepared by Dr. Plotkin entitled “Testing

13 Respondent offered other testimony from that proceeding into

evidence in this case. Petitioner objected to the introduction of such other testimony on grounds that it was not relevant to this proceeding, and the objection was sustained. See, generally, Tr. at 577-588.

26

A Related-Party Royalty for Compliance With the Arm’s-Length

Standard” (the “Plotkin Report”).14 Dr. Plotkin was

qualified at hearing as an expert in the field of

microeconomics and the study of intercompany pricing under

Internal Revenue Code [“IRC”] §482. The Plotkin Report

deals generally with valuing intangibles and specifically

addresses the issue whether the royalties paid Geoffrey by

the Operating Companies are “consistent with those that

might be charged between unrelated parties:” i.e., whether

they conform to an arms’ length standard.15 Plotkin Report,

p. 1.

Dr. Plotkin defines an intangible asset to be “any non-

physical asset that allows a firm to earn higher profits

than would be expected given its stock of tangible

(physical) assets.” Plotkin Report p. 25. Dr. Plotkin

notes in his report that the value of an intangible varies

according to the “ability” of the intangible to generate

above-average profits and according to the economic

environment in which it exists. Dr. Plotkin believes that

an “income approach,” which is premised on the principle

that the value of the intangible should “be equal to the

difference between income that would have been earned absent

use of the intangible and the income that is earned with its

use,” is the best method for valuing an intangible. Plotkin

Report, p. 27.

14 Dr. Plotkin is the author of several articles and publications, and has testified in many proceedings as an expert in the field of economics on behalf of the Internal Revenue Service, plaintiffs, and defendants.

15 A copy of Dr. Plotkin’s November 1994 working paper, “The Eye

of the Needle: Uses of Ranges and Results in §482,” was submitted with his report.

27

The Plotkin Report analyzes the royalties paid by the

Operating Companies for the license to use Geoffrey’s

intangibles according to a “rate of return” model; that is,

where it is not possible to identify an exact uncontrolled

comparable (the preferred valuation methodology under IRC

§482), the arm’s length nature of a royalty payment may be

determined by looking to whether its rate of return falls

within a reasonable range of such rates. The reasonable

range is referred to as the “interquartile” range, a range

of rates of return which represents between 25% and 75% of

the comparable universe.16 See, also, Treasury Regulation

(“Treas. Reg.”) §1.482-1(e)(2)(iii)(C), which defines

“interquartile range” in the context of determining a

comparable arm’s length range.

Dr. Plotkin computes rate of return by multiplying

profit margin by turnover. In his report, he expressed this

computation as the formula “R = M x T,” where R is the rate

of return (which equals the ratio of profit to assets);

M is the margin (which equals the ratio of profit to sales);

and T is the turnover (which equals the ratio of sales to

assets). Dr. Plotkin applies a “frequency distribution”

methodology to arrive at a “median retailer” arm’s length

rate of return.

Examining comparable transactions, Dr. Plotkin points

out that assertedly comparable profit margins (the ratio of

profits to sales) must be adjusted for factors which are

different between the comparables or which have a “definite

and ascertainable effect” on the variable.

16 Acknowledging that some economists believe that rate of return

analysis is simply an accounting exercise, Dr. Plotkin states that the “universal standard for judging the attractiveness of any type of business activity is its rate of return.” Plotkin Report, p.14.

28

The rate of return on the Geoffrey intangibles was

compared to: (a) data from 2,198 United States corporations

reported in Standard & Poor’s COMPUSTAT data base for a ten-

year period which included the Tax Years; and (b) data from

212 of those corporations which were retailers operating

during the same period.

Dr. Plotkin observed that the Operating Companies had

higher rates of return after paying royalties to Geoffrey

than did approximately 80% of the considered retailers.

Accordingly, he concluded that the royalty charged to the

Operating Companies was an “arm’s length” charge pursuant to

IRC §482.

80. Petitioner also offered the testimony of Mohamed

Sherif Lotfi, a member of the economics group of the

international accounting firm of Ernst & Young, LLP. Mr.

Lotfi contributed to and supervised the preparation of the

E&Y Report which was submitted into evidence. Mr. Lotfi was

qualified at the hearing as an expert in economics.

The E&Y Report analyzes three types of transfer pricing

transactions between Toys Inc.’s affiliates during the Tax

Years: (a) the royalty payment to Geoffrey by the Operating

Companies for their use of certain trademarks and trade

names; (b) the management fees paid to Toys-NJ by Related

Corporations for the provision of various services; and (c)

the intercompany loans between TRU and Toys Inc. (the “TRU

Loans”) and between ABG and Toys Inc. (the “ABG Loans”).

The E&Y Report tested the three categories of

transactions to determine if they were made at arm’s length

according to the principles of IRC §482. The Report was

limited to a review of the Tax Years’ transactions. Mr.

29

Lotfi did not consider any antecedent transactions and

specifically did not consider the substance of the initial

incorporation and capitalization of the Related Corporations

at the time of the 1984 reorganization.

The E&Y Report took into account IRC §482 and

applicable Treasury Regulations which pertain to the three

types of transactions examined. With respect to its review

of the royalty payments to Geoffrey, the E&Y Report applied

the final Treasury Regulations which were effective for

periods beginning after October 6, 1994. E&Y Report, p. 33.

According to the E&Y Report, when intercorporate

transactions are examined pursuant to IRC §482, the “best

method rule” applies; that is, the method which provides

“the most reliable measure of an arm’s length result” must

be used. Treas. Reg. §1.482-1(c)(1).

(a) The E&Y Report first examined Geoffrey’s licensing

of intangibles to the Operating Companies and their payment

of royalties to Geoffrey. The Report noted that the

principal Treasury Regulation methods for examining

transactions involving intangible property include the

comparable uncontrolled transaction method (“CUT”) (Treas.

Reg. §§1.482-3(a)(1), 1.482-3(b)), the comparable profits

method (“CPM”) (Treas. Reg. §§1.482-3(a)(4) and 1.482-5),

the profit split method (Treas. Reg. §§1.482-3(a)(5) and

1.482-6), and/or any “unspecified” method which “provides

the most reliable measure of an arm’s length result under

the principles of the best method rule.” Treas. Reg.

§1.482-3(e)(1).

Mr. Lotfi applied both the CUT and CPM methods. Under

the CUT method he performed two analyses: (1) an internal

30

CUT analysis which compared a transfer of intangibles

between Geoffrey and an unrelated third party (in this case,

the licensing agreement with the Kuwaiti company, infra at

Finding of Fact ¶27) to the transfer of intangibles between

Geoffrey and the Operating Companies; and (2) an external

CUT analysis which compared licensing agreements between two

unrelated parties to the licensing agreement between

Geoffrey and the Operating Companies.

The E&Y Report concluded that the internal CUT analysis

could not be used. Notwithstanding that the royalty rate

for the transfer of intangibles was the same between the

Kuwaiti company and Geoffrey as it was between the Operating

Companies and Geoffrey, in Mr. Lotfi’s opinion, an

adjustment in the analysis could not be made to compensate

for the differences in territory, markets, and terms of

exclusivity between the Kuwaiti company and the U.S.

Operating Companies.

An external CUT analysis was then performed, to the

extent that a search was undertaken for license agreements

between two independent parties comparable to the agreements

between Geoffrey and the Operating Companies. Eighteen

agreements were identified for comparison.17 However, the

Report concluded that there were significant differences

between these eighteen agreements and the Geoffrey

agreements as none of the agreements involved licensing of a

trade name which identified a business (rather than a

product) and only two agreements were non-exclusive. In Mr.

17 The external CUT analysis first identified agreements between

companies active in wholesale and retail sales based on Standard Industrial Classification (SIC) codes and using the internal data resources of Ernst & Young LLP. Initially 163 agreements were identified which were reduced to 18 agreements when classifications of time period, territory, and form of agreement (i.e., trademark vs. patent) were applied.

31

Lotfi’s opinion, these differences reduced the reliability

of this type of analysis and, therefore, an external CUT

analysis also was not appropriate.

The Geoffrey transactions were next examined according

to a CPM analysis; i.e., the profitability of the Operating

Companies after royalty payments was compared to the

profitability of functionally comparable companies which do

not have or use any valuable intangibles. The premise of

this analysis is that where the profitability of the

Operating Companies falls within the interquartile range of

profitability computed for the group of comparable

companies, the royalty should be deemed to have been made at

arm’s length.

Mr. Lotfi used specific ratios, referred to as Profit

Level Indicators (“PLI”s),18 to make his comparison: the

rate of return on capital employed (measured by return on

net assets), the ratio of operating profit to sales (i.e.,

operating margins), and the ratio of gross profit to

operating expense (the “Berry ratio”).

Six functionally comparable companies (the “CPM

comparables”) were identified according to the following

parameters: (1) companies that engaged in mass merchandise

retail sales and did not engage in other activities (i.e.,

manufacturing); (2) companies that experienced seasonal

sales; (3) companies that did not sell merchandise on

credit; (4) companies that were sufficiently large to enjoy

“economies of scale”; (5) companies that did not own their

own non-routine intangible assets; (6) companies that were

18 See, Treas. Reg. §1.482-5(b)(4), which defines PLIs as “ratios

that measure relationships between profits and costs incurred or resources employed.”

32

publicly held; and (7) companies that were in operation

during the Tax Years 1985-1988.19

Asset return PLIs (total assets less current

liabilities) and operating margin PLIs were computed for

each of the CPM comparables, and three-year average

interquartile ranges for the combined CPM comparables’

indices were developed.20 After Operating Companies’ PLIs

were compared to the CPM comparables’ PLIs,21 the report

concluded that the best method for establishing an arm’s

length range was the asset return PLI. The report found

that the Operating Companies’ return on net assets (after

royalties) was within the appropriate comparables’

interquartile range. Mr. Lotfi concluded that the one

percent royalty charge was at arm’s length. Tr. at 401.

(b) The E&Y Report next examined the Agreements between

the Related Corporations and Toys-NJ to determine whether or

not an arm’s length fee was paid by the affiliates to Toys-

NJ.

19 The comparable companies were: Burlington Coat Factory

Warehouse Corp., Deb Shops, Inc., Jamesway Corp., Rose’s Stores Inc., Ross Stores Inc., and Wal-Mart Corp.

20 For the 1986 and 1987 fiscal years, data from FYE 85, 86 and 87

were used. For the 1988 fiscal year, data from FYE 86, 87 and 88 were used.

21 For example, the Report compared adjusted operating margins as

follows: FYE 86 FYE 87 FYE 88

Comparables: Average Inter- Quartile Range

7.65%-11.03%

7.65%-11.03%

6.89%-10.55%

Operating Companies

8.61% 8.61% 9.32%

33

The Report found that, pursuant to the Agreements,

Toys-NJ performed similar services for all three companies

(e.g., accounting, administrative, incidental and advancing

working capital), and other services only for certain of the

companies (e.g., acting as TRU’s agent in purchasing

securities). Each Agreement was reviewed separately in the

E&Y Report in the context of the Treas. Reg. §1.482-2(b)

rules for examining the performance of services by one

member of an affiliated group and the compensation paid for

those services by another member.

Initially, the E&Y Report found that the services

provided by Toys-NJ were not stewardship expenses, but were

expenses which could be charged to the affiliates.22

The E&Y Report considered two methods to determine

whether an intercompany charge for services met the IRC’s

arm’s length standard: (1) the comparable uncontrolled price

method (“CUP”); and (2) the mark-up on total costs method.

The report concluded that the information required for the

mark-up method, principally information on actual costs

incurred by Toys-NJ to perform the services, was not readily

available. Therefore, the CUP method was applied.

Three types of services provided by Toys-NJ pursuant to

the Agreements were isolated: cash management, accounting,

and legal services. Data with respect to comparable charges

between unrelated parties for accounting and legal services

was identified (“CUP rates”). For accounting services, the

22 The E&Y Report relied on Young & Rubicam v. U.S., 410 F.2d 1233

(Ct. Cl. 1969), as well as a published IRS Private Letter Ruling 8806002 (1988), to determine whether the services provided were stewardship expenses. The report defines a stewardship expense as an expense “allocable to the parent . . . limited to items that do not benefit an affiliate in the conduct of business operations.” E&Y Report p. 95.

34

report computed “average billing rates” for senior

accountants and partners, based on information published by

the National Society of Public Accountants. For legal

services, the report developed a range comprised of fees

charged for junior partners and/or junior associates in

metropolitan New York City law firms as published in a

survey by The National Law Journal.23

The E&Y Report extrapolated the time each Toys-NJ

employee spent on each of the three types of services (cash

management, accounting and legal) for each of the Related

Corporations.24 The CUP fee range for each type of service

was then multiplied by the hours of such service provided by

employees of Toys-NJ.

Although the greater percentage of services which Toys-

NJ performed for ABG were specific mortgage accounting

services performed by the Toys-NJ real estate group, they

were accounted for in the E&Y Report as “real estate manager

time,” were not separately considered in the comparative

study, and were treated generally as “accounting type

services.” E&Y Report, p. 88-91.

For Geoffrey and ABG, the range of CUP accounting fees

was added to the range of CUP legal fees to arrive at a

basis for comparison. For TRU, the report made the

23 The National Law Journal, “Hourly Rates for Partners and

Associates,” New York Law Publishing Company, 1987 and 1988. 24 The specific information available concerning the provision of

actual cash management services to TRU was limited to records for February through April 1986, December 1986 and January 1988. For the remaining months, TRU’s general ledger opening and closing balances were reviewed to arrive at monthly and annual averages. The report estimated that between 880 and 900 hours per year were spent on cash management services, the largest category of services provided by Toys NJ to TRU.

35

comparison to only the CUP accounting fees range based on

the nature of the services performed.

The costs of the separate services rendered to each

affiliate, calculated according to this methodology, were

combined to arrive at a range of total costs to Toys-NJ.

The report calculated the range of CUP accounting and legal

fees charged each affiliate as follows:

GEOFFREY ABG TRU

FYE 86 $35,474-$91,944

$48,257-$99,465

$51,440-$76,247

FYE 87 $40,329-$98,385

$39,926-$107,067

$61,342-$90,294

FYE 88 $45,183-$104,827

$43,558-$114,668

$60,983-$90,392

Total costs were then compared to the fees actually charged

(i.e., the annual fee of $50,000 paid by Geoffrey and the

sales percentage amounts paid by ABG and TRU).25

The E&Y Report concluded that the fees charged by Toys-

NJ for the services provided each of the three affiliates

were within an acceptable range of fees charged by unrelated

parties performing the same services and therefore were at

arm’s length.

25 For example, applying a range of FYE 87 fees for accounting

services for unrelated parties of from $65-$96 per hour to the extrapolated 849 hours of cash management services which the report identified as performed for TRU in that period, it was concluded that it would have been appropriate for Toys-NJ to charge TRU between $54,994 and $81,515 for these services. This amount was added to the other estimated range of costs of services to arrive at a range of “total fees based on unrelated transactions” of between $61,342 and $90,924. The actual charge of $71,540 was within that accepted range.

36

Although Geoffrey paid the unrelated McAulay firm for

legal services, and Geoffrey and TRU paid the unrelated

Simon firm for accounting work, Mr. Lotfi testified that he

did not look to those transactions as evidence of comparable

uncontrolled transactions. Rather, it was his testimony

that the transactions between Geoffrey and the McAulay firm

were not similar to those between Geoffrey and Toys-NJ, and

therefore would not qualify as comparables. Tr. at 514-515.

Similarly, the fees paid the Simon firm and the compensation

paid the part-time Simon employee were not used as bases for

comparison.

(c) The E&Y Report also analyzed the mortgage loans

between ABG and Toys Inc. and the intercorporate loans

between TRU and Toys Inc. The ABG Loans, used to finance

real estate development for the Operating Companies, were

for 30-year fixed terms with an average interest rate of

11.90%. The TRU Loans, made for the purpose of meeting the

working capital needs of the Operating Companies, were

short-term loans (on an average, for terms of eight months)

made at an average interest rate of 7.79%.

The Report examined whether the interest rates charged

on these loan transactions fell within Treas. Reg. §1.482-2

“safe haven” rates which the IRS would have accepted as

arm’s length for the particular Tax Year in issue.26 Treas.

Reg. §1.482-2(a)(2)(iii)(A) and (B).

For the 1986 Tax Year, the Treasury Regulation safe

haven interest rate range was 11% to 13% simple interest per

annum. For the 1987 and 1988 Tax Years, the Treasury

26 Treas. Reg. §1.482-2(a)(1)(i) addresses loans and advances between affiliates, and provides for allocation of interest where an arm’s length rate has not been charged.

37

Regulation safe haven interest rate was calculated as a

percentage (from 100% to 130%) of the Applicable Federal

Rate (“AFR”), computed using a three percent range; i.e., if

the AFR rate was 9%, the acceptable range was from 9% to

11%. Treas. Reg. §1.482-2(a)(2)(iii)(B)(1). The AFR for

the last two Tax Years as determined under the IRC, is based

on the yield of U.S. securities, taking into account the

term of the loan.

Since the ABG loans were for a fixed 30-year term, the

E&Y Report used long-term rates, while the report used semi-

annual compounding of a range of rates for short-term loans

for the TRU Loans. For the TRU Loans for the 1986 Tax Year,

the study developed a range starting from the lower arm’s

length interest rate (7.85%), which was based on Treasury

bill rates adjusted for borrowing rates, and extending to

the lowest AFR (11%). For 1987 and 1988, the report used

the “safe haven” AFRs (of 6.13% to 13%) and arm’s length

interest rates (of 6.12% to 8.25%).

Of the 112 ABG Loans reviewed, 108 were within the safe

haven range. Of the 78 TRU Loans examined, 50 were within

the safe haven range. The E&Y Report concluded, and Mr.

Lotfi testified, that as the majority of the loans were

within the safe haven ranges, both the ABG mortgage loans

and the TRU intercorporate loans met an arm’s length

standard. Tr. at 415, 417.

STATEMENT OF POSITIONS

Respondent argues that Petitioner’s income and GCT

liability will not be properly reflected unless the Related

Corporations are required to be included in a combined

38

report with Petitioner and other Toys “R” Us affiliates.

Respondent asserts that the 1984 initial capital

contributions made by Toys Inc. to the Related Corporations

in return for 100% of the stock of each Related Corporation,

and the subsequent transactions between the Related

Corporations and Toys Inc. (including the Tax Years

intercorporate transactions), should be considered together

as integrated transfers-licensebacks and disregarded as

separate transactions for GCT purposes. Respondent asserts

that since, for tax purposes, no transfers took place,

Petitioner’s income was not properly reflected regardless of

whether the subsequent Tax Years intercompany transactions

were at arm’s length; i.e., that any intercompany charge for

property not owned is distortive. Respondent neither argues

nor abandons his prior position that the subsequent Tax

Years transactions between the Related Corporations and

their affiliates were not made at arm’s length.

Petitioner asserts that Toys Inc.’s initial transfers

to and capitalization of the Related Corporations were valid

separate transactions which should be respected for GCT

purposes and should not be integrated with subsequent

transactions. Petitioner asserts that the subsequent Tax

Years transactions between the Related Corporations and

their affiliates were made at arm’s length. Therefore,

Petitioner argues, its income and GCT liability would be

properly reflected by combined returns which do not include

the Related Corporations.27

27 Petitioner concedes, for purposes of this proceeding only, that

it should file its City GCT returns for the Tax Years on a combined basis with the following affiliated corporations: Toys, Inc., Toys-NJ, Toys-Penn, and Toys-Mass, and for the 1988 Tax Year only, Toys-UK Group. Stip. ¶1, fn. 1.

39

CONCLUSIONS OF LAW

The statutory preference for corporations doing

business in the City is to file GCT reports on an individual

basis, as each corporation is considered to be a separate

taxable entity. Code §11-605.1. See, also, 19 RCNY §11-91.

However, the statute grants Respondent the discretion to

require a taxpayer to file its GCT reports on a combined

basis with related corporations if it is necessary to

properly reflect income and tax liability. Code §11-605.4.

The Commissioner may require a combined filing where:

(1) there is common ownership among the corporations to be

combined;28 (2) the corporations in the proposed combined

group are engaged in a unitary business;29 and (3) filing on

a separate reporting basis “distorts” a taxpayer’s income

and GCT liability. Code §11-605.4; 19 RCNY §§11-91(a)(3)

and (f)). The Commissioner may not require a foreign

corporation (i.e., one which does not do business in the

City) to be included in a combined report “unless . . . such

report [is] necessary, because of inter-company transactions

or [an agreement pursuant to Code §11-605.5] in order

properly to reflect” GCT tax liability. Code §11-605.4.

Petitioner concedes that the ownership and unitary business

28 The statute speaks to “substantial” ownership or control among

the proposed corporations, and the GCT regulations establish a threshold of 80% ownership of voting stock. See, 19 RCNY §11-91(e)(1).

29 For purposes of this proceeding only, Petitioner does not

dispute that it is engaged in a unitary business with the Related Corporations within the meaning and intent of 19 RCNY § 11-91(e)(2). As these corporations are engaged in a unitary business, there is no question that the Related Corporations have nexus to the City sufficient to subject them to City taxation. See, Allied Signal, Inc. v. Division of Taxation, 504 U.S. 768 (1992); Matter of USV Pharma-ceutical Corp., DTA No. 801050, 92-2 NYTC T-822 (NYS Tax Appeals Tribunal, July 16, 1992). Therefore, cases decided in other tax jurisdictions (e.g., the South Carolina Geoffrey case, supra, at Finding of Fact ¶78) which speak primarily to issues of nexus, are not relevant to this determination.

40

criteria are met with respect to the foreign Related

Corporations. Stip. ¶¶56, 57.

The GCT regulations establish a presumption of

distortion where there are substantial intercorporate

transactions between members of a related group. 19 RCNY

§11-91(f). “Substantial” is defined as that circumstance

where “as little as 50 percent of a corporation’s receipts

or expenses are from one or more qualified activities.” 19

RCNY §11-91(f)(3).

There were substantial intercorporate transactions

between the Related Corporations and members of the

affiliated group30 during the Tax Years. Geoffrey’s income

was primarily from royalties which it received from

licensing intangibles to affiliates. ABG’s income was

primarily interest paid by affiliates on mortgages it held

on properties used for the benefit of Group members. TRU’s

income was primarily interest income from investments

transferred from its parent. It also received contributions

of excess cash from affiliates. In addition, many expenses

of the Related Corporations were incurred and paid

intercompany. Respondent therefore is entitled to the

regulatory presumption that Petitioner’s income was

distorted when GCT reports were filed on a basis which

excluded the Related Corporations. 19 RCNY §11-91(f).

To overcome this presumption of distortion, Petitioner

must establish that the subject transactions were carried on

at arm’s length. Matter of Standard Manufacturing Co.,

Inc., DTA No. 801415, 92-2 NYTC T-202 (NYS Tax Appeals

30 For federal income tax purposes, Toys Inc., the Operating

Companies and the Related Corporations comprise the “affiliated group.” Stip. ¶16; Stip. Ex. 34-36.

41

Tribunal, February 6, 1992); USV Pharmaceutical, supra.

Petitioner asserts that it has overcome the presumption of

distortion by demonstrating that the transactions which gave

rise to that presumption were made on an arm’s length basis.

Although there is no express statutory or regulatory

incorporation of the IRC §482 arm’s length standard,31 State

decisions have consistently looked to that principle to

determine whether the presumption of distortion is overcome

and income is properly reflected. USV Pharmaceutical,

supra; Matter of The New York Times Co., DTA. No. 809776

95-1A NYTC 1045 (NYS Tax Appeals Tribunal, August 10, 1995).

Under IRC §482, transactions between corporations are

adjusted to the extent that “the results of the transactions

are consistent with the results that would have been

realized if uncontrolled taxpayers had engaged in the same

transaction under the same circumstances.” Treas. Reg.

§482-1(b)(1).

Petitioner has presented thorough and credible evidence

that the Tax Years transactions between the Related

Corporations and affiliated corporations were: (1) at arm’s

length; or (2) on such terms that combined reporting should

not be required.

Petitioner’s two expert witnesses, Dr. Irving Plotkin

and Mohamed Sherif Lotfi, testified that the royalty which

Geoffrey charged the Operating Companies and Toys Inc. was

an arm’s length charge and each witness submitted a detailed

report supporting his conclusion. See, Findings of Fact

31 The IRC permits the Secretary of the Treasury to adjust items

of income, deduction and expense between members of an affiliated group of corporations if he determines that the adjustment is required “to clearly reflect the income” of the examined corporations. IRC §482.

42

¶¶79 and 80. Dr. Plotkin examined the “operating rates of

return” for 212 unrelated corporations which were in

business from 1985-1994. His analysis took into account

profit margins and turnovers, compared the Operating

Companies’ pre-royalty and post-royalty rates of return, and

determined that the Operating Companies had higher rates of

return after paying royalties to Geoffrey than did the

majority of the unrelated corporations examined.

Mr. Lotfi examined Geoffrey’s licensing of the

intangibles to the Operating Companies. He applied a

detailed IRC §482 analysis, examining the subject

transactions against transactions entered into by comparable

unrelated parties according to several IRC §482 methodo-

logies. See, Finding of Fact ¶80(a). Mr. Lotfi also

examined two additional categories of transactions between

the Related Corporations and Toys Inc. affiliates: (1) the

Service Agreements between Toys-NJ and the Related

Corporations; and (2) the intercorporate ABG Loans and TRU

Loans. See, Findings of Fact ¶80(b) and 80(c). He

concluded that in each of the three instances, the

transactions between the Related Corporations and affiliates

were at arm’s length pursuant to the IRC §482 standard.

Respondent did not argue that intercompany transactions

which did not involve transfers of intangible property and

rights (i.e., payments pursuant to the Service Agreements)

were distortive. Further, Respondent did not offer any

expert testimony to rebut, or even challenge, the

conclusions of Petitioner’s witnesses that the Tax Years

royalty or interest charges were at arm’s length (assuming

the tax validity of the initial 1984 transfers of the

underlying properties). Respondent did not attack the

different valuation methodologies used by the experts or the

43

factual bases on which they relied. Nor did he rebut the

specific evidence which they presented.

Petitioner therefore has established that the Tax

Years’ intercorporate transactions between Geoffrey and the

Operating Companies, and between the Related Corporations

and Toys-NJ, were made at arm’s length, thus overcoming the

presumption of distortion occasioned by those transactions.

The same conclusion cannot be reached, though, with

respect to the third category of transactions examined: the

TRU Loans and the ABG Loans. Mr. Lotfi examined 78 TRU

Loans and found that the interest charged on 50 of the 78

was within the “safe haven” range. The interest rates on

the remaining 28 loans, however, were not within that

parameter, and he concluded that there was a “total net

undercharge of about $300,000.” Tr. at 416. Nevertheless,

Mr. Lotfi posited that as the majority of the loans

reviewed were made at safe haven rates, the totality of

these intercorporate transactions should be considered to be

arm’s length. Tr. at 417. I disagree.

Mr. Lotfi’s conclusion that all TRU loans were made at

an arm’s length rate cannot be accepted where approximately

one-third of those transactions were outside the IRS

sanctioned fair market range. Nor is an undercharge of

approximately $300,000 de minimus.

Although the presumption of distortion therefore has

not been overcome with respect to TRU, the inquiry is not

ended. Respondent may require a foreign corporation to be

included in a combined report only to remedy a distortion of

income and tax liability which results from reporting on

another basis. USV Pharmaceutical, supra. Toys Inc.’s

44

payment of less than fair market value interest on some TRU

Loans resulted in Toys Inc. incurring a smaller interest

deduction than it should have, and therefore overstating its

income to the extent of the undercharge. Consequently the

GCT liability of the combined group (excluding the Related

Corporations) would be greater than if the interest actually

charged by TRU was at fair market value. Requiring that TRU

be included in the combined filing on this factual basis

would disproportionately increase the Group’s allocated

combined income and not fulfill the statutory purpose. See,

e.g., Matter of Campbell Sales Co., DTA No. 805017 and

805018, 93-2 NYTC T-1071 (NYS Tax Appeals Tribunal, December

2, 1993).

The E&Y Report also notes that of the 112 ABG Loans, 4

were not made within the federal AFR safe harbor interest

rate range. E&Y Report, p. 111. These 4 mortgage loans,

all transacted in Tax Year 1987, represented an overcharge

outside the safe haven range of $21,006, or 0.38% of the

total interest charged by ABG for the Tax Years. On a

reporting basis which excludes ABG, the overcharge would

result in an understatement of GCT liability because it

would increase ABG’s income and decrease the Group’s

combined income. While it therefore cannot be found that

there is no distortion, the amount of the understatement is

so small that it is de minimus. Under these circumstances,

Respondent should not require items of ABG’s income, gain

and deduction to be included in the combined report.

Transfer of the Underlying Property

Respondent argues that the inquiry whether the Related

Corporations should be included in the combined report

cannot be resolved merely by examining whether the Tax

45

Years’ transactions between these corporations and Group

affiliates were at arm’s length, notwithstanding that this

characterization of the transactions was the sole issue

presented throughout pre-hearing conference proceedings.

See, generally, Stip. Ex. 75 (the January 11, 1996 Letter

from Respondent’s Representative). Only in the middle of

the formal hearing did Respondent change his theory of

assessment and raise a substantively new basis for the

Revised Deficiency.

Respondent now asserts that combination is appropriate

because the 1984 transfers of intangibles and other property

interests to the Related Corporations and the subsequent

transactions between the Related Corporations and affiliates

lacked economic substance for GCT purposes. As a result, he

argues, Group income was not properly reflected on a basis

which excluded those corporations.

Specifically, Respondent posits that the initial

capitalizations were ineffective as discrete transactions

and should be integrated with any subsequent transactions

involving the intangibles, including the Tax Years’

licensing of trademarks and payment of royalties or

interest.32 Respondent argues that Toys Inc. remained in

the same economic position during the Tax Years that it

enjoyed before the 1984 transfers and that Petitioner’s

income would therefore be improperly reflected if the

combined reports exclude the Related Corporations. In his

post-hearing written arguments, Respondent supports his

32 Respondent’s representative stated at the close of the hearing:

“the question isn’t whether the royalty that was charged was overstated, which means it wasn’t arm’s length, there was no basis for any royalty to be charged whatsoever . . .” Tr. at 529. Later, he stated that the: “payment under the license is one transaction.” Tr. at 537.

46

position by reference to federal tax law and federal patent

and trademark law.

The belated articulation of this new position is

problematic, particularly since Respondent’s representative:

(1) was directed before the formal hearing to advise

Petitioner of his position; (2) waived an opening statement

of that position; and (3) relied upon his cross-examination

of Petitioner’s witnesses to apprise Petitioner of the new

basis for the deficiency asserted.33

Until Respondent’s representative responded to my

inquiries after the close of Petitioner’s direct case (Tr.

at 525-540), there is nothing in the record which directly

advised Petitioner of the Commissioner’s new basis for

asserting combination or of the transactions on which

Respondent was relying to assert the Revised Deficiency.

This is of particular concern since, in combined reporting

cases where the agency determination is based upon the

presumption of distortion arising from substantial

intercorporate transactions, it is “incumbent upon the

[agency] to first identify those transactions which it

claims give rise to the distortion” (U.S. Trust Corporation,

DTA No. 810461, 96-1 NYTC T-486 (NYS Tax Appeals Tribunal,

April 11, 1996)), and the agency must specify those

transactions with particularity. See, Matter of Silver King

Broadcasting of N.J., Inc., DTA No. 812589, 96-1 NYTC T-537

(NYS Tax Appeals Tribunal, May 9, 1996).

33 It is noted the testimony of Respondent’s sole witness was

primarily confined to his audit activities which are not in issue in this proceeding, or to mechanical revisions he made in response to the State changes. Tr. at 540-573. Respondent also waived any closing arguments. Tr. at 590.

47

Petitioner argues that it has been prejudiced in

meeting its burden of proof because Respondent has raised

new factual issues at a point in the administrative process

when such action is precluded. See, Matter of U.S. Trust

Corp. and Subsidiaries, TAT(E) 93-204(BT), TAT(E) 94-

205(BT), and TAT(E) 93-804 (BT), 97-1 NYTC CT-233(NYC Tax

Appeals Tribunal, November 25, 1997). Although Petitioner

correctly points to the potential prejudice inherent in the

timing of Respondent’s new arguments, the record in this

matter was not closed at the time the new argument was made.

Moreover, Petitioner did not request that the proceeding be

continued or that the record remain open in order to present

additional evidence. Accordingly, Respondent’s arguments

will be addressed.

Respondent relies on a series of ostensibly

interrelated legal principles to support its argument that

the Related Corporations must be included in the proposed

combined filing because the 1984 capitalization transactions

were integrated with the subsequent Tax Years transactions

between the Related Corporations and Toys Inc. Respondent

argues that the 1984 transactions were not transfers for GCT

purposes sufficient to make the Related Corporations the

owners of the transferred property, although he does not

affirmatively assert that the 1984 transactions were

ineffective IRC §351 transfers.34

34 IRC §351 provides:

No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control. . . of the corporation. IRC §351(a).

To qualify for non-recognition under IRC §351, the transfer must be of property (IRC §351(d)), which includes intangible property. E.I. Du Pont de Nemours and Company v. U.S., 471 F.2d 1211 (Ct. Cl. 1973). A parent corporation’s transfer of property to a subsidiary in exchange

48

The Toys Inc. transfers to the Related Corporations

(the transfer of the Toys “R” Us trademarks and trade names

to Geoffrey in exchange for all of Geoffrey’s stock; the

transfer of mortgages on Group properties to ABG in exchange

for all of ABG’s stock; the transfer of cash and investments

to TRU in exchange for all of TRU’s stock) will not be

disregarded for tax purposes if they were effected for

legitimate business purposes and were not entered into

merely to avoid taxation. See, Frank Lyon Company v. U.S.,

435 U.S. 561, 577, 580 (1978).

Two factors are considered in determining whether

transactions between controlled corporations will be

respected: (1) whether the transactions were accomplished

for a valid business purpose; and (2) whether they had

economic substance. Lyon, supra, at 572-3, 584. See also,

Rice’s Toyota World, Inc. v. Commissioner, 752 F.2d 89, 91-2

(4th Cir. 1985). The “business purpose” test looks to the

taxpayer’s motives for entering into the subject

transaction, while the “economic substance” test looks to

whether there was “a reasonable possibility of profit . . .

apart from tax benefits.” Rice’s Toyota, supra, at 94-95.

A tax avoidance motivation does not preclude respecting a

transaction if that was not the only basis for entering into

the transaction. Lyon, supra, at 573, 580; Rice’s Toyota,

supra, 96.

The 1984 transactions between Toys Inc. and the Related

Corporations, and the subsequent transactions between the

Related Corporations and Group affiliates (including the

for all of the subsidiary’s stock satisfies the “control” requirement, and gain on that transaction is not recognized for federal tax purposes. See, also, USV, supra, and Matter of Mohasco Corp., DTA Nos. 808901 and 808956, 94–1A NYTC T-1283 (NYS Tax Appeals Tribunal, November 10, 1994), which involved IRC §351 transfers.

49

identified Tax Years transactions), are separate trans-

actions which satisfy the Lyon requirements. With respect

to the Toys Inc.-Geoffrey transfer (intangible property for

stock), the facts overwhelmingly establish that Geoffrey

received the actual benefit of the ownership of the intan-

gibles. Lyon, supra, at 572-73. Geoffrey was created for

several valid business purposes, including but not limited

to owning and protecting the existing Toys “R” Us trademarks

and trade names; establishing and registering new trademarks

and trade names; licensing those trademarks and trade names

to both related and unrelated entities; and defending the

integrity of the trademarks in litigation with third

parties. Geoffrey paid its own expenses, including fees to

unrelated law firms and accounting firms. The credible

testimony and evidence demonstrate not only that it was

anticipated that Geoffrey would realize a profit from its

licensing activities, apart from any tax benefit, but that

in fact Geoffrey did realize such a profit.

Similarly, ABG was established to consolidate and

manage real estate holdings which were essential to the

operation of the Group’s business. Each of the mortgage

notes contributed to ABG was fully secured by real property

and the majority bore interest at an arm’s length recognized

rate. ABG realized interest income and profit.

Finally, TRU was established for a legitimate business

purpose: to perform cash management and investment functions

for the Group. See, Matter of Sears, Roebuck and Co., DTA

No. 801732, 94–1 NYTC T-328 (NYS Tax Appeals Tribunal, April

50

28, 1994).35 TRU realized substantial income from a

diversified portfolio of short term investments.

In sum, Toys Inc.’s 1984 capitalization transactions

with the Related Corporations were accomplished for valid

business purposes, were characterized by economic substance,

and were not motivated solely by tax avoidance. They were

independent transactions which must be recognized.

Respondent also invokes a variation on the federal

“step-transaction doctrine”36 in an attempt to establish

distortion. Respondent maintains that, for GCT purposes,

the 1984 transactions were not separate transactions but

rather were only steps in integrated transactions.

Respondent’s position is most fully articulated with respect

to the transactions between Geoffrey and Toys Inc., where he

avers that Toys Inc.’s transfer of intangibles to Geoffrey

in exchange for Geoffrey’s stock37 should be integrated with

35 In Sears, supra, SRAC, a wholly-owned captive finance company

was engaged primarily in investing and loaning the proceeds of its investments only to its parent, Sears. SRAC was not required to file on a combined basis with its parent corporation notwithstanding its participation in the unitary business of the Sears Group, as its intercorporate transactions were found to be at arm’s length.

36 For purposes of this determination, the issue of whether a “transfer-licenseback” may be analogized to a “sale-leaseback” was not raised and is not addressed.

37 Petitioner correctly notes that Respondent’s “transfer/license-

back” analysis ignores the fact of the intervening 1985 transfer of the stock of Geoffrey to TRU. See, addendum to Petitioner’s Reply Brief. As a result, Geoffrey held intangibles in which TRU had the more direct interest, as sole shareholder, and Toys Inc. had a less direct interest as sole shareholder of TRU. TRU was not an operating company, and therefore it cannot be argued that TRU benefited directly from the goodwill associated with the trademarks, etc. This is not simply form over substance. The foundation for Respondent’s argument is that Toys Inc. in reality never relinquished control of the marks because the contribution of the marks to Geoffrey is simply one step in a leaseback transaction which left Toys Inc. in the same position that it was before the 1984 reorganization. However, the intervening stock transfer to TRU belies this interpretation.

51

Geoffrey’s subsequent licensing of the intangibles to Toys

Inc. and the Operating Companies.

Under step-transaction principles, the separate

identity of transactions is disregarded for tax purposes if

they have no economic substance and/or the transactions were

entered into solely to avoid taxation. Carroll v.

Commissioner, T.C. Memo 1978-173 1978 Tax Ct. Memo LEXIS

340 (May 10, 1978); Peck v. Commissioner, T.C. Memo 1982-17;

1982 Tax Ct. Memo LEXIS 732 (January 12, 1982).

Similar to the IRC §351 analysis, an integrated

transaction inquiry looks to the business purpose for the

transaction to determine motivation and economic substance.

Peck, supra; Carroll, supra. The ownership relationship

between Toys Inc. and the Related Corporations is not

determinative as transactions entered into for legitimate

business objectives (i.e., which have economic substance)

are respected as individual transactions and their integrity

is not ignored simply because the parties are related

entities.38

While the United States Tax Court has held that tax

planning plays a role in corporate development, the

independence of transactions which are “simply motivated by

a desire to minimize taxes” will be disregarded. Carroll,

supra. However, transactions will not be integrated simply

38 As the Tax Court noted in Carroll, supra: “[I]f the element of

retention of control were considered the determining factor, no transfer and leaseback between a corporation and its shareholders could be sustained. Any such tenet would raise havoc in situations that otherwise have all elements of a normal commercial transaction and fails to recognize the realities of the use of the corporate structure in the business world.”

52

because they were structured to take advantage of a

particular tax scheme. As the Court in Carroll acknow-

ledged, referencing their decision in McLane v. Commis-

sioner, 46 T.C. 140 (1966), aff’d per curiam, 377 F.2d 557

(9th Cir. 1967): “the building may not be constructed

entirely from the tax advantage, but if the foundation and

bricks have economic substance, the economic or financial

inducement of the tax advantage can provide the mortar.”

Carroll, supra.

The 1984 reorganization had legitimate business

purposes39 and the transfers from Toys Inc. to the Related

Corporations, and the subsequent transactions between the

Related Corporations and Toys Inc., had economic substance.

The reorganization transactions were not simply motivated by

a desire to minimize GCT liability. Under a step-trans-

action analysis, it is clear that the subject transactions

did not lose their independent identities and their form may

not be disregarded. Therefore, the 1984 capitalization of

the Related Corporations, and the subsequent Tax Years

intercorporate transactions, must be respected for GCT

purposes.

Finally, to support his argument that the 1984

capitalization transactions lacked economic substance,

Respondent argues that when Toys Inc. transferred the Toys

“R” Us trademarks and trade names to Geoffrey, it retained

all associated goodwill.

39 See, Finding of Fact ¶8 which references the uncontroverted

testimony of Michael Goldstein with respect to the motivations for the 1984 reorganization.

53

Goodwill is that element associated with a product or

service which protects consumers against confusion or

deception.40 Under principles of trademark law, a transfer

of trademarks without goodwill is in essence an assignment

in gross or an assignment of a “naked” trademark. Marshak

v. Green, 746 F.2d 927 (2nd Cir. 1984)].41 See, also, Visa,

40 Goodwill is the “sum total of those imponderable qualities

which attract the custom of a business, - - what brings patronage to the business.” Grace Bros., Inc. v. Commissioner, 37 AFTR 1006, 173 F.2d. 170, 175 (9th Cir. 1949). The Court in Grace Bros., stated that good will:

may attach to (1) the business as an entity, (2) the physical plant in which it is conducted, (3) the trade- name under which it is carried on and the right to conduct it at the particular place or within a particular area, under a trade-name or trademark; (4) the special knowledge or the “know-how” of its staff; (5) the number and quality of its customers.” Id. at 1012.

See, also, Nestle Holdings, Inc. v. Commissioner, TC Memo 1995-441, aff’d in part, vacated in part, remanded in part, 82 AFTR 98-5467, 152 F.3d 83 (1998), where the Tax Court noted (citing Stokely USA Inc. v. Commissioner, 100 T.C. at 447, and Philip Morris Inc. v. Commissioner, 96 T.C. at 634) that: “although trademarks represent goodwill, . . . they do not equal goodwill and are only one straw in the bundle than makes up goodwill.”

41 Respondent places great reliance on the U.S. Tax Court’s memorandum decision in Medieval Attractions, N.V. v. Commissioner, TC Memo 1996-455, 1996 Tax Ct. Memo Lexis 471 (appeal pending). Medieval Attractions is a lengthy and complex case, only a portion of which deals with royalty payments for the use of intangibles. The facts involve consideration of several levels of corporate relationships, and a series of transactions between U.S. and alien corporations and partnerships. The royalty issue in Medieval Attractions is raised in the context of whether the royalty payments deducted by the taxpayer were “ordinary and necessary business expenses” pursuant to IRC §162, and whether the alleged transfer of certain unprotected intangibles occurred and was at arm’s length.

Respondent is correct that the Tax Court in Medieval Attractions discussed issues of control of rights and economic benefits, as well as the principle that original transactions may be taken into account in determining the tax status of subsequent transactions. However, the case involves such factual issues as whether an intangible existed, whether and when it was protected, whether back-dated documents were used to support the taxpayer’s position that a transfer existed which would justify a deduction, and whether there was a subsequent transfer for which no compensation was paid. The Court emphasized that the record revealed “a complete lack of arm’s length dealing.” As there are

54

Inc. v. Birmingham Trust National Bank, 696 F.2d 1371, 1375

(Fed. Cir. 1982).

In his Sur-Reply Brief at p. 46, Respondent admits that

Toys Inc. made a valid transfer of the intangibles to

Geoffrey, and that Geoffrey was their legal owner.42

Nevertheless he argues that since Geoffrey and Toys Inc.

were affiliated “under tax law,” the “beneficial ownership”

of the marks was not transferred and therefore neither was

the goodwill associated with those marks. This is a

distinction without a difference: either Respondent argues

that the marks were transferred without goodwill or he

agrees they were transferred with goodwill.

Where an intangible such as a trademark is assigned

between affiliated companies which are “united in a common

enterprise,” goodwill is not separated from the marks as a

matter of federal trademark law. Browne-Vintners Co., Inc.

G.H. Mumm & Co., Societe Vinicole de Champagne Successeurs,

G. H. Mumm & Co. of New York, Inc. v. National Distillers

and Chemical Corporation, 151 F.Supp. 595, 602 (S.D.N.Y.

1957). Further, the assignment of a trademark or trade name

which includes the transfer of goodwill is valid as long as

the licensor maintains “control” over the licensee. Arthur

Murray, Inc. v. Horst, 110 F. Supp. 678, 679 (D. Mass.

1953).

At the time that Toys Inc. transferred the trademarks

and trade names to Geoffrey in 1984, it also transferred

no similar facts presented in the instant case, the Tax Court’s findings in Medieval Attractions are distinguishable.

42 Meeting the responsive criticism that he was arguing that the

transfer was an assignment in gross, Respondent states that he “never argued” that position and “certainly never argued that Geoffrey was not the legal owner under trademark law.” Brief at p. 44-45.

55

goodwill associated with those marks. When Geoffrey

licensed the right to use the trademarks and trade names to

the Operating Companies and to Toys Inc., it licensed

intangible property to which goodwill attached. The

Licensing Agreements require the licensees to protect the

marks and names and to provide Geoffrey with recourse to

enforce that protection, including the right to protect and

maintain the goodwill. See, e.g., Stip. Ex. 9, License

Agreement, Art. VI, 6.1-6.3; Art, VII. The subsequent

actions by the registered owner, Geoffrey, to protect the

marks and names (including litigation with third parties)

establishes not only that Geoffrey owned the intangibles,

but that Geoffrey assumed the responsibility for overseeing

and protecting the associated goodwill and only transferred

that responsibility under defined circumstances pursuant to

licensing agreements. Neither the Group’s retention of some

undefinable goodwill associated with the Toys “R” Us

business, nor the subsequent licensing of the marks to which

goodwill attached, in any way establishes that Toys Inc. did

not transfer goodwill to Geoffrey when it contributed the

names and marks to that affiliate in 1984. Since the

transfer of the trade names and trademarks to Geoffrey was

not an assignment in gross, the substance of the 1984

capitalization transactions may not be disregarded on this

basis.

ACCORDINGLY, IT IS CONCLUDED THAT:

A. The Tax Years’ transactions between the Related

Corporations and Toys Inc. and other affiliates were: (1) at

arm’s length; or (2) on such terms that reporting on a

combined basis with other Group affiliates is not required

to eliminate distortion.

56

B. The 1984 capitalization transactions between Toys

Inc. and the Related Corporations, and the Tax Years’

transactions between the Related Corporations and Toys Inc.

and other affiliates, are: (1) separate transactions which

evidence economic substance and genuine business purpose;

and (2) were not entered into solely for tax avoidance.

These transactions cannot be disregarded for GCT purposes.

C. Toys Inc.’s transfer of trademarks and trade names

to Geoffrey in 1984 was a valid transfer of the intangibles

and the associated goodwill.

D. Petitioner has overcome the regulatory presumption

of distortion.

For the reasons set forth above, the Revised Deficiency

asserted against Petitioner is cancelled to the extent that

such combined filing includes income, gain and deduction

attributable to the Related Corporations.

DATED: August 4, 1999 New York, New York

________________________

ANNE W. MURPHY Administrative Law Judge