Skechers USA, Inc v Wisconsin Department of Revenue: Lack of substance in US-US transactions

The decision of the Wisconsin Tax Appeals Commission in the case of Skechers USA, Inc (filed on 24 February 2023) is an interesting example of a transfer pricing challenge to domestic US arrangements.

It’s also a good reminder of what corporates should not do in the context of group restructuring projects, namely:

• Fail to document the commercial rationale of the proposed arrangements (as opposed to tax benefits)
• Rely on ‘sample’ intercompany agreements provided by tax advisers, without carrying out a proper legal review
• Rely on journal entries as a means of implementing proposed arrangements
• Disregard the terms of intercompany agreements when operating a structure.

In brief, Skechers USA, Inc (“Skechers”) formed Skechers USA Inc II (“SKII”) as a 100% subsidiary. Skechers contributed to SKII all of its US domestic IP, plus a substantial sum in cash, in return for shares issued by SKII. SKII remained a 100% subsidiary throughout.

SKII immediately licensed the IP rights back to Skechers. As a royalty, Skechers was required to pay all of its operating margin in excess of 2% to SKII, with interest accruing on unpaid royalties. Skechers then claimed a Wisconsin franchise tax deduction for the royalties paid to SKII.

The Wisconsin Department of Revenue denied the whole of the franchise expense as a sham transaction or otherwise lacking a valid business purpose. The Wisconsin Tax Appeals Commission found in favour of the Department.

The arrangement was initiated by KPMG, which approached Skechers offering ‘State Tax Minimisation’ services and proposed the structure which was designed to produce a significant tax benefit over five years. KPMG provided a detailed implementation plan, as well as ‘sample’ intercompany agreements.

However, in the words of the Commission, “Skechers did not engage its corporate law firm, or anyone else, to develop a corporate reorganization plan focused on any non-tax benefits.”

The facts as found by the Commission included the following:

• The royalties were reflected in journal entries only. No cash actually moved
• The parties did not strictly adhere to the terms of the intercompany licencing agreement – from 1999 to 2005 the royalties varied from 1.7% to 3%, and Skechers subsequently ceased booking royalty payments altogether
• No changes were made to the intercompany licensing agreement to reflect those changes.

Interestingly, the Commission did not rule out the theoretical possibility that a commercial rationale for the arrangement might have existed. The issue was the lack of evidence of any actual commercial rationale, and the fact that the relevant executives did not seem to have been aware of what such a rationale might have been. So fit-for-purpose documentation might have saved the day – and a substantial amount of money.