Skechers Transfer Pricing Lacked Economic Substance

Skechers was found to owe more than $1 million in taxes after losing a transfer pricing dispute that involved a royalty expense taken as a tax deduction for purposes of Wisconsin’s corporate franchise tax. The Wisconsin Tax Appeals Commission ruled in February 2023 that the company did not provide adequate evidence that its transfer of intellectual property to a holding company and the payment of royalties to the holding company was for a non-tax related business purpose and that it had economic substance.

Skechers vs. Wisconsin Department of Revenue

Skechers, a footwear manufacturer, formed a related party entity known as SKII in 1999. It then transferred the rights to its U.S. domestic intellectual property and $18 million in cash to SKII in exchange for 100 percent of that entity’s stock. SKII then licensed the intellectual property back to the company in exchange for a royalty, which was set at 2 percent above its operating margin. Skechers then claimed a Wisconsin franchise tax deduction for the royalties paid to the entity for each of the tax years in question.

The Wisconsin Department of Revenue tax auditor disallowed Skechers the deduction for royalties and interest paid to SKII and adjusted the amount of the deduction taken for management fees charged to and paid by SKII. The Wisconsin Department of Revenue tax auditor identified “…the transfer and leaseback of intangible assets as a sham transaction or otherwise lacking business purpose.” The Department assessed more than $1 million in corporate franchise tax for the tax years 2000-2004.

In the subsequent case of Skechers vs. Wisconsin Department of Revenue, the court focused primarily on the business purpose and economic substance of the establishment of an entity and the transfer of intercompany licensing of intangible assets and intercompany payment of royalties. The Court noted that the initial transfer of cash and stock were the only apparent transactions in SKII’s bank account. The royalty payments were also based solely on journal entries, as all funds began and ended in the same Skechers bank account. Skechers, however, maintained that SKII helped it to protect its existing intellectual property.

The Wisconsin Tax Appeals commission ruled in favor of the Wisconsin Department of Revenue by finding that Skechers did not provide adequate evidence of non-tax related business purpose and economic substance.

Implications

The case highlights the importance of aligning transfer pricing and state income tax planning with economic substance and the broader business planning functions of a company. The case provides a variety of takeaways for taxpayers operating in separate filing states. First, transfer pricing impacts taxable income in separate filing states. In this case, Wisconsin computed corporate taxable income separately during the tax years involved in this case, though in 2009 it required corporations to use combined reporting when reporting Wisconsin taxable income. Second, state governments are increasingly willing and able to challenge transfer pricing issues. Lastly, facts and circumstances are weighted more heavily than strictly legal form in aligning transfer pricing and state income tax planning appropriately with economic substance and business purpose.

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