The only state planning idea?

• Author: Zemsky, Kenneth T.
• Position: Delaware Holding Company concept

Introduction

After decades of state tax consulting, handling scores of merger and acquisition transactions, and reflecting on the opening of a new millennium, we are struck by the vitality of the Delaware Holding Company concept. Like the holiday fruitcake in the famed David Letterman skit, the Delaware Holding Company at first blush appears to be the only state planning idea on the planet.

The concept goes by many names and call letters: Delaware Holding Company (DHC), Delaware Royalty Company (DRC), Passive Investment Company (PIC), Intellectual Property Company (IPCO), and so forth. Not that Delaware is the only haven for this concept. Indeed, one enterprising deputy tax commissioner bemoaned that Puerto Rico was not an appropriate haven. He thought it fitting for accountants and attorneys to be saddled with the acronym for a putative Puerto Rican Investment Company.

Perhaps most amazing is how widespread the concept is. Consider any M & A transactional analysis for a major public U.S. company. The due diligence aspect will focus largely on the propriety of the DHC structure, with the buyer's and seller's hired guns intellectually battling to a draw. In the structuring phase of the M & A activity, practitioners will establish a DHC if it is not in place, extend its scope if it is in place, or present a variety of silver bullets to safeguard the device.

Consultants extolling the DHC's virtues generally cite three key phrases to the corporate buyer:

* The idea is the best thing since sliced bread.

* It is turn key.

* And amazingly, it is proprietary!

Whether this bespeaks marketing agility on the part of state tax consultants, or intellectual bankruptcy, is a matter of conjecture. But it is inescapable that the DHC is virtually the only arrow in many consultant's quivers.

Variations of proprietary planning items often include (1) raising your existing three-percent royalty to five percent; (2) shifting the DHC to a different jurisdiction; and (3) applying the DHC rules to a wider variety of intangible assets. What each of these planning ideas had in common is two-fold: They were the result of a costly state tax analysis, and in each case they were the only idea presented. Some enterprising practitioners have extended and camouflaged the concept. But look deeply at your buy-sell company, REIT, RIC, factoring company, financing company, etc. At the heart of each idea beats the sturdy DHC. And merrily the consultants roll along.

This is not to say there is no place for the DHC. Indeed, in some cases and in some states, it is viable. But the important point is that the corporate buyer, CEOs, Tax Directors, and the Managers of Corporate America, deserves a three-fold caveat:

* The concept should not be oversold.

* Problems with DHCs must be aired.

* Alternative state tax planning techniques should be presented.

Potential Sore Spots

We have identified at least 10 specific sore spots in the undue reliance on DHC:

* The DHC may be lacking the appearance of substance.

* The DHC may be lacking in substance.

* States are increasingly challenging the concept.

* Consolidated reporting negates the intended savings.

* Foreign (non-U.S.) tax issues are rarely identified.

* Legal issues may exist, cutting to the heart of the asset being monetized.

* Myriad hidden costs gush forth from this "turnkey" idea.

* Financial statements may be distorted.

* Practitioners' credibility is called into question.

* Overreliance by tax directors breeds unwarranted complacency.

Each of these will be pursued, before concluding with a modest proposal.

Failed Cosmetics

Many a tax director started down the road of the DHC with the best of intentions. He or she was given a check list of items to adhere to in order for the newly established holding company to have substance. The reason for this is that the DHC was in all likelihood established in a tax-free section 351 transaction. Stated differently, Newco was established by the parent corporation, which transferred the intangible asset into it in exchange for 100 percent of Newco stock. After all, there would be little point in trimming the state tax tail, only to be devoured by the federal dog. Structuring the operation from the outset as valid section 351 transaction was critical. Under section 351 of the Internal Revenue Code, an essential element requirement is that the transaction have business purpose and substance.(1) More about business purpose later.

Substance over form is vital for another reason, this one closer to the state tax side of the equation. If the jurisdictions of the parent corporation (either its state of incorporation or commercial domicile, or the states in which it conducts significant business operations) viewed the special purpose subsidiary as lacking in substance, they could well disregard the corporate existence. In such a case, all taxable incidents of the subsidiary would revert to the parent and be taxable in the parent jurisdiction making the assertion. Thus, substance is necessary to avoid having Newco's veil pierced.

There is a curious conundrum. Tax advisers will tell state tax directors of the need for substance but not too much substance. The reason? With a Delaware-domiciled PIC, the balance of the entire scheme rests on section 1902(b)(8) of the Diamond State's tax code.(2) That provision grants an income tax exemption for passive income or non-Delaware realty income, with respect to a passive corporation. Thus, a parent must impart enough substance to the DHC to avoid an attack by the home jurisdiction (of the parent) without crossing the line (for Delaware purposes) into Newco's being engaged in an active trade or business.

Beyond the difficulty of balancing the not -always- consistent tax laws of the various states, there can be a problem where even the illusion of substance is lacking. Many companies do not have considerable presence in Delaware. True, it is a bastion of incorporation, but not of active corporate government or presence. The inconvenience of establishing major contacts in Delaware, possibly coupled with the home office's desire to cut costs, often leads to the indicia of Delaware substance becoming watered down over time.

For example, those directors' meetings that were supposed to occur quarterly, become annual meetings. Then every other year. Then they cease to take place in Delaware altogether. The requirement that all key investment and legal decisions take place within Delaware falls by the wayside as two realities set in: (1) the key decision-makers are at the parent's headquarters out-of-state; and (2) when litigation threatens the value of the intangible, corporation counsel is at the parent headquarters' state, as are outside counsel. Thus, adhering to the key rules falls by the wayside. As time goes on, the temptation to water down substance becomes powerful, a planning opiate the tax director becomes addicted to.

Until he is caught. And when that time comes, it is a relatively easy matter for the attaching state to pierce the DHC's veil.

Beyond Illusion

Two principles suffuse the Internal Revenue Code in terms of business transaction: substance over form and bona fide business purpose.(3) With respect to substance, the tax consultant may use a checklist that includes the following items (among others):

* Have at least annual directors' meetings in Wilmington.

* Establish a mailing address in Delaware.

* Open Delaware bank accounts.

* If possible, rent office space (several Delaware banks and accountants lease space in their own offices to hundreds of corporations).

* File the annual Delaware franchise tax return. Pay the $60 fee.

Even assuming a company adhered to these points, the pertinent inquiry becomes whether there is true substance in addition to the form. As a general rule, there is not a body of state tax law dealing with substance. A few states, however, have addressed the issue of substance in the context of a PIC. In Georgia, for instance, the Fulton County Superior Court determined that the royalty PIC had engaged in sufficient business activities to constitute a valid, separate, and distinct corporate entity, where the PIC carries on the following business activities:

* Maintains a separate corporate office in Delaware.

* Maintains separate bank accounts in the name of the Investment Company.

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