STATE OF NEW YORK
DIVISION OF TAX APPEALS
________________________________________________
In the Matter of the Petition
of
KELLWOOD COMPANY
DETERMINATION
for Redetermination of a Deficiency or for Refund
of
DTA NO. 820915
Corporation Franchise Tax under Article 9-A of the
Tax Law for the Fiscal Years Ended January 31, 2000
through January 31, 2003.
________________________________________________
Petitioner Kellwood Company filed a petition for redetermination of a deficiency or for refund of corporation franchise tax under Article 9-A of the Tax Law for the fiscal years ended January 31, 2000 through January 31, 2003.
A hearing was held before Timothy J. Alston, Administrative Law Judge, at the offices of the Division of Tax Appeals, 500 Federal Street, Troy, New York, on March 19, 2007 through March 23, 2007, with all briefs submitted by September 27, 2007, which date began the six-month period for the issuance of this determination. Petitioner appeared by Jane Wells May, Esq., Catherine Battin, Esq., and John A. Biek, Esq. The Division of Taxation appeared by Daniel Smirlock, Esq. (Jennifer L. Baldwin, Esq. and Clifford M. Peterson, Esq., of counsel).
I. Whether the Division of Taxation may properly require petitioner, Kellwood Company, to file its New York State Corporation Franchise Tax Report on a combined basis with its wholly-owned nontaxpayer subsidiaries Kellwood Financial Resources, Inc., and Kellwood Shared Services, Inc., because petitioner has failed to rebut the presumption of distortion under section 6-2.3 of the Division's regulations (20 NYCRR 6-2.3).
II. Whether petitioner has established reasonable cause and that it acted in good faith for the abatement of penalty asserted by the Division of Taxation pursuant to Tax Law § 1085(k).
FINDINGS OF FACT
Introduction
1. Petitioner, Kellwood Company (Kellwood), is a Delaware corporation with its principal place of business located in Chesterfield, Missouri.
2. Through several operating divisions and subsidiaries, Kellwood is a supplier of moderately priced fashion apparel and recreational products under a variety of brand names to retail stores and other businesses. Kellwood's core products are women's sportswear, men's sportswear, children's apparel, newborn and infant apparel, intimate apparel, and camping and recreational products.
3. Kellwood Financial Resources, Inc. (KFR) and Kellwood Shared Services, Inc (KSS) are wholly-owned subsidiaries of Kellwood.
4. Kellwood is subject to corporation franchise tax under Article 9-A of the Tax Law.
5. Kellwood timely filed New York general business corporation franchise tax reports on a separate company basis for each of the fiscal years at issue and paid the tax computed to be due.
6. During the audit period, Kellwood, KFR, and KSS were engaged in a "unitary business" and had "substantial intercorporate transactions" as those terms are defined under Article 9-A and the regulations promulgated thereunder.
7. It is the position of the Division of Taxation (Division) that Kellwood's separately filed reports distort its New York income and that, as a result, combined returns with KFR and KSS are necessary to properly reflect Kellwood's income.
8. It is Kellwood's position that its filed franchise tax reports for the audit period properly reflect its liability.
The Audit
9. The Division audited Kellwood's filed franchise tax reports for the fiscal years at issue.
10. During the course of the audit, the Division made numerous information and document requests. Kellwood's responses to the Division's requests were made part of the Division's audit file.
11. By letters dated September 29, 2004 and December 10, 2004, the Division requested the following:
(1) Provide copies of any and all internal correspondence or documentation within [Kellwood] that discussed the creation or establishment of Financial and/or Shared Services before, during, and after said creation or establishment. . . .
(2) Provide copies of any and all external correspondence or documentation between [Kellwood] and any third party discussing the creation or establishment of Financial and/or Shared Services before, during, and after said creation or establishment . . .
12. By the same letters, the Division also requested "copies of any correspondence, documents, work papers, and other materials used or generated by Ernst and Young" for petitioner's 2001 and 2003 reports (see Findings of Fact 123 and 127).
13. By letter dated December 14, 2004, Kellwood responded to the Division's request for external correspondence or documentation relating to the creation of KFR and KSS with the following:
Enclosed are five binders of information provided by Ernst & Young at the time both Financial and Shared Services were created. Some of the information has been sent to you previously. The information is in the same format as provided to Kellwood by Ernst & Young.
14. For purposes of computing the combined receipts factors, the auditor used $62,858,147.00, $56,785,500.00 and $46,324,497.00 as KFR's receipts for the fiscal years ended January 31, 2002, January 21, 2002 and January 31, 2003, respectively. Kellwood reported these amounts on its federal tax returns (Forms 1120). The auditor also eliminated $37,714,888.00 for the fiscal year ended January 31, 2001 and $37,152,714.00 for the fiscal year ended January 31, 2002 from Kellwood's combined receipts factors, which represent KFR's intercompany receipts with Kellwood.
15. KFR's taxable income represents between 40.88 percent and 74.84 percent of the Kellwood Consolidated Group's taxable income for the following years:
Kellwood Company Consolidated
Group
Federal Form 1120 Taxable Income
| FYE 1-31-03 | FYE 1-31-02 | FYE 1-31-01 | |
| Consolidated Group | $62,887,791 | $122,417,710 | $71,119,276 |
| KFR | $46,489,608 | $ 50,048,190 | $53,226,748 |
| KFR Income as % of Consolidated Group |
73.91% | 40.88% | 74.84% |
16. As a result of the audit the Division issued to Kellwood a Notice of Deficiency, dated October 11, 2005, which asserted total additional tax due of $1,620,646.00, plus interest of $425,372.20 and penalty of $162,061.00, for the fiscal years ended January 31, 2000 through January 31, 2003. Additional tax due in the notice includes both corporation franchise tax under Article 9-A and the Metropolitan Commuter Transportation District tax surcharge. Penalty is asserted pursuant to Tax Law § 1085(k) for a substantial understatement of liability.
17. The Division's computation of additional tax due and the subsequent issuance of the Notice of Deficiency were premised on the Division's position that Kellwood was required to file combined reports that included KFR and KSS for each fiscal year in the audit period.
History of Kellwood
18. Sears Roebuck and Company (Sears) formed Kellwood in 1961 by combining 15 of Sears' independent suppliers. Sears owned approximately 20 percent of Kellwood and had a representative on Kellwood's board of directors.
19. Kellwood's business at that time consisted of manufacturing men's, women's and children's apparel for Sears under its private label. Kellwood also had a recreational products division and a home fashions division.
20. During this early period, Kellwood essentially operated as a holding company, and there was little centralization of business operations among its individual business units, with the exception of its legal, treasury, accounting, tax, and audit functions. The individual business units retained their autonomy, essentially running their business operations in the same manner as before they were combined to form Kellwood.
21. The process of manufacturing clothes for Sears entailed agreeing on a design with Sears, purchasing the raw materials (which included fabric, zippers and buttons), producing the product, warehousing the product and distributing the product to Sears.
22. Kellwood sold over 90 percent of its products to Sears until the mid-1980s. Sears paid Kellwood its cost of production plus six percent. Sears also guaranteed Kellwood's accounts receivable and inventory with financial institutions, which insured a good financial rating for Kellwood. Kellwood was a highly leveraged company with a debt to equity ratio of one to one.
23. The cost of production plus six percent arrangement between Kellwood and Sears was favorable for Kellwood because Sears dominated the apparel industry at that time. Kellwood's plants were fully utilized and Kellwood prospered. In the early 1980s, however, Sears' business started to decline and Kellwood's business declined dramatically. As a result, Kellwood had to close a number of its manufacturing plants and was in poor financial health.
24. When Sears began to lose market share in the mid-1980s, Kellwood made a number of efforts to increase its profitability including moving toward manufacturing products with higher margins and expanding its customer base.
25. Kellwood broadened its operations beyond private label products for Sears to market-driven labels that had higher margins and profitability. Market-driven labels are those labels or brand names that consumers recognize.
26. Kellwood initially had difficulty expanding its customer base. Competitors of Sears were hesitant to become customers of Kellwood because of Sears' 20 percent ownership interest and its resulting access to Kellwood's financial data.
27. Kellwood ultimately purchased Sears' 20 percent interest in the mid-1980s. The loss of Sears as an owner resulted in a loss of the Sears guarantee of Kellwood's accounts receivable and inventory, which weakened Kellwood's financial status.
28. Kellwood acquired approximately 20 companies from 1985 to the early 2000s as part of its strategy to broaden its customer base. By the early 1990s, Kellwood's customer base had already become diversified, with sales to its largest customer accounting for only about 12 to 13 percent of Kellwood's total sales. Kellwood's customers included department stores (such as Federated and Macy's), chain stores (such as Gap and Hilfiger's), and discounters (such as Target, Wal-Mart and Kmart).
29. The acquisitions did not change Kellwood's decentralized business structure. Similar to the original Sears supplier companies that were merged to form Kellwood, the newly acquired companies were run by their former owners. These individual "business units" handled virtually all business functions with the exception of the few functions performed by Kellwood corporate.
30. Kellwood organized the company into three separate groups: men's, women's and "other," each of which was headed by its own president. Despite the existence of the group presidents, the business units continued to make their own business decisions and act autonomously. The business units often sold products to the same customers and thus functioned as competitors.
31. During the period 1985 to 2000, Kellwood faced two principal types of business risks: inventory risk and credit and collection risk. The inventory risks were associated with Kellwood's production of a significant amount of private label products, which could only be sold to a specific customer. Thus, if a particular customer had a problem (e.g., fell out of favor or was subject to a Kellwood-imposed credit hold), Kellwood would have significant problems selling that inventory already in the pipeline. The credit and collection risks related to the risks of noncollectibility, delayed collectibility, and partial collectibility of accounts receivable. Partial collectibility refers to the tendency of customers in the apparel industry to charge suppliers for any deviation from compliance with the customer's policies or instructions, a practice known as charge-backs.
32. For private label transactions, Kellwood extended credit to its customers from the time it purchased raw materials, since private label products can only be sold to a specific customer. In non-private label transactions, credit is not extended to the customer until the goods are shipped.
33. Each of Kellwood's business units handled its own credit and collection function, either through its own credit department or through an independent factoring company.
34. During 1985 to 1998, the personnel of the individual business units independently decided how much credit to extend to a particular customer. Each individual business unit also independently determined the payment terms with the customers, which were typically anywhere from 60 to 90 days. As a result of these independent decisions, prior to 1998, the payment terms varied from business unit to business unit. The individual business units invoiced their customers and collected the accounts receivable.
35. Kellwood management made efforts to try to gain information about credit and collections from each business unit. Such efforts were not successful because of a lack of common systems among the business units and Kellwood's historically autonomous culture and organization. Kellwood management encouraged the business units to have strong credit and collection departments, but did not have the tools necessary to do anything other than consult with the business units and give them broad guidelines.
36. Despite having some of the same customers, the individual business units did not coordinate to determine how much total credit to extend to a customer. Given Kellwood's historically autonomous culture and organization, Kellwood management did not exercise control over how much credit was extended to a particular customer. The individual business units made the final decisions.
37. By the late 1990s, Kellwood management believed that its decentralized structure had a negative impact on its profit margins because of the inefficiencies within Kellwood and the inability to implement best practices. Kellwood management was unable to get accurate, timely information from the business units about credit and collections and did not, in all cases, have a professional staff in place at the business unit level.
38. Some of the companies that Kellwood acquired retained their agreements with factoring companies. Since the owners of the businesses generally continued to run them after they were acquired, the prior owners decided whether to retain the factoring agreement or to build their own credit staff. Kellwood benefitted by the decision to leave the factoring agreement in place in at least one instance, because Kellwood's factor bore the expense for Montgomery Ward's uncollectible receivables.
Factoring
39. Factoring companies buy accounts receivable at a discount from retailers either with recourse or without recourse. If accounts receivable are purchased without recourse, the factor assumes the complete collection responsibility and risk. If the accounts receivable are purchased with recourse and the factor is unable to collect the receivables, the factor has the right to send the receivables back to its client.
40. Factors often advance some percentage, typically 70 to 90 percent, of the face value of the accounts receivable. A factoring arrangement allows a company to accelerate its cash flow by converting accounts receivable into cash and also provides a company with a professional, organized credit function.
41. Factoring is very prevalent in the apparel industry. Companies enter into factoring agreements to outsource their credit and collections functions. Selling accounts receivable to a factor reduces head count and administrative responsibilities and allows the apparel companies to focus on their core business.
42. Under a factoring agreement, a factor typically receives a commission for bearing the bad debt risk and managing the receivable. The commission is expressed as a percentage of the receivables that are factored. In consideration for the commission charge, the factor analyzes the creditworthiness of the customers, approves credit limits, manages and tracks the accounts receivable, and handles collection issues that arise. The commission charge also reflects the assumption of the risk relating to the receivables, and therefore, factors receive greater compensation for factoring riskier receivables.
43. In addition to the commission, miscellaneous fees are also charged for the factoring function. For example, factors commonly charge additional amounts if the accounts receivable terms of sale are longer than 60 days. Factors also charge fees for late payments, audits, legal fees associated with collection, and setting up new customer accounts.
44. Factors are also compensated for the funds the factor advances the company in exchange for the accounts receivable, which is usually referred to as an interest charge. Such advances usually account for the largest part of the consideration paid to a factor. While not a loan, this is a form of financing as it provides the company with access to working capital. Along with outsourcing of credit and collections, the short term financing through factoring is a primary reason why companies factor. As noted, factors typically advance 70 to 90 percent of the total receivables. The interest charge tends to be tied to market interest rates, generally to the prime rate. The cost of financing through a factoring agreement is generally higher than other sources of financing, including a revolving credit facility.
45. In a typical factoring agreement, the commission charge, the miscellaneous charges and the interest charge on the advance are separately stated.
Economic Climate in the Apparel Industry
46. The economic climate in the apparel industry was difficult in the late 1980s and 1990s. There were a number of retailer bankruptcies during this period which resulted in uncollectible accounts receivable, pipeline inventory that could only be sold to discounters, and a general weakening of the industry from a credit standpoint.
47. The apparel industry also suffered during the late 1980s and 1990s from the growth of discounters such as Wal-Mart. The unusual combination of fewer customers, because of bankruptcies, and more stores, because of the growth of discounters, put continuing pressure on the margins of wholesalers and manufacturers.
48. The apparel industry was also impacted by the outsourcing of manufacturing to Asia, which drove the cost of goods down in an already competitive industry.
49. Some apparel manufacturers went bankrupt during the late 1980s and 1990s; others were sold or consolidated because they were facing difficult times.
50. These industry changes greatly impacted Kellwood. During this time period, Kellwood's prices decreased due to consolidation in the industry. Kellwood's margins were tighter because it was forced to sell at a lower operating margin to big discount retailers such as Wal-Mart. Kellwood's operating margins during the late 1990s and 2000s were similar to those of a low third or fourth quartile (i.e., poorly performing) company.
51. During the late 1990s and early 2000s, Kellwood's credit rating was weak because it had so much inventory. The reduced credit rating impacted the interest rate that Kellwood had to pay financial institutions and it limited the amount of money banks were willing to lend.
52. Kellwood was turned down for a credit increase in the early 2000s. As a highly leveraged company, Kellwood had to continuously search for financing.
53. During the early 2000s, Kellwood was considered to be a weaker company in the very competitive apparel industry. In March of 2002, Moody's downgraded the ratings of Kellwood based on its decline in sales and earnings resulting from a difficult operating environment and changes in the market position and strategy of Kellwood's customers. The downgrade also reflected Moody's acknowledgment of the risks that Kellwood's performance would be more volatile going forward because of industry bankruptcies and an overall weakening of the credit environment for apparel companies.
54. During the early 2000s, the credit ratings of a number of Kellwood's customers were also downgraded, which also negatively impacted Kellwood's credit rating. Kellwood also suffered losses when several of its customers, including Montgomery Ward, Kmart and Ames Department Stores, filed for bankruptcy because accounts receivable were difficult to collect and inventory had to be sold at distressed prices. For example, when Ames Department Stores filed for bankruptcy, Kellwood had roughly one and a half million dollars worth of uncollectible receivables and an almost equal amount of inventory in the pipeline that it was forced to sell at distressed prices.
55. A Moody's Investor Services Report dated July 2002 described a number of challenges facing the apparel industry including the dominance of retailers over distributors and increasingly concentrated distribution. Apparel companies also faced the increasing demand for private label products, which could only be sold to specific stores.
Centralization of Kellwood's Credit and Collection Function
56. At hearing former Kellwood executive Lawrence E. Hummel(1) testified that in the late 1990s Kellwood had approximately $400 million in accounts receivable, net of reserves, at any one point in time. Kellwood measured the length of time it took to collect its accounts receivable by looking at DSOs ("days sales outstanding"). DSO is a measure of how effectively Kellwood was utilizing its working capital and cash flow; DSO also impacted Kellwood's debt and interest expense.
57. While Kellwood management desired to lower its DSOs, this goal was not a top priority for the business units. Kellwood management lacked the real-time information relating to the amount of receivables, collections, shipments and inventory in the pipeline because of a lack of common operating systems and was, therefore, unable to effectively impact DSOs. Each of the companies that Kellwood acquired had its own operating system.
58. Kellwood corporate typically received information from the business units about a month's data two or two and a half weeks after the end of the month. In several circumstances, this delay in receiving the information resulted in some business units extending credit to customers that were already in bankruptcy. On a regular basis, one business unit would extend credit to a customer that was behind on its payments to another business unit. This situation created an increased level of competition between the business units that was further heightened when one business unit placed a customer on hold and another business unit continued to ship to the same customer; the customer would then attempt to use the shipment by one business unit as a reason for the other business unit to resume shipment.
59. If Kellwood corporate had information that a customer was a credit risk, Kellwood would alert the business units and recommend that they try to expedite collection of their debt and hold their individual credit limits down. While the business units were encouraged to follow the directives from Kellwood corporate, there were instances where the directives or guidelines were not followed. If the business units overrode the credit guidelines, they were required to take the full responsibility for the write-off if the account receivable was not collected.
60. In 1996, Kellwood's CEO, Hal Upbin, formulated a strategy named "Vision 2000," which called for the centralization of Kellwood's "behind the curtain" functions, including the credit and collection function. The goal of the centralization was to achieve a significant reduction of costs and to make the back office functions more efficient and effective. Benchmarking studies had indicated that Kellwood was either in the third or fourth quartile for the cost of performing "behind the curtain" functions.
61. The goal of Vision 2000 was to create a financial shared services center where a number of the "behind the curtain" activities would be consolidated. The shared services center would, among other things, allow Kellwood to operate its credit and collection function in a consolidated manner, with credit approval to be done on a company-wide basis rather than at the individual business unit level.
62. As part of the Vision 2000 plan, the individual business units were to migrate into being serviced by the shared services center gradually, allowing time to train personnel. Jerry Betro, a credit manager with one of the business units, was chosen as the corporate credit manager of the shared services center.
63. As part of Vision 2000, Kellwood's senior financial management made a presentation to the financial leaders of Kellwood on October 23, 1998, embodied in a document entitled, "Kellwood Company Vision 2000 Financial Process Improvement." According to the document, a "Financial Shared Services Center in St. Louis" would be responsible for credit, collections, and cash applications activities, and "chargeback/deduction management" responsibility would remain with the divisions. The goals of Vision 2000 as they pertained to Kellwood's "behind the curtain" functions included forming a financial shared services center to consolidate certain "behind the curtain" functions, streamlining certain financial processes, reducing costs through economies of scale, and implementing a customer service and team oriented environment. According to the "Kellwood Company Vision 2000 Financial Process Improvement" document, the centralization of Kellwood's credit and collections functions would involve the development of customer rating policies and procedures and approval of credit on a consolidated basis, monitoring of customer payment histories, maintaining information on the financial condition of its customers, improvement of customer relations with respect to payments, and coordinating "follow-up" and a "workout" program for those customers making late payments.
64. The "Kellwood Company Vision 2000 Financial Process Improvement" document set as a goal the replacement of the then-current 32 employees in credit and collections activities and 15 in cash applications at the divisional level with 15 employees in a consolidated shared services or credit and collections department.
65. The "Kellwood Company Vision 2000 Financial Process Improvement" document also stated that the creation of the shared services department would "eliminate factor fees."
66. Kellwood employed Price Waterhouse to assist in the implementation of Vision 2000. Price Waterhouse prepared a report, entitled "Kellwood Company Financial Shared Services Business Case" and dated "October 23, [1998]" which provided the written business case for creating a shared services division. Specifically, the report memorialized the problems that Kellwood was encountering with its present system, such as increased costs, inconsistent financial processes across the business units and a lack of best practices. According to the Price Waterhouse report, Kellwood anticipated saving $1,262,000.00 each year in 1999, 2000, and 2001 from the centralization of the credit and collections functions of Kellwood and its subsidiaries in a shared services division.
67. Kellwood implemented the Shared Services Division in accordance with the Vision 2000 plan. As a result of the Shared Services Division Kellwood became able to evaluate credit situations on a consolidated and real-time basis, obtain accurate information on a daily basis, and use that information to determine the proper course of action.
68. The managers of the shared services center implemented a system of monitoring and alerting the Business Units regarding two categories of riskier accounts called "risk" accounts and "monitor" accounts. Customers that were having financial difficulties (such as Kmart and Ames) were designated as "risk" accounts. Customers that had undergone a single credit downgrade or had slowed in making payments were designated as "monitor" accounts. Over time, the Shared Services Division serviced virtually all of Kellwood's receivables.
69. The shared services center was located in its own office space in Saint Louis County, Missouri. Fourteen employees of Kellwood's Sportswear Division Accounts Receivable Claims Department (the "Sportswear Division Employees"), who were located in Rutherford, Tennessee, assisted with the credit and collection functions.
Pursuit of Securitization as an Alternative Financing Vehicle
70. Kellwood traditionally raised capital through revolving letters of credit. In the 1990s, as part of its continuous search for financing in an increasingly difficult economic climate, Kellwood management discussed an alternative financing tool - securitizing its accounts receivable. Kellwood received presentations from financial institutions describing various ways to raise additional funds through participation in an asset-backed securitization transaction. Specifically, Banc One Company made a presentation, memorialized in a document entitled "Fundamentals of Securitization" and dated September 28, 2000. Later, Scotia Capital made a presentation, memorialized in a document entitled "Kellwood Company Industry Funding Corporation" and dated December 2002, which described asset securitization financing.
71. In 1999, Kellwood was not able to enter into a securitization transaction under its then-current structure because, although they were serviced by the Shared Services Division, the accounts receivable were still owned by a variety of legal entities (Kellwood and its subsidiaries) and a securitization transaction would require that they be owned by a single, bankruptcy-remote entity, referred to as a special purpose entity (SPE).
72. Kellwood began negotiations with its banks for a carve-out provision in its 1999 revolving credit loan that would enable it to enter into a $75 million asset-backed securitization transaction. This carve-out provision would allow Kellwood to gain additional financing on a short-term basis over and above the amounts loaned through the revolving credit agreement.
73. The banks were reticent to agree to the carve-out provision because it weakened their own credit situation by carving out more than $75 million worth of receivables from their asset group to give to another lender. However, Kellwood management believed that the carve-out provision was necessary, because Kellwood was continually bumping up against its credit lines, the apparel industry was facing a downturn, and Kellwood was concerned about its ability to secure enough credit in the future.
74. Kellwood successfully negotiated the $75 million carve-out provision which was memorialized in Kellwood's credit agreement dated August 31, 1999.
The Factoring Strategy
75. Sometime in 1999 Kellwood, through its then-chief financial officer, Gerald Chaney, sought out Ernst & Young LLP (E&Y) to advise Kellwood on multistate tax planning ideas and strategies. E&Y interviewed employees of Kellwood on August 3 and 4, 1999. Additional meetings took place on August 24 and 31, 1999. E&Y presented its "SALT [State and Local Tax] Value Analysis" ideas to Kellwood on September 7, 1999. E&Y's tax savings ideas included an intercompany charge based on asset allocations, a trademark holding company and the formation of a factoring company. With respect to two of the three ideas, Mr. Hummel testified at hearing that it was his decision and that he turned them down because "They did not fit our business model. And, quite frankly, they had no purpose other than tax reduction. Businesses make decisions based on business considerations. At least Kellwood does." Kellwood elected to proceed with forming a factoring company because, according to Mr. Hummel, it made business sense. E&Y's proposal estimated annual tax benefits from the factoring company at $900,000 to $1,3000,000. Kellwood agreed to E&Y's proposal of a factoring company on October 6, 1999.
76. To implement the factoring strategy, E&Y proposed the following transaction:
Kellwood would create a new legal entity for the purpose of acquiring the accounts receivable generated by the operating company. The acquisition of the accounts receivable would be at less than face value, thereby creating a deduction at the operating company level.
77. E&Y described the "tax strategy" of the transaction as follows:
Because of the discounted purchase price, the operating companies will realize a loss on the sale of the receivables, and the factoring company will realize a gain, thereby shifting income out of the higher effective rate entities.
78. As noted, Kellwood accepted E&Y's proposal and engaged E&Y to assist in the organization, establishment, and implementation of what E&Y called the Factoring Strategy.
79. As part of the Factoring Strategy, E&Y delivered to Kellwood six binders of documents, including memoranda, informational templates, legal documents, and calculations, along with a detailed work plan that listed every step accomplished during the execution of the Factoring Strategy.
80. E&Y included in the binders an "Executive Summary of Restructuring," dated December 31, 1999, which "summarize[d] the evaluation, in-depth analysis, and implementation of a factoring company, Kellwood Financial Resources [KFR], and the transfer of Kellwood's shared services department to a wholly-owned subsidiary, Kellwood Shared Services [KSS]. According to E&Y, implementation of the Factoring Strategy required the following steps:
(1) Effective January 1, 2000, [Kellwood] will form a wholly-owned Tennessee subsidiary, KFR which will be headquartered in Rutherford, Tennessee. The new subsidiary will operate as a factoring company and will purchase, with all the rights and obligations of ownership including the obligation to collect the monthly payments and bear the expenses in connection with their collection, accounts receivable generated from the operations of the selling corporations. KFR will buy the receivables on a non-recourse basis with respect to bad debts. Prior to KFR's formation, Kellwood will purchase $48,075,581.87 of trade receivables from [the Factoring Subsidiaries]. [Kellwood] will then contribute these purchased receivables and the receivables of [Kellwood's] participating operational division to KFR. [Kellwood's] total contribution will be $273,069,944.95 of the selling corporations' total outstanding trade accounts receivable and miscellaneous assets in exchange for 100% of KFR's stock.
(2) [Kellwood] and all subsidiaries had a previous fiscal year end of 4/30/99. [Kellwood] is changing its fiscal year end to 1/31/00, and will operate on a 52-53 week basis. Although the contribution will be made on 1/1/2000, KFR will not begin operating until 2/1/2000.
(3) [Kellwood] will transfer fourteen (14) employees associated with [Kellwood's] Sportswear accounts receivable claims department to KFR on 1/31/2000 in order to avoid any payroll related compliance complications. Since KFR will not begin purchasing the receivables until February, KFR will lease its newly transferred employees to [Kellwood's] Sportswear division for them to continue performing accounts receivable claim functions for Sportswear during the month of January. Thereafter, these transferred employees will work for KFR and will be considered common law employees; however, to the extent these employees perform services for Sportswear, KFR will charge [Kellwood] an arm's length fee for those services. [Kellwood] will also assign all necessary Sportswear leases to KFR.
(4) One month after the contribution, KFR will purchase all the receivables generated by the selling corporations during the month of January. Afterwards, KFR will purchase, on a weekly basis, the receivables generated from the selling corporations' previous week's sales. These accounts receivable will be purchased at an arm's length discount value as determined by E&Y and as detailed in the Receivables Purchase and Sale Agreement. This discount rate will be applied on net receivables, and will not be adjusted based on the ultimate collection of the receivables (net receivables = gross receivables less charge back reserve, trade discounts reserve, over-billing reserves and return reserves). This discount rate will be based upon (1) time value of money, (2) bad debt exposure, (3) collection expense, and (4) fixed fee/profit amount. As mentioned in the valuation report, this discount rate should be updated annually, and at least every three years by an independent valuation expert.
(5) Effective January 1, 2000, [Kellwood] will form a wholly-owned subsidiary, KSS. KSS will be organized in Delaware and commercially domiciled in Missouri. [Kellwood] will transfer all the assets associated with [the Shared Services Division] in exchange for 100% of KSS's stock. [Kellwood] will transfer to KSS all the employees of [the Shared Services Division] and will assign all leases with [the Shared Services Division] to KSS.
(6) Acting as an independent contractor, KSS will perform credit analysis, provide credit approvals, collect cash from customers, distribute cash to and provide administrative support for the accounts receivable system (e.g. changes to customer master headers and update terms table) for DDDG, Sportswear, Lingerie and CLC. Beginning 2/1/00, this function will also include Koret [a Kellwood subsidiary] and its subsidiaries. Eventually, management anticipates a majority of [Kellwood's] business units will contract with KSS for the management of their credit and collection functions. KSS also performs accounts payable and payroll functions for all business units. KSS will charge all business units an arm's length charge, as determined by E&Y, for these administrative services.
(7) KFR will contract with KSS to service and collect its receivables. KFR will pay KSS a servicing fee in an arm's length transaction, as outlined in the Receivables Collection and Administrative Service Agreement.
(8) Certain [Kellwood] business units will continue to collect payments related to their accounts receivable and will reconcile receivable balances for a short period of time. [Kellwood] has identified business reasons for this decision, including the complexity of changing payment methods by its clients, and the likely delay of payment by the clients upon adjustment of payment terms. Therefore, the collection of such payments on KFR's behalf and remittance to KFR will be included in the administrative services agreements between KSS, KFR and these business units.
(9) KFR will initially have fourteen (14) employees in its Tennessee corporate office who will manage the business affairs of KFR. These employees will be responsible for the following: calculating the purchased receivables; calculating the discount fee; establishing appropriate reserves for bad debts; year-end reporting; tax information gathering and all administrative functions of a factoring company.
(10) On a weekly basis, the selling corporations will submit the appropriate information to KFR in order for KFR to calculate and input the proper entries into the system as discussed in the Accounting Manual.
(11) [Kellwood's] current financial and management reporting system will not be affected except the adjustments discussed in the Accounting Manual. All accounting entries will be made on the appropriate adjustment division books in order to maintain the integrity of management reports.
Note: The Accounting Manual is an integral part of this project and should be reviewed independently of this executive summary in order to fully comprehend the accounting for this Factoring Strategy.
(12) KFR will file a separate company tax return in Tennessee and Massachusetts.
(13) KSS will file a separate company tax return in Missouri.
(14) Immediately upon formation and thereafter, KFR and KSS will join in the filing of a consolidated federal income tax return with [Kellwood] and its other consolidated group members.
81. Tax savings, according to E&Y, resulted from the following:
Savings of multistate income taxes are achieved upon KFR's purchase of receivables from the selling corporations. KFR will be established in Tennessee due to the significant accounts receivable function that currently resides there, and due to Tennessee's tax laws which create advantageous tax results upon implementation of the Factoring Strategy. KFR will purchase the receivables of the aforementioned companies at an arm's length discount as determined by an E&Y economist as stated in the transfer pricing report. The selling corporations will receive an ordinary deduction equal to the amount such receivables were discounted. Conversely, KFR will recognize income upon collection to the extent the amount ultimately collected exceeds the original purchase price. This income will be subject to taxation in California, Illinois, Massachusetts, and Tennessee, as well as other unitary states. However, due to the favorable sourcing rules in these states, only a fraction of the income will be subject to tax. As a result, the vast majority of income generated by KFR should escape separate-state taxation. Furthermore, having KSS service and collect KFR's purchased receivables will preclude KFR from having nexus, based upon a physical presence, with numerous states.
82. The summary also included representations made by Kellwood upon which E&Y's advice depended, analysis concerning the impact of the implementation of the Factoring Strategy on Kellwood's state tax liability, and potential risks associated with the Factoring Strategy.
83. E&Y also included as part of the six binders a "Review of the Factoring Project," dated May 31, 2000. This document summarized E&Y's evaluation of Kellwood's operations from January 1, 2000 to May 31, 2000 to ensure that implementation of the Factoring Strategy followed expectations. E&Y concluded that if Kellwood properly implemented the Factoring Strategy and, after the reallocation of a management fee among those participating entities, Kellwood "should generate approximately all of [sic] state tax savings as presented by E&Y."
84. The majority of the other documents included in the six binders are memoranda, prepared by E&Y, analyzing specific aspects of the Factoring Strategy. E&Y considered the funding mechanism of KFR, the personnel of both KFR and KSS, prepared the corporate bylaws of KFR and KSS, assisted Kellwood in obtaining board of director and shareholder approval, prepared minutes of initial organizational meetings for both KFR and KSS, and provided Kellwood with draft copies of intercompany agreements.
85. E&Y also considered the necessity of forming KSS. Since KFR would not be able to service the accounts receivable it purchased from Kellwood and other subsidiaries, E&Y concluded that Kellwood "will form Kellwood Shared Services (KSS) in Missouri to perform, or contract out, the credit and collect [sic] function for KFR in exchange for an arm's length fee." E&Y reasoned that the formation of KSS would: (1) limit KFR's nexus with several states; (2) provide a small state tax benefit as a result of the fee charged by KSS for its credit and collections services; and (3) allow Kellwood to better evaluate and manage its shared services concept.
86. E&Y determined the internal and external "substance items" that needed to occur to establish KFR and KSS as active subsidiaries. E&Y documented "a list of functions and activities that should be completed by KFR in order to fulfill the business purpose for which it has been created" and identified those substance items that Kellwood could implement "without significant disruption to operations" and those "not absolutely necessary to the successful implementation of the strategy." E&Y identified internal indicators such as signs, company manuals, and phone books, and external indicators such as stationery, business cards, and advertising.
87. E&Y also drafted a multi-page memorandum analyzing the "business purposes for the creation and contribution of assets to KFR and KSS and whether they are significant enough for the IRS to respect the formation of the entity and its operational substance for future transactions."
88. According to the memorandum, Kellwood's management identified the following business purposes for KFR:
(1) The centralization of accounts receivable furthers the Company's objective to better manage and control working capital and provides a management tool (i.e., separate profit center) to measure and reward the success of the servicing and collection activities thereby improving Kellwood's management and control of working capital.
(2) Kellwood's aging of accounts receivable continues to deteriorate as customers lengthen their payment cycles. It is a goal of Kellwood management to focus on this issue and reverse the current trend. Creation of KFR will facilitate this effort by focusing the accounts receivable function in an entity separate and apart from the operational units, and holding this function accountable to the goals set by management.
(3) Segregating the accounts receivable servicing operations and financing operations from Kellwood's business units will allow the Company to better measure the true economic income associated with its various activities (i.e., the manufacturing and sale of goods, the financing of customer purchases, and the servicing of its loans to customers) and to better manage the performance of these various activities.
(4) In conjunction with the revision of the Company's debt agreement, it is envisioned that the pooling of the accounts receivable together into a single factoring company will facilitate secured financing or possible securitization of the receivables at some point in the future.
(5) Segregating the accounts receivable servicing operations and financing operations from Kellwood's business units will provide for a better measure of Kellwood's true economic income for which it has nexus in separate return states (i.e., it will provide a better measure of the income from manufacturing and sales activities with respect to which has established nexus in various states, as opposed to lending activities with respect to which it should not have nexus in the various states).
(6) The formation of KFR will allow Kellwood to lower the overall administrative costs of managing the accounts receivable by centralizing the functions into a specialty area rather than keeping the function decentralized and handled by individuals without such expertise.
(7) Through state and local tax savings that should be derived from the Company's restructuring of its accounts receivable operations, the Company will enhance earnings, cash flows, earnings per share, and shareholder value.
89. The business purposes for KSS set forth in the memorandum included the following:
(1) Following the management decision to create a shared services function, the creation of KSS will facilitate this decision by setting the division separate and apart from Kellwood Company and other legal entities, thereby giving it autonomy to conduct the business for which it was created.
(2) As the Company's other subsidiaries continue to migrate to the shared services platform, for financial accountability, this function needs to be managed and accounted for separate from the business units within Kellwood. The separate legal entity allows for arm's length charges to be utilized to charge for services performed on behalf of all business units, and will not thereby affect the financial performance of Kellwood to the detriment of other subsidiaries.
(3) Cost control savings, that will be realized by each business unit, should be derived by centralizing administrative functions within a central location and managing those functions on a consistent and continual basis. This transaction allows the business units to focus on the business for which it was created, and allows KSS to focus on the business for which it was created.
90. E&Y concluded that these "business reasons, along with the reduction of state income taxes, should be sufficient to overcome any challenges the IRS may present in [Kellwood's] §351 contribution of assets to KFR and KSS." Furthermore, "[Kellwood's] transfer of assets to KFR and KSS should not reduce its federal income taxes, and therefore, the IRS will have no motive in challenging [Kellwood's] transaction."
91. E&Y also examined the Factoring Strategy from a state tax perspective. E&Y considered KFR's filing status, the apportionment details of KFR and KSS and the effect on Kellwood and other subsidiaries, and the sales and income tax nexus requirements of KFR and KSS. E&Y determined that Kellwood would realize the most tax savings in New York, followed by New York City, Massachusetts, Texas, Virginia, West Virginia, Georgia, and Pennsylvania. In addition, E&Y analyzed the "potential state challenges" resulting from the Factoring Strategy. With respect to New York, E&Y concluded that "[g]iven the arm's length nature of the sale of accounts receivable and the economic substance of the new entities, it is more likely than not that New York will not successfully challenge the restructuring through forced combination."
92. E&Y drafted an 18-page memorandum, entitled "Kellwood Accounting Procedures Manual," which it "intended to provide accounting and tax reporting guidance to Kellwood Company relating to its formation of, and future transactions with, Kellwood Financial Resources, Inc. and Kellwood Shared Services, Inc." This memorandum details the accounting entries to be made by Kellwood to effect the Factoring Strategy, including the creation of an "Adjustment Division," described as follows:
This Adjustment Division will be a separate accounting book located within [Kellwood's] general ledger and within the subsidiaries' ledgers which will allow [Kellwood] and its subsidiaries to properly reflect the transferring of the accounts receivable and cash to KFR while maintaining the integrity of its established accounting and cash collection systems. When a sale is made, the generation of the invoice and the recording of the sale will continue to be done on the operational books. A recording will be made on a weekly basis within the appropriate Adjustment Division to transfer the accounts receivable and cash from the operational books to KFR's books. This transfer will only be evident on the Adjustment Division books. Therefore, at any given time, the books of the business units will remain intact. When taken as a whole, the business unit and the Adjustment Division together will produce the business unit's financial position including the impact of the factoring activity on a tax basis. When the business unit's books are combined with the Adjustment Division's and KFR's books, management reporting will be intact for financial reporting purposes.
93. E&Y explained that "essentially, [Kellwood's] and its subsidiaries' daily accounting process will be unchanged by the accounts receivable reorganization . . ." and that "the entries simply are intended to transfer to KFR all of [Kellwood's] accounts receivable-related activities and entries (e.g., collections and bad debt write-offs) and record the factoring related activities so as to leave the business units' books intact." E&Y noted that "[t]he existing banking structure and physical flow of cash will remain unchanged as a result of the restructuring."
94. In the memorandum, E&Y recognized that "[a]fter the restructuring, all Selling Corporations will continue to make sales, establish payment terms, issue invoices and credit memos, and resolve charge-back disputes as they currently do," but that KFR would not have the ability to service and collect on the accounts receivable. Therefore, E&Y explained, "KFR will contract with KSS to service and collect the accounts receivable it purchases in the factoring transaction. KFR will pay KSS a servicing fee at a fair market rate in an arm's length transaction. Business units that do not have shared services perform their credit and collection functions will continue to service their own accounts receivable and will be reimbursed by KSS for these services . . . ." E&Y prepared an Excel spreadsheet to assist in calculating the necessary weekly and monthly entries and support documents for the transactions.
95. Kellwood compensated E&Y for the Factoring Strategy on the basis of 40 percent of the amount of Kellwood's first full-year's tax savings.
Formation of KFR and KSS
96. On November 23, 1999, consistent with the Factoring Strategy and in order to continue the direction toward centralization of financial administration and managerial functions, Kellwood management authorized the formation of two wholly-owned subsidiaries, Kellwood Financial Resources, Inc. (KFR) and Kellwood Shared Services, Inc. (KSS). As indicated by the minutes of the meeting of Kellwood's board on November 23, 1999, KFR was formed to provide factoring services to Kellwood for its receivables, and KSS was formed to provide centralized payroll, accounts payable and accounts receivable functions.
97. On December 9, 1999, KFR was incorporated under the Tennessee Business Corporation Act as a wholly owned subsidiary of Kellwood. KFR was incorporated in Tennessee because the greatest number of credit and collection employees were already located in Tennessee. The tax implications of incorporating in Tennessee as noted in the E&Y memoranda were also a factor in the decision to incorporate KFR there.
98. At the time of KFR's formation, Lawrence Hummel was elected as vice president. The officers and directors of KFR followed the corporate formalities: they adopted bylaws, obtained a federal employer identification number, obtained an employer number from the State of Tennessee Department of Labor and Workforce Development, created letterhead for correspondence, attended annual meetings of the board of directors or executed consents in lieu of the annual meetings, and opened a bank account for payroll.
99. In connection with the reorganization, the 14 employees of Kellwood's Sportswear Division claims department in Jackson, Tennessee, who were engaged in charge-back processing, were transferred to the staff and payroll of KFR. In 2002, KFR had as many as 30 credit and collection employees. KFR also entered into a lease agreement with Kellwood to lease the facility in Jackson, Tennessee, to house the KFR employees.
100. The formation of KFR and subsequent purchase of Kellwood's accounts receivable accomplished Kellwood's stated business objective of isolating the ownership of the accounts receivable into a single entity. The transfer of title to the receivables and the advance of the value of the receivables (less the discount rate) by KFR at the time of the transfer distinguished the centralization of Kellwood's credit and collection function under KFR from centralization under the Shared Services Division. KFR acted as an inside factoring company for Kellwood.
101. On December 31, 1999, Kellwood purchased all the accounts receivable on the books of several of its subsidiaries. On January 1, 2000, Kellwood contributed the purchased accounts receivable, plus its own accounts receivable, to KFR in exchange for the stock of KFR.
102. On January 31, 2000, KFR purchased all of the accounts receivable existing on the date of the agreements and accounts receivable created thereafter on a nonrecourse basis from Kellwood and its subsidiaries Halmode Apparel, Koret of California, American Recreation Products and Fritzi California. On January 5, 2003, KFR purchased all of the accounts receivable existing on the date of the agreements and accounts receivable created thereafter on a nonrecourse basis from the following business units: Biflex International, Dorby Frocks, Gerber Children's Wear and Auburn Hosiery Mills. On May 10, 2004, KFR purchased all of the accounts receivable from New Campaign existing on the date of the agreement and accounts receivable created thereafter on a nonrecourse basis. Pursuant to all of these agreements, following the initial purchase, KFR continued to purchase the receivables on a weekly basis.
103. KFR purchased net receivables from the business units. That is, gross receivables (i.e., the face value of the invoice) less charge-back reserve, trade discounts reserve, over-billing reserve and return reserve. These reserves were estimated at the time of the transfer to KFR. Such estimates were later corrected when customers made actual payments. This procedure did not affect the factoring discount. Under the terms of the agreements with the business units, KFR was required to purchase all of the business units' net receivables. The purchase price for the receivable purchased by KFR was the face value of the net receivables less the discount rate. The agreements between KFR and the business units required that KFR pay the purchase price for the receivables at the time of transfer of the receivables to KFR.
104. KFR purchased the receivables of Kellwood and its subsidiaries slowly over time so that there was ample time to train personnel to service the accounts. KFR purchased the receivables of some of Kellwood's subsidiaries at a later date because Kellwood did not previously own those subsidiaries.
105. Kellwood entered into a Revolving Credit Agreement with KFR on January 1, 2000, pursuant to which Kellwood loaned KFR the funds necessary to purchase receivables from Kellwood and its subsidiaries. KFR required funds to purchase the accounts receivable of Kellwood and its subsidiaries and borrowed from Kellwood when it was created. Also on January 1, 2000, KFR entered into a Revolving Credit Agreement with Kellwood which provided that Kellwood could borrow money from KFR when it began generating income. After KFR began to generate income, KFR loaned funds to Kellwood.
106. The record is unclear as to how long KFR borrowed from Kellwood and when Kellwood began to borrow from KFR. According to its federal form 1120, Kellwood reported KFR incurred interest expenses of $4,240,018.00 and $2,412,864.00 for the fiscal years ended January 31, 2001 and January 31, 2002, respectively. As of March 9, 2002, KFR owed Kellwood $12,992,998.79.
107. As the legal owner, KFR bore all the risks associated with the accounts receivable including the risk of nonpayment.
108. KFR was responsible for setting the total credit limits for Kellwood's customers and the individual credit limits for Kellwood's business units, which is typical of an independent factoring company. The credit manager of KFR gained information about the credit situation of Kellwood's customers through membership in a number of industry groups and organizations and subscription to various credit rating organizations. The information obtained was used to identify "monitor" and "risk" accounts and to set credit limits.
109. When customers were designated as "risk" accounts by KFR personnel, active negotiations were undertaken to reduce the terms and the amount owed to Kellwood, and a checks and balances system was put in place to insure that new credit was not extended until payments were made on existing accounts receivable. When customers were designated as "monitor" accounts, KFR personnel would monitor their credit balances more closely and more frequently and would attempt to obligate the customer to make payments prior to shipping goods. Despite the additional workload associated with "risk" and "monitor" accounts, KFR purchased those accounts receivable without recourse.
110. KFR routinely prepared monthly reports summarizing the actions that KFR took in relationship to Kellwood's customers. When customers were in financial trouble, KFR personnel would very closely monitor the relationship and would issue periodic status reports. If a significant customer was facing financial difficulties, KFR personnel would meet with them and attempt to limit Kellwood's financial exposure while preserving the relationship with the customer.
111. KFR was also responsible for collecting the amount due from customers. If the customers had either large or overdue balances, KFR personnel would contact them once a day or several times a week. KFR was also responsible for monitoring the pipeline inventory and making sure that the business units did not ship more goods to the customer until they collected corresponding amounts from current receivables.
112. KFR employees were also responsible for dealing with customer requests for charge-backs, a common practice in the apparel industry. Customers would regularly attempt to charge Kellwood for any deviation from the customer's policies such as shipping the products early or placing labels in the wrong place. Processing requests for charge-backs was an integral part of the credit and collection function because charge-backs had a significant impact on Kellwood's profits and losses. The percentage of sales price that was ultimately charged back to Kellwood ranged from two to seven percent. Customers also would use charge-backs as a method of delaying payment; they would refuse to pay an invoice until all of the requests for charge-backs associated with that invoice had been resolved.
113. KFR was also responsible for negotiating the terms of the sale (i.e., how long the customer had to remit payment). Prior to the centralization of the credit and collection function, the business units had widely divergent terms with the same customers. However, after the credit and collection function was centralized, the terms became more standard.
114. Contemporaneous with the formation of KFR, Kellwood formed another wholly-owned subsidiary to integrate the payroll, accounts payable, accounts receivable, credit and collection activities and other similar financial process improvement functions into one entity, Kellwood Shared Services, Inc. (KSS). On December 6, 1999, KSS was incorporated under the General Corporation Laws of the State of Delaware. At the time of KSS's formation, Lawrence Hummel was elected as vice president. According to Mr. Hummel, KSS "was formed to be the legal entity that was dealing with the financial behind the curtain activities that Kellwood was consolidating for [Kellwood's] divisions and subsidiaries."
115. Effective as of January 1, 2000, Kellwood transferred all of the assets, liabilities, and personnel of the shared services center to KSS in exchange for the stock of KSS. It was Kellwood's intent, by this transfer, to consolidate its payroll, accounts payable, credit and collections and process improvement functions in its Kellwood Shared Services facility in the St. Louis area. Jerry Betro, who was responsible for credit and collection in the Shared Services Division, ran the credit and collection operation for KSS.
116. KFR could not service its purchased receivables on its own. Accordingly, effective as of January 31, 2000, KFR entered into a Receivables Collection and Administrative Services Agreement with KSS whereby KSS would provide receivables collection services for KFR for a fee based upon the actual cost of the services plus eight percent. The rate of cost plus eight percent was determined based on a study completed by E&Y. In early 2004, once KFR's activities and employees were relocated from Tennessee to Missouri, KSS employees located in Missouri who had been providing services to KFR were transferred into KFR and the administrative services agreement was cancelled. At that point, then, KFR performed both the credit and collection function and the factoring function.
117. Kellwood engaged E&Y to compute an arm's length range for the cost markup that should be charged for the provision of credit and collection, accounting/data processing, payroll, human resources, and related services provided by KSS. E&Y concluded that an arm's length range for the markup was 1.08% to 18.72% with a median of 7.92% and that the most reasonable figure to choose was 8%. In accordance with the E&Y report, Kellwood and KFR compensated KSS for the services it provided at a rate of actual cost plus eight percent during the years at issue. The Division did not challenge the eight percent markup at the hearing, nor did its experts.
118. According to E&Y's memorandum, entitled "Engagement Summary," E&Y reviewed, among other services, "the provision of credit and collection services by KSS to KFR" and "the provision of credit and collection services by Kellwood, Fritzi, Halmode and ARP to KSS." Kellwood, Fritzi, Halmode, and ARP performed their own credit and collections functions from the onset of the Factoring Strategy and billed KSS for these services. As of December 7, 2005, KFR did not perform credit analysis for ARP. Kellwood intended that KFR would perform ARP's credit analysis sometime in the 2006 fiscal year.
119. As of about January 2000, employees responsible for the credit and collection function were 5 or 6 high level individuals employed by KSS and charged to KFR; 14 employees in Tennessee employed and paid by KFR; and several lower level individuals employed by the various divisions and charged to KFR.
120. Effective as of January 1, 2000, Kellwood, KFR, American Recreational Products, Inc., Fritzi California, Inc., Halmode Apparel, Inc., Koret of California, Inc., MJF Imports, Inc., New Campaign, Inc. and Robert Scott & David Brooks Outlet Stores, Inc., entered into an Administrative Services Agreement with KSS whereby KSS agreed to provide payroll, accounts payable, credit and collections, and process improvement services for a fee based upon the actual cost of the services plus eight percent. The credit and collections services referenced in this agreement were the same credit and collections services KFR provided to Kellwood and its other subsidiaries.
121. The officers and directors of KSS followed corporate formalities: they adopted bylaws, obtained a certification to do business in Missouri, obtained federal and state employer identification numbers, created letterhead for correspondence, attended annual meetings of the board of directors or executed consents in lieu of the annual meetings, and opened a bank account for payroll.
122. Effective January 31, 2000, Kellwood entered into an Administrative Services Agreement to provide legal, treasury, cash management, corporate accounting, tax, human resources, risk management, information systems support, and other corporate administrative services to KFR, KSS, and other subsidiaries. Kellwood charged the subsidiaries actual cost plus eight percent for these services.
The Ernst & Young Reports
123. As part of the Factoring Strategy, E&Y prepared a report, entitled "Kellwood Financial Resources, Inc. Analysis of Certain Intercompany Transactions Under Internal Revenue Code § 482 for the Tax Year Ending January 31, 2001" and dated March 2000 (E&Y 2001 Report). E&Y described the report as "a transfer pricing study to assist [Kellwood] in establishing and documenting arm's length terms for the provision of accounts receivable factoring services by Kellwood Financial Resources, Inc. ('KFR') to Kellwood and certain of its operating subsidiaries for the tax year ending January 31, 2001."
124. Mr. Hummel met with E&Y personnel regularly as they were conducting their study so that he would understand the process and the assumptions that E&Y personnel were making in reaching their conclusions. After establishing the qualifications of the E&Y personnel preparing the report, Mr. Hummel relied on their professional expertise in determining the arm's length discount rate for KFR's purchase of receivables from Kellwood since neither he nor anyone at Kellwood was an expert in the field of transfer pricing.
125. In this report, E&Y characterized the transactions between KFR and Kellwood as the provision of services. Utilizing internal company data and, to a lesser extent, data from third- party factoring companies, E&Y calculated the compensation to be paid to KFR for its factoring services based upon: (1) the time value of money; (2) bad debt exposure; (3) collection expense; and (4) a fixed fee. E&Y determined an arm's length value for each of these components as follows: (1) time value of money, 1.83 percent, (2) bad debt exposure, .24 percent, (3) collection expense, .10 percent, and (4) fixed fee, .89 percent. E&Y totaled these components and concluded that the arm's length terms for the sale of receivables from Kellwood and its operating subsidiaries to KFR entailed KFR purchasing the receivables from the seller at a discount of 3.06 percent off of the face value of the receivables. The report recommended that for "ease of administration and to be conservative [Kellwood] may wish to establish a discount of 3 percent."
126. Mr. Hummel accepted E&Y's recommendations and decided to use a three percent discount rate.
127. In December 2002, Kellwood engaged E&Y to update the E&Y 2001 Report for the fiscal year ending January 31, 2003. This updated study was intended to take into account changes in economic conditions that would affect the discount rate. John L. Gegg, Kellwood's tax manager, provided E&Y personnel with the information requested and verified that E&Y personnel were using the correct facts in their transfer pricing study.
128. By a memorandum dated January 15, 2003, E&Y concluded that the arm's length discount rate should be in the range of 2.13 percent to 2.69 percent The 2.13 and 2.69 percent figures were three-year averages of lower and upper quartile discount rates of purportedly comparable companies. Such discount rates had a commission component and a time value of money component. The 2.13 percent amount consisted of an average commission rate of .60 percent and an average time value of money rate of 1.53 percent. The 2.69 percent upper quartile amount consisted of an average commission rate of .83 percent and an average time value of money rate of 1.86 percent. Kellwood used a rate of 2.41 percent for the receivables purchased by KFR for the year ending January 31, 2003, which was the average of the lower and upper quartile discount rates identified by E&Y. By extrapolation, the 2.41 percent rate consisted of a commission rate of .715 percent and a time value of money rate of 1.695 percent (that is, the average of the commission and time value of money rates which comprised the lower and upper quartile discount rates).
129. Although KFR agreed to the reduction in the discount based on economic conditions, Mr. Hummel could not recall what changes in economic conditions necessitated a reduction to the discount rate. Nor could Mr. Hummel remember whether KFR purchased the accounts receivable at the 2.4 percent discount rate during the fiscal year ended January 31, 2003. Mr. Hummel also could not remember whether KFR and Kellwood amended the Receivables Purchase and Sale Agreement to reflect the lower rate.
130. Kellwood management relied on E&Y's professional expertise in the preparation of the second transfer pricing report and on its recommendation as to the range of the arm's length discount rate because no one at Kellwood had the transfer pricing expertise to determine the proper rate.
131. E&Y prepared a report, entitled "Kellwood Financial Resources, Inc. Analysis of Certain Intercompany Transactions Under Internal Revenue Code § 482" and dated January 31, 2003 (E&Y 2003 Report). E&Y described this report as "provid[ing] arm's length pricing recommendations with respect to certain intercompany transactions amongst Kellwood Company ('Kellwood') affiliates for the tax year ending January 31, 2003."
132. In the E&Y 2003 Report, E&Y states it applied two methodologies in determining an arm's length consideration for the transactions between KFR and Kellwood: (1) the Comparable Uncontrolled Transaction (CUT) method and (2) an "unspecified method."
133. According to E&Y, "[t]he CUT method evaluates whether the amount charged in an intercompany transaction is at arm's length by reference to the amount charged in comparable uncontrolled transactions." The CUT method is one of the methods prescribed by Treasury Regulation § 1.482-4(a) for determining arm's length consideration for transfers of intangible property. E&Y selected the intangible methods as the more appropriate means to analyze KFR's factoring services.
134. In applying the CUT method, E&Y identified five factoring agreements with which to compare the transactions between KFR and Kellwood. After making an adjustment for "days' float," E&Y concluded that the arm's length range of discount rates for the factoring transactions should be 2.13 percent to 2.69 percent.
135. Similar to the E&Y 2001 Report, in the E&Y 2003 Report, E&Y based its "unspecified method" upon: (1) the time value of money; (2) bad debt exposure; (3) collection expense; and (4) a fixed fee. Internal company data provided the majority of the information used by E&Y to apply this method, along with information from third-party factoring companies. E&Y concluded that the arm's length range of discount rates should be 1.82 percent to 2.61 percent.
136. As noted, E&Y recommended that KFR purchase Kellwood's accounts receivable at a discount from face value in the range of 2.13 percent to 2.69 percent, explaining that its
recommendations are primarily based on the results of the CUT analysis. The CUT method generally involves fewer and less significant adjustments to comparable data than other methods and is therefore generally accepted as the most reliable measure of an arm's length result. In addition, there is significant overlap between the results derived by the two methods and, therefore, no need to reconcile them.
Success of Centralization in KFR and KFS
137. In 2003, Kellwood hired Protiviti, a risk consulting group, to evaluate the effectiveness of the functions that were centralized in KFR. Protiviti concluded that Kellwood had a highly effective collection process. The Protiviti study indicated that "Credit and Collection also utilizes a number of best practices to produce excellent results despite the encumbrance of multiple systems." Protiviti concluded that 4 of 15 measures of KFR's credit and collection function ranked in the first quartile; 8 measures ranked in the second quartile, of which 5 were near the top of the second quartile; only 3 measures were in the third quartile; and none were in the fourth quartile.
138. The centralization of Kellwood's credit and collection function in KFR, a continuation of a process that began with the implementation of the Shared Services Division in 1998, resulted in dramatic improvements. As a result of the centralization, Kellwood management was able to obtain and review up-to-date consolidated information regarding its customers, which resulted in better control of how much credit was extended to any one customer and better control of pipeline inventory.
139. The centralization of Kellwood's credit and collection function in KFR resulted in more consistent terms with customers throughout the different business units. The centralization also accelerated the collection of Kellwood's accounts receivable, thus reducing Kellwood's DSOs, which provided an additional cash flow. DSOs dropped from approximately 62 days in January 2001 to less than 56 days in January 2004, based on data which includes subsidiaries that did not sell their receivables to KFR. In Mr. Hummel's opinion, "KFR and the centralization of the receivables was the single most important element in the reduction of the accounts receivables days outstanding."
140. The centralization of Kellwood's credit and collection function in KFR also had a positive impact on Kellwood's ability to manage its inventory. Kellwood management had up-to-date consolidated data to better manage the production of inventory by the business units.
141. Kellwood also reaped benefits from separating the business unit employees from the credit and collection function. By separating the authority of the credit and collection department from the sales departments, salesmen became better negotiators with their customers and were more able to deflect customer pressure to change the sale terms. The salesmen were now able to tell customers that they did not have the authority to change the terms.
142. The centralization also eliminated some of the inefficiencies associated with multiple parties dealing with the same customers. Kellwood was able to assign a specific credit group within KFR to a customer, which eliminated the need for multiple people to relearn the same characteristics about each customer.
143. The centralization of the credit and collection function allowed Kellwood to reduce head count, which resulted in significant cost savings. Between fiscal year 2002 and September of 2006, Kellwood reduced its head count in the credit and collection area by 25 people at the business unit level, with an increase in head count of only 5 people at KFR. The net decrease of 20 people resulted in a savings of approximately one million dollars.
144. As of the end of the 2002 fiscal year, the last year of the audit period, 26 credit and collections employees remained in the business units and 30 credit and collections personnel were employed at KFR. The credit and collections employees remaining with the business units were likely involved in charge-back functions. The charge-back function migrated to KFR on a different basis than the credit function because of the number of employees necessary to perform this function.
145. As a result of the centralization, Kellwood's cash flow improved significantly. According to a Kellwood fiscal year 2002 report, by the third quarter of 2002, the centralization of the credit and collection functions in KFR enabled Kellwood to reduce company-wide credit and collection expenses by approximately $2.8 million annually. The centralized credit and collection department reduced company-wide interest expense by approximately $1.2 million annually and freed up approximately $15 million in cash. The savings were the result of improved collection effectiveness. For the first eight months of 2002, collection effectiveness averaged 98 percent, compared to less than 93 percent prior to any centralization. The improvement is attributable to implementing best practice collection procedures and leveraging the strength of Kellwood.
146. According to an executive summary of Kellwood's credit and collections planning for the 2003 fiscal year, in comparing the 2001 fiscal year with the 1997 fiscal year, Kellwood experienced "substantial savings from the elimination of factors at six business units - Sag Harbor, Koret, New Campaign, Romance du Jour, Democracy and Dorby."
147. Kellwood terminated Koret's third-party factoring agreement because cheaper funds were available through Kellwood's credit facility. New Campaign did not sell its accounts receivable to KFR during the audit period. Kellwood acquired Dorby, Romance du Jour, and Democracy in the fiscal year ended January 31, 2001. Darby did not begin to sell its accounts receivable to KFR until January 2003. There is no evidence in the record that Romance du Jour or Democracy sold their accounts receivable to KFR.
148. Mr. Hummel was familiar with those six factoring agreements "generically," but could not recall specific terms. He believed that the percentage of receivables advanced in those agreements was approximately 75 percent. Those six business units terminated their factoring agreements when KFR became "effective" so that they could rely on KFR.
149. According to Mr. Hummel, Kellwood could have achieved its objective to better manage and control working capital by improving cash flow through better management and efficiency in credit and collection without selling its accounts receivable to KFR. Mr. Hummel also testified that it was not necessary for Kellwood to form KFR to reduce its administrative costs, that is, centralization of Kellwood's credit and collections functions in a centralized division would have accomplished the same goal. According to Mr. Hummel, a "significant reason" why Kellwood transferred its accounts receivable to KFR was to save taxes. Managing the company's expenses, including taxes, was part of Mr. Hummel's job as a Kellwood executive. Mr. Hummel did not know how much Kellwood saved in taxes by implementing the factoring strategy.
150. According to Mr. Hummel, Kellwood chose to implement the factoring strategy because it met Kellwood's objectives with respect to centralization of credit and collection and also with respect to asset-backed securitization. Kellwood evaluated factoring based on E&Y's proposal.
151. In January 2004, KFR's board of directors recommended a $20 million dividend to Kellwood. According to Mr. Hummel, the excess cash resulted from more efficient collection of the accounts receivable and the profitability of KFR. KFR's profitability resulted from its factoring income; it did not have any other income.
152. Mr. Hummel did not know if Kellwood, on a stand-alone basis, incurred taxable losses due to the expense of factoring its accounts receivable. He also did not know whether the money Kellwood saved as a result of its improved DSOs was less than the cost of factoring.
153. On March 7, 2002, Kellwood's chief financial officer, Lee Capps, reported to Kellwood's audit committee that "[t]he continued consolidation of credit and collection activities within Kellwood Shared Services has improved the accounts receivable situation."
2002 Pursuit of Asset-Backed Securitization Transaction
154. In addition to tax savings Mr. Hummel also testified that Kellwood formed KFR for "financing flexibility," that is, asset-backed securitization. Mr. Hummel identified such financing flexibility, along with tax savings, as the principal reasons for the formation of KFR.
155. Kellwood senior management gave serious consideration to entering into an asset-backed securitization transaction as an additional source of financing. Kellwood spent months negotiating with its lenders in 1999 to carve out $75 million of receivables from the revolving credit agreement to allow Kellwood to do a securitization transaction. As noted previously, Kellwood management identified the possible facilitation of a securitization transaction as a business purpose for the formation of KFR and the transfer of receivables from Kellwood to KFR. In addition, in 2000 Kellwood management had received a presentation from Bank One Company in September 2000 on the "Fundamentals of Securitization."
156. In December 2002, Kellwood treasury personnel forecasted future cash flow and borrowing needs and became concerned that Kellwood might need additional cash even if it did not make any additional acquisitions.
157. Kellwood personnel evaluated the asset-backed securitization proposals that it received from Banc One and Scotia Capital. Kellwood personnel analyzed the costs of an asset-based securitization program and contrasted it with other types of financing. Kellwood personnel also analyzed whether the addition of an asset-backed securitization facility would jeopardize any of its bank covenant agreements. After performing a cost/benefit analysis of entering into an asset-backed securitization program, treasury personnel recommended that Kellwood put an asset-backed securitization facility in place in order to give Kellwood a buffer in the event of unforeseen expenditures.
158. Kellwood treasury personnel indicated that the "Administrative Fee" also known as the "Program Fee," had been reclassified from a fixed fee to a variable (usage) fee. The result of this change was that the additional expense of approximately $130,000.00 for an unused asset-backed securitization program disappeared, and therefore, establishing the asset-backed securitization facility was not any more expensive than having additional commitments in the 2002 Credit Facility. If the fee had not been reclassified, the ABS facility would have been more expensive than the credit facility. Banc One indicated that it could offer a slightly better interest rate than Scotiabank, so treasury personnel recommended establishing the $75 million asset-backed securitization facility with Banc One.
159. On February 4, 2003, John Bruenger, assistant treasurer of Kellwood, entered into an agreement with Banc One whereby Banc One would provide Kellwood with an asset-backed securitization facility under certain terms and conditions.
160. As of April 21, 2003, Kellwood intended to implement the ABS program. In the treasury department memorandum indicating Kellwood's intention, John Bruenger states that the accounts receivable to be made part of the ABS program included Sag Harbor, Menswear, Intimate Apparel Group, and Kellwood Distribution Division. Sag Harbor, Menswear, Intimate Apparel Group, and Kellwood Distribution Division are divisions of Kellwood.
161. At some point thereafter, Kellwood management became concerned about the securitization transaction with Banc One after the bank altered the terms of the transaction by reducing the amount of money that Kellwood would be able to borrow against its receivables. Banc One proposed an advance rate of 50 percent or less, which meant that in order to borrow $75 million, Kellwood would need to secure an average of $150 million of its accounts receivable. Banc One also added covenants to the agreement that were unacceptable to Kellwood. Additionally, Kellwood was advised by Bank of America that an ABS was "not the most efficient way to raise long-term capital." As a result of the changes to the terms, in June 2003 Kellwood decided not to enter into an asset-backed securitization transaction.
162. Kellwood management was aware that KFR was not a bankruptcy-remote entity at the time it was created and that securitization required a bankruptcy-remote entity.
Expert Testimony Regarding Business Purpose and Economic Rationale
163. Kellwood retained Deloris R. Wright, Ph.D. (Dr. Wright) to render an expert opinion about the arm's length factoring fee for the factoring transactions between KFR and Kellwood (see Findings of Fact 189-198). Dr. Wright testified that part of her evaluation as an economist of an intercompany transaction requires an analysis of whether the transaction has a business purpose and has substance, which examines the functions and risks of the entity, and what value it adds. If the transaction lacks either a business purpose or substance, then her analysis of the transaction ends. Dr. Wright's analysis with respect to economic substance focused on the entities, that is, "whether or not KFR would be an entity that would be respected for tax purposes."
164. Dr. Wright performed a detailed analysis of the KFR transaction, examining documents and intercompany agreements and conducting interviews. Dr. Wright concluded that Kellwood's business purposes for the formation of KFR were a logical step in its centralization of the credit and collection function and to provide a way to facilitate a securitization of its accounts receivable. According to Dr. Wright, these business purposes were typical of other situations Dr. Wright had analyzed and were sufficient to justify continuing her arm's length analysis.
165. Dr. Wright's opinion concerning business purpose was not affected by the fact that Kellwood did not securitize its receivables, but would have been affected if there was insufficient evidence that the company was serious in its consideration of a securitization. In Dr. Wright's experience, companies often consider transactions that do not ultimately take place.
166. Concerning substance, Dr. Wright concluded that KFR had substance, performed the functions and assumed the risks of a factor, and added value. Dr. Wright based this conclusion in part on the fact that KFR had a significant number of employees doing the KFR functions.
167. The Division retained Dr. Alan C. Shapiro, Ph.D., to analyze the transfer of accounts receivable from Kellwood to KFR and other transactions related to the accounts receivable between Kellwood and its subsidiaries. Dr. Shapiro also analyzed the avowed business purposes of the receivables transactions. Dr. Shapiro prepared a report entitled "Economic Analysis of Kellwood Company's Transfer of Accounts Receivable to Kellwood Financial Resources," revised February 15, 2007 (the Shapiro Report).
168. Dr. Shapiro is the Ivadelle and Theodore Johnson Professor of Banking and Finance at the Marshall School of Business, University of Southern California. Prior to joining the Marshall School, Dr. Shapiro taught at numerous other universities and has also conducted many in-house training and executive programs in corporate finance and international finance and economics for corporations, government agencies, and law firms. Dr. Shapiro has published several books on corporate finance and many articles in academic and professional journals. Dr. Shapiro has also written in the area of securitization. In 1993 Business Week named Dr. Shapiro one of the ten most in-demand business school professors in the United States for in-house corporate executive education programs.
169. Dr. Shapiro based his opinions in the Shapiro Report on his professional knowledge and experience and certain documents provided to the Division during and after the audit. Dr. Shapiro testified at hearing and was accepted as an expert in economics and corporate finance.
170. In the Shapiro Report, Dr. Shapiro reviewed the factoring industry and determined that factoring may make economic sense for those companies that "have limited access to other sources of financing, have high capital requirements, have a lot of capital tied up in accounts receivable, have few sources of credit information regarding their customers, do not benefit from the retention of control over trade credit policies, outsource their sales functions, are not well-equipped to bear risk, and whose receivables are risky." Dr. Shapiro also determined that "factoring may not make economic sense for a company that has access to other sources of capital, has low working capital requirements, has a small number of large customers (making customer relationships and retention of control over trade credit policies more valuable as well as simplifying the gathering of credit risk information), uses its own sales force, and either is well-equipped to bear risk or has receivables that carry little risk."
171. Dr. Shapiro concluded that "[f]actoring did not make economic sense for Kellwood due to its access to other sources of capital that were much less expensive, its reliance on a small number of large customers, the lack of risk associated with its receivables, and the importance of information sharing between its selling and credit policy personnel."
172. Dr. Shapiro analyzed the business purposes provided by E&Y in its "Business Purpose" memorandum, dated December 31, 1999, which was provided to the Division during audit. Dr. Shapiro concluded that there was no connection between E&Y's listed purposes and the factoring transactions. He also concluded that no actual segregation of the accounts receivable occurred; that is, the only change from the status quo was that KFR would now own the receivables. Dr. Shapiro also looked at E&Y's stated purposes relating to securitization and found no evidence in the documents he reviewed that KFR was a bankruptcy remote entity or that KFR had the ability to securitize Kellwood's accounts receivable.
173. As a result of his analysis, Dr. Shapiro concluded that the transfers of title to the accounts receivable to KFR lacked economic rationale.
174. In his report, Dr. Shapiro also concluded that there was no economic rationale or business purpose for centralizing Kellwood's credit and collection function. In reaching this opinion summarized in his report, Dr. Shapiro believed that the principal reason Kellwood had entered into the transactions was to save taxes.
175. After hearing testimony and reviewing documents, Dr. Shapiro changed his expert opinion to conclude that there was an economic rationale and business purpose for the centralization of Kellwood's credit and collection functions. Dr. Shapiro conceded that he had "heard testimony and had the opportunity to look at some documents which certainly suggested to me that Kellwood was able to achieve a variety of cost savings and cash generation through the centralization of credit, the credit and collection functions."
176. In reaching the conclusion contained in his report, Dr. Shapiro admitted that he had relied on E&Y documents, some of which were not accurate, and that he had not taken into account that Kellwood's different business units had common customers which led to economies of scale in centralizing the credit and collection function.
177. Dr. Shapiro did not change his opinion that transferring title to Kellwood's receivables to KFR lacked an economic rationale and a business purpose.
178. Dr. Shapiro believed that in late 2002 Kellwood needed additional sources of funds and was seriously considering securitization. Dr. Shapiro also acknowledged that Kellwood made a serious attempt to compare the costs of financing via a line of credit, which he presumed was Kellwood's principal alternative, with the cost of the securitization transactions proposed by Scotia Bank and Banc One. In contrast, testifying that he did not see documents evidencing a similar analysis regarding a possible securitization transaction at the time KFR was set up, Dr. Shapiro concluded that Kellwood was not serious about using KFR as a vehicle for securitization. This conclusion impacted Dr. Shapiro's opinion that the KFR transactions lacked a business purpose and an economic rationale.
179. Dr. Shapiro acknowledged that Kellwood had negotiated a $75 million carve-out of accounts receivable from its bank credit agreement in August 1999 to allow Kellwood to do a securitization transaction and that the August 1999 credit agreement Kellwood entered into with its bank was negotiated for a significant amount of time prior to that date.
180. Dr. Shapiro testified that a company could outsource its credit and collections function without selling its accounts receivable. Dr. Shapiro explained that accounts receivable are different from tangible commodities in that accounts receivable are promises to pay. A company can transfer information about its accounts receivable, title to those receivables, or both. To engage in credit and collections, all a company needs to transfer is information about the receivables, not title.
181. As an example, Dr. Shapiro noted a factoring agreement involving the Tommy Hilfiger Corporation pursuant to which Hilfiger's factor did not provide financing, only credit and collections services. That is, upon collection of the receivables the factor would provide the collected cash to Hilfiger, but it did not take title to the accounts receivable until it actually paid Hilfiger.
182. Dr. Shapiro concluded that Kellwood could have centralized its credit and collections functions without having to transfer title to its accounts receivable to KFR and, in fact, did this in 1998 when it started the shared services division to provide centralized credit and collections services.
183. Dr. Shapiro testified that any shifting of risk associated with selling Kellwood's accounts receivable to KFR was ultimately shifted back to Kellwood since Kellwood financed KFR's purchase of the accounts receivable. In addition, Dr. Shapiro noted that even when KFR began to loan money to Kellwood under the Revolving Loan Agreement, Kellwood ultimately bore the risk, that is, had it not been for the factoring arrangement Kellwood would have retained those funds.
184. Dr. Shapiro explained that a bankruptcy-remote entity is an entity "set up to receive assets from another entity. The bankruptcy-remote entity, or SPE, would issue securities. The investors in those securities would look solely to the cash flow generated by those securities for satisfaction of its debts." Dr. Shapiro noted that a bankruptcy remote entity can only engage in activities granted to it in its organizational documents and concluded that, in his opinion, KFR would not qualify as a bankruptcy-remote entity because it engaged in credit and collections activities.
185. Dr. Shapiro agreed that companies do look for alternative sources of financing. In his opinion, if Kellwood was serious about using KFR as a vehicle for securitization he would have expected to see analysis, that is, a comparison of the costs of asset backed securitization with the costs of financing with a line of credit, similar to the analysis Kellwood conducted in 2003 when it received offers from Scotia Bank and Banc One.
186. Dr. Shapiro further testified that Kellwood did not need to transfer title to its accounts receivable to KFR to engage in securitization. A company could centralize its credit and collections function to determine the quality of its receivables and then transfer only those creditworthy accounts receivable in the amount necessary to obtain the amount of desired financing to an asset-backed securitization facility. Instead of transferring title first to KFR and then from KFR to a bankruptcy-remote entity, Kellwood could have transferred title directly to a bankruptcy-remote entity and avoided the additional step of transferring title to KFR. In Dr. Shapiro's opinion, Kellwood created a "convoluted structure" to engage in asset-backed securitization.
187. In Dr. Shapiro's opinion, considering that, through 2003 Kellwood loaned KFR the money it used to buy Kellwood's receivables, KFR was not a source of financing for Kellwood because of the circularity of cash flows. Dr. Shapiro also testified that, even after KFR became a net lender to Kellwood, KFR was not a source of net new financing for Kellwood.
188. In response to the Shapiro Report Dr. Wright prepared a report entitled "Review of Expert Report of Allan [sic] C. Shapiro, Ph.D.," revised March 15, 2007 (the Wright-Shapiro Report). In the Wright-Shapiro Report, Dr. Wright concluded that
[her] experience in transfer pricing audits around the world is that the questions raised by Dr. Shapiro are not relevant to determining whether a legitimate business purpose existed for the creation of KFR. That said, it is clear that Kellwood had several legitimate business purposes for the creation of KFR, and therefore KFR must be respected.
Expert Testimony Regarding Arm's Length Pricing of Transactions
The Wright Report
189. Kellwood presented the testimony and written report of Dr. Wright to support the arm's length fees charged by KFR to Kellwood for the factoring services. Dr. Wright has a bachelor of science in business with a major in economics from Oklahoma State University and a Ph.D. in economics from Iowa State University.
190. Since earning her doctorate degree in economics, Dr. Wright was an assistant professor of economics at Auburn University from 1973 to 1976. She was then an assistant professor of economics at Southwest Missouri State University from 1976 to 1979 and was promoted to associate professor prior to her departure.
191. Early in her career, Dr. Wright joined the Chicago district office of the Internal Revenue Service as an industry economist where she audited corporations' transfer pricing policies. Transfer pricing refers to the pricing terms for transactions between legal entities within multinational corporation that are governed by IRC § 482.
192. Following her tenure at the Internal Revenue Service, Dr. Wright joined the accounting firm of Coopers & Lybrand where she was charged with developing and managing the transfer pricing practice globally. During her time at Coopers & Lybrand, Dr. Wright performed transfer pricing work for a number of clients in the apparel industry.
193. Dr. Wright left Coopers & Lybrand and became the vice president of Charles River Associates, an economics consulting firm, where she led the transfer pricing practice. During the course of Dr. Wright's career, she has performed work for corporations and the governments of Australia, New Zealand, Malaysia, Canada, Taiwan, as well as for the Internal Revenue Service.
194. Dr. Wright is currently a managing principal of the Analysis Group and has served as the head of the transfer pricing practice since August of 2001. She has almost 30 years of experience working in the transfer pricing field.
195. Dr. Wright speaks frequently on transfer pricing subjects and has written a plethora of articles and two books on transfer pricing, one of which is The U.S. Transfer Pricing Guide. Dr. Wright is currently the chairman of the IBFD Transfer Pricing Advisory Board and also serves on the editorial board of the International Transfer Pricing Journal.
196. Dr. Wright was engaged to determine an arm's length factoring fee for the factoring transactions between KFR and Kellwood that began in January of 2000. Kellwood engaged Dr. Wright when it was audited by New York State to get a second opinion about whether the discount rates that Kellwood used, i.e., the rates recommended by E&Y, were within arm's length ranges. Specifically, Dr. Wright was engaged in February 2005 to prepare "a complete transfer pricing study to develop documentation sufficient to support the discounted price of the accounts receivable that KFR purchases from the operating divisions within the Kellwood group." Dr. Wright prepared a report, entitled "Expert Report of Dr. Deloris R. Wright" and dated May 10, 2006 (the Wright Report).
197. Dr. Wright testified that Kellwood engaged her to determine the arm's length discount rates, not defend the rates already being used. Dr. Wright knew the actual discount rates Kellwood used during the audit period from the beginning of her engagement. Dr. Wright's engagement with Kellwood was the first time she has been engaged to determine arm's length pricing for a factoring transaction between related parties. Dr. Wright testified that she was not an expert in securitization.
198. Dr. Wright was accepted as an expert in economics, transfer pricing and Internal Revenue Code (IRC) § 482.
199. Dr. Wright testified that both of the E&Y reports set forth the proper arm's length transfer price despite the fact that she did not agree with the methodologies used. Dr. Wright opined that the reduction of the discount rate from 3 percent in the first years to 2.4 percent in the remaining years was required because interest rates were dropping generally.
200. In Dr. Wright's opinion, a typical business person would not possess the requisite knowledge of IRC § 482 to see the flaws in the E&Y transfer pricing methodologies employed in the reports.
201. The first step in Dr. Wright's analysis of KFR's purchase of accounts receivable from the various business units was to conduct an industry analysis of both the apparel and factoring industries. An industry analysis is conducted to obtain a better understanding of the industries. Despite Dr. Wright's knowledge about the apparel industry, she conducted additional research and reviewed numerous documents provided by Kellwood.
202. Dr. Wright's industry analysis revealed that factoring is very prevalent in the apparel industry. In 2003, approximately 60 percent of all factoring was done by apparel companies.
203. The second step in Dr. Wright's analysis of KFR's purchase of accounts receivable from various business units was to conduct a functional analysis. As noted previously, as a threshold issue, Dr. Wright examined the transactions and concluded that Kellwood had a business purpose for selling its receivables to KFR and that the transaction had economic substance.
204. In analyzing the business reasons for the transaction, Dr. Wright was not troubled by the fact that Kellwood had not yet entered into an asset-backed securitization transaction because it was clear that Kellwood was seriously considering it.
205. According to Dr. Wright, the business purposes that Kellwood executives articulated for the KFR transaction were consistent with those cited by companies that factor with third parties.
206. As part of her functional analysis, Dr. Wright reviewed all the operative documents and relevant SEC filings, traveled to Kellwood's corporate headquarters, and interviewed executives of KFR and Kellwood to understand the facts surrounding the creation of KFR and KSS and the sale of accounts receivable to KFR. As a result of her functional analysis, Dr. Wright concluded that factoring was a logical extension of Kellwood's process of centralizing some of its back office services such as credit and collection.
207. Based on the facts derived from the functional analysis, Dr. Wright concluded that KFR provided factoring services to Kellwood and must receive arm's length compensation for those services. Dr. Wright then sought to determine whether factoring agreements from closely comparable uncontrolled transactions were available. Dr. Wright examined the functions and risks of an independent factor and compared them to the functions that KFR performed and the risks it assumed. Dr. Wright determined that KFR performed the functions and assumed the risks of an independent factor.
208. The only differences that Dr. Wright noted in comparing KFR to independent factors are that KFR advanced 100 percent of the net receivables and KFR purchased 100 percent of the accounts receivable on a nonrecourse basis. Dr. Wright noted that these differences resulted in KFR's assuming more risks than an independent factor, which differences would need to be accounted for with adjustments to the discount rate.
209. The third step in Dr. Wright's analysis of KFR's purchase of accounts receivable from the business units was to select the best transfer pricing method under the IRC § 482