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STATE OF NEW YORK DIVISION OF TAX APPEALS ________________________________________________ In the Matter of the Petition of
KELLWOOD COMPANY 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:
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:
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
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:
77. E&Y described the "tax strategy" of the transaction as follows:
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:
81. Tax savings, according to E&Y, resulted from the following:
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:
89. The business purposes for KSS set forth in the memorandum included the following:
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:
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