Commissioner v. Claus, a Redux

'Twas the night before Christmas and all through the land, the holiday spirit was one certainly grand.

The scene at the Internal Revenue Service (in 1993), however, was altogether different. IRS officials were busy discussing the “Santa Claus problem”: Was the eccentric old man and his closely held Santa's Workshop taxable in the U.S.? Strong arguments were being made that this year would prove different.

One IRS official was heard to say, "We have to make an example of the old man and his business. How can we go after other foreign businesses operating in the U.S. when Santa's Workshop goes untaxed?"

So began a Christmas tale, in a 1993 Tax Notes International article, co-authored by  MFR’s tax director, Bill Leary: “Commissioner v. Claus: A Lesson For Foreign Nationals Doing Business in the United States” (93 TNI 248-18).

After all these years, the case is still not closed.  The only difference is that 17 years ago when this issue first came to light, some of today’s advocates for the government were asleep waiting for the jolly old man to visit their houses, eat cookies and leave presents.  Today, they have become vigorous enforcers of the country’s tax laws and, in some cases, have become elected officials.  

Added to the today’s controversy are state sales tax collectors and Homeland Security officials, in addition to Customs officials that can no longer turn a blind-eye to the old man’s massive importations and questionable use of free-trade zones for restocking.  Foreign revenue authorities keep talking about the VAT consequences of Christmas imports.

The Case against Santa Claus and His Workshop

The issue at hand was whether this North Pole resident and the closely held Santa's Workshop have been "engaged in trade or business" in the U.S. A key element of the IRS case is that the North Pole, the purported place of residence of Mr. and Mrs. Claus and Santa's Workshop, has no income tax treaties to mitigate U.S. taxes.

One would think that Santa Claus is the paragon of a "commercial traveler," being present in the U.S. only one day a year. Not so, according to IRS officials who years ago reminded us that, no treaty is involved here and given his demanding schedule, the old man must make well in excess of $3,000 for his one night of work. In addition, Customs and Immigration has no record of the many public appearances he has made. For all we know, Santa's been in the U.S. long enough to qualify as a resident alien for tax purposes. Rumors are currently circulating that he and his wife are spending longer and longer vacation in a Disney property in Florida.  And yet after all these years, IRS records show that he has never filed an income tax return.

Many estate tax advisors are concerned about how their clients’ estates will be taxed in the event of their death.  “Getting one’s hands around Santa’s estate would overload the capabilities of the existing service provider system and short-circuit the IRS,” according to a confidential source close to Santa.   

In 1993, although the IRS conceded that Claus and Santa's Workshop did not have an office or other fixed place of business in the U.S., it contends that Claus nevertheless had a U.S. trade or business by virtue of his "regular and continuous" activities in this country over a period of many years. According to the IRS, these activities included, but were not limited to, the storage of raw materials and finished product, numerous "personal appearances" and the delivery and installation of products in many private residences. 

Most recently, new delivery logistics apparently have caused finished goods to be stored in various strategic locations throughout the United States – some in free-trade zones and others in special state incentive zones – thereby complicating his tax position.

An IRS official observed that, "The Claus group operates an integrated marketing and sales organization with activities in all 50 states and the District of Columbia. Let's face it: They have agents all over.  If we look hard, we are likely to find numerous partnership arrangements for which U.S. withholding is required.” The short-term facilities set-up in stores makes offices available to Claus yearly and in some locations for almost 2 months not counting set-up time."  And then there are all his compensated special appearances where there should be withholding on his earnings.  Few Americans would even think of securing a W-7 or W-8 from Santa and withholding on his compensation.    

Most recently Internet orders have sky-rocketed, and, with that, arose a high-tech network purchase and inventory management system centered in California.  Newly-created positions in some sectors of the organization are being increasingly filled by former “dot-com” techies, rather than elves.

The case against Santa's Workshop also may raise transfer pricing issues.  According to one IRS official, "Creating a legal precedent against Santa's Workshop will make it a lot easier to pursue an action against treaty and non-treaty residents benefiting from the U.S. markets but paying no tax to the U.S."   We understand that the IRS is focusing on possible commercial links between Santa's Workshop and thousands of apparently independent commercial businesses in the U.S. 

Today, one has to wonder whether there are related party transactions with the Santa network that need to be disclosed to the IRS.  If so, the required supporting documentation might be difficult or impossible to develop.  In addition, the IRS would be most interested in securing related party agreements to determine whether they are truly "arm’s length.”  Who can even imagine that Santa would consider entering into self-serving arrangements?  If you even think it is possible, avoid looking in your Christmas stocking.

The IRS also is evaluating whether Santa's Workshop and Santa himself should be reporting royalty income for the use of Santa's name and other intangibles. It is unlikely that sufficient control could be established in this case to apply Code Sec. 482, but the
economic integration cannot be overlooked.

Separately, the IRS is reviewing whether Santa Claus received fees for his appearance and use of his name in the film, "Miracle on 34th Street." What they are looking for here, at a minimum, is unpaid U.S. withholding tax.

Possible Congressional Action

Given the present political tensions in Washington in 2010, it is unlikely that any agreements can be reached; no matter how many times "Miracle on 34th Street" is re-broadcast in the Capital.  Obviously, a public hearing is not in the cards.  

Other Developments

State officials were watching the IRS with glee. "Let the IRS do the leg work," a South Carolina revenue official said in 1993, “and all 50 states will benefit. Not only can we tax the Claus people directly and raise a significant amount of sales tax revenue, but we also may be able to tax the Workshop. If we can get 'Toys R Us,' we can get the Workshop." California also is evaluating the tax implication of Claus's U.S. activities as part of a worldwide unitary business.

After 17 years, numerous other states looking for revenues anywhere are focusing their attention on taxing Santa and his network in whatever way possible.

Customs officials have said that, although some of the goods distributed by Santa have been "round-tripped" from the U.S. to the North Pole and back again, Santa's helpers have been adding significant value that, according to Customs records, has gone untaxed. And then, there's the problem of all the foreign purchased goods that Santa imports directly.

IRS officials would not comment publicly on Mrs. Claus' U.S. income tax exposure, but they unofficially remarked that, "There is no basis for an innocent spouse defense; she's an integral part of his Christmas thing and knows everything.  Who thinks about “Clyde” and not “Bonnie?”   

Final Thoughts

“It is possible that foreign taxpayers have taken too much comfort in the lack of closure in the case of Santa,” according to Bill Leary.  “Over the past seventeen years, the IRS has vigorously pursued actions against foreign taxpayers with far less connections and activities in the U.S.  We all know that despite the law, Santa has to be dealt with as a ‘political hot potato.’  No one wants to see the old man in court for tax matters.  Other taxpayers have not been as lucky.”