Document Number
02-127
Tax Type
Corporation Income Tax
Description
Virginia combined income tax return
Topic
Accounting Periods and Methods
Appropriateness of Audit Methodology
Date Issued
10-06-2002

October 6, 2002


Re: § 58.1-1821 Application: Corporate Income Tax


Dear *****:

This will reply to your letters in which you contest the corporate income tax assessments issued to your client, ***** (the "Taxpayer") and its affiliates for the taxable years ended December 31, 1992 and 1993. I apologize for delay in the Department's response.

FACTS


The Taxpayer and its Virginia affiliates (the "Virginia Group") filed combined Virginia income tax returns for the 1992 and 1993 taxable years. The Virginia Group was audited and several adjustments were made.

One of the adjustments disallowed special management fees, which had been allocated to the Virginia Group by its parent corporation (the "Parent"). The auditor found that such allocation improperly reflected Virginia taxable income. The Parent granted nonqualified stock options to a number of its employees and the employees of its subsidiaries in 1989 in connection with a leveraged buy out. When a substantial number of stock options were exercised in 1992 and 1993, the Parent recognized large deductions related to these options for income tax purposes. In addition, the Parent incurred significant debt with regard to the leveraged buyout. These expenses were allocated among the Virginia Group as a special management fee. The interest paid on this debt was allocated to operating units based on relative net value.

Two methods were used by the Parent to allocate the special management fee. A portion of the expense was allocated to the subsidiaries in proportion to the compensation of employees assigned to the operating unit. The larger portion of the stock option compensation was allocated to operating subsidiaries in a manner similar to management fees.

Among the other adjustments, the auditor disallowed the payroll reported in the numerator of the payroll factor for one of the Virginia affiliates (the "Affiliate") for the 1993 taxable year on the basis that the employees are on the payroll of another subsidiary (the "Employer"). Also, the auditor estimated 1993 Virginia sales for purposes of the sales factor because actual gross receipts for sales were not provided at the time of the audit.

The Taxpayer has contested these assessments. These issues will be addressed separately below.

DETERMINATION


Improper Reflection of Income

Code of Virginia § 58.1-446 provides, in pertinent part:
    • When any corporation liable to taxation under this chapter by agreement or otherwise conducts the business of such corporation in such manner as either directly or indirectly to benefit the members or stockholders of the corporation .... by either buying or selling its products or the goods or commodities in which it deals at more or less than a fair price which might be obtained therefor, or when such a corporation . . . acquires and disposes of the products, goods or commodities of another corporation in such manner as to create a loss or improper taxable income, and such other corporation . . is controlled by the corporation liable to taxation under this chapter, the Department . . . may for the purpose determine the amount which shall be deemed to be the Virginia taxable income of the business of such corporation for the taxable year .
    • . . . In case it appears to the Department that any arrangements exist in such a manner as improperly to reflect the business done or the Virginia taxable income earned from business done in this Commonwealth, the Department may, in such manner as it may determine, equitably adjust the tax. (Emphasis added.)

It has been the Department's policy to make determinations based on statutes and regulations in force during the tax period for which the taxpayer is seeking relief. Therefore, Virginia Regulation ("VR") § 630-3-446, effective January 1, 1985, is the applicable regulation for the 1992 taxable year. VR § 630-3-446 provides in pertinent part:
    • Parent corporations and subsidiaries. When any corporation liable to taxation under this chapter owns or controls . . . another corporation the Department may require the corporation liable to taxation to make a report consolidated with such other corporation and furnish such other information as the Department may require. If the Department finds that any arrangements exist which cause the income from Virginia sources to be inaccurately stated then the Department may equitably adjust the tax of the corporation liable to taxation under this chapter. (Emphasis added.)
    • The conduct or manner in which business is conducted reached by this section is not restricted to the case of improper accounting, to the case of a fraudulent, colorable, or sham transaction or to the case of a device designed to reduce or avoid tax by shifting or distorting income, deductions, credits or allowances. The conduct may be legal or even encouraged by the laws of other jurisdictions, including laws of the United States. The determining factor is whether the conduct of taxpayer's affairs bar inadvertence or design causes the income from Virginia sources to be inaccurately stated. (Emphasis added.)

Effective for taxable years beginning on or after January 1, 1993, the Department issued expanded regulations related to the application of Code of Virginia § 58.1-446. In 1996, the Department's regulations were renumbered and included in the Virginia Administrative Code ("VAC"). Hence, Code of Virginia § 58.1-446 is regulated by 23 VAC 10-120-360, 361, 362, 363, and 364. Specifically, 23 VAC 10-120-361(C), which is the applicable for the 1993 taxable year, sets forth the factors that would create a rebuttable presumption that income from business done in Virginia is distorted. These factors include, but are not limited to:
    • 1. Whether intragroup services are rendered or received without adequate consideration;
      2. Whether a member of the group has a significant amount of capital gains, interest, dividend, or similar income, with only minimal capital, activity, or expenses because essential corporate functions are performed for the group member by other group members without an arm's length charge;
    • 3. Whether there are significant intragroup lending transactions other than those described in subdivision E 3 of this section, especially where the lending party has no other significant activity, and the source of funds is either (i) dividends or capital contributions by other members of the group, if a substantial portion of the funds received is loaned to any member of the group within 24 months of the dividend or contribution and the loan provides working capital to the borrower; or (ii) borrowed funds guaranteed by, or secured by the property of, a group member other than the lending party;
    • 4. Whether tangible or intangible property was contributed to or acquired from a group member in anticipation of a sale to an unrelated party;
    • 5. Whether the accounting records of a group member adequately reflect the unconsolidated information required for the Virginia income tax returns of group members with Virginia nexus; or
    • 6. Whether a corporate group engages in such a high level of transactions which are not made on an arm's length basis that separate or combined group return filing cannot accurately represent the group's income from business done in Virginia.

The Virginia Supreme Court's opinion in Commonwealth v. General Electric Company 236 Va. 54 (1988) upheld the Department's authority to equitably adjust the tax of a corporation pursuant to Code of Virginia § 58.1-446 (or its predecessor) where two commonly owned corporations structure an arrangement in such a manner as to improperly, inaccurately, or incorrectly reflect the business done in Virginia or the Virginia taxable income. Generally, the Department will exercise its authority if it finds that a transaction, or a party to a transaction, lacks economic substance.

Management Fees

The Taxpayer asserts that the allocation of the stock option expense and the related interest expense is proper and is required under federal consolidation rules in order to properly reflect Virginia taxable income. Under Treas. Reg. § 1.1502-12, the separate taxable income of a member (including a case in which deductions exceed gross income) is computed in accordance with the provisions of the Internal Revenue Code ("IRC") covering the determination of taxable income of separate corporations with certain modifications. The Taxpayer avers that the allocation of the stock option and interest deductions is required to accurately reflect the separate taxable income of each member included in the Virginia consolidated return.

Because the Virginia Group does not file a Virginia consolidated return and the Parent is not a member of the Virginia Group, the Taxpayer's argument concerning the regulations for federal consolidated returns is inapplicable.

However, the Department has addressed the issue of management fees in Public Document ("P.D.") 97-132 (3/19/97). In this ruling, the Department recognized that the taxpayer would have had to either engage an outside firm to perform the essential corporate services or develop its own in-house capability. Because no intercompany profit was incorporated into the overall management fee charged by the parent, the Department allowed the deductions. The Department concluded that a cost reimbursement arrangement between related parties, without any intercompany profit, could not be characterized as one that distorts Virginia taxable income.
In P.D. 97-132, the costs grouped under the management fees were similar to those normally allocated by the Parent to the Virginia Group. In fact, the Parent has shown a history of allocating overhead expenses to its subsidiaries through management fees. The fees are for services provided for the benefit of operating subsidiaries and include accounting, legal, data processing, finance, tax, corporate planning, and corporate relations. The Department made no adjustment to these management fees.

Stock Option Expense

Based on the Tax Commissioner's determination in P.D. 97-132, the Virginia group is entitled to deductions for the stock options expense that relates directly to compensation for the employees and officers of the members of the Virginia Group. In addition, the stock option expense attributable to the Parent's employees is part of the costs incurred by the Parent to provide the services mentioned above to the Virginia Group. Accordingly, the special management fee deduction for the stock option expense for the 1992 and 1993 taxable years will be allowed.

Interest Expense

In addition, the management fee in P.D. 97-132 included a charge for interest expense on loans obtained by the parent whose proceeds were utilized on behalf of the taxpayer. However, under P.D. 97-132, the interest expense was only allowed on loans from which the proceeds were utilized on behalf of the taxpayer. In P.D. 97-132, the taxpayer was able to show that the interest incurred by the parent directly benefited the taxpayer. In this case, it is not clear that interest resulting from the leveraged buy out would meet this criterion. As such, the allocation of the interest portion of the special management fee will not be allowed.

Payroll Factor Adjustment

You contend that the payroll that was filed on the returns of Employer, a common payroll agent, should be included in the numerator of Affiliate's payroll factor.

The Department has previously ruled that wages paid by a parent corporation are not included in the payroll factor of a subsidiary, despite bookkeeping allocations by the parent corporation to the subsidiary for a portion of the expense. See P.D. 90-17 (1/11/90).

There is a strong presumption that total wages reported to Virginia for unemployment compensation purposes represent compensation paid or accrued in Virginia. See 23 of the VAC 10-120-190. The Virginia Unemployment Compensation Act (Code of Virginia § 62.1 et. seq.) does not provide for any type of common paymaster arrangement. Each employer is separately liable for taxes on its wages. Accordingly, a common paymaster arrangement is not recognized for purposes of determining Virginia apportionment.

No compensation was reported by the Affiliate for Virginia unemployment compensation tax purposes. Rather, wages attributed to Affiliate were reported by Employer. You now attempt to attribute a portion of the compensation attributed to Employer for corporation income tax purposes. The Department's policy on this issue is clear. A taxpayer may not attribute wages to one corporation for Virginia Unemployment Compensation ("VEC") purposes and to another corporation for income tax purposes; reporting must be consistent. See P.D. 93-116 (4/29/93). The manner of reporting with the VEC is not inconsequential, as the experience rating of each taxpayer determines its tax rate. Because no compensation was reported to the VEC by Affiliate, it will have no payroll factor in Virginia.

Furthermore, services provided by employees of other corporations and stewardship services performed by officers of a taxpayer do not constitute compensation paid by such taxpayer's affiliates. While you contend that the overlapping officers performed services in Virginia for Affiliate, it is clear from the VEC reports that the overlapping officers performed these functions in their capacity as employees of Employer, not as officers of Affiliate. It is, therefore, likely, though not addressed in this audit, that Employer had income from Virginia sources and sufficient business activities in Virginia that would subject the income of Employer to Virginia tax. When a taxpayer's employees perform services on behalf of a third party, regardless of what those services may be, the taxpayer will be considered to be conducting activities in Virginia that exceed the protection of P.L. 86-272. See P.D. 00-160 (8/28/2000).

Sales Factor Adjustment

The auditor estimated Affiliate's 1993 Virginia sales for purposes of the sales factor. You have provided documentation showing gross receipts for Affiliate's 1993 Virginia sales. The assessments will be adjusted accordingly.

Conclusion

The assessments for the 1992 and 1993 taxable years have been adjusted according to the enclosed schedules. Please remit payment to the Virginia Department of Taxation, Office of Policy and Administration, Appeals and Rulings, P.O. Box 1880, Richmond, Virginia 23218, Attention: *****. Payment must be made within 30 days to avoid the accrual of additional interest.

Copies of the Code of Virginia sections, regulations, and public documents cited, along with other reference documents, are available online in the Tax Policy library section of the Department's web site located at www.tax.state.va.us. If you have any questions regarding this determination, you may contact ***** at *****.


Sincerely,


Kenneth W. Thorson
Tax Commissioner




AR12899/13142B

Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46