Document Number
03-57
Tax Type
Corporation Income Tax
Description
Consolidated Returns
Topic
Appropriateness of Audit Methodology
Corporate Distributions and Adjustments
Date Issued
08-08-2003
August 8, 2003



Re: § 58.1-1821 Application: Corporate Income Tax


Dear *****:

This will reply to your letter in which you seek correction of the corporate income
tax assessment issued to your client, ***** (the "Taxpayer") for the taxable year ended February 28, 1994. I apologize for the delay in the Department's response.
FACTS

The Taxpayer is incorporated in ***** and has its headquarters in *****. It performs merchandising, warehousing and administrative functions for its subsidiaries. OS, a wholly-owned subsidiary of the Taxpayer, is incorporated in another state ("State A") and headquartered in *****. For the taxable year at issue, OS filed separate Virginia returns. It is a retailer with store locations in numerous states. Several other out-of-state corporations are subsidiaries of OS.

FS is a wholly-owned subsidiary of the Taxpayer and is incorporated (and has its sole location) in *****. It purchases receivables from the Taxpayer and OS.

The Taxpayer and OS finance many of the retail purchases of property made by their customers. In May 1990, the Taxpayer and OS made loans to FS. On the same day, the Taxpayer and OS transferred their customer receivables from these retail purchases to FS.

The Taxpayer and OS filed separate Virginia corporate income tax returns for the taxable year at issue. FS did not file a corporate income tax return in Virginia. Under audit, an adjustment was made to consolidate the taxable income of FS and OS with the Taxpayer's taxable income. The auditor concluded that the income of the Taxpayer was improperly reflected because transactions between the Taxpayer and FS and OS lacked economic substance and were not made at arm's length.

You contend that the Taxpayer and OS properly filed separate corporate income tax returns. You also contend that FS's transactions with the Taxpayer and OS did not distort Virginia taxable income and the auditor had no basis to consolidate the Virginia taxable income of the Taxpayer, OS and FS. You state that under the safe harbor provisions provided by Title 23 of the Virginia Administrative Code ("VAC") 10-120-360 through 364, the transactions between the Taxpayer and FS and OS do not cause the improper reflection of Virginia taxable income.
DETERMINATION

Although Virginia utilizes federal taxable income as the starting point in computing Virginia taxable income and generally respects the corporate structure of taxpayers, Va. Code § 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.)

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 Va. Code § 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 or transactions between the parties are not at arm's length.

For taxable years beginning on or after January 1, 1993, Title 23 VAC 10-120--361 sets forth the factors considered by the Department in deciding whether transactions create an improper reflection of Virginia taxable income. The regulation also lists examples of transactions deemed not to cause a distortion of the participants' income from business done in Virginia. The "safe harbor" transactions relating to lending transactions and the transfer of receivables are described as follows:
    • 3. Lending Transactions. In an intragroup lending transaction, the lending party must be a discrete, separate business enterprise with its own employees, office space, and books and records. Funds must be loaned at a fair market value interest rate, with collateral, payments, and credit standing substantially similar to those which the borrower could obtain from an unrelated lending institution.
    • 4. Transfer of Receivables. Intragroup transfers of receivables must occur at arm's length, taking into account: the creditworthiness of the underlying debtor of debtors, the collectibility of the transferred receivables, and the rate of return required by the transferor corporation with regard to the similar assets

According to 23 VAC 10-120-360, arm's length means "a charge for goods or services such that the price structure of intragroup transactions is substantially equivalent to the price structure of transactions between unrelated taxpayers, each acting in its own best interest." In accordance with this definition, the Department will look beyond the "fair market" price of the transaction and into the structure and nature of a transaction in comparison with transactions between unrelated parties in determining if an improper reflection of Virginia taxable income has occurred. Also, the Department will appraise the economic substance of the entity receiving the income in considering whether each party is acting in its own best interest.

You contend that the accounts receivable factoring and the intercompany loans are arm's length transactions. You state that the factoring arrangement replicates common financing transactions between retailers and unrelated finance companies. The Taxpayer and OS transfer all of their current receivables to FS each month. The transfer price is the total unpaid balance of the receivables at the close of business on the date of transfer. In lieu of transferring receivables at a discount, the Taxpayer and OS are charged a finance fee equal to the monthly interest expense multiplied by a financing factor. The charges are accounted for through the cancellation of an equivalent amount of intercompany debt. If the charges exceed the debt, an intercompany note is issued in lieu of an actual payment.

The only evidence you have provided that shows that the factoring arrangement between the Taxpayer, OS and FS is financially equivalent to the industry standard of factoring at a discount is a letter from a bank to an unrelated company. In this letter, the bank states that a fair factor rate would be to factor the receivables at 70% and charge a fee of between 1½ to 3% a month on the receivables. The Department finds this letter unpersuasive. The factoring arrangement described in this letter is significantly different than the arrangement between the Taxpayer, OS and FS.

The Taxpayer and OS's factoring arrangement with FS does not resemble a typical transaction involving the factoring of receivables. Usually receivables are purchased at a discounted amount. The purchaser then provides the necessary management, administration and collection activities to collect the receivables. Any amounts collected belong to the purchaser. Amounts collected that exceed the purchase price paid by the purchaser and any other operating expenses represent a profit.

A review of the safe harbor provision for the transfer of receivables indicates that the intragroup transfer of receivables must be performed at arm's length, taking into account the underlying debtor, the collectibility of the transferred receivables, and the rate of return required by the transfer corporation with regard to similar assets. I am not convinced that the transfer of receivables between the Taxpayer, OS and FS represents an arm's length transaction. As such, the safe harbor provision relating to the transfer of receivables does not apply in the instant case.

You further contend that FS has economic substance and FS is physically located in an office in *****. FS employs two individuals full time to perform debt acquisitions, cash management and bookkeeping, including calculating interest expense and preparing monthly reconciliation reports on all outstanding debt. They also record and analyze daily interest rate bids and track lending institution interest rates and other cash management tasks.

The Taxpayer and OS record and file financing statements for each of the factored receivables. A majority of the Taxpayer and OS's customers finance their purchases through the Taxpayer. Further, the tasks performed by FS's employees do not include direct collection activities. The Taxpayer provides all administration, management and collection activities on the receivables after they are transferred to FS. The Taxpayer and OS incur significant expense in the administration and management of the receivables held by FS.

You contend that a $1,000 per month administrative fee charged to FS by the Taxpayer offsets the Taxpayer's costs of accounting for the administration of FS. A review of these administrative expenses indicates they are insufficient to cover the costs to collect and process the amount of receivables reported on the balance sheets of FS. As such, it appears that the Taxpayer is not fully compensated for its management services.

A review of the Taxpayer's income statement provided in its consolidated federal corporate income tax returns indicates that transactions between the Taxpayer, OS and FS are merely bookkeeping entries. No evidence has been provided to show that payments for these transactions were actually remitted or collected. Accordingly, the Department finds that FS lacks economic substance.

Finally, you contend that the intercompany loans are similar to those that exist between unrelated third parties because the interest rates on the notes are either 11% per annum or, for the note payable balance created as a result of the subsequent monthly transfer of receivables, one percentage point above a leading bank's prime rate. Based on a review of the available information, the loans between the Taxpayer, OS and FS do not include payment schedules, are not secured by any collateral, and do not contain any provisions for penalties if there is a failure to pay. Regular payments of loan principal and interest are not made on the loan balances. Instead, payments are made by the cancellation of the loan payable owed to FS.

A review of the safe harbor provision of the regulations addressing lending transactions indicates that the funds must be loaned at a fair market value interest rate, with collateral, payments and credit standing substantially similar to those that the borrower could obtain from an unrelated third party. As stated above, there is no evidence that the loans were made at a market rate of interest. No collateral secured the various notes. Based on these facts, I must conclude that the loan arrangements between the Taxpayer, OS and FS do not reflect arm's length arrangements. As such, the safe harbor provision for lending transactions does not apply to the lending transactions made between the Taxpayer, OS and FS.

Conclusion

Remedies used by the Department to adjust a taxpayer's tax to more appropriately reflect business done in Virginia include adjusting the price of the transactions to a true arm's length price, consolidating the accounts of the parties conducting the contested intercompany transactions, or disallowing a taxpayer's deduction for the contested transactions. Based on the analysis of the transactions between each of the entities involved, the Department has not been able to establish the true arm's length value of these transactions. In the absence of this alternative, I must conclude that OS and FS were properly consolidated with the Taxpayer for Virginia income tax purposes.

Accordingly, the auditor's adjustment to consolidate the incomes of the Taxpayer, OS, and FS is upheld. The assessment for the taxable year ended February 28, 1994, is now due and payable in accordance with the enclosed schedule. Please contact ***** at ***** to arrange payment of this assessment.

Copies of the Code of Virginia sections and regulations cited, and other reference documents, are available on-line in the Tax Policy Library section of the Department's web site, located at www.tax.state.va.us. If you have additional questions regarding this response, you may contact ***** in the Office of Policy and Administration, Appeals and Rulings, at *****.
                • Sincerely,


                • Kenneth W. Thorson
                  Tax Commissioner



AR/11905B


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46