Document Number
04-159
Tax Type
Corporation Income Tax
Description
Transactions done in Virginia, Regulatory safe harbor provisions
Topic
Corporate Distributions and Adjustments
Taxable Transactions
Date Issued
09-30-2004


September 30, 2004


Re: § 58.1-1821 Application: Corporate Income Tax

Dear *****:

This will reply to your letter in which you seek correction of the corporation income tax assessments issued to your client, ***** (the "Taxpayer") for taxable years ended July 31, 1994 and 1995. I apologize for the delay in responding to your letter.


FACTS


The Taxpayer is incorporated and located in ***** ("State A"). In July 1990, ***** ("Corporation A"), a wholly owned subsidiary of the Taxpayer, was incorporated in ***** ("State B") for the purpose of holding the Taxpayer's intangible property. Thereafter, the Taxpayer transferred its trademarks and tradenames to Corporation A in exchange for Corporation A stock pursuant to Internal Revenue Code ("IRC") § 351. The Taxpayer paid royalties to Corporation A for the use of the trademarks and tradenames during the taxable years at issue.

The Department's auditor determined that the arrangement between the Taxpayer and Corporation A improperly reflected the business performed in Virginia. As a result, the taxable incomes of the Taxpayer and Corporation A were consolidated, and (an) assessment was issued for additional tax and interest.

The Taxpayer appeals the assessment on the basis that, pursuant to the Department's regulations, the transactions at issue do not distort income from business done in Virginia and that the intragroup transactions fall within the regulatory safe harbor provisions. In connection with its review of the Taxpayer's appeal, the Department requested information and documentation from the Taxpayer in order to analyze fully the facts surrounding the audit issues. The Taxpayer responded to the request asserting that the Department's delay in issuing a determination violated the Taxpayer's due process rights and raised a defense of laches. The Taxpayer provided no information or documentation.

DETERMINATION


Consolidation of Income - Taxpayer and Corporation A

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 adjust equitably 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 reflect improperly, inaccurately, or incorrectly 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.

Title 23 of the Virginia Administrative Code (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 the transfer of patents or similar transactions under Title 23 VAC 10-120-361 (E) are as follows:

    • a. If a patent or similar asset is transferred to or from an entity subject to
      Virginia income tax to another group member or noncorporate entity, two-thirds of the taxable income to be derived from the patent must have been received by the transferor prior to the transfer.
    • b. If the taxable income to be derived from a patent or similar asset is undeterminable (in some instances, for example, a trademark), a transferor must receive a minimum payment equivalent to the asset's development cost, plus the transferor's stated internal rate of return requirement for similar assets created in the ordinary course of the transferor's business, plus a reasonable amount for anticipated future profits.
    • c. If a patent or similar asset is transferred between group members, with the transferor's compensation being future royalty payments, those payments must be at an arm's length price.

According to Title 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 transactions between the Taxpayer and Corporation A are at arm's length and do not distort income from business done in Virginia. The Taxpayer provided no evidence at the time of its appeal to support its assertion that the Department's adjustments are invalid.

The Department requested that the Taxpayer provide information to substantiate the sales factor reported on the original return. The Department has the authority to investigate any books and records of a taxpayer in order to ascertain the proper tax liability. See Va. Code § 58.1-219. Further, Va. Code § 58.1-205 provides that in any proceeding relating to the interpretation of the tax laws of Virginia, an "assessment of a tax by the Department shall be deemed prima facie correct." As such, the burden of proof is on the Taxpayer to show that the transactions with Corporation A did not improperly reflect the Virginia taxable income of the Taxpayer. Inasmuch as the Taxpayer has not provided the requested information, the auditor's adjustments to consolidate the income of Corporation A with the Taxpayer are upheld.

Laches

The Taxpayer is asserting the defense of laches on the basis of the Department's failure to request timely the additional information of issue a determination. Laches is the neglect or failure to assert a known right or claim for an unexplained period of time under circumstances prejudicial to the adverse party. See Bazzle v. Bazzle, 37 Va. App. 737 (2002). The burden of proving laches and prejudice is upon the litigant asserting the defense. However, in Clyde S. Morris v. Commonwealth of Virginia, 13 Va. App. 77 (1991), the Court of Appeals ruled that "laches may not be set up as a defense against the Commonwealth acting in its governmental capacity." As such, laches is not a valid defense for the Taxpayer in this case.

Due Process

You also contend that the Department's delay in issuing a determination violated the Taxpayer's right to due process. Specifically, you contend that even though the Department issued the assessments within the applicable statute of limitations period, the Department's failure to issue a determination violates the "spirit" of the statute of limitations in that the Taxpayer's ability to defend itself has been prejudiced. Virginia Code § 58.1-1802.1 provides in pertinent part:
    • Where the assessment of any tax imposed by this subtitle has been made within the period of limitation properly applicable thereto, such tax may be collected by levy, by a proceeding in court, or by any other means available to the Tax Commissioner under the laws of the Commonwealth, but only if such collection effort is made or instituted within twenty years from the date of the assessment of such tax.

Thus, Virginia law permits the Department to collect any tax properly assessed within the statute of limitations within 20 years of the date of the assessment. The Department's efforts to respond to the Taxpayer's appeal by requesting additional information, while delayed, occurred well within the twenty-year period mandated by Virginia law. Therefore, the Taxpayer's argument that the Department's failure to issue a determination violated its due process rights is without merit.

Conclusion

Based on the foregoing, I uphold the Department's assessment of tax and interest issued to the Taxpayer for the taxable years ended July 31, 1994 and 1995.

The Taxpayer should remit its payment for the tax and updated interest as shown on the enclosed schedule to: Virginia Department of Taxation, Office of Policy and Administration, Appeals and Rulings, P.O. Box 27203, Richmond, Virginia 23261-7203, Attention: *****. Payment must be received within 30 days from the date of this letter to avoid the accrual of additional interest and the imposition of an additional 20% penalty in accordance with the terms of Virginia's recent Amnesty.

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 determination, you may contact ***** at *****.
                    • Sincerely,


                      Kenneth W. Thorson
                  Tax Commissioner




AR/15345B


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46