Tax Type
Corporation Income Tax
Description
Management fees charged by the Parent; Virginia taxable income
Topic
Accounting Periods and Methods
Corporate Distributions and Adjustments
Date Issued
10-08-2004
October 8, 2004
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 ***** (the "Taxpayer") for the taxable year ended August 31, 1993. I apologize for the unusual delay in response.
FACTS
The Taxpayer is an out-of-state corporation that files a separate Virginia corporate income tax return. Pursuant to a field audit, an adjustment was made to disallow a portion of expenses labeled as "management fees" that were deducted and paid to its parent company, ***** (the "Parent"). You contest the assessment on the basis that the management fees charged by the Parent did not distort the Taxpayer's 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:
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- 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.
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- 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.]
Virginia Regulation (VR) 630-3-446, effective during the tax period for which the Taxpayer is seeking relief, provides in pertinent part:
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- 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.]
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- 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, by 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 Va. Code § 58.1-446. These regulations can be found in Title 23 of the Virginia Administrative Code (VAC) 10-120-360 through 364. Because the taxable year addressed by this appeal occurred before the effective date of the expanded regulations, the safe harbor provisions, as they exist in Title 23 VAC 10-120-361, do not apply in this case.
The Virginia Supreme Court's opinion in Commonwealth v. General Electric Company, 236 Va. 54,372 S.E.2d 599 (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.
In the present case, the Parent performed a myriad of administrative functions on behalf of the Taxpayer, such as contract negotiation, electronic data interchange, management of national accounts, legal services, accounting and financial reporting services. The performance of these services by the Parent reflected the consolidation of administrative functions in a general corporate reorganization implemented at the beginning of the taxable year ended August 31, 1993.
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 engage either 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. 97-290 (6/26/97), however, the Department disallowed a profit percentage added to a management fee because the parent holding company lacked independent economic substance and failed to provide any evidence to show that the profit element of the management reflected fair market value.
The Department has reviewed the economic substance of the Parent. The Parent did record a variety of assets, liabilities, income and expenses for the taxable year at issue. In computing the management fee, the Parent allocated substantially all of its costs to the Taxpayer. This includes 100% of numerous deductions. Because the Parent does not offer products for sale to unrelated parties, the Department finds it reasonable that some deductions, such as costs for advertising, selling, credit, and collections should be allocated to the Taxpayer in full. On the other hand, numerous expenses that any normal business would incur were also allocated entirely to the Taxpayer. These include deductions for repairs, rents, depreciation, supplies, data processing, janitorial, security, insurance, telephone, utilities, and directors' fees. It is doubtful that the Parent could operate as a viable business without incurring at least some of these types of expenses.
Further, the management income was recorded as other income on the books of the Parent and as other deductions on the books of the affiliates. The management fee charged to affiliates made up almost 95% (more than 93% from the Taxpayer) of the Parent's income. The Parent, however, never booked a receivable for this income. The evidence indicates that the management fee was computed once annually and entered on the books through a tax-adjusting entry. The Parent incurred no expenses to accrue, bill, collect, or record management fees earned throughout the year. These facts and observations make it appear the Parent does not operate independently from its affiliates.
The Department has also reviewed the evidence provided by the Taxpayer in support of its contention that the transactions were conducted at arm's length. The management fee tripled from the taxable year ended August 31, 1992 to 1993. The Taxpayer argues that the increase was due to reorganization of the operations of the affiliated group. The Taxpayer avers that the increase in the management fee is directly related to shifting significant administrative responsibilities to the Parent. In fact, while the gross sales of the Taxpayer increased by 8% for the 1992 taxable year, many of the deductions associated with the general administration of the business decreased.
The Department's analysis shows that the additional administrative responsibilities taken on by the Parent could only account for a portion of the increase to the management fee. Our review indicates the management fee was also affected by three other factors.
First, the Parent used book records to determine the management fee. This resulted in the inclusion of expenses for depreciation, travel and entertainment, and other administrative costs in the computation of the management fee that were not eligible as a deduction by the Parent on its federal income tax return. Because Virginia conforms to the Internal Revenue Code pursuant to Va. Code § 58.1-301, the Department will only allow the allocation of deductions as set forth in P.D. 97-132 for deductions permitted for federal or Virginia income tax purposes.
Second, the management fee included a large charge for a restructure expense. It appears the Parent is allocating all of the expenses related to the reorganization to the Taxpayer. However, this expense was not deducted in the computation of the Parent's federal taxable income. Accordingly, the Department will not permit the restructure expense to be allocated to the Taxpayer.
Lastly, the Parent included a profit percentage in the computation of the management fee. The Taxpayer has submitted a cost allocation study performed by an independent third party. The study concludes, "a 16% gross-up on costs incurred would simulate the cost of contracting for the same services on an arm's length basis." The computation of the cost allocation provided by the Taxpayer, however, shows that the costs were marked up 20%. Consequently, the Taxpayer has failed to show that the management fee reported on its federal income tax return is consistent with an arm's length transaction.
Based on the facts presented and a review of the relevant documentation, it is my determination that the Parent possessed little independent economic substance and the management fee charged to the Taxpayer does not reflect an arm's length transaction. Thus, to the extent that the operations of the Parent and the management fee transactions with the Taxpayer primarily reflect "paper" intercompany transactions, the facts fit that of Commonwealth v. General Electric Company and satisfy the Court's requirement of (1) an arrangement (2) between two commonly owned corporations (3) in such a manner improperly, inaccurately, or incorrectly to reflect (4) the business done or the Virginia taxable income earned from business done in Virginia.
The federal tax laws affecting corporate cost allocations and consolidated returns allow this action to be taken without adverse federal tax consequences, even where the transactions are not performed at arm's length. Under these circumstances, Va. Code § 58.1-446 authorizes the Department to deem income of an affiliate Virginia income even if the affiliate does not have nexus.
Based on the information provided, the Department is unable to determine fully the amount of expenses the Parent incurred on behalf of the Taxpayer. Accordingly, the Department finds it equitable to consolidate the incomes of the Parent and the Taxpayer in order to properly reflect the income of the Taxpayer for the taxable year ended August 31, 1993.
Conclusion
The assessment had been adjusted pursuant to the enclosed revised audit, which reflects the consolidation of the Taxpayer and the Parent. No additional interest will accrue provided the outstanding balance is paid within 30 days from the date of this letter. Please remit payment to: Virginia Department of Taxation, 3600 West Broad Street, Suite 160, Richmond, Virginia 23230, Attention: *****. If you have any questions concerning payment of the assessment, you may contact ***** at *****.
The Code of Virginia sections and regulations cited, along with 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 any questions regarding this determination, you may contact ***** in the Office of Policy and Administration, Appeals and Rulings, at *****.
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- Sincerely,
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- Kenneth W. Thorson
Tax Commissioner
- Kenneth W. Thorson
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AR/9389B
Rulings of the Tax Commissioner