Document Number
04-188
Tax Type
Corporation Income Tax
Description
Commercial domicile of several subsidiaries
Topic
Accounting Periods and Methods
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 assessments issued to your client, ***** (the "Taxpayer") for the taxable years ended December 31, 1991 and 1992. I apologize for the delay in the Department's response.
FACTS

The Department audited the Taxpayer and its subsidiaries for the taxable years ended December 31, 1991 and 1992. Numerous adjustments were made involving the commercial domicile of several subsidiaries and the application of Va. Code § 58.1-446. The Taxpayer contests the auditor's adjustments.
DETERMINATION

Adjustments Under Va. Code § 58.1-446

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 therefore, 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.]

Virginia Regulation (VR) 630-3-446, effective during the taxable period for which the Taxpayer is seeking relief, 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, by inadvertence or design, causes the income from Virginia sources to be inaccurately stated. [Emphasis added.]

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 the tax of a corporation equitably 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.

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) 10-120­360 through 364. Because the taxable years 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.

Interest Income of *****

The Department's auditor consolidated the federal taxable income of ***** ("Corporation A") after finding the corporation was commercially domiciled in Virginia. You have provided evidence to show that Corporation A was not commercially domiciled in Virginia. In your appeal, you also assert that the Department should not have consolidated Corporation A with the Taxpayer under Va. Code § 58.1-446.
    • Corporation A was incorporated in ***** ("State A") in December 1973 for the purpose of managing the intangible assets of affiliates. Specifically, the sole purpose of Corporation A was to provide financing to its affiliates and manage the notes evidencing the borrowers' indebtedness.

While you recognize that the current regulations were not in effect for the taxable years at issue, you state that the regulations should act as a guide for the Department's determination. You contend that the intercompany transactions between Corporation A and the Taxpayer would fall under the safe harbor of Title 23 VAC 10-120-361(E) had such regulation been in effect. As indicated earlier, this regulation was not in effect for the 1992 taxable year and is not applicable to this case. Furthermore, even if the Department were to accept your position, the transactions between Corporation A and the Taxpayer do not meet the requirements of the safe harbors in the expanded regulations.

An analysis of the facts does not support the Taxpayer's argument that Corporation A has economic substance. Corporation A leased office space in State A. It had one employee who dedicated a small portion of his time to administering Corporation A's business. The Taxpayer has provided evidence that all of its officers and two of the three board members were State A residents. The source of the funds that Corporation A would lend to affiliates was received through the capital contributions from the Taxpayer and retained earnings from Corporation A's operations.

A review of Corporation A's income statement reveals that the operating expenses consisted of a modest salary for its sole part-time employee and minimal office expenses. Corporation A's balance sheet shows only two assets, cash and a current receivable. The receivable declined significantly during the 1992 taxable year while the cash balance remained stable. This would indicate that the staff of Corporation A lacked the knowledge or expertise to generate new loan business. In fact, it appears that all the loans made by Corporation A were actually made and approved by the Board of Directors. It is unlikely that this is normal operating procedure for most entities in the lending business. As such, the Taxpayer has not demonstrated that Corporation A had economic substance.

Corporation A provided an example of a loan given to one of its affiliates. The loan application provided by Corporation A is a one page document that requires only the name of the entity, the date the loan would be needed, and wire transfer information of the borrower's bank. The application requires no submission of financial statements, credit reports, or possible collateral. No evidence has been provided to show that an analysis was done to determine the feasibility of the loan. It appears that the loan approval process is no more than a rubber-stamping operation.

The loan note is a demand note with no payment schedule or collateral, although there is a 5% late payment penalty. Interest is 2% over the prime rate for commercial banks as published in the Wall Street Journal. However, the loan terms between Corporation A and the affiliate do not include payment schedules and are not secured by any collateral. It is apparent that the loan arrangements between Corporation A and its affiliates do not reflect an arm's-length arrangement.

In addition, the Taxpayer has not provided documentation that would establish that the balances of the accounts on the books of Corporation A are anything other than mere paper transfers. Based on the information provided, the facts satisfy the Court's requirement in General Electric of (1) an arrangement (2) between two commonly owned corporations (3) in such a manner to reflect improperly, inaccurately, or incorrectly (4) the business done or the Virginia taxable income earned from business done in Virginia. Because the relationship between the Taxpayer and Corporation A lacks economic substance and the loan transactions have not been conducted under an arm's-length arrangement, it is my determination that consolidating Corporation A with the Taxpayer would most equitably reflect Virginia taxable income earned from business done in Virginia. Accordingly, the auditor's adjustment is upheld.

Interest Income of *****

The Department included the federal taxable income of ***** ("Corporation B") in the Taxpayer's consolidated Virginia corporate income tax return for the taxable year ended December 31, 1992, on the basis that Corporation B lacked economic substance and its intercompany transactions with affiliates were not at arm's length. The Taxpayer contends that Corporation B lacks nexus with Virginia. In addition, the Taxpayer contends that the Department lacks the authority to consolidate the income of Corporation B with the Taxpayer under Va. Code § 58.1-446.

The Taxpayer contends that, because Corporation B has no nexus with Virginia, consolidating it with the Taxpayer distorts income from Virginia sources. However, the interest payments result in the transfer of income from the Taxpayer and its subsidiaries to Corporation B. Absent of the creation of this arrangement, the interest would not have been expensed from the taxable income of the Taxpayer and its subsidiaries in Virginia. The federal tax laws affecting corporate transfers 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, the Department is authorized under Va. Code § 58.1-446 to deem the income of an affiliate to be Virginia income even if the affiliate does not have nexus.
    • Corporation B was created in December 1991, when the Taxpayer transferred cash to Corporation B in exchange for Corporation B common stock pursuant to Internal Revenue Code § 351. Corporation B is incorporated in ***** ("State B") and issued loans to the Taxpayer and its subsidiaries.

The Taxpayer has provided evidence to document the economic substance of Corporation B. Information provided includes minutes from meetings of the board of directors, the bylaws of Corporation B, an office lease agreement, sample notes, a sample loan application, employment agreements, and documentation of the wages paid to employees.

The Department has examined the evidence provided to substantiate the claimed economic substance of Corporation B. According to the corporate bylaws, Corporation B's activities are limited to lending funds to the Taxpayer and its subsidiaries, issuing dividends to the Taxpayer, and paying operating expenses. Based on the information presented, Corporation B's activities during the year at issue consisted of making loans to related parties out of capital provided by the Taxpayer, receiving interest income on the loans, and paying substantially all of the income as dividends to the Taxpayer.

Corporation B rented six square feet of office space in the offices of a related entity whose vice president is also the president of Corporation B. It is not reasonable to believe that six square feet of office space is sufficient to conduct a viable lending business.

Corporation B had four part-time employees in 1992. Based on the minimal salaries paid to these employees, Corporation B lacks sufficient staff with the knowledge or expertise to operate a viable lending business. For example, under the employment agreement, the vice president's duties include establishing and maintaining an office, supervising the daily operations of Corporation B, maintaining the minutes of the corporation, approving loan applications, preparing and maintaining notes receivable, reviewing monthly financial statements, and requesting additional capital contributions. According to the agreement, these duties are to be performed for an annual salary of *****.

Corporation B's board of directors is made up of two of its part-time employees and an officer of the Taxpayer employed in Virginia, who serves as chairman. The chairman of the board called six special meetings during 1992 for the sole purpose of determining the amount of the dividend to be paid to the Taxpayer. Based on the minutes, the board approved dividends in excess of ***** million for the 1992 taxable year.

The loan application provided by Corporation B is a one page document that requires only the name of the entity, the date the loan would be needed, and wire transfer information of the borrower's bank. The application requires no submission of financial statements, credit reports, or possible collateral. No evidence has been provided to show that an analysis was done to determine the feasibility of the loan. It appears that the loan approval process is no more than a rubber-stamping operation.

Corporation B also provided a sample note. The note is a demand note with no payment schedule or collateral, although there is a 5% late payment penalty. Interest is equal to the prime rate for commercial banks as published in the Wall Street Journal. However, the loan terms between Corporation B and the borrower do not include payment schedules and are not secured by any collateral. Clearly, these loan arrangements do not reflect an arm's-length arrangement.

Based on the information provided, the facts satisfy the Court's requirement in General Electric of (1) an arrangement (2) between two commonly owned corporations (3) in such a manner to reflect improperly, inaccurately, or incorrectly (4) the business done or the Virginia taxable income earned from business done in Virginia. Because the relationship between the Taxpayer and Corporation B lacks substance and the loan transactions have not been conducted under an arm's-length arrangement, it is my determination that consolidating Corporation A with the Taxpayer would most equitably reflect Virginia taxable income earned from business done in Virginia. Accordingly, the auditor's adjustment is upheld.

Removal of Subsidiaries

The auditor removed the **** ("Corporation C"), ***** ("Corporation D"), ***** ("Corporation E"), ***** ("Corporation F"), ***** ("Corporation G"), and the ***** ("Corporation H"), (collectively, the "Group") from the Taxpayer's 1992 consolidated return on the basis that they lacked nexus with Virginia. Each of these six subsidiaries reported a net operating loss for 1992.

Virginia Code § 58.1-400 imposes income tax "on the Virginia taxable income for each taxable year of every corporation organized under the laws of the Commonwealth and every foreign corporation having income from Virginia sources." Generally, a corporation will have income from Virginia sources if there is sufficient business activity within Virginia to make any one or more of the applicable apportionment factors positive. The existence of positive Virginia apportionment factors clearly establishes income from Virginia sources.

Public Law (P.L.) 86-272, as codified at 15 U.S.C. §§ 381-384 prohibits a state from imposing an income tax on businesses when the only contacts with the state are a narrowly defined set of activities. P.L. 86-272 protection has been extended by the U.S. Supreme Court to include activities that are ancillary to direct sales solicitation, as well as de minimis activities. See Wisconsin Department of Revenue v. William Wrigley Jr., Co., 505 U.S. 214 (1992). The Department has a long-standing policy of narrowly interpreting the provisions of P.L. 86-272.

Corporation H is in the television broadcasting business and is based in ***** ("State C"). The remaining corporations in the Group are engaged in the newspaper publishing business and are located in various states throughout the United States. The Taxpayer contends that the Group had nexus with Virginia in 1992. The Taxpayer has provided leases that show that the Group had property in Virginia during the 1992 taxable year.

A review of the leases indicates that each of the six subsidiaries entered into a lease in mid-December 1992 with a wholly owned subsidiary of the Taxpayer. The warehouse space leased by the Group ranged from 16 square feet to 1,516 square feet.

The Taxpayer has provided documentation to show that property owned by the Group was stored in Virginia. Personal property tax assessments issued to the Group have been provided. The Taxpayer also enclosed a bill of lading that shows that exhibition property owned by Corporation H was shipped in December to the Virginia warehouse. No documentation has been provided to show what property the other corporations in the Group were storing in Virginia. In addition, there is no explanation as to how this property was used in the business operations of the Group.

Other than the property stored in Virginia, none of the corporations in the Group had any other activities in Virginia during the 1992 taxable year. None of the corporations of the Group generated sales in Virginia or had employees that entered Virginia. It does not appear that any members of the Group directed any of their business activities toward Virginia. This raises the question as to why the Group would want to store property in Virginia.

The Taxpayer has numerous subsidiaries engaged in businesses in various states outside Virginia similar to those of the Group. Yet, only the six corporations reporting a net operating loss in 1992 entered into lease agreements with a related corporation to store tangible personal property in Virginia.

Under audit, the Department discovered that unlike all of the Taxpayer's other subsidiaries operating without Virginia, the Group incurred significant net operating losses for federal income tax purposes. The Taxpayer and its Virginia affiliates, on the other hand, reported significant federal taxable income. Absent some arrangement, the Taxpayer would not be able to use the net operating losses of the Group to offset the income of the Taxpayer and its Virginia affiliates. In order to do so, the Taxpayer would have to create some connection with Virginia that would make the Group subject to Virginia income tax.

The effect of leasing or storing property in Virginia was to create nexus artificially and allow the Group to be included in the Taxpayer's 1992 consolidated Virginia corporate income tax return. Without the creation of a positive property factor in Virginia, the Group had no other connection with Virginia that would have created nexus. Clearly, the timing of the placement of the tangible personal property in Virginia in the last half of the last month of the taxable year, the relative minimal value of the property, the low rental rate, and the fact that the warehouse space was owned by a related party indicates that sole reason for placing this property in Virginia was to lower the Virginia taxable income for 1992.

Based on the information provided, the facts satisfy the Court's requirement in General Electric of (1) an arrangement (2) between two commonly owned corporations (3) in such a manner to reflect improperly, inaccurately, or incorrectly (4) the business done or the Virginia taxable income earned from business done in Virginia. Because the sole purpose of moving property owned by the Group into Virginia was to reduce Virginia income tax, the auditor was correct in removing the Group from the 1992 Virginia consolidated income tax return.

Conclusion

The assessments resulting from the audit adjustments for the taxable years ended December 31, 1991 and 1992 are upheld. The Taxpayer should remit its payment of the outstanding balances, as reflected on schedules sent under separate cover, to: Virginia Department of Taxation, 3600 West Broad Street, Suite 160, Richmond, Virginia 23230, Attention: *****. No additional interest will accrue provided the outstanding balances are paid within 30 days from the date of this letter. If you have any questions concerning payment of the assessment, you may contact ***** at *****

The Code of Virginia sections and public documents cited, as well as 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 about this determination, you may contact ***** of the Office of Policy and Administration, Appeals and Rulings, at *****.


                • Sincerely,

                  • Kenneth W. Thorson
                    Tax Commissioner


AR/21713B

Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46