Tax Type
Corporation Income Tax
Description
Intercompany license fees at arm's length
Topic
Accounting Periods and Methods
Date Issued
10-12-2004
October 12, 2004
Re: § 58.1-1821 Application: Corporate Income Tax
Dear ************:
This will reply to the letter in which you seek correction of the corporation income tax assessments issued to********** (the "Taxpayer") and affiliates for taxable years ended December 31, 1994 and 1995, January 26, 1996 and December 31, 1996. I apologize for the unusual delay in the Department's response.
FACTS
The Taxpayer is incorporated and located in ***** ("State A") and filed separate Virginia corporate income tax returns, but was included as part of an affiliated group on a consolidated return for federal income tax purposes for the taxable years at issue. The Taxpayer wholly owns ***** ("Corporation A").
The Department's auditor consolidated the taxable income of the Taxpayer and Corporation A and assessed additional tax and interest. The auditor determined that Corporation A lacked economic substance because its sole income was derived from license fees, and its only expense was for federal income taxes paid. In addition, the auditor reduced the Taxpayer's employee benefit program deduction to reflect the proportion of the Taxpayer's wages and salaries to the consolidated total of wages and salary.
The Taxpayer appeals the assessment and argues that Corporation A had substance and that the intercompany license fees were at arm's length. In addition, the Taxpayer contends that the reported employee benefit programs deduction reflected actual costs. The Taxpayer also asserts that the Department failed to issue refunds for the taxable years ended December 31, 1992 and 1994 for net operating loss carrybacks. Finally, the Taxpayer attached to its appeal an amended federal income tax return for the taxable year ended December 31, 1996 and requests that the Department revise its Virginia taxable income accordingly.
The Department sent an information request to the Taxpayer in order to gather sufficient documentation to address the Taxpayer's appeal. The Taxpayer has not responded to the Department's request.
DETERMINATION
Consolidation of the 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:
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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 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.
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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.)
The Virginia Supreme Court's opinion in Commonwealth v. General 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 intangible assets and lending transactions is as follows:
1) Patent or similar intangible asset.
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 Corporation A has substance and that its intercompany transactions with the Taxpayer are at arm's length. The Taxpayer provided no evidence at the time of its appeal to support its assertion that the Department's adjustments were invalid.
The Department requested that the Taxpayer provide information to substantiate the substance of Corporation A and the arm's length nature of its intercompany transactions. 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 you have not provided the requested information, the auditor's adjustments to consolidate the income of Corporation A with the Taxpayer is upheld.
Employee Benefits Program Expense
The auditor reduced the Taxpayer's employee benefit program deduction to reflect the proportion of the Taxpayer's wages and salaries to the consolidated total of wages and salary. As such, the auditor made a reasonable adjustment to reflect the employee benefit program expenses. The Taxpayer contends that the auditor's estimate did not reflect the actual employee benefit program costs. However, the Taxpayer has not provided the Department a detailed accounting of the program's costs.
As noted above, 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 what the actual employee benefit program deductions were. Because you have not provided the requested information, the auditor's adjustment to the employee benefit program deductions are upheld.
Refund Requests
The Taxpayer reported a net operating loss ("NOL") for the taxable year ended December 31, 1995. The Taxpayer contends that it filed amended returns requesting a refund for the taxable years ended December 31, 1992 and 1994. Those original returns were not received by the Department. A review of the documentation of those returns furnished will permit the Taxpayer to be deemed to have timely filed an application for a refund based on a carryback of the NOL. Accordingly, the Taxpayer's application will be forwarded for processing and review.
The Taxpayer has also sent a revised Federal Form 1120 for the Taxpayer's parent company for the taxable year ended December 31, 1996, and requests that the Department adjust its Virginia taxable income accordingly. The form provided does not clearly show the appropriate adjustments to be made to Virginia taxable income. As such, the form has been forwarded to the Department's Compliance Unit for review.
I have enclosed a copy of the information previously requested. Please complete it and return it to: Virginia Department of Taxation, Office of Policy and Administration, Appeals and Rulings, Post Office Box 27203, Richmond, Virginia 23261-7203, Attention: *****. If the completed requested information is not returned within 30 days from the date of this letter, I will uphold the Department's assessment of tax and interest issued to the Taxpayer for the taxable year ended December 31, 1996, as shown on the enclosed schedule. In addition, the assessment for the taxable year ended December 31, 1994, will be adjusted, and a revised bill issued, after the Taxpayer's NOL carryback for 1994 is processed.
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 any questions regarding this determination, you may contact ***** at *****.
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- Sincerely,
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- Kenneth W. Thorson
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- Tax Commissioner
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- Kenneth W. Thorson
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AR/20457B
Rulings of the Tax Commissioner