Document Number
05-139
Tax Type
Corporation Income Tax
Description
Application of Va. Code § 58.1-446
Topic
Basis of Tax
Corporate Distributions and Adjustments
Date Issued
08-23-2005



August 23, 2005



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 January 31, 1992 and January 31, 1993. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayer is an out-of-state corporation that files a separate Virginia corporate income tax return. In January 1984, the Taxpayer created three wholly owned subsidiary corporations, ***** ("IHC"), ***** ("MHC") and ***** ("NHC"). IHC and NHC were incorporated in ***** ("State A") and MHC was incorporated in ***** ("State B").

IHC was formed to hold the trademarks and tradenames of the Taxpayer. The Taxpayer and other Taxpayer affiliates pay royalties to IHC for the right to use the trademarks and tradenames. MHC was formed to hold mortgages on real estate held by the Taxpayer and by non-Virginia affiliates. NHC loans capital to the Taxpayer and Taxpayer affiliates.

Under audit, an adjustment was made to consolidate the taxable income of IHC, MHC and NHC with the Taxpayer's taxable income. The auditor concluded that the income of the Taxpayer was improperly reflected because transactions between the Taxpayer and IHC, MHC and NHC lacked economic substance and were not made at arm's length.

You contest the Department's assessments. You contend that IHC, MHC and NHC's transactions with the Taxpayer do not distort Virginia taxable income, and the auditor had no basis to consolidate the Virginia taxable income of the Taxpayer, IHC, MHC and NHC. 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 IHC, MHC and NHC do not cause the improper reflection of Virginia taxable income. Finally, you contend that if distortion is determined to have occurred, the Department's proper remedy would be through pricing adjustments.

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.]

Virginia Regulation (VR) 630-3-446, effective during the taxable periods 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 equitably the tax of a corporation pursuant to Va. Code § 58.1-446 (or its predecessor) where two or more 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) 10-120-360 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.

IHC

IHC received trademarks from the Taxpayer in exchange for a proportionate share of stock in IHC in relation to the value of the trademarks contributed pursuant to Internal Revenue Code ("IRC") § 351. According to the Taxpayer, IHC was incorporated to: (1) enable the Taxpayer to separate the ownership of its valuable trademarks and tradenames from its retail operations in order to measure the financial performance of various facets of the business on a stand-alone basis; (2) prevent any potential hostile takeover; and (3) take advantage of tax benefits.

The Taxpayer asserts that the transfer of the trademarks was necessary to measure the financial performance of various facets of the business. The value of the Taxpayer's trademarks was created over time by the Taxpayer's operations. The Taxpayer has provided no evidence to identify any costs directly related to the value of the trademarks. It is unlikely any business can evaluate a trademark's contribution to its business if it cannot identify the costs incurred in creating that trademark. In addition, the ongoing advertising, investment and operating policies of the Taxpayer and its affiliates continue to maintain and enhance the favorable recognition of the trademarks. IHC has incurred little or no costs relating to maintaining and increasing the value of the trademarks. Based on the information provided, the Department fails to see how the Taxpayer can evaluate the financial performance of the licensing activities separately from the overall operations under their current structure.

Virginia follows the general rule of law concerning corporate separateness. Under this rule, corporations will generally not be held liable for the acts or debts of an affiliated corporation. I acknowledge that the transfer of the trademarks to a separate corporation can provide some level of protection for the intangible assets. Because of the interrelationship of a trademark to the entity that created it, however, I am not convinced that actions by or against the Taxpayer would not significantly impact the value of the trademarks held by IHC. For example, even if IHC were to be spun off as a result of a hostile take over, the lost connection with the underlying assets and operations of the Taxpayer would adversely affect the value of the trademarks.

The Taxpayer admits that IHC was located in State A to take advantage of certain tax benefits. In fact, transactions engaged in by IHC are exempt from income taxation in State A. As such, the Taxpayer can reduce Virginia income tax by deducting royalties paid to IHC in determining Virginia taxable income. When such arrangements improperly reflect income from Virginia sources, the Department is authorized under Va. Code § 58.1-446 to make an equitable adjustment.

The Department has reviewed the information provided concerning the economic substance of IHC. IHC had only three members of the board of directors. The same three individuals served as officers of IHC. One of the individuals was also employed by the Taxpayer. The Taxpayer asserts that the board held regular meetings, but IHC reported no expenses as a result of such meetings. In addition, no evidence has been provided to show that the officers or directors were fairly compensated for their services. The amount of payroll reported by IHC could not be considered to be the fair market value of compensation for a corporation generating more than one hundred million dollars in revenues.

For the taxable years 1991 and 1992, IHC incurred minimal expenses for payroll, rent, and communications. The amount of payroll expense indicates that IHC's employees spent minimal time conducting the business. IHC's operating expenses were minimal in relation to the amount of income generated.

IHC did incur legal fees and the Taxpayer appears to have allocated some deductions from its books. No documentation was provided as to the nature of the professional fees or allocated deductions. Further, the fact that deductions are being allocated indicates that the Taxpayer or one of its affiliates is incurring expenses to administer the same trademarks for which the Taxpayer is paying royalties. In fact, the deductions allocated far exceed the expenses directly incurred by IHC. This management arrangement is not evidenced by any contractual agreement or analysis as to accuracy or fair market value.

In addition, trademark guidance materials provided indicate that any users of the trademarks were to contact the Taxpayer instead of IHC concerning information on the artwork or production elements of the trademarks. Such services should be performed by IHC as the owner of the trademarks. As such, the Department concludes that IHC lacks economic substance.

The Taxpayer has provided copies of the trademark licensing agreement and portions of an appraisal performed by an independent third party to show that the royalty rates were established at fair market value. The Department does not look solely to the royalty rate when examining this type of transaction. Because IHC is essentially a 100%­owned subsidiary, the Taxpayer never lost the ability to control the subject assets, the rate or terms of the license agreement, or the unrestricted use of the trademarks. The Taxpayer is essentially free to undo the transactions with IHC at any time.

The royalty rate charged by IHC was tripled in 1992 based on an appraisal. The appraisal is based on comparable royalty rates. The appraisal, however, acknowledges that there were no prevalent royalty rates directly comparable to the Taxpayer's business. The accounting firm that prepared the appraisal, therefore, develops analyses of inexact comparables pulling from different segments of the Taxpayer's business, rates charged by the Taxpayer to foreign affiliates, and publicly traded companies.

The appraisal gives no analysis or consideration as to the Taxpayer's historical performance, the financial condition or earning capacity of the Taxpayer, or the economic outlook of the Taxpayer's industry. The Taxpayer would have the Department believe that the median rate from a list of royalty rates from business activities in which the Taxpayer is not engaged should be an acceptable way to determine a royalty rate.

The Taxpayer has also provided an advance pricing agreement with the Internal Revenue Service for the 1994 through 1997 taxable years. The agreement governs rates the Taxpayer charges to foreign affiliates and joint ventures. The agreement allows an initial royalty rate that is increased once certain criteria are met. The appraisal, however, contradicts this agreement by stating that the royalty rates charged to foreign affiliates cannot be directly compared to the rate that should be charged by IHC. As such, the Department does not find the advance pricing agreement persuasive.

Further, the Taxpayer and other affiliates, through activities such as advertising, investment, company management, business and employment practices, and operating efficiencies, have created the favorable recognition for the trademarks. The Department acknowledges the trademark has value. The fact is that the Taxpayer continues to engage in these same activities that maintain and enhance the favorable recognition of the trademarks. No evidence has been presented to show that the Taxpayer and other affiliates are compensated for these continuing contributions. As such, while IHC reaps the benefits of the Taxpayer's hard work in creating the fame and recognition enjoyed by the trademarks, the Taxpayer goes uncompensated for past and ongoing contributions to the trademarks' value.


The Department has examined the license agreements themselves. The agreements contain very little authority for IHC to maintain the proper use of the trademarks. The authority is limited to an approval process, but does not allow for a periodic review of the Taxpayer's use of the trademarks. In addition, the agreements call for only one annual royalty payment. It has been the Department's experience that similar agreements between unrelated third parties require more frequent remuneration. Consequently, the Department finds that the license agreements between the Taxpayer and IHC do not meet an arm's length standard.

Finally, you contend that the IHC's facts are analogous to that described in Public Document ("P.D.") 94-309, (10/11/94), in which the Department reversed the auditor's consolidation of a taxpayer with an intangible holding company. Unlike the intangible holding company in P.D. 94-309, IHC did not incur significant routine business expenses, manage its own accounts, engage in transactions with unrelated third parties, or establish that the royalties are reasonable when compared to royalties charged to third parties.

Thus, to the extent that IHC does not appear to have valid economic substance and the intercompany transactions were not conducted at arm's length, the facts fit those of General Electric and satisfy the Court's requirement of (1) an arrangement (2) between two or more 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. Accordingly, the adjustment to consolidate IHC with the Taxpayer is upheld.

MHC

MHC holds mortgage loans and deeds of trust on real estate on the books of the Taxpayer and other affiliates. MHC was capitalized through a contribution of mortgage receivables from the Taxpayer. It is unclear whether the mortgages held by MHC are loans for the purchase of new real estate, refinancing arrangements, or equity loans.

The Department has reviewed the information provided concerning the economic substance of MHC. MHC had only three members of the board of directors. The same three individuals served as officers of MHC. One of the individuals was also employed by the Taxpayer. The Taxpayer asserts that the board held regular meetings, but MHC reported no expenses as a result of such meetings. In addition, no evidence has been provided to show that the officers or directors were fairly compensated for their services. The amount of payroll reported by MHC could not be considered to be the fair market value of compensation for a corporation generating more than one hundred million dollars in revenues.

For the taxable years 1991 and 1992, MHC incurred minimal expenses for payroll, rent, and communications. The amount of payroll expense indicates that MHC employees spent minimal time conducting the business. MHC operating expenses were minimal in relation to the amount of revenues generated.

MHC did incur legal fees and the Taxpayer appears to have allocated some deductions from its books. No documentation was provided as to the nature of the professional fees or allocated deductions. Further, the fact that deductions are being allocated indicates that the Taxpayer or one of its affiliates is incurring expenses to administer the same mortgage notes on which the Taxpayer is paying interest. In fact, the deductions allocated far exceed the expenses directly incurred by MHC. The arrangement is not evidenced by any contractual agreement or analysis as to accuracy or fair market value.

The Taxpayer contends that the transactions with MHC are at an arm's length interest rate. The Department, however, does not look only to the rate when examining this type of transaction. The Taxpayer transferred assets to a newly created subsidiary in exchange for stock, in a tax-free transaction. If the Taxpayer were dealing with an unrelated third party, it would not transfer assets without consideration. Because MHC is wholly owned by the Taxpayer, the Taxpayer never lost the ability to control the subject assets, the rate or terms of the note agreements. The Taxpayer is essentially free to undo the transaction with MHC at any time.

MHC has provided an example of a mortgage given to the Taxpayer. At first glance, it appears that the mortgage notes held by MHC are at arm's length. The evidence shows that these notes were secured by collateral and provided a payment schedule and penalties for the failure to pay. Instead of a typical payment plan requiring monthly payments, the example mortgage note and deed of trust provided call for quarterly payments. Because interest is accrued on the outstanding principal, such an arrangement, even where the interest rate is at a going rate, allows an additional two months for interest to accumulate.

Thus, to the extent that MHC does not appear to have valid economic substance and the intercompany transactions were not conducted at arm's length, the facts fit those of General Electric and satisfy the Court's requirement of (1) an arrangement (2) between two or more 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. Accordingly, the auditor's adjustment to consolidate MHC with the Taxpayer is upheld.

NHC

NHC was capitalized through a contribution of stock of various foreign and domestic subsidiaries from the Taxpayer, including IHC and MHC. Dividends from these stock investments are used to make loans to the Taxpayer and other affiliates.

The Department has reviewed the information provided concerning the economic substance of NHC. NHC had only three members of the board of directors. The same three individuals served as officers of NHC. One of the individuals was also employed by the Taxpayer. The Taxpayer asserts that the board held regular meetings, but NHC reported no expenses as a result of such meetings. In addition, no evidence has been provided to show that the officers or directors were fairly compensated for their services. The amount of payroll reported by NHC could not be considered to be the fair market value of compensation for a corporation generating more than one hundred million dollars in revenues.

For the taxable years 1991 and 1992, NHC incurred minimal expenses for payroll, rent, and communications. The amount of payroll expense indicates that NHC employees spent minimal time conducting the business. NHC operating expenses were minimal in relation to the amount of revenues generated.

NHC did incur legal fees and the Taxpayer appears to have allocated some deductions from its books. No documentation was provided as to the nature of the professional fees or allocated deductions. Further, the fact that deductions are being allocated indicates that the Taxpayer or one of its affiliates is incurring expenses to administer the same investments and notes on which the Taxpayer pays interest. In fact, the deductions allocated far exceed the expenses directly incurred by NHC. The arrangement is not evidenced by any contractual agreement or analysis as to accuracy or fair market value.

NHC provided an example of a loan given to one of its affiliates. The note is a demand note with a payment schedule, but there is no collateral and no penalty for the failure to pay. The fact that there is no collateral or penalty makes sense when the Taxpayer is in complete control of the NHC. If the Taxpayer were to default on the loans from NHC, the original transaction that created NHC could simply be reversed and the balance of the loans would be eliminated by a simple journal entry. Essentially, the Taxpayer transferred investments to NHC, manages the investments of NHC, and decided to have NHC make loans back to the Taxpayer resulting in a large interest deduction on its corporation income tax returns. In sum, the Taxpayer is paying interest to NHC on loans resulting from assets that the Taxpayer both owns and directly controls.

From the facts and observations presented, it appears that NHC possesses little economic substance and the interest payments improperly reflect Virginia income. Thus, to the extent that the intercompany interest primarily reflects "paper" intercompany transactions, the facts fit those of General Electric and satisfy the Court's requirement of (1) an arrangement (2) between two or more 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. Accordingly, the auditor's adjustment of consolidate NHC with the Taxpayer is upheld.

Application of Va. Code § 58.1-446

The Taxpayer asserts that the Department seeks to remedy the alleged distortion by consolidating subsidiaries that are not directly owned by the Taxpayer. NHC is wholly owned by an affiliate of the Taxpayer that provides management services to various members of the group, and IHC and MHC are wholly owned by NHC. The Taxpayer does, however, exhibit the ability to control IHC, MHC and NHC as the sole owner of the affiliate that owns NHC. It is clear that this degree of interlocking management permits the Taxpayer to control the activities of IHC, MHC and NHC.

In General Electric, the Court stated that the Department may equitably adjust the tax if there is (1) an arrangement (2) between two or more 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 second criterion clearly does not restrict the application of Va. Code § 58.1-446 to only those cases involving a direct parent-subsidiary relationship. Rather, the statute upholds the Department's authority to adjust the tax equitably in any instance in which improper reflection of Virginia taxable income is created by intercompany transactions between two corporations with common ownership. This criterion is plainly met in the instant case because the Taxpayer owned 100% of the stock of the subsidiary that owns NHC, which in turn wholly owns IHC and MHC.

Further, the Taxpayer contends that the consolidation of the Taxpayer with IHC, MHC, and NHC creates a distortion of income from Virginia sources because the three subsidiaries entered into similar transactions with related entities that have no connection with Virginia and, thereby, includes income that has no connection with the Commonwealth. The auditor, however, properly included the revenues from these other intercompany transactions in the denominator of the sales factor. In doing so, the auditor accounted for these other intercompany transactions as income from sources outside Virginia.

The Taxpayer further asserts that, if the Department determines that the transactions were not conducted at an arm's length rate, the appropriate remedy would be for the Department to adjust the rates for the transactions. The statute does not prescribe a method for correcting Virginia taxable income when it is determined to be inaccurately stated. As such, depending on the facts and circumstances, the Department may disallow a deduction (P.D. 96-387 (12/26/1996)), adjust the rate of the transactions (P.D. 95-143 (6/5/1995)), or consolidate corporations (P.D. 94-179 (6/8/1994)) for purposes of determining properly reflected Virginia taxable income. Based on the evidence, the Department concludes that the consolidation of IHC, MHC, and NHC with the Taxpayer most accurately reflects Virginia taxable income.

Accordingly, the assessments resulting from the audit adjustments are upheld pursuant to the enclosed schedule. No additional interest will accrue provided the outstanding balance in paid within 30 days from the date of this letter. The Taxpayer should remit its 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, regulations and public documents cited, as well as other reference documents, are available on-line in the Tax Policy Library section of the Department web site, located at www.tax.virginia.gov. If you have any questions regarding this determination, you may contact ***** in the Office of Policy and Administration, Appeals and Rulings, at *****.
                • Sincerely,

                    • Kenneth W . Thorson
                      Tax Commissioner



AR/11056B


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46