Document Number
05-29
Tax Type
Corporation Income Tax
Description
Trademarks/Royalty Fee
Topic
Accounting Periods and Methods
Assessment
Date Issued
03-02-2005


March 7, 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 ***** (the "Taxpayer') for the taxable years ended June 30, 1994 through 1996. I apologize for the delay in responding to your appeal.

FACTS

In July 1988, ***** (the "Parent") transferred all its trademarks and trade names (the "Trademarks") to a wholly owned subsidiary ("S1") in a tax-free exchange under Internal Revenue Code ("IRC") § 351. S1, which owns the Taxpayer, in turn contributed the Trademarks to another one of its wholly owned subsidiaries ("IHC"). As described in your letter, the primary function of IHC is to concentrate trademark protection activities, protect the Trademarks from creditors and insulate the Trademarks from lawsuits filed against the Taxpayer.

The Taxpayer entered into a license agreement with IHC, entitling the Taxpayer to use the Trademarks for a royalty fee based on a percentage of revenue earned.

According to the Taxpayer, IHC monitored the use of the Trademark, managed the legal defense of trademark violations, invoiced and collected royalties from licensees, and invested royalty proceeds. The investments made by IHC include securities and loans to related parties.

In computing federal taxable income for the taxable years at issue, the Taxpayer deducted royalties paid or accrued to IHC. The Department's auditor determined that the royalty fees and interest for the late payment of the royalties charged to the Taxpayer by IHC was an arrangement that improperly reflected business done in Virginia. As a result, the auditor disallowed the royalty and interest deductions reported by the Taxpayer.

You contest the disallowance of the royalty expense reported by the Taxpayer. You argue that Va. Code § 58.1-446 only applies to tangible goods and not to intercompany trademark and loan transactions. In addition, you contend that IHC had sufficient economic substance and a business purpose. Finally, you assert that consolidation of income rather than expense reattribution is the only proper remedy allowed pursuant to Va. Code § 58.1-446.

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 [night 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 Mixable 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, 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.

Application of Va. Code § 58.1-446

Because the first paragraph of Va. Code § 58.1-446 refers specifically to transactions of commodities, products, and goods, the Taxpayer asserts that the statute does not apply to transactions involving intangible personal property. The second paragraph of Va. Code § 58.1-446, however, grants the Department broad authority to adjust equitably the Virginia corporate income tax in any case where "any arrangements exist in such a manner as improperly to reflect business done in this Commonwealth or the Virginia taxable income earned from business done in the Commonwealth."

Further, in General Electric, the issue involved the creation of a Domestic International Sales Corporation ("DISC") that permitted General Electric to transfer income in the form of commissions to a wholly owned subsidiary at less than arm's length business standards. This arrangement included neither products nor services. The only asset created was deferred income taxes. See General Electric at 236 Va. 54, 59 (1988). Thus, contrary to your assertion, the Department's authority under Va. Code § 58.1-446 is not limited to transactions of commodities, products, and goods.

The Taxpayer also argues that the Department is not authorized to disallow the deductions under the statute. According to the Taxpayer, the Department in limited to consolidating the accounts of corporations subject to Virginia income tax. I disagree. Virginia Code § 58.1-446 grants the Department authority to adjust the tax "in such manner as it may determine." Accordingly, the Department has set forth a number of remedies in Title 23 of the Virginia Administrative Code ("VAC") 10-120-363.

The Taxpayer further argues that, because IHC does not have nexus with Virginia, the Department lacks the authority to impose income tax on IHC under Public Law 86-272, codified at 15 U.S.C. §§ 381-384, and the Due Process Clause: of the United States Constitution. Where there is an arrangement between two or more commonly owned corporations that results in the improper reflection of income in Virginia, however, the Department is authorized under Va. Code § 58.1-446 to adjust the tax "in such manner as it may determine." As such, the Department may determine that income of an affiliate be deemed Virginia income even if the affiliate does not have nexus. See Public Document ("P.D.") 96-346 (11/25/96).

Again, the Virginia Supreme Court's decision in General Electric supports the Department's policy. The decision upheld the Department's authority to consolidate the DISC even though the DISC did not engage in business in Virginia, was not qualified to do business in Virginia, and had no assets, property, employees or offices in Virginia. See General Electric, 236 Va. 54, 58, 62.

The Taxpayer asserts that the transactions with IHC are not distortive because IHC had sufficient economic substance and a business purpose. The Department has reviewed the documentation provided concerning the economic substance and business purpose of IHC.

For the taxable years ended June 30, 1994 and 1995, IHC incurred expenses for salaries, rent, and other office expenses in ***** ("State A"). For the taxable year ended June 30, 1996, all of the activities of IHC were handled through a patent attorney located in ***** ("State B").

The Taxpayer states that IHC's board of directors conducted regular meetings in State A and State B. However, IHC has reported no expenses related to these meetings. In fact, all of IHC's officers and directors were employees of the Taxpayer or affiliates of the Taxpayer, and none of the officers or directors were compensated for their services.

The Taxpayer has produced several letters to show that IHC was involved with protecting the Trademarks. These documents show that the protection activities occurred outside the taxable years at issue. Further, while the license agreement permits IHC to inspect the Taxpayer's operations and use of the Trademarks, no evidence has been provided to show that IHC conducted any activities related to maintaining the quality of the Trademarks.

Further, under the license agreement, the Taxpayer is required to maintain records of its activities with regard to use of the Trademarks. These records are open to inspection by IHC. No evidence has been provided to show that IHC conducted such inspections, or was even capable of doing so.

In addition, the license agreement requires IHC to provide legends for the appropriate use of the Trademarks. Again, no evidence has been provided to show that IHC provided guidance or legends concerning use of the Trademarks.

Accordingly, while some information has been provided showing that IHC had its own employees, office space, and books and records, I find that the lack of evidence demonstrating IHC's ability to evaluate the Taxpayer's use of the Trademarks, and the lack of independence of the officers and directors, raise doubts as to IHC's ability to operate as a discrete, separate business enterprise.

The Taxpayer also contends that the royalty rates IHC charges related companies to use the trademarks are at arm's length. The Taxpayer has presented a study that determined the royalty rates should be 4.9% of gross revenues for employee services and 3.41% of gross revenues for other services.

A review of the license agreement between the Taxpayer and the IHC calls for a royalty rate of up to 5% of the Taxpayer's gross revenues. A review of the information provided reveals that the royalty fees charged by IHC to the Taxpayer totaled 5.1% of the Taxpayer's gross receipts for the 1994 taxable year, 5.0% for the 1995 taxable year, and 5.4% for the 1996 taxable year. These amounts exceed royalty rates established by the study. The Taxpayer has provided no explanation as to why the actual royalty fees charged far exceeded the amounts proposed by the study. I can only conclude that the arrangement was not intended to reflect an arm's length arrangement.

Further, the Taxpayer accrued and paid interest on the royalties payable to IHC. The license agreement does not provide for any interest to be charged to the Taxpayer for unpaid royalties. No evidence has been provided to show that the interest on the payables reflected an arm's length transaction. Accordingly, I find that transactions between IHC and the Taxpayer are not at arm's length.

CONCLUSION

To the extent that the intercompany license fees and interest primarily reflect "paper" intercompany transactions, the facts are consistent with those addressed in General Electric 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. Under these circumstances, Va. Code § 58.1-4413 authorizes the Department to adjust equitably the tax of the Taxpayer.

The license fees result in the transfer of income from the Taxpayer to IHC. Absent the creation of these arrangements, the royalties would not have been deducted from the Taxpayer's taxable income apportioned and taxed in Virginia. The federal tax laws affecting corporate transfers and consolidated returns allow this action to be taken without penalty or corrective action by the Internal Revenue Service, even where the transactions are not performed at arm's length. In this case, the Department finds that the reattribution of the Taxpayer's and IHC's expenses would correctly reflect Virginia income.

Accordingly, the assessments for the taxable years ended June 30, 1994 through 1996 are upheld. The outstanding balances are shown on the enclosed schedule. No additional interest will accrue provided the outstanding balances are paid within 30 days from the date of this letter. While you request a conference in your letter, your request is declined because the Department's policy is well established in case law and the regulations.

You should also be aware that failure to submit full payment within the 30-day period may result in the imposition of an additional 20% penalty on the tax due under the terms of Virginia's recent Amnesty. See the enclosure entitled "Important Payment Information."

The Taxpayer should remit its payments 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 section and regulations cited, as well as other inference documents, are available on-line in the Tax Policy Library section of the Department's web site, located at www.policylibrary.tax.virginia.gov. If you have any questions about this determination, you may contact ***** in the Office of Policy and Administration, Appeals and Rulings, at *****.
                • Sincerely,


                • Kenneth W. Thorson
                  Tax Commissioner




AR/16781B


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46