Document Number
06-33
Tax Type
Corporation Income Tax
Description
Foreign source income subtraction adjusted to include the foreign royalty fees
Topic
Assessment
Subtractions and Exclusions
Date Issued
03-22-2006


March 22, 2006



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 December 31, 1994 through 1996. I apologize for the delay in responding to your appeal.

FACTS


The Taxpayer, an out-of-state corporation, filed a separate Virginia corporate income tax return for each taxable year at issue. In an audit by the Department, the auditor disallowed interest expense reported by the Taxpayer on an outstanding loan from its wholly owned subsidiary, ***** ("IHC"). The auditor determined IHC lacked substance and the intercompany loan transactions were not at arm's length. The Taxpayer contends that IHC is a viable independent company with economic substance, and as such, its intercompany loan with the Taxpayer is valid and the interest expense should be allowed.

In addition, the Taxpayer included amounts characterized as technical services fees in the Virginia foreign source income subtraction. The Department's auditor concluded that these amounts did not qualify as foreign source income pursuant to Va. Code § 58.1-302, and reduced the amount of the subtraction. The Taxpayer contests the auditor's adjustment, asserting that these amounts are eligible for the Virginia foreign source income subtraction.

DETERMINATION


Intangible Holding Company

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.]

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.

According to Title 23 of the Virginia Administrative Code ("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.

IHC was formed in the 1980's to manage loans for affiliates of the Taxpayer that were located in several foreign countries. In 1986, many loans for foreign affiliates were repaid and the proceeds were loaned to domestic affiliates.

IHC loaned funds to the Taxpayer and other domestic affiliates. The loans took the form of intercompany demand notes that were not collateralized. The floating rate of interest on the notes is equal to the "Prime Rate interest per annum," although one note had a rate set at 8%.

The Department has also reviewed the information provided concerning the substance of the loan transactions. Title 23 VAC 10-120-361 E provides a safe harbor for intragroup loan transactions. It states:
    • In an intragroup lending transaction, the lending party must be a discrete, separate business enterprise with its own employees, office space, and books and records. Funds must be loaned at a fair market value interest rate, with collateral, payments, and credit standing substantially similar to those which the borrower could obtain from an unrelated lending institution.

The Department has reviewed the information provided concerning the economic substance of IHC. IHC had eight members on the board of directors. Four of the directors served as officers of the Taxpayer. No evidence has been provided to show that the officers or directors were fairly compensated for their services. For the taxable years under review, IHC incurred minimal expenses for payroll and rent. In fact, IHC had only one employee whose pay reflected at most some part-time work on behalf of IHC. The amount of payroll reported by IHC could not be considered to be the fair market value of compensation for a corporation with a portfolio of receivables in excess of $100,000,000. Although no information concerning job duties has been provided, it would appear that the employee did not possess either the authority or the expertise to negotiate, manage, or enforce the loan agreements between IHC and its related debtors.

IHC provided several examples of loan agreements. The notes are demand notes with interest payments due either monthly, quarterly, or on demand. There is no collateral and no penalty for the failure to pay. As such, IHC's loan agreements do not meet the requirements of the safe harbor.

Further, neither the Taxpayer nor IHC has incurred any risk in exercising this arrangement. If the Taxpayer were to default on the loans from IHC, the original transactions could simply be reversed and the balance of the loans would be eliminated by a simple journal entry. The Taxpayer is paying interest to IHC on loans resulting from assets that the Taxpayer both owns and directly controls.

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 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.

Foreign Source Income - Technical Services Fees

Virginia Code § 58.1-302 defines foreign source income, in pertinent part, as:
    • Rents, royalties, license, and technical fees from property located or services performed without the United States or from any interest in such property, including rents, royalties, or fees for the use of or the privilege of using without the United States any patents, copy rights, secret processes and formulas, good will, trademarks, trade brands, franchises, and other like properties.

The Department has previously ruled that the words "technical fees from . . . services performed" cannot be taken out of context to create a subtraction for income earned from the performance of services outside the United States for any service that can be characterized as of a technical nature. See Public Document ("P.D.") 86-209 (11/3/86). In order to qualify for the Virginia foreign source income subtraction, "technical fees" must be incidental to a contract relating to the rental of real property or the licensing of a patent or other like property outside the United States. See P.D. 91-57 (3/29/91).

In a case such as this, the Taxpayer must prove by clear evidence that the technical services are incidental to a contract relating to the rental of real property or the licensing of a patent or other like property outside the United States. The Taxpayer states that the income is derived from royalty payments made by wholly owned foreign subsidiaries to the Taxpayer for the subsidiaries' use of patents, patent applications, and trademarks.

The Taxpayer has provided copies of the licensing agreements that produced the income at issue. It is clear from the terms of the agreements that the fees in question were royalty payments for the use of the Taxpayer's patents, patent applications, and trademarks. As such, "technical service fees" will be reclassified as royalties for the purposes of computing the Taxpayer's foreign source income subtraction.

CONCLUSION


Based on the foregoing, the audit adjustment to disallow the interest expenses charged by the IHC results in an equitable correction to reflect properly the Virginia income of the Taxpayer for the taxable years ended December 31, 1994 through 1996. I find no error in this adjustment. The foreign source income subtraction will be adjusted to include the foreign royalty fees and to reflect the change in expenses related to the foreign source income subtraction.

The assessment has been adjusted pursuant to the enclosed schedules. A revised bill, with interest accrued to date, will be sent to the Taxpayer. 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, regulations, and public documents cited, along with other reference documents, are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. 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/18357B


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46