Document Number
06-52
Tax Type
Corporation Income Tax
Description
Does not meet the economic substance safe harbor under Title 23 VAC 10-120-361
Topic
Corporate Distributions and Adjustments
Property Subject to Tax
Date Issued
04-28-2006



April 28, 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 assessment issued to ***** (the "Taxpayer') and its subsidiaries for the taxable years ended April 30, 1995 and 1996. I apologize for the delay in responding to your appeal.

FACTS


The Taxpayer is a member of an affiliated group of corporations (collectively, the "Group") that filed a consolidated Virginia corporate income tax return for the taxable years ended April 30, 1995 and 1996. The Department audited the Group and made several adjustments, resulting in additional Virginia income tax liability for the taxable year ended April 30, 1995. Specifically, the auditor consolidated three out-of-state corporations with the Group on the basis that these corporations lacked economic substance. The Taxpayer contests the consolidation of the three corporations with the Group.

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.]

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 and after January 1, 1993, the Department promulgated expanded regulations concerning the application of Va. Code § 58.1-446. Title 23 of the Virginia Administrative Code ("VAC") 10-120-361 through 364 set forth factors for determining whether intragroup transactions distort income from business done in Virginia and remedies that may be applied by the Department.

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.

In light of this background, I will address each out-of-state corporation consolidated with the Group.

IHCA

********** ("IHCA") was incorporated in Delaware in May 1990. IHCA received trademarks from two members of the Group in exchange for stock in IHCA. The value of the stock received was proportionate to the value of the trademarks contributed. The value of the trademarks exchanged was based on an appraisal prepared by an independent third party. The royalty rates charged by IHCA vary depending on the product. No intangible assets are licensed to parties outside the Group.

IHCA also loaned funds to members of the Group. The loans took the form of intercompany demand notes with no collateral. The rate of interest on the notes is equal to a percentage "above the annual rate for federal funds in the interbank term federal funds market in New York City through brokers of recognized standing."

The Taxpayer has made several arguments to justify the need for a separate entity to hold the trademarks. According to the Taxpayer, IHCA was created to provide centralized management for the trademarks, facilitate licensing and sale of such property, and permit better measurement of the value of the components of its business. The Taxpayer also contends that IHCA was created for the valuable business purpose of protecting the Group's trademarks and tradenames. The Taxpayer has provided evidence to document the stated business purposes.

The Department has examined the evidence concerning centralization of management, licensing, and measurement of the trademarks. IHCA engaged a law firm to file trademark applications, renewals, and registrations. IHCA, however, licensed the trademarks only to two members of the Group that contributed the trademarks to IHCA. No evidence has been provided to show how the Taxpayer measured the business components through IHCA.

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 the actions of the Group would not significantly affect the value of the trademarks held by IHCA. Consequently, if the reputation of the Group or its ability to produce its products were to be severely damaged through a legal or illegal action, the value of the trademarks would be adversely affected.

According to the Taxpayer, Delaware was chosen as IHCA's state of domicile because of Delaware's favorable corporate statutes and strong business climate. Delaware has long sought to attract corporations to the state by, among other things, exempting from income tax those corporations whose activities within the state "are confined to the maintenance and management of their intangible investments" such as trademarks. See Del. Code Ann. § 1902(b)(8). Based on the information provided, it appears that avoiding state income tax was a primary consideration in locating IHCA in Delaware.

Under Title 23 VAC 10-120-361 C 2, one of the factors considered by the Department in determining whether intragroup transactions distort income from business done in Virginia is whether a member of a controlled group of corporations has a significant income, with only minimal capital, activity, or expenses as a result of essential corporate functions performed by other group members without an arm's length charge. This means that the Department will analyze the economic substance of a member of a group to determine whether it conduct's sufficient activities to operate in its own best interest.

You maintain that IHCA meets the economic substance safe harbor under Title 23 VAC 10-120-361 by retaining employees, office space, and books and records. The office, however, was rented from ***** (the "Landlord'), which specializes in providing services to absentee corporations. In fact, hundreds of other corporations share the same office space with IHCA. You contend that each of the three intangible holding companies had their own office space. Yet the leases with the Landlord indicate that IHCA shared the same office suite as ***** ("IHCB") and ***** ("IHCC").

In addition, the president of the Landlord is also the president of IHCA, as well as numerous other absentee corporations. In fact, IHCA shares directors with a number of other intangible holding companies. The Taxpayer has asserted that IHCA had four full time employees that managed its day-to-day operations. The evidence, however, shows that IHCA's officers spent minimal time in conducting business and total annual payroll was less than $2,000. Further, IHCA's operating expenses were minimal in relation to the amount of income generated. As such, it is my determination that IHCA lacks substance for purposes of Va. Code § 58.1-446.

The Taxpayer has also 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. When examining this type of transaction, the Department does not look solely to the royalty rate. IHCA came into existence when the two wholly owned subsidiaries of the Taxpayer transferred intangible assets in exchange for IHCA's stock. Because IHCA 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 assets. The Taxpayer is essentially free to undo the transactions with IHCA at any time.

In the trademark license agreements, the licensee is required to produce the product in "a first rate manner" and maintain a standard of quality at least as high as products produced prior to the conveyance of the trademarks to IHCA. The quality of the products along with advertising, investment, business practices, and expertise are the primary factors that contributed to creating the value in the trademarks. The affiliated corporations, by agreement, were required to continue to operate in the same manner that created the value in the trademarks. In fact, these same operations continue to add to the value of the trademarks. The Taxpayer claims that the royalty rates were structured to recognize the continuing value added by the contributing corporations. Nevertheless, the royalty rates charged by IHCA are not significantly different from the comparable royalty rates charged to unrelated third parties listed in the appraisal.

The license agreement assigns the task of monitoring the licensees' use of the trademarks to the Taxpayer. No evidence has been produced to indicate that the Taxpayer was compensated for ensuring the proper use of the trademarks. In addition, the fact that IHCA could not perform the monitoring function is further evidence that it lacked sufficient economic substance to be a viable business enterprise.

As for the intercompany loans, the evidence does not demonstrate that the loans between IHCA and members of the Group were at arm's length. The loans' interest rates were set at slightly more than one-half percent above the federal funds per annum rate. Although the interest payments received do not appear to be mere paper transactions, the notes do not include payment schedules, are not secured by any collateral, and do not contain any provisions for penalties if there is a failure to pay.

Accordingly, the Department finds that the intragroup transactions between IHCA and other members of the Group satisfy the requirements of Title 23 VAC 10-120-361 A that (1) there is an arrangement; (2) between one or more members of a group subject to Virginia income tax, engaging in one or more intragroup transactions; (3) where the consideration for an intragroup transaction does not accurately reflect the income from business done in Virginia of the participating group members; and (4) the intragroup transaction has the purpose or effect of distorting income from business done in Virginia.

IHCB

***** ("IHCB") was incorporated in Delaware in 1991. According to the Taxpayer, IHCB was created "to provide centralized management for intercompany debt, secure long-term financing opportunities for the Group and facilitate the movement of monies within the Group to minimize the overall cost of borrowing." However, the fact that IHCA and IHCC were also making loans to the Group appears to discredit the Taxpayer's stated purpose for the creation of IHCB.

IHCB loaned funds to members of the Group. The loans took the form of intercompany demand notes with no collateral. The rate of interest on the notes is equal to a percentage "above the annual rate for federal funds in the interbank term federal funds market in New York City through brokers of recognized standing."

According to the Taxpayer, Delaware was chosen to be IHCB's state of domicile because of Delaware's favorable corporate statutes and strong business climate. Delaware has long sought to attract corporations to the state by, among other things, exempting from income tax those corporations whose activities within the state "are confined to the maintenance and management of their intangible investments" such as trademarks. See Del. Code Ann. § 1902(b)(8). It is apparent that IHCB was located in Delaware in order to avoid paying state income tax on income associated with the loans made to affiliated businesses.

Under Title 23 VAC 10-120-361 C 2, one of the factors considered by the Department in determining whether intragroup transactions distort income from business done in Virginia is whether a member of a controlled group of corporations has a significant income, with only minimal capital, activity, or expenses as a result of essential corporate functions performed by other group members without an arm's length charge. This means that the Department will analyze the economic substance of a member of a group to determine whether it conduct's sufficient activities to operate in its own best interest.

You maintain that IHCB meets the economic substance safe harbor under Title 23 VAC 10-120-361 by retaining employees, office space, and books and records. IHCB, however, shares office space with IHCA and IHCC. The Landlord specializes in providing services to absentee corporations. Hundreds of other corporations share the same office space with IHCB. Yet the leases with the Landlord indicate that IHCB shared the same office suite as IHCA and IHCC.

In addition, the president of the Landlord is also the president of IHCB, as well as numerous other absentee corporations. IHCB shares directors with a number of other intangible holding companies. The Taxpayer asserts that IHCB had four full time employees that managed its day-to-day operations. IHCB's officers spent minimal time in conducting business and its total annual payroll was less than $2,000 per year, indicating that employees were part-time and that IHCB had minimal operations. In fact, three of the four employees had salaries of less than $100 per year. IHCB's operating expenses were minimal in relation to the amount of income generated. Based on these facts, it is my determination that IHCB lacks substance for purposes of Va. Code § 58.1-446.

The evidence regarding the intercompany loans does not demonstrate that the loans between IHCB and members of the Group were at arm's length. The loans' interest rates were set at slightly more than one-half percent above the federal funds per annum rate. Although the interest payments received do not appear to be mere paper transactions, the notes do not include payment schedules, are not secured by any collateral, and do not contain any provisions for penalties if there is a failure to pay.

In addition, the Department has concluded that lending transactions between the Taxpayer and IHCB fail to meet the safe harbor provided under Title 23 VAC 10-120-361 E 3. The Department finds that IHCB is not a discrete, separate business enterprise and loans are not made at a fair market value interest rate, with collateral, payments, and credit standing substantially similar to those that the Taxpayer could obtain from an unrelated lending institution.

As such, the Department finds that the intragroup transactions between IHCB and other members of the Group satisfy the requirements of Title 23 VAC 10-120-361 A that (1) there is an arrangement; (2) between one or more members of a group subject to Virginia income tax, engaging in one or more intragroup transactions; (3) where the consideration for an intragroup transaction does not accurately reflect the income from business done in Virginia of the participating group members; and (4) the intragroup transaction has the purpose or effect of distorting income from business done in Virginia.

IHCC

***** ("IHCC') was incorporated in State A in 1994 for the purpose of holding the trademarks and tradenames of one member of the Group that principally operated in one geographic region. IHCC received trademarks and cash from one member of the Group in exchange for all the proportionate stock in IHCC. The value of the trademarks exchanged was based on an appraisal prepared by an independent third party. The royalty rates charged by IHCC vary depending on the product. No intangible assets are licensed to parties outside the Group.

IHCC also loaned the cash received from the member of the Group back to the same member. The loans took the form of intercompany demand notes that were not collateralized. The rate of interest on the notes is equal to a percentage "above the annual rate for federal funds in the interbank term federal funds market in New York City through brokers of recognized standing."

The Taxpayer has made several arguments to justify the need for a separate entity to hold the trademarks. According to the Taxpayer, IHCC was created to provide management for the trademarks, facilitate licensing and sale of such property, and permit better measurement of the value of the components of its business. The Taxpayer also contends that IHCC was created for the valuable business purpose of protecting the Group's trademarks and tradenames. The Taxpayer has provided evidence to document the stated business purposes.

The Department has examined the evidence concerning centralization of management, licensing, and measurement of the trademarks. IHCC engaged a law firm to file trademark applications, renewals, and registrations. IHCC licensed the trademarks, however, only to the one member of the Group that contributed the trademarks to IHCC. No evidence has been provided to show how the Taxpayer measured the business components through IHCC.

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. Nevertheless, because of the interrelationship of a trademark to the entity that created it, I am not convinced that the actions of the Group would not significantly impact the value of the trademarks held by the IHCC. Consequently, if the reputation of the Group or its ability to produce its products were to be severely damaged through a legal or illegal action, the value of the trademarks would be adversely affected.

According to the Taxpayer, Delaware was chosen to be IHCC's state of domicile because of Delaware's favorable corporate statutes and strong business climate. Delaware has long sought to attract corporations to the state by, among other things, exempting from income tax those corporations whose activities within the state "are confined to the maintenance and management of their intangible investments" such as trademarks. See Del. Code Ann. § 1902(b)(8). Based on the information provided, it appears that avoiding state income tax was a primary consideration in locating IHCC in Delaware.

Under Title 23 VAC 10-120-361 C 2, one of the factors considered by the Department in determining whether intragroup transactions distort income from business done in Virginia is whether a member of a controlled group of corporations has a significant income, with only minimal capital, activity, or expenses as a result of essential corporate functions performed by other group members without an arm's length charge. This means that the Department will analyze the economic substance of a member of a group to determine whether it conduct's sufficient activities to operate in its own best interest.

You contend that IHCC meets the economic substance safe harbor under Title 23 VAC 10-120-361 by retaining employees, office space, and books and records. IHCC, however, shares office space with IHCA and IHCB. The Landlord specializes in providing services to absentee corporations. Hundreds of other corporations share the same office space with IHCC. Yet the leases with the Landlord indicate that IHCC shared the same office suite as IHCA and IHCB.

In addition, the president of the Landlord is also the president of IHCC, as well as numerous other absentee corporations. IHCC shares directors with a number of other intangible holding companies. The Taxpayer asserts that IHCC had four full time employees that managed its day-to-day operations. The evidence, however, shows that IHCC's officers spent minimal time in conducting business and total annual payroll was less than $2,000. Further, IHCC's operating expenses were minimal in relation to the amount of income generated. Based on these facts, I must conclude that IHCC lacks substance for purposes of Va. Code § 58.1-446.

The Taxpayer has also 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. As previously mentioned, the Department does not look solely to the royalty rate when examining this type of transaction. IHCC came into existence when a wholly owned subsidiary of the Taxpayer transferred intangible assets and cash in exchange for IHCC's stock. Because IHCC 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 assets. The Taxpayer is essentially free to undo the transactions with IHCC at any time.


In the trademark license agreements, the licensee is required to produce the product in "a first rate manner" and maintain a standard of quality at least as high as products produced prior to the conveyance of the trademarks to IHCC. The quality of the products along with advertising, investment, business practices, and expertise are the primary factors that contributed to creating the value in the trademarks. The affiliated corporations, by agreement, were required to continue to operate in the same manner that created the value in the trademarks. In fact, the operations continue to add to the value of the trademarks. The Taxpayer claims that the royalty rates were structured to recognize the continuing value added by the contributing corporations. Nevertheless, the royalty rates charged by IHCC are not significantly different from the comparable royalty rates charged to unrelated third parties listed in the appraisal.

The license agreement assigns the task of monitoring the licensees' use of the trademarks to the Taxpayer. No evidence has been produced to indicate that the Taxpayer was compensated for ensuring the proper use of the trademarks. In addition, the fact that IHCC could not perform the monitoring function is further evidence that it lacked sufficient economic substance to be a viable business enterprise.

The evidence regarding the intercompany loan does not demonstrate that the loans between IHCC and members of the Group were at arm's length. The loans' interest rates were set at slightly more than one-half percent above the federal funds per annum rate. Although the interest payments received do not appear to be mere paper transactions, the notes do not include payment schedules, are not secured by any collateral, and do not contain any provisions for penalties if there is a failure to pay.

The Department, therefore, finds that the intragroup transactions between IHCC and other members of the Group satisfy the requirements of Title 23 VAC 10-120-361 A that (1) there is an arrangement; (2) between one or more members of a group subject to Virginia income tax, engaging in one or more intragroup transactions; (3) where the consideration for an intragroup transaction does not accurately reflect the income from business done in Virginia of the participating group members; and (4) the intragroup transaction has the purpose or effect of distorting income from business done in Virginia.

CONCLUSION


Based on the evidence provided, the Taxpayer has not shown that IHCA, IHCB and IHCC were formed and located in Delaware for any purpose other than the avoidance of state income tax. Accordingly, the Department concludes that the audit adjustments result in an equitable correction to reflect properly the Virginia income of the Group for the taxable years ended April 30, 1995 and 1996.

A revised bill, with interest accrued to date, will be sent to the Taxpayer. No additional interest will accrue provided the outstanding balance in paid within 30 days from the date of the revised bill. Please remit your 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 *****.

You should note 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 Code of Virginia and regulation sections cited, along with other reference 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 regarding this determination, please contact ***** in the Department's Office of Policy and Administration, Appeals and Rulings, at *****.
              • Sincerely,

              • Kenneth W. Thorson
                Tax Commissioner





AR/21190B


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46