Document Number
06-74
Tax Type
Corporation Income Tax
Description
Va. Code § 58.1-446
Topic
Assessment
Computation of Income
Computation of Tax
Partnerships
Subtractions and Exclusions
Taxpayers' Remedies
Date Issued
08-18-2006


August 18, 2006



Re: § 58.1-1824 Application: Corporate Income Tax

Dear ***********:

This will reply to your letter in which you seek correction of the corporation income tax assessments issued to your client, ***** (the "Taxpayer"), for taxable years ended December 31, 1993 through 1995.

FACTS


The Taxpayer was audited for the 1993 through 1995 taxable years, and numerous adjustments were made resulting in an assessment of additional corporate income tax. The Taxpayer paid the assessment and filed a protective claim for refund contesting numerous items, each of which will be addressed separately below.

DETERMINATION


Protective Claim

Pursuant to the authority granted the Tax Commissioner under Va. Code § 58.1-1824, a protective claim for refund can be held pending the outcome of another case before the courts or the claim may be decided based upon its merits pursuant to Va. Code § 58.1-1821. As permitted by statute, the Taxpayer's request has been treated as an appeal under Va. Code § 58.1-1821.

Royalty Income of a Subsidiary

In computing federal taxable income for 1993 through 1995, the Taxpayer deducted royalties charged by ***** (IHC), a wholly owned subsidiary. The Department's auditor removed the royalty deductions after determining the loan agreements between the Taxpayer and IHC lacked economic substance and created an improper reflection of Virginia taxable income.

According to the Taxpayer, IHC was formed to protect, manage and market trademarks and tradenames (the "Trademarks"). The Taxpayer further states that IHC specifically engaged in the licensing of trademarks, instruction on the use and display of trademarks, and protection from infringement.

For the 1993 taxable year, the activities of IHC consisted solely of transferring the Trademarks and executing the agreement to license the same Trademarks back to the Taxpayer. The auditor disallowed the Taxpayer's entire royalty deduction for the 1993 taxable year. The license agreement between the Taxpayer and IHC called for royalty fees to begin November 1, 1993, with payments to be made within 60 days of the end of the quarter. However, neither IHC nor the Taxpayer accrued royalty fees pursuant to this agreement for the taxable year ended December 31, 1993. Accordingly, the audit adjustment to remove the Taxpayer's royalty deduction for 1993 will be reversed.

In the subsequent years, the royalties charged to the Taxpayer and its subsidiaries by IHC were based on the Taxpayer's ability to manufacture products. According to the licensing agreement, the license fee consisted of a percentage of the production costs for all products produced bearing the Trademarks. The Taxpayer asserts that, because the Taxpayer conducted no manufacturing, production, or assembly within Virginia, the royalties charged by IHC had no direct connection to the Taxpayer's business conducted in Virginia. As such, the Taxpayer believes the royalties were legitimately deductible and the denial of the deduction distorts Virginia taxable income.

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 an 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 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.

The Taxpayer argues that the royalties charged by IHC had no direct connection to the Taxpayer's activity within Virginia because it was not based on a percentage of sales. The basis of the royalty computation has no bearing on the Department's authority. The Taxpayer and IHC are commonly owned corporations that engaged in intercompany transactions. This is one of the types of arrangements targeted for scrutiny under Va. Code § 58.1-446.

Further, the Taxpayer asserts that I HC was a viable corporation functioning independently from the Taxpayer. The Taxpayer, however, transferred assets to IHC in a tax-free transaction. If the Taxpayer had been dealing with an unrelated third party, it would not transfer assets without consideration, and then agree to pay a royalty fee for the use of these same assets. Had the assets been transferred to an unrelated third party for their fair market value, the gain realized by the Taxpayer would have been subject to tax by Virginia. Because IHC is a wholly owned subsidiary, the Taxpayer never lost the ability to control the subject assets, the rate or terms of the license agreements, or the unrestricted use of the assets. The Taxpayer is essentially free to undo the transactions with IHC at any time.

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.

The Department has reviewed the economic substance of IHC. IHC incurred significant expenses for professional and consulting fees, rent, depreciation, Trademark expenses, and finance charges. IHC's largest expense was income taxes. In addition, for the 1994 taxable year, the Taxpayer attributed expenses incurred on behalf of its subsidiaries. Almost half of these expenses were attributed to IHC on the federal consolidated income tax return. No such attribution was performed for the 1995 taxable year.

IHC's employees were paid salaries that appear comparable to the skills required to administer a trademark business. The Taxpayer has also provided a copy of a trademark guide produced by IHC that sets forth the appropriate usage of the Trademarks. The Taxpayer has, however, provided no evidence to show that IHC engaged in infringement protection of the Trademarks, or licensing of intangible assets to unrelated third parties. Further, no documentation has been provided to show that IHC actively monitored the quality control of the usage of the Trademarks by the Taxpayer and its subsidiaries.

Title 23 VAC 10-120-361 establishes factors utilized in determining whether intragroup transactions distort income from business done in Virginia. Under Title 23 VAC 10-120-361 C 2, one of the factors considered is whether a member of the group has a significant amount income and only "minimal capital, activity, or expenses because essential corporate functions are performed for the group member by other group members without an arm's length charge." Although IHC has established some activity, the overall expenses incurred are minimal in comparison to the revenue generated from the license agreements. Further, it is clear that the Taxpayer conducted essential corporate functions for IHC for which it was not compensated in the 1995 taxable year. Consequently, the Taxpayer has not clearly established that IHC had economic substance.

In addition, the substance of the royalty transactions is in doubt. The Taxpayer claims that actual cash payments were made to IHC. Yet no records have been provided to document any cash transactions between the Taxpayer and IHC. The ending cash on the books of IHC at the end of each of the taxable years is a very small fraction of the revenue generated. It does not appear that IHC held or invested the cash. IHC made no loans nor paid any significant dividends to the Taxpayer. Based on the information provided, the Department must conclude that the transactions between the Taxpayer and I HC were merely journal entries that reflect "paper" intercompany transactions.

The Taxpayer contends that the transactions between IHC and the Taxpayer were at a fair market rate. It has been the Department's experience that royalties for intercompany transactions have been based on a percentage of sales. In this case, however, the royalty rate was based on a percentage of the manufactured cost of a product carrying the insignia of the Trademarks. The Taxpayer indicates that appraisals were periodically performed to determine the market value of the Trademarks. For proprietary reasons, the Taxpayer only provided a copy of the cover page of an appraisal dated in May 1997. The Department does not consider appraisals conducted after the taxable years at issue to be compelling evidence that the transactions under review were conducted at arm's length. Therefore, the Department is unable to conclude that the royalties charged by IHC reflect fair market transactions.

In addition, while recognizing that the Trademarks do add value to the Taxpayer's business, the Department understands that a wide range of activities including advertising, investment, business practice and expertise, manufacturing processes, quality merchandise, and dependable service to the consuming public conducted by the Taxpayer over a number of years primarily contributed to the Trademarks achieving the high degree of recognition with the purchasing public. The Taxpayer did not stop these activities when the Trademarks were transferred to IHC. When it is clear that an entity that created a trademark or tradename continues to contribute value to a trademark and is paying a fee for the use of such trademark or tradename, there must be consideration for the entity's continuing contributions. The Taxpayer has not responded to inquiries concerning the value it continued to contribute to the Trademarks during the 1994 and 1995 taxable years.

Another factor included in Title 23 VAC 10-120-361 C 2 is whether a group of corporations "engages in such a high level of transactions which are not made on an arm's length basis that separate or combined group return filing cannot accurately represent the group's income from business done in Virginia." In this case, the Taxpayer performed essential activities for the IHC for which it was not compensated, the validity of the royalty transactions is questionable, and no consideration has been given to the Taxpayer's continuing contributions to the value of the Trademarks.

Based the facts and observations presented, it appears the royalty charges are mere accounting entries and the transactions between the Taxpayer and IHC are not made at an arm's length rate so as to reflect improperly the income from business done in Virginia. Thus, to the extent that the intercompany license agreements primarily reflect "paper" intercompany transactions, the facts in this case satisfy the Court's requirement of (1) an arrangement, (2) between two commonly owned corporations, (3) in such a manner as to reflect improperly, inaccurately, or incorrectly, (4) the business done or the Virginia taxable income earned from business done in Virginia.


The Department's auditor disallowed royalty expenses charged by IHC. Because of the nature and number of transactions conducted between the Taxpayer and IHC, and the activities conducted by IHC, I find it appropriate to require the Taxpayer and IHC to be consolidated in accordance with Title 23 VAC 10-120-363 3.

Partnership Income

In 1990, the Taxpayer formed ***** (P1) with an unrelated third party. The Taxpayer's contributed one of its operating divisions and received a minority general partnership interest for its investment. ***** (S2), a wholly owned subsidiary of the Taxpayer, was designated to hold the minority general partnership interest in P1.

During the audit of the 1991 and 1992 taxable years, the Department discovered that the income from P1 was inadvertently included on the federal income tax return as income of the Taxpayer. Because the Taxpayer files a separate Virginia income tax return, P1's income was removed from the Taxpayer's Virginia taxable income. See Public Document (P. D.) 97-207 (4/28/97).

In 1994, P1 was sold. The Taxpayer included the gain in its computation of federal taxable income and deducted the gain on its Virginia return as a nonbusiness deduction. The auditor disallowed the deduction.

Virginia's conformity to federal law is set forth in Va. Code § 58.1-301. This section states that, except as otherwise provided, the terms used in the Virginia income tax statutes will have the same meanings as used in the Internal Revenue Code (I.R.C.). Therefore, federal taxable income for corporations is identical to that as defined by the I.R.C. The computation of Virginia taxable income for a separate corporate income tax return begins with federal taxable income. The Department, therefore, relies on the amount and character of each item reported on the federal return and supporting schedules. When a taxpayer alleges an item should be treated differently on a Virginia return than it was on a federal return, the taxpayer must clearly show why different treatment is required.

Because S2 owned the partnership interest in P1, the gain from the sale of the interest should not have been reflected in the Taxpayer's federal taxable income. Federal tax laws affecting consolidated returns permitted the improper reporting without adverse federal tax consequences. The gain, however, must be removed in order to determine the Taxpayer's appropriate income subject to Virginia tax.

In its appeal, the Taxpayer also pointed out that P1's income and deductions for the 1993 and 1994 taxable years were included in the Taxpayer's federal taxable income. In accordance with P. D. 97-207, P1's income and deductions have been removed from the Taxpayer's federal taxable income for Virginia income tax purposes.

Foreign Source Income

The Taxpayer deducted royalties and interest as nonbusiness deductions for the 1993 taxable year. The auditor disallowed the deductions because Virginia law does not provide a subtraction for nonbusiness income. The Taxpayer has asserted that the income included in these deductions was from sources without the United States and would, therefore, be eligible for the Virginia foreign source income subtraction.

In addition, no foreign source subtractions were reported on the Taxpayer's original corporate income tax returns for the 1994 and 1995 taxable years. The auditor discovered that the Taxpayer was entitled to a foreign source income subtraction and included an adjustment for the subtraction for 1995. Insufficient information was provided at the time of the audit to properly compute a foreign source income subtraction for the 1993 and 1994 taxable years.

For corporate income tax purposes, Va. Code § 58.1-402 C 8 provides a subtraction to the extent included in federal taxable income for foreign source income as defined in Va. Code § 58.1-302. It has been the Department's long-standing policy that the computation of the Virginia subtraction for foreign source income consider expenses related to the income, determined in accordance with I.R.C. §§ 861 through 863. See P. D. 86-154 (8/14/1986) and P. D. 91-229 (9/30/91). Virginia Code § 58.1-302 requires the use of the federal sourcing rules of I.R.C. § 861 et seq., whether or not a taxpayer believes that certain expenses have any connection to income from foreign sources and regardless of what expenses would be under generally accepted accounting principles. Title 23 VAC 10-120-20 states, "The federal procedure in Treasury Reg. § 1.861-8 is applied to allocate and apportion expenses to income derived from U.S. and foreign sources."

In computing the foreign source income subtraction for the 1995 taxable year, the auditor failed to use foreign source income and expenses with respect to all categories of income (commonly called "baskets"), including passive income, financial services income, and dividends from each noncontrolled I.R.C. § 902 corporation used to compute the foreign tax credit. The Department has previously ruled that the Virginia subtraction for foreign source income is computed without regard to the limitations contained in I.R.C. § 904. Accordingly, all foreign source income reported on Form 1118 must be considered for purposes of the foreign source income subtraction regardless of the federal basket limitations. See P. D. 91-59 (3/29/91).

The Taxpayer has now provided documentation concerning its foreign source income. This documentation was submitted along with computations of the foreign source income subtraction for the 1993 through 1995 taxable years. Because the Taxpayer reduced the Virginia subtraction for foreign source income by expenses, determined in accordance with I.R.C. §§ 861, 862 and 863 without regard for the limitations under I.R.C. § 904, the foreign source income subtractions for the taxable years at issue will be allowed.

Sales Factor

As a result of removing the income and deductions of P1 and permitting foreign source income subtractions for the taxable years at issue, adjustments are required for the Taxpayer's sales factor for the 1993 through 1995 taxable years.

Virginia Code § 58.1-414 provides:
    • The sales factor is a fraction, the numerator of which is the total sales of the corporation in the Commonwealth during the taxable year, and the denominator of which is the total sales of the corporation everywhere during the taxable year, to the extent that such sales are used to produce Virginia taxable income and are effectively connected with the conduct of a trade or business within the United States and income therefrom is includable in federal taxable income.

Virginia Code § 58.1-302 defines the term "sales" as the gross receipts of the corporation from all sources (except dividends, which are allocated), whether or not such gross receipts are generally considered sales. Sales are to be included in the sales factor if the gross receipts are included in Virginia taxable income and are connected with the conduct of the taxpayer's trade or business within the United States.

P1's income and the gain from the sale of P1 were incorrectly included in the Taxpayer's Virginia taxable income. Accordingly, P1's ordinary and interest income, as well as the gain from the sale of P1, have been removed from the denominator of the Taxpayer's sales factor.

Title 23 VAC 10-120-20 states, "All income and expenses included in foreign source income and property or other activity associated with such income and expenses shall be excluded from the factors in the Virginia formula for allocating and apportioning Virginia taxable income to sources within and without Virginia." In accordance with this regulation, appropriate adjustments have been made to the sales factor

Net Operating Loss Deduction

The Taxpayers original 1995 reported a net operating loss. The Taxpayer filed an amended Virginia corporate income tax return in order to carry the loss back to the 1992 taxable year. The Department informed the Taxpayer that the refund application would be held pending the final audit determination for the taxable year ended December 31, 1995.

The Code of Virginia does not include a provision that expressly addresses a Net Operating Loss Deduction ("NOLD"). Because the starting point in computing Virginia taxable income is federal taxable income, Virginia allows a NOLD to the extent it is allowable in computing federal taxable income. See P. D. 84-172 (10/01/1984).

The Department has reviewed the 1995 Virginia taxable income after the final audit changes were made pursuant to this determination. Because the final 1995 taxable year results in net operating income, no NOLD is available to be carried back to the 1992 taxable year. Accordingly, the refund requested on the amended income tax return for 1992 must be denied.

CONCLUSION


The audit assessments for the 1993 through 1995 taxable years have been adjusted as shown on the enclosed schedules and the revised audit report in accordance with this determination. Refunds, including applicable refund interest, will be issued shortly.

The Code of Virginia sections, regulations, and public documents cited, as well as 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 regarding this determination, you may contact ***** in the Office of Policy and Administration, Appeals and Rulings, at *****.
                • Sincerely,

                • Janie E. Bowen
                  Tax Commissioner




AR/17191O

Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46