Document Number
08-34
Tax Type
Corporation Income Tax
Description
Primary purpose of the intercompany royalty and loan arrangements with IHC is the avoidance of state income tax.
Topic
Accounting Periods and Methods
Appropriateness of Audit Methodology
Records/Returns/Payments
Taxable Income
Date Issued
04-04-2008


April 4, 2008


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 September 30, 2001 through 2003.

FACTS


The Taxpayer, a corporation headquartered in ***** (State A), reported net operating losses on consolidated Virginia corporate income tax returns filed with its Virginia subsidiaries for the taxable years at issue. Following an audit by the Department, the auditor determined that transactions between the Taxpayer and *****(IHC) caused income reported to Virginia to be reflected improperly. As a result, the auditor disallowed royalties and interest deducted by the Taxpayer and the Virginia affiliates. The Taxpayer contends that IHC is a viable independent company with economic substance, and the intercompany transactions with the Taxpayer were at fair market value.

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 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 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.

The Taxpayer argues that the royalty fees and interest charged by IHC were deductible for federal income tax purposes and were specifically structured by its Certified Public Accountant (CPA) firm to fall within the range of arm's length rates permissible under Internal Revenue Code (IRC) § 482. However, the federal tax laws affecting corporate transfers and consolidated returns allow for the arrangement between the Taxpayer and IHC without adverse federal tax consequences, even where the transactions are not performed at arm's length. Under such circumstances, Va. Code § 58.1-446 authorizes the Department to make an equitable adjustment when income from Virginia sources is improperly reflected.

In this case, the Taxpayer and its affiliates reported net operating losses for the taxable years at issue. A review of the Taxpayer's records indicates that the consolidated Virginia returns reported net operating losses to Virginia almost every year since the inception of IHC and it has never paid Virginia corporate income tax (a span of more than 15 years). The records also show the Taxpayer would have had positive Virginia taxable income for almost every taxable year if it were not paying royalties and interest to IHC. In such cases, the Department is obligated to scrutinize intercompany transactions that may be causing an improper reflection of income.

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.

Economic Substance

The Department has reviewed the information provided concerning the economic substance of IHC. The Taxpayer argues that IHC is a viable business engaged in substantial economic activity over an extended period of time. IHC had employees, office space, bank accounts and a valuable portfolio of assets. IHC paid its own expenses and has entered into contracts with unrelated third parties in addition to members of the Taxpayer's affiliated group.

IHC had three members on its board of directors. Two of the three individuals were employed by the Taxpayer. There is no indication members of the board were compensated for their services or reimbursed for travel expenses. In addition, two of IHC's officers were also employees of the Taxpayer and received no compensation from IHC.

IHC sublet office space from an established business (the "Landlord") located in *****. Numerous unrelated parties also contracted with the Landlord for the right to sublet the same office space as IHC. IHC paid the landlord a minimal amount for rent, certain administrative services, and telephone and postage charges. IHC had two part­time employees for the taxable year ended September 30, 2001 and one part-time employee for the subsequent two taxable years. The amount of payroll expense indicates that IHC's employees spent minimal time conducting the business. IHC's operating expenses were also minimal in relation to the amount of income generated.

The trademark licensing agreements did provide procedures for the IHC to use in order to protect the Taxpayer's trademarks. There is, however, no effective date for the procedures, nor is there any evidence to show when the procedures were put into place. No evidence has been provided to show that the procedures were followed or that quality control reports were submitted by the licensees as required by the procedures. Such procedures have no meaning unless implemented by IHC. The Taxpayer has provided no evidence that IHC had the means or expertise to enforce the procedures.

The only documented activity conducted by IHC related to the administration and protection of the trademarks was engaging a law firm to register new trademarks and tradenames. No evidence has been provided to show that IHC conducted any activities to create the new trademarks and enhance the value of the existing trademarks. This raises the question as to how IHC obtained the trademarks and tradenames.

Further, the original tradename and trademark created by the Taxpayer were transferred pursuant to an agreement. No such agreement exists for the 30 to 40 other trademarks supposedly owned by IHC. The fact that IHC incurred no costs to develop the trademarks raises doubts as to whether it actually is the owner.

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 established some activity, the overall expenses incurred were 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 during the taxable years at issue. Consequently, the Taxpayer has not clearly established that IHC had economic substance.

Trademarks

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. 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, and then agree to pay a royalty 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 royalty agreement, or the unrestricted ruse of the assets. The Taxpayer is essentially free to undo the transaction with IHC at any time.

The Taxpayer asserts that the transfer of the trademarks provided easier profit analysis for the Taxpayer, by separating the profit associated with the original trademarks in a separate profit center. According to the Taxpayer, this enables it to maximize investment returns associated with the original trademarks.

The value of the Taxpayer's trademarks was created over time by the Taxpayer's operations. The Taxpayer states that it has been one of the most successful and emulated businesses in its industry, and has been responsible for introducing several new products and marketing concepts. In its appraisal, the Taxpayer's CPA noted the company focuses on "fast and friendly" service, quality products, and clean and convenient locations.

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. No evidence has been presented to show that the Taxpayer and its other subsidiaries are compensated for these continuing contributions.

The Taxpayer contends that IHC increases the value of its trademarks because IHC continually adds trademarks to its portfolio. IHC, however, 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.

The Taxpayer argues that IHC can insulate the trademarks from liability of other members of the Taxpayer's affiliated group. Virginia follows the general rule of law concerning corporate separateness. Under this rule, corporations generally will 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.

None of the stated business purposes for transferring the trademarks necessitate locating IHC in a different state that is a significant distance from the Taxpayer's headquarters. The fact is that the transfer of the trademarks to an entity incorporated in Delaware creates certain tax advantages. 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). The Department finds it very likely that avoiding state income tax was a primary consideration in locating IHC in Delaware.

The Taxpayer provided copies of the trademark licensing agreements and an appraisal performed by an independent third party to show that the royalty rates were established at fair market value. The appraisal was completed in 1995 and included only the original trademarks. No appraisal was provided for the 30 plus trademarks and tradenames established since then.

In the appraisal, the CPA's financial analysis showed that the Taxpayer rated below industry average in 7 of 16 measures. The Taxpayer outperformed the industry averages in only 3 measures. Even so, the CPA concluded that the Taxpayer's performance is consistent with or outperformed industry statistics. Further, when determining the rate of the royalty to be charged, the Taxpayer selected the highest rate of the range suggested by the appraisal. Given these findings and the fact that the Virginia consolidated group has never reported positive Virginia taxable income despite being one of the most successful businesses in its industry, the Taxpayer has failed to substantiate that the royalty rate is reflective of fair market value.

Intercompany Loans

The Taxpayer contends that the transactions with IHC are at an arm's length interest rate. The Department, however, does not look only to the rate when examining this type of transaction. IHC originally loaned the Taxpayer a flat amount of money in 1988. The note has become a revolving line of credit with a principal balance that has increased pursuant to amendments made in Board of Director meetings.

The original note set a principal balance, but established no payment schedule for the principal and required quarterly payments of interest. The Taxpayer states that the note was intended to be set up as a revolving line of credit. The principal balance was increased each year as needed. IHC's Board of Directors approved new balances. No evidence has been provided to show that the Board gave any consideration as to the Taxpayer's ability to pay the new principal balance. Thus, the Department is not convinced IHC acted in its own best interest when the Board of Directors voted to increase the principal balances.

Based on the facts, neither the Taxpayer nor IHC incurred any credit risk in exercising the loan arrangement. Thus, the argument could be made that there was no need for IHC's Board to consider the risks of increasing the principal balance. The establishment of interest rates is predicated in part on the credit risk of the debtor to repay the debt. On the open market, no borrower is considered to have no credit risk. This raises the question as to whether the published prime rate is a fair value of the interest that IHC could obtain under this type of arrangement.

The Taxpayer has provided documents concerning debt obtained from unrelated third parties during the period at issue. While the interest rates are similar, the IHC loan was by far the largest debt almost equaling the amount of all loans made by third party lenders combined. No evidence has been provided to show that these unrelated lenders considered the IHC debt in their approval process. In reality, there would be no need to do so because, as mentioned above, no credit risk occurred in creating the debt.

Further evidence of the lack of credit risk is that, if the Taxpayer were to default on the loans from IHC, the transactions creating IHC could simply be reversed and the balance of the loans would be eliminated by a simple journal entry. As a result of this arrangement, the Taxpayer paid interest to IHC on loans resulting from assets that the Taxpayer both owned and directly controlled with no risk of being penalized for failing to pay the debt.

Equitable Adjustment

The Taxpayer contends that the auditor's adjustment to the royalty deductions were incorrect. The auditor disallowed the entire royalty income of IHC on the Virginia consolidated returns. Documents provided by the Taxpayer clearly show that IHC received royalty income from a number of the Taxpayer's subsidiaries that were not included in the Virginia consolidated returns. Consequently, the auditor disallowed more royalty expenses than the Taxpayer and its Virginia subsidiaries deducted.

In reviewing this case, however, it is clear that there were a number of transactions between IHC and the Virginia affiliated group for which inadequate or improper consideration was tendered. These include officers' salaries, management fees, royalty fees, and the ongoing value the Taxpayer and its related entities continued to add to the trademarks. Accordingly, the Department finds that the most equitable method of properly reflecting business done in Virginia is to consolidate IHC with the Virginia affiliated group.

CONCLUSION


The Taxpayer has filed corporate income tax returns since 1990. Since it first began reporting income tax, the Taxpayer has steadily increased its presence in Virginia. In each of those taxable years, the Virginia consolidated return has reported a loss and consequently has never paid Virginia corporate income tax. While there may be a number of legitimate business reasons for the creation of the IHC, one can conclude that the primary purpose of the intercompany royalty and loan arrangements with IHC is the avoidance of state income tax.

While IHC earns income from the trademarks created by the Taxpayer, it goes uncompensated for past and ongoing contributions to the trademarks' value. Thus, to the extent that IHC did not appear to have sufficient 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.

Based on this determination, the audit will be returned to the audit staff to adjust the assessment as noted above. After the auditor makes the appropriate adjustments, the Taxpayer will receive a revised bill. The Taxpayer should remit its payment for the outstanding balance as shown on the revised bill within 30 days from the date of the bill to avoid the accrual of additional interest.

The Code of Virginia sections and regulations cited are available on-line at www.tax.virginia.gov. If you have any questions regarding this determination, please contact ***** in the Department's Office of Tax Policy, Appeals and Rulings, at *****.
                • Sincerely,

                • Janie E. Bowen
                  Tax Commissioner



AR/56847B


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46