Document Number
10-135
Tax Type
Individual Income Tax
Description
Royalty paid as part of the management fee, insufficient information provided for statute requirements.
Topic
Computation of Income
Federal Conformity
Records/Returns/Payments
Royalties
Date Issued
07-12-2010


July 12, 2010



Re: § 58.1-1821 Application: Individual Income Tax

Dear *****:

This will reply to your letter in which you seek correction of the individual income tax assessments issued to ***** (the "Taxpayers") for the taxable years ended December 31, 2005 through 2007.

FACTS


The Taxpayers were residents of ***** (State A). They are the sole owners of two ***** S corporations and two Virginia S corporations (collectively the "Virginia Group") that operate restaurants in Virginia. The Virginia Group pays management fees to a State A C Corporation (ACC), which is wholly owned by the Taxpayers. During the taxable years at issue, ACC made royalty payments to the Taxpayers and paid them a salary. The Taxpayers filed nonresident Virginia individual income tax returns for the 2005 through 2007 taxable years in which they attributed income from Virginia commercial property to Virginia.

Under review, the Department's auditor stated that the management fees paid by the Virginia Group to ACC were improperly reflected in the Taxpayers' Virginia taxable income and attributed these fees to Virginia pursuant to Va. Code § 58.1-446. These adjustments resulted in additional tax being assessed for the taxable years at issue.

The Taxpayers contest the assessments, asserting that the management fees had economic substance and were made at arm's length.

DETERMINATION


Improper Reflection of 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 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 (1988) has upheld the Department's authority to equitably adjust 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 improperly, inaccurately, or incorrectly reflect 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.

Because Va. Code § 58.1-446 specifically addresses transactions between corporations, the Department has limited equitable adjustments to corporate income tax returns. Such adjustments have included adjusting the transaction amount to fair market value, disallowing deductions, and consolidating incomes of corporations involved in such arrangements. Attributing management fees to the Taxpayers that were paid from the Virginia Group to ACC does not satisfy the requirement of appropriately reflecting the Virginia income of the corporations at issue.

Management Fees

Moreover, even if the attribution of the management fees were permissible under Va. Code § 58.1-446, the adjustment would not be valid in the instant case. The Department has addressed the issue of management fees in Public Document (P.D.) 97-132 (3/19/1997). In this ruling, the Department recognized that the taxpayer would have had to engage either an outside firm to perform the essential corporate services or develop its own in-house capability. Because no intercompany profit was incorporated into the overall management fee charged by the parent, the Department allowed the deductions. The Department concluded that a cost reimbursement arrangement between related parties, without any intercompany profit, could not be characterized as one that distorts Virginia taxable income.

In P.D. 97-290 (6/26/1997), however, the Department disallowed a profit percentage added to a management fee because the parent holding corporation lacked independent economic substance and failed to provide any evidence to show that the profit element of the management fee reflected fair market value.

In the instant case, some of the services ACC provides the Virginia Group include human resources, inventory control, maintenance, accounting, and information technology services. The documentation provided to the Department indicates that ACC has substance and ACC's federal income tax returns demonstrate that the management services are provided to the Virginia Group at cost. As such, the management fee reflected fair market value because there was no markup for profit. As such, no adjustment would have been necessary.

Royalties

During the course of its review, the Department identified a deduction for royalties on ACC's returns. Further investigation found that the royalties were payments to the Taxpayers. No explanation was provided concerning the royalty payments, but they were included in the management fee charged to the Virginia Group.

Virginia Code § 58.1-402 B 8 provides that there shall be added back to the extent excluded from federal taxable income:
    • the amount of any intangible expenses and costs directly or indirectly paid, accrued, or incurred to, or in connection directly or indirectly with one or more indirect transactions with one! or more members to the extent that such expenses and costs were deductible or deducted in computing federal taxable income for Virginia purposes.

The statute provides several exceptions to the general rule that an add back is required. In this case, it appears the Virginia Group paid a royalty to ACC as part of the management fee, but the information provided does not indicate whether any of the exceptions were met.

In addition, the statutory provision requiring the addition (and allowing exceptions) specifically states in Va. Code § 58.1-402 B 8 c, "Nothing in subdivision B 8 shall be construed to limit or negate the Department's authority under § 58.1-446." Because the latter section authorizes an equitable adjustment when the Department finds that arrangements between affiliated corporations improperly reflect business done in Virginia, the quoted language clearly authorizes the Department to invoke Va. Code § 58.1-446 when it finds that allowing an exception would result in the taxpayer's income improperly reflecting the business done in Virginia.

Under such circumstances, to the extent that royalties are unsubstantiated, 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. See P.D. 05-29 (3/7/2005).

CONCLUSION


Based on the forgoing, the methodology used to make the assessments for the 2005 through 2007 is not consistent with Virginia law or Department policy. Further, the Taxpayers are granted the opportunity to provide documentation to show that the royalty payments meet one of the exceptions under Va. Code § 58.1-402 B 8 and do not improperly reflect Virginia source income pursuant to Va. Code § 58.1-446.

Accordingly, the Taxpayers will have 30 days from the date of this letter to provide sufficient documentation concerning the royalties included in the management fees paid by the Virginia Group. This information should be sent to: Virginia Department of Taxation, Appeals and Rulings, P.O. Box 27203, Richmond, Virginia 23261-7203, Attn: *****.

Once the information is provided, this case will be remanded to the auditor to make the appropriate adjustments to the assessments for the taxable years at issue. If the requested documentation is not received within the allotted time, the assessments will be adjusted based on the information available.

The Code of Virginia sections and public documents cited 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 Tax Policy, Appeals and Rulings, at *****.
                • Sincerely,


                • Linda Foster
                    • Deputy Tax Commissioner



AR/1-3228935642.B


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46