Tax Type
Corporation Income Tax
Description
Price manipulation and intercorporate transactions; Transfer of intangibles to subsidiary
Topic
Returns and Payments
Date Issued
06-08-1994
June 8, 1994
Re: §58.1-1821 Application: Corporate Income Taxes
Dear**************
This will reply to your letters of April 23, April 11, 1994, and May 5, 1994, in which you apply for correction of assessments of additional corporate income taxes to*********(the "Taxpayer") for the 1989 taxable year.
FACTS
The Taxpayer was the subject of a field audit by the department, and numerous adjustments were made. One of the adjustments made by the auditor was with respect to royalty payments owed by the Taxpayer to a newly formed subsidiary ("S"). The department's auditor found that S lacked substantial economic substance, consolidated the taxable income of S with the Taxpayer, and apportioned the consolidated total to Virginia. You contest this adjustment, and aver that the department lacks the authority to consolidate the income of S with the Taxpayer.
DETERMINATION
The Taxpayer is incorporated outside Virginia, and engaged in the manufacture and sale of tangible personal property both within and without Virginia. During 1989, the Taxpayer transferred patents and trademarks to S in exchange for 100% of the stock of S. No gain or loss was recognized on the transfer pursuant to Internal Revenue Code (IRC) S 351.
The assets transferred included trademarks, trade names, and patents. After the transfer, the Taxpayer entered into a license agreement, thereby agreeing to pay a royalty to S, based upon a percentage of the Taxpayer's sales. Approximately 83% of the royalties charged were for use of the trademarks; the remaining 17% of the royalties charged were for the use of the patents. Pursuant to an appraisal provided by the Taxpayer, trademarks and trade names constitute approximately 90% of the value of assets transferred to S, patents constitute the remaining 10% of the value of assets transferred.
S's only activities in 1989 are described as the maintenance and management of its intangible assets. S did not license any intangible assets to third parties or receive royalty income from anyone other than the Taxpayer. The tasks performed by S in managing its intangible assets are described as verification that the payments from the Taxpayer were in accordance with the terms of the royalty agreement. S also engaged the assistance of legal counsel to assist in monitoring its assets.
The Taxpayer has listed the following business purposes for the
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- 1. Centralized control leading to reduction in costs to enforce and protect the patents and trademarks.
2. Insulation of the intangibles from the liabilities of the Taxpayer.
3. Insulation of the assets of the Taxpayer from any liabilities arising from unforeseen infringement actions brought by third parties in connection with the patents and/or trademarks.
4. Ability to acquire new intangibles without disclosing the name of the ultimate user, leading to lower acquisition costs.
5. Better measurement of the financial operating performance of the Taxpayer and its respective managers.
6. Ability to sell operating units while retaining control of patents and/or trademarks employed by such units.
7. Posturing the Taxpayer for potential expansion via joint venture or partnership.
- 1. Centralized control leading to reduction in costs to enforce and protect the patents and trademarks.
The Taxpayer believes that the department is without authority to include the income of S in the income of the Taxpayer. Furthermore, the Taxpayer believes that because it had several valid business purposes for separating intangibles from its operating assets, and because the royalty was set at "arm's-length" the department is obligated to respect the structure which it has created.
Va. Code Sec. 58.1-446 provides, in pertinent part:
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- 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.)
- 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.
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- Parent corporations and subsidiaries. When any corporation liable to taxation under this chapter owns or controls ... another corporation the department may require the corporation liable to taxation to make a report consolidated with such other corporation and furnish such other information as the Department may require. If the department finds that any arrangements exist which cause the income from Virginia sources to be inaccurately stated then the department may equitably adjust the tax of the corporation liable to taxation under this chapter.
The conduct or manner in which business is conducted reached by this section is not restricted to the case of improper accounting, to the case of a fraudulent, colorable, or sham transaction or to the case of a device designed to reduce or avoid tax by shifting or distorting income, deductions, credits or allowances. The conduct may be legal or even encouraged by the laws of other jurisdictions, including laws of the United States. The determining factor is whether the conduct of taxpayer's affairs, by inadvertence or design, causes the income from Virginia sources to be inaccurately stated. (Emphasis added.)
- Parent corporations and subsidiaries. When any corporation liable to taxation under this chapter owns or controls ... another corporation the department may require the corporation liable to taxation to make a report consolidated with such other corporation and furnish such other information as the Department may require. If the department finds that any arrangements exist which cause the income from Virginia sources to be inaccurately stated then the department may equitably adjust the tax of the corporation liable to taxation under this chapter.
The Taxpayer contends that the transaction between S and the Taxpayer was at an arm's length royalty rate. However, it is not adequate to simply look to the royalty rate when examining this transaction. 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 S is a 100% owned subsidiary, the Taxpayer never lost the ability to control the subject assets, the rate or terms of the royalty agreement, or the unrestricted use of the assets. The Taxpayer is essentially free to undo the transaction with S at any time.
The department has reviewed the appraisal which the Taxpayer provided as support for its royalty payments. The appraisal states that an industry standard for such royalties does not exist, the Taxpayer's industry is low margin, very competitive, and that technology is shared among others in the industry. The appraisal seemed to concentrate on the Taxpayer's long heritage and market presence, and how the Taxpayer's name stands for quality and customer service. The appraisal did not leave a clear impression that the trade names and intangibles transferred could readily be separated from the intrinsic goodwill or going concern value of the company. Accordingly, it appears unlikely that an arm's length transaction could be structured whereby a third party could purchase, or the Taxpayer could sell the subject assets independent of a sale of the entire company. Additionally, it would appear difficult to separate the Taxpayer's going concern value or goodwill from its operating assets, physical locations, or personnel.
The department has also reviewed the economic substance of S. The corporation is stated to have seven part-time employees. A review of the employment records reveals that S's total payroll for 1989 was $**** A total of 3.2 hours were worked by these seven employees for the year. Six employees worked less than one hour, and two employees received gross pay of $**** each for the year.
A review of S's balance sheet reveals that in addition to the transferred assets, S had a small amount of cash, and a large receivable from an affiliate. The amount of the receivable was exactly equal to the amount of royalties charged. It unclear if cash was ever physically transferred to S in payment of the royalties. From these facts and observations, it appears that S possesses little corporate substance. The books of S primarily reflect "paper" intercompany transactions. The revenue related activities of S are limited to the intercompany transactions. The royalty payments were immediately returned to the operational companies in the form of intercompany loans. Other than statements of the potential purposes that S could serve, there is no evidence that activity other than intercompany transactions will occur, or that such activities will be directed by a party other than the Taxpayer.
The business purposes cited by the Taxpayer do not appear to readily support the Taxpayer's position. For example, one of the business purposes cited by the Taxpayer was to insulate the intangibles from the liabilities of the Taxpayer. However, 100% of the stock of S is an asset held by the Taxpayer, fully subject to the liabilities of the Taxpayer. It appears that the other purposes cited could have been accomplished without the creation of S. Additionally, when the Taxpayer's personnel were questioned about this corporation by the department's auditor, the only purpose which could be cited for S was "tax planning".
The royalty arrangement results in the transfer of income from the Taxpayer to S. Absent the creation of S, this income would have been included in the Taxpayer's taxable income, and thus apportioned and taxed in Virginia. The federal tax laws affecting corporate transfers and consolidated returns allow this action to be taken without adverse federal tax consequences, even where the transactions are not at an arm's length. The Taxpayer also chose to incorporate S in Delaware, where the royalty income would not be taxed.
In reaching its decision in General Electric Company, the Court cited a similar fact pattern. General Electric had created a "paper" corporation (a DISC) to which it shifted income. Here, pursuant to federal tax laws, an arrangement existed which permitted General Electric to engage in business dealings with its wholly-owned subsidiary at less than arm's length business standard. The facts in the instant case are analogous to those in General Electric Company.
In summary, based upon General Electric Company, the department possesses the authority to consolidate the income of S with the Taxpayer. Va. Code § 58.1-446 provides this authority and VR 630-3-446, promulgated in 1984, provides for this action with clear and specific reference to parent-subsidiary transactions. The Taxpayer has not provided clear evidence demonstrating that the purpose for the creation of S and transfer of intangible assets served any significant purpose other than tax planning. Finally, the intangible assets transferred do not appear to be clearly severable from the Taxpayer's operations.
The fact pattern fits that of Commonwealth v. General Electric Company, and satisfies 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.
The Taxpayer believes that application of §58.1-446 to its situation would reflect inconsistent treatment of similarly situated taxpayers. However, Commonwealth v. General Electric proves that the department has had a long standing policy of applying this law to situations similar to the Taxpayer's. In addition, the department's auditors have frequently made adjustments in similar situations over the past several years, several of which are currently pending as §58.1-1821 appeals. The department began to see a proliferation of tax planning utilizing a Delaware corporation beginning in the late 1980's. The timing of the department's audit cycle and subsequent taxpayer protests results in the delay between audit adjustments and published rulings on a particular issue. As the Court made clear in Commonwealth v. General Electric, the department does not need to publish a statement of administrative policy in anticipation of every conceivable set of circumstances to which the basic interpretation may possibly apply. Accordingly, the department's regulations, promulgated in 1984, and actions pursuant to Commonwealth v. General Electric indicate a long history of consistent policy with respect to transactions of the type undertaken by the Taxpayer.
Of course, the department does not apply §58.1-446 to every intercompany transaction. For example, in P.D. 94-66 (3/16/94), copy attached, the auditor's adjustment was overturned. The facts of that ruling can be distinguished from the instant case in several key areas. In that case, the related company to which royalties were paid was actively engaged in the development of new technology, and paid for such development from its own funds. Furthermore, that company licensed its intangibles to third parties, engaged in joint ventures, licensed its technology to foreign affiliates, and acquired technology from third parties. The facts clearly documented that the subject intangibles represented technology, subject to license agreements, which could be easily be distinguished from goodwill. Based on its substantial economic activity and third party transactions, and the fact that the subject technology was not used in Virginia, §58.1-446 was not applied to adjust intercompany activity.
Accordingly, the assessment is correct. However, because of the department's delay in responding to your protest, interest will be waived from the period beginning with the date of your original letter, April 23, 1992, through the 30th day following the date of this letter pursuant to the authority granted to the Tax Commissioner by Va. Code § 58.1-105.
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/6143M
Rulings of the Tax Commissioner