Tax Type
Corporation Income Tax
Description
Apportionment of income; Sale of interest in joint venture
Topic
Allocation and Apportionment
Date Issued
07-01-1994
July 1, 1994
Re: Protective Claim: Corporate income taxes
Dear*****************
This will reply to the protective claim filed on October 30, 1991, and your letters dated June 24, 1994, and June 3, 1994, in which you applied for a refund of corporate income taxes on behalf of **************(the "Taxpayer") for the 1989 taxable year.
PROCEDURAL HISTORY
Pursuant to an amended 1989 Virginia income tax return, the Taxpayer has claimed a subtraction from Virginia apportionable income equal to the amount of a capital gain recognized on the sale of the stock of another corporation ("Company A"). You contend this capital gain is not properly subject to apportioned taxation in Virginia.
The Code of Virginia does not provide for the allocation of income other than certain dividends. Accordingly, a taxpayer's entire federal taxable income, adjusted and modified as provided in Va. Code §§ 58.1-402 and 58.1-403, less dividends allocable pursuant to Va. Code § 58.1-407 is subject to apportionment. The Taxpayer's subtraction of the capital gain has been treated as a request for an alternative method of allocation and apportionment in accordance with Va. Code §58.1-421.
The decision of the U. S. Supreme Court in Allied-Signal, Inc. v. Director Div. of Taxation, 112 Su Ct. 2551 (1992) made it clear that the payee and payor need not be engaged in the same unitary business as a prerequisite to apportionment in all cases. In the absence of a unitary relationship, apportionment is permitted when the investment serves an operational rather than a passive investment function. The Court also made it clear that the test is fact sensitive.
The Taxpayer and Company A entered into a highly detailed agreement for the purchase and sale of spare parts and supplies. The agreement provided for the continued manufacture by the Taxpayer and purchase by Company A of certain spare parts and components. The price for such parts was provided for in the joint venture agreement, and the agreement had an initial 5 year term.
The Taxpayer and Company A had entered into an agreement for the purchase and resale of Company A's products by the Taxpayer's foreign operations. Pursuant to this agreement, the Taxpayer's foreign subsidiaries were allowed to purchase products from Company A at factory cost for export and resale.
The Taxpayer had an agreement with Company A to provide specific general and administrative services. As requested by Company A, the Taxpayer agreed to provide sales, marketing, field service, laboratory, tech service, quality analysis, manufacturing, engineering, service part center, technical education center, financial and accounting, data systems and billing, account receivable and management, credit, invoice control, warehousing, physical distribution, tax planning and compliance, contract processing, risk management, contract administration, and other similar general administrative assistance and planning services, consultation, and support and advice. The joint venture agreement provided that the Taxpayer would be reimbursed for its costs of providing these services, but would not be entitled to a profit from such services. The agreement provided specific terms of 3 to 6 months for certain services, while other services were to be provided for longer, negotiated terms.
The Taxpayer granted a nonexclusive, royalty-free, worldwide license to Company A to use certain of its trademarks on labels affixed to Company A's products. The Taxpayer granted a nonexclusive, royalty-free, worldwide license to use its tradename
as part of Company A's name, and restricted Company A from changing its name without permission.
The Taxpayer also granted to Company A a nonexclusive, royalty-free world-wide right to use its technology. Similar agreements provided for the license of certain copyrights and training manuals. The Taxpayer also granted Company A a paid-up nonexclusive perpetual license to use and sublicense certain computer software.
The Taxpayer and Company B were subject to an extensive stockholders agreement which, among other things, restricted the free transferability of Company A's stock.
The net assets contributed to Company A by the Taxpayer had a significantly greater value than those contributed by Company B. Accordingly, the Taxpayer was entitled to a preferential dividends from Company A.
DETERMINATION
In this particular matter, the Taxpayer must do more than show that the payor of the income is an unrelated third party. Rather, the Taxpayer must bear the heavy burden of demonstrating that the imposition of Virginia's statute is a violation of the standards enunciated by the United States Supreme Court in Allied-Signal, Inc. v. Director, Division of Taxation (112 S. Ct. 2251 (1992)). In Allied-Signal, the court stated:
-
- The existence of a unitary relation between payee and payor is one justification for apportionment, but not the only one. Hence, for example, a State may include within the apportionable income of a nondomiciliary corporation the interest earned on short-term deposits in a bank located in another state if that income forms a part of the working capital of the corporation's unitary business, notwithstanding the absence of a unitary relationship between the corporation and the bank.
We agree that the payee and the payor need not be engaged in the same unitary business as a prerequisite to apportionment in all cases. Container Corp. says as much. What is required instead is that the capital transaction serve an operational rather than an investment function.
- The existence of a unitary relation between payee and payor is one justification for apportionment, but not the only one. Hence, for example, a State may include within the apportionable income of a nondomiciliary corporation the interest earned on short-term deposits in a bank located in another state if that income forms a part of the working capital of the corporation's unitary business, notwithstanding the absence of a unitary relationship between the corporation and the bank.
Where an asset (or group of assets) was once a part of a taxpayer's unitary business, or was once clearly of an operational nature, there is a particularly heavy burden of proof. In the instant case, the Taxpayer has not provided objective evidence demonstrating that its unitary relationship with the assets transferred changed significantly after the transfer. However, even if a unitary relationship had ceased to exist at a moment prior to the sale, there were a significant number of operational connections after the transfer of assets to Company A.
The choice and manner in which the Taxpayer and Company B created and operated Company A is of particular significance. Company A was created as a joint venture. A joint venture is defined by Blacks Law Dictionary, 6th Ed. as "An association of persons or companies jointly undertaking some commercial enterprise; generally all contribute assets and share risks. It requires a community of interest in the performance of the subject matter, a right to direct and govern the policy in connection therewith, and duty, which may be altered by agreement, to share both profits and losses." That definition certainly describes the intensive commitment and involvement of the Taxpayer and Company B in the operations of Company A. Also, the Taxpayer consistently referred to Company A as a joint venture in its annual reports.
Company A's name was in part derived from that of the Taxpayer's. The Taxpayer's name is a well known and its trademark is easily recognizable. Its prominent use in Company A's name implies that the intent was to create and foster name brand recognition. Also, Company A received the worldwide rights to valuable intangibles, such as software, technology, copyrights, and trademarks. The fact that there were no royalty payments fosters the impression that the investment was a joint venture for profit, as opposed to a passive investment.
Finally, the transfer of assets to Company A was accomplished in a tax free transaction pursuant to I.R.C. §351. Had the Taxpayer sold the assets to Company A in 1985 in a taxable transaction, the gain would have clearly been apportionable. The fact that assets were transferred to a corporation should not change this result unless the Taxpayer can demonstrate by objective evidence the moment in time that their objective and purpose for holding the investment changed. The intensive involvement by the Taxpayer in a "joint venture" lends the impression that the Taxpayer's objective had not become that of a passive investor.
The Taxpayer has stated that the purpose of the joint venture was to allow the Taxpayer to exit the line of business, a decision made by its Board of Directors. In addition, the joint venture contained an option whereby Company B could purchase the Taxpayer's interest in Company A, and a put option whereby the Taxpayer could cause Company A to acquire its shares. The Taxpayer's statements and the signed agreements add to the impression that the Taxpayer's intent was to dispose of a part of its unitary business.
There was clearly a flow of values between the companies from the initial transfer in 1985 through the time of sale in 1989. The Taxpayer and Company shared intangible assets, technology, trade names and trademarks, and engaged in significant business activities with each other. In summary, this does not appear to be a passive investment in which the Taxpayer relied on the management of Company A for earnings growth and enhanced value, and for which there were no operational reasons to select, acquire, manage or dispose of the investment.
In any proceeding relating to the interpretation of the tax laws of the Commonwealth of Virginia, the burden of proof is on the taxpayer. In this particular matter, the Taxpayer must bear the heavy burden of demonstrating that the imposition of Virginia's statute is a violation of the standards enunciated by the United States Supreme Court in Allied Signal. Based upon the information provided, the Taxpayer has not met the burden of proof. Accordingly, permission to use an alternative method of allocation and apportionment for the gain realized on the sale of the subsidiary cannot be granted.
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/6479M
Rulings of the Tax Commissioner