Tax Type
Corporation Income Tax
Description
Price manipulation and intercorporate transactions; Consolidation
Topic
Returns and Payments
Royalties
Date Issued
10-11-1994
October 11, 1994
Re: §58.1-18:21 Application: Corporate Income Taxes
Dear
This will reply to your letters of May 4,1992, July 22, 1993, August 2,1993, and August 4, 1994 in which you apply for correction of assessments of additional corporate income taxes to 'the "Taxpayer") for the 1987, 1988, 1989, and 1990 taxable years .
FACTS
The Taxpayer was the subject of a field audit by the department, and numerous adjustments were made. During the course of the audit, the department's auditor discovered that substantial royalty payments were owed by the Taxpayer to a second-tier subsidiary ("'i"). The Taxpayer deducted these royalties in determining Virginia taxable income. 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.
The Taxpayer is incorporated outside Virginia, and is engaged in the manufacture and sale of tangible personal property both within and without Virginia. The Taxpayer caused intangible assets to be transferred to S in 1972 in exchange for 100% of the stock of S. No gain or loss was recognized on the transfer pursuant to Internal Revenue Code (IRC) § 351. After the transfer, the Taxpayer entered into a license agreement, thereby agreeing to pay a royalty to S.
S's sole business activity is the maintenance and licensing of patents. Its income is derived from royalties from the use of patents and from interest on its investments. S employed a general manager on a part-time basis to handle financial transactions, accounting and administration. S out-sourced the handling of its day-to-day banking and investment activities to a bank located outside of Virginia. It engaged a law firm with extensive experience in patents to handle its legal matters related thereto. S paid substantial amounts for such services to third party providers and to its own employees. S paid substantial amounts in legal fees to maintain and protect its patents. S's domestic officers were all experienced in patent and financial matters, and were independent of the Taxpayer. S's officers were not employees, officers or directors of the Taxpayer.
S had four (4) directors which were entirely independent of the Taxpayer. The directors were all experienced in patent and financial matters, and met in person on a quarterly basis. Minutes of these meetings were maintained. S paid these directors a substantial fee for their duties.
S licensed 28 separate patents to third parties and received royalty income therefrom. Certain of the patents in question have been sublicensed to third parties, generally as a result of patent infringement awards, at rates in excess of those charged by S to the Taxpayer. These patents have also been licensed to foreign affiliates at rates in excess of those charged by S to the Taxpayer. These royalty rates have been successfully defended in every case where it has been challenged by foreign taxing authorities. These royalty rates have also been accepted by the Internal Revenue Service in numerous examinations.
S holds itself out as a separate corporate entity. S has maintained its own bank account, its own stationary, maintains its patent portfolio outside of Virginia, and has joined in patent infringement litigation in its own name.
DETERMINATION
The Taxpayer believes that the department is without authority to include the income of S in the income of the Taxpayer because of Virginia's conformity to federal taxable income. Furthermore, the Taxpayer believes that because the royalty was an "arm's-length" agreement with an independent corporate entity the department is obligated to respect the structure which was created.
Although Virginia starts its tax computations with federal taxable income and generally respects the corporate structure of taxpayers, Code of Virginia §58.1 -446 gives the department the authority to consolidate entities and make adjustments if an arrangement between affiliated corporations distorts income subject to Virginia taxation. See Commonwealth v. General Electric Company, 236 Va. 54 (1988). Generally the department will exercise its authority if it finds that a transaction, or a party to the transaction, lacks economic substance.
The department has reviewed the economic substance of S. Based on observations made from S's federal tax return, it appears that S has substantial amounts of investments, which it manages for its own account. The books of S primarily reflect actual cash transactions, as opposed to "paper" intercompany transactions. The revenue related activities of S are not limited to intercompany transactions, but reflect S's own investment activity as well as royalties received from the Taxpayer and others. Additionally, S incurs such routine business expenses as travel and entertainment, telephone, rent, payroll taxes, and legal and accounting.
The Taxpayer has demonstrated that the royalties paid to S are reasonable when compared to royalties charged to third parties. The Taxpayer has also provided evidence that the royalty rates have been accepted by the Internal Revenue Service and foreign taxing authorities. Given the substantial documentation provided, the Taxpayer has demonstrated that the royalties are at an arm's length rate. It is therefore logical to conclude that the patents are in fact valuable intangible assets which can be accurately identified, valued, and licensed.
In reaching its decision in General Electric Company. the Virginia Supreme Court cited a fact pattern quite different from the instant case. General Electric had created a Domestic International Sales Corporation ("DISC") to which it shifted income. 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 standards. Whereas in General Electric Company the DISC was a paper company which essentially did nothing to earn the income which was shifted to it, in the instant case S is a bona fide corporate entity with independent management, substantial assets, and business activities aimed at earning royalties from the license of valuable assets. The facts in the instant case are not analogous to those in General Electric Company.
It is also important to distinguish the facts of this case from those of the department's ruling in Public Document 94-179 (618194), copy attached. In that ruling the department found that the assets transferred to the holding company could not readily be separated from the intrinsic goodwill or going concern value of the company. This made it impossible to conclude that the royalties paid to the holding company were determined at an arm's length value, or that the subject assets could in fact be separated from the company as a whole. In that case, the holding company lacked the economic substance necessary to conclude that the entity was other than a "paper company" designed to manipulate the amount of taxable income reported to the states in which business activity was conducted.
The department finds a clear and logical basis to distinguish the instant case from the facts contained in General Electric and P.D. 94-179. Accordingly, the adjustments made to consolidate the income of S into the Taxpayer shall be reversed.
The assessment shall be adjusted as provided herein and as reflected on the attached schedules. The balance due,*******, should be paid within 30 days of the date of this letter to prevent the accrual of additional interest.
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/7245M
Rulings of the Tax Commissioner