Tax Type
Corporation Income Tax
Description
Alternate method of allocation and apportionment; Capital gain from sale of related company's stock
Topic
Allocation and Apportionment
Date Issued
03-22-1994
March 22, 1994
Re: §58.1-1821 Application: Corporate income taxes
Dear**************
This will reply to your letter dated October 26, 1992 in which you made an application for correction of an assessment for additional corporate income taxes to***** (the "Taxpayer") for the 1988 taxable year.
PROCEDURAL HISTORY
On its 1988 Virginia tax return, the Taxpayer 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"). The Taxpayer was audited by the department, and the subtraction was disallowed on the basis that the Code of Virginia does not provide for such a subtraction. You protest this adjustment, and aver that 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 S. 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.
FACTS
The Taxpayer is a large multi-national corporation, headquartered outside of Virginia. In 1969, the Taxpayer acquired 49% of the stock of Company A. Company A was incorporated in a foreign country, and was formed to carry on business in that country. The remaining 51% of Company A was acquired by an unrelated third party ("Company B"). Company B is incorporated under the laws of the same foreign country. It is in no way related to the Taxpayer, and had its headquarters and commercial center in the foreign country. Company B had the skill and know-how to carry on the business purpose for which Company A was formed.
In 1988, the Taxpayer sold the stock of Company A to Company B. For state and local income tax purposes, the gain from the sale of Company A was allocated to the Taxpayer's state of commercial domicile.
The principal office of Company A, as well as its center of commercial activity was in the foreign country. Company A never had any commercial activity outside of the foreign country.
The Taxpayer's investment in Company A was made from excess cash of the company - no borrowing was required for the acquisition. The amount invested by the Taxpayer was clearly immaterial to its total assets. The Taxpayer made no subsequent investments in Company A after the initial purchase of the minority interest. Further, the Taxpayer did not lend Company A any money.
All shareholder action of Company A required a majority vote. Hence, the Taxpayer could take no action unilaterally. All action required the approval of the other shareholder in order to achieve a majority. Company B, however, could achieve a majority without the Taxpayer's approval.
The Taxpayer originally held 2 of the 5 seats on Company A's board of directors. By 1988, the Taxpayer held 5 of the then 11 seats on the board. With a minority share-holding and minority representation on the board, the Taxpayer was unable to control the overall financial decisions of Company A. Further, the Taxpayer had no control over the day-to-day management of Company A. Nor was the Taxpayer asked for its input regarding day-to-day operations. Company A operated in a foreign market with which the Taxpayer was not familiar.
None of the Taxpayer's executives or employees were involved in the day-to-day operations of Company A. No employee of the Taxpayer ever became an employee of Company A. On the other hand, the majority shareholder, Company B, was involved in the day-to-day operation of Company A. Many Company B employees worked for Company A. Company A was launched with 20 employees on loan from Company B. The President of Company B was also the first president of Company A. The financial auditors were also from Company B. In fact, the employees of Company A and Company B moved back and forth between the two companies on a regular basis. Employees of Company B at various levels were loaned to Company A for six month periods. By 1988, the sharing of employees continued and approximately 20% of Company A' s employees were loaned from Company B. The sharing of employees was facilitated by the location of the headquarters of Company A in space subleased from Company B in its headquarters.
The operation of Company A was under the control of Company B, not the Taxpayer. The officers of Company A were concerned that Company A have a focus and attitude toward business that reflected the culture of the foreign country. Further, it operated under standard business practices so as to attract quality employees from the foreign country who would not be required to adopt foreign business procedures.
There was a continuing "culture" clash between the Taxpayer and Company B. Company A was an investment for the Taxpayer, rather than a part of its operations. The Taxpayer was interested in receiving a return on its investment - dividends. The board members of Company A representing the Taxpayer consistently insisted on higher dividends than the majority shareholder approved. Company B's board members did not view Company A as an investment, but rather as an operational asset. Hence, they were committed to leaving all excess cash in Company A so it could expand and become a major company in the foreign country. This created a financial problem for the Taxpayer.
The dividends actually paid by Company A were always a very small percentage of its earnings and profits. While the Taxpayer was not unconcerned with the success of Company A, it measured Company A's success in terms of the dividends it paid to the Taxpayer. As a minority investor, the Taxpayer had no power to force dividends out of Company A, even in years when there were significant earnings that far exceeded the future needs of Company A.
There was no attempt at any time to integrate the businesses of the Taxpayer and Company A. There was no centralized management or sharing of resources or expertise. Company A is a company operating in a foreign culture under business, accounting and legal
principles of the foreign country. Any attempts to apply American practices or concepts would have been met with resistance.
Intercompany transactions between the Taxpayer and Company A were de minimis. Even for these transactions, the Taxpayer was compensated at an arm's length price. The total intercompany transactions were clearly de minimis. There was no training of Company A employees according to the Taxpayer's culture or mode of operation. In contrast to the intercompany transactions with the Taxpayer, the intercompany transactions with Company B provided that Company A would receive from Company B its commercial, managerial and other services. Further, Company B provided Company A with the benefits of its experience in the foreign market, and its reputation vis-a-vis suppliers and advertising agencies. These are not the types of services that would be available to unrelated third parties for any fee.
The Taxpayer has provided an analysis of functional integration, centralization of management, and economies of scale as evidence that a unitary relationship did not exist between the Taxpayer and Company A. The following analysis of each part of the unitary business test was provided:
Functional Integration.
Company A selected the content of its product without any input from the Taxpayer and set all policy without consulting the Taxpayer.
Company A selected the locations for its operations.
Company A performed its own advertising. Company A used Company B's network of advertisers for placing advertising.
Company A performed its own accounting and financial reporting under rules of the foreign country. The employees performing these functions were on loan from Company B.
Company A obtained its own outside counsel in the foreign country. It used either Company B's in-house counsel or outside counsel.
Company A obtained its own warehousing in the foreign country for its products. The warehousing, in some instances, was shared with Company B.
Company A performed its own personnel training in conjunction with Company B.
Company A obtained its own outside financing. The Taxpayer did not make any investment in Company A after the initial stock investment. Further, it did not lend Company A any money or guarantee any loans obtained by Company A.
Centralization of Management
There were no centralized purchasing, manufacturing or warehousing activities.
There was no centralized employee training. Company A had its own style manual. Company A and Company B shared centralized training.
There was no centralized financing. Further, no loans to Company A from the Taxpayer were made, and the Taxpayer did not guarantee third party loans.
There was no sharing of employees. Company A shared employees extensively with Company B. All the original employees of Company A were loaned from Company B, and there was a regular program for loaning Company B employees to Company A for six month periods. No employee of Company A had any ever been from the Taxpayer.
There was no rotating or training of management. Company A rotated management personnel with Company B. The President of Company A was also the President of Company B. No officers of the Taxpayer worked for Company A.
There was no training regarding merchandising (retailing). Company A depended upon Company B, not the Taxpayer, for assistance with sales activities.
The Taxpayer did not monitor the day-to-day operation of Company A.
The Taxpayer did not review the tax returns of Company A. They were prepared by Company B's tax advisors under tax principles of the foreign country. In fact, Company A declined to provide copies of its tax return to the Taxpayer, which caused in problems in obtaining foreign tax credits. There was no consulting by Company A with the Taxpayer regarding tax issues. The tax work was the responsibility of Company B's tax advisors.
No policy meetings to discuss overall operations. The Taxpayer was not involved in the business operations of Company A.
Economies of Scale
There was no central purchasing.
The Taxpayer and Company A had no centralized credit system for customers.
There was no uniform packaging and promotional displays with brand names. The Taxpayer's and Company A's logos were not the same.
Company A received no technical assistance from the Taxpayer. Company A did receive technical assistance from Company B including assistance with policy, location of offices, advertising, accounting, financial reporting, obtaining legal counsel, warehousing, personnel training and obtaining outside financing.
DETERMINATION
The department has examined the evidence provided by the Taxpayer in order to determine if a unitary relationship existed between the Taxpayer and Company A, and to determine if the Taxpayer's activities related to the investment in Company A were in any way connected to the Taxpayer's operational activities.
In considering the existence of a unitary relationship, the Supreme Court has focused on three objective factors: (1) functional integration; (2) centralization of management; and (3) economies of scale. (See Mobil Oil Corp. v Commissioner of Taxes, 445 U.S., 425 (1980); F. W. Woolworth Co. v. Taxation and Revenue Dept. of N.M., 458 U.S., 352 (1982); and Allied-Signal.) Each of these factors was addressed in depth by the Taxpayer in clear and objective terms. There was no indication of a flow of goods or of a flow of values between the Taxpayer and Company A. Based on the information provided to the department it does not appear that a unitary relationship existed between the Taxpayer and Company A.
In considering the operational aspects of the investment, the department considered the evidence provided to support the Taxpayer's position. The evidence indicated that: the business did not complement the Taxpayer's operational activities before or after the acquisition; no integration of the two businesses ever occurred; no economies were achieved; the two companies were physically separated at all times; the management of Company A was at all times separate and distinct from the Taxpayer; there was no intent to create consumer awareness of the common ownership; there was no attempt to take advantage of the fact that common ownership existed; and with few immaterial exceptions, no business transactions of any type occurred between the companies. In light of the substantial evidence provided, it does not appear that the Taxpayer used its own operational activities to enhance the value of its investment in Company A, nor does it appear that the ownership of the Company A enhanced the operational activity of the Taxpayer. Accordingly, I conclude that the Taxpayer made a passive investment in the Company A that was not of an operational nature. As the Taxpayer's headquarters and management of its investment function was located outside of Virginia, the gain recognized by the Taxpayer on the sale of Company A did not relate to the Taxpayer's operational business carried on in Virginia.
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 prove by clear and cogent evidence that Virginia's statutory method of allocation and apportionment would result in a tax on income derived from a discrete investment function having no connection with Virginia in violation of the principles set forth in Allied-Signal. Based upon the information provided, I find that the Taxpayer has demonstrated that an alternative method of allocation and apportionment is appropriate. Because of the extraordinary circumstances surrounding the relationship between the Taxpayer and Company A, permission is hereby granted to allocate the capital gain recognized by the Taxpayer on the sale of the Company A stock in 1988 out of Virginia apportionable income. The sales factor for 1988 will also be adjusted to remove allocable income from the denominator.
All other aspects of the Taxpayer's 1988 allocation and apportionment shall be determined in accordance with §§58.1-406 through 58.1-420. The audit report will be revised in accordance with this ruling and the attached schedules, and a refund will be issued in due course with interest at statutory rates.
This ruling is limited to the 1988 taxable year, and further limited to the transaction described herein, and shall not be considered as pertaining to any other taxable year or transaction.
Sincerely,
Danny M. Payne
Acting Tax Commissioner
OTP/6510M
Rulings of the Tax Commissioner