Tax Type
Corporation Income Tax
Description
Price manipulation and intercorporate transactions; Royalties
Topic
Returns and Payments
Date Issued
06-05-1995
June 5, 1995
Re: §58.1 -1821 Application; Corporate income taxes
Dear**********
This will reply to your letters in which you contest the assessment of additional corporate income taxes to**************(the "Taxpayer") for the taxable years ended March 31, 1991, 1992 and 1993.
FACTS
The Taxpayer files a combined Virginia return with two affiliated corporations (the "Affiliates"). The Taxpayer was the subject of an audit by the department, resulting in numerous adjustments. One of the adjustments made by the auditor was with respect to royalty payments owed by the Affiliates to a related party. The department's auditor found that the royalty payments lacked substantial economic substance, and disallowed the deductions, thereby increasing the Affiliates' Virginia taxable income. You contest this adjustment, and believe that the royalty amounts should be deductible in full.
DETERMINATION
The Affiliates are engaged in the distribution and sale of tangible personal property ("product") both within and without Virginia. The Affiliates distribute and sell product under a license agreement which requires a royalty for the use of trade names and trademarks in the United States. The product and trademarks are internationally known and recognized. The trademarks can be considered to be "household words" which identify and represent the product and its quality. The trademarks are utilized in international advertising campaigns, and it is reasonable to expect that a broad cross section of consumers would recognize the trademarks even if they don't personally purchase the product.
The Taxpayer believes that because the royalty was set at "arm's-length" the department is obligated to respect the transaction as structured. The Taxpayer has provided evidence that the trademarks and trade names in question have in fact been licensed to third parties in other countries. The Taxpayer has also provided comparables based upon agreements whereby related parties are licensees of similar trademarks from third parties. The Taxpayer believes that these third party agreements are sufficient evidence to justify the royalty rate it has chosen to use between the members of its affiliated group.
Code of Virginia §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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Virginia Regulation (VR) 630-3-446, effective January 1, 1985, provides in pertinent part:
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- Parent corporations and subsidiaries....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....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.
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The Taxpayer contends that the royalty rate was determined at arm's length. However, the third party agreements cited by the Taxpayer differ as to the nature of the rights and privileges conveyed. In addition, evidence provided by the Taxpayer indicates that in taxable years subsequent to the audit period at issue, the license agreement entered into by the Affiliates was in fact modified and licensed to a third party. The license to the third party appears to be equivalent; however, the royalty rate is lower than that charged to the Affiliates.
The royalty arrangement results in the transfer of income out of the Affiliates' Virginia taxable income. Absent the creation of the license agreement, this income would have been included in the Affiliates' 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 and domicile the licensor 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.
Based upon General Electric Company, the department possesses the requisite authority to examine and, if necessary, adjust the amount of the royalty payment made by the Affiliates. Code of Virginia §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 the license with a Delaware corporation served any significant purpose other than tax planning.
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.
Accordingly, the department believes that the royalty rate used by the Affiliates results in a deduction which incorrectly reflects Virginia taxable income. The fact that essentially the same agreement was entered into with a third party in subsequent taxable years at a lower royalty rate is prima facie evidence that the royalty rate is too high. While the department does not feel compelled to disallow the deduction for royalties in its entirety, it does find that an adjustment is necessary to correctly state Virginia taxable income. Accordingly, the Affiliates' deduction for royalty expense shall be adjusted consistent with the royalty rate charged to a third party in subsequent taxable periods, as reflected on the attached schedules.
Net Operating Loss: The department's auditor adjusted the Affiliates' taxable income to reflect a federal net operating loss carryback from the taxable year ended March 31, 1993. These adjustments shall be revised as provided for corrected royalty rates.
Accordingly, the assessments shall be adjusted as provided herein and as reflected on the attached schedules.
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- Sincerely,
Danny M. Payne
Tax Commissioner
- Sincerely,
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OTP/8611M
Rulings of the Tax Commissioner