Tax Type
Corporation Income Tax
Description
Consolidated income
Topic
Appropriateness of Audit Methodology
Returns and Payments
Date Issued
09-06-1995
September 6, 1995
Re: § 58.1-1821 Application; Corporate income taxes
Dear***********:
This will reply to your letters of May 31, 1994, May 11, 1995, June 26, 1995, and August 3, 1995, in which you apply for correction of assessments of additional corporate income taxes to********** ("Taxpayer") for the taxable years ended September 30, 1990, 1991 and 1992.
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 royalties charged to the Taxpayer from a newly formed subsidiary ("S1"). Another adjustment was made with respect to investment income earned by another subsidiary ("S2"). The department's auditor found that S1 and S2 lacked substantial economic substance, consolidated the taxable income of S1 and S2 with the Taxpayer, and apportioned the consolidated total to Virginia. You contest these adjustments, and believe that Virginia Regulation ("VR") 630-3-446 does not give the department the authority to consolidate the income of either S1 or S2 with the Taxpayer.
DETERMINATION
The Taxpayer is incorporated outside Virginia, and is engaged in the production and sale of computer software both within and without Virginia. The Taxpayer has indicated that its corporate headquarters is located in Virginia. The Taxpayer's President, Chief Financial Officer, Secretary, Chief Operating Officer, Chief Technology Officer and several Vice Presidents are all physically located at its Virginia corporate headquarters facility. Pursuant to VR 630-3-407 D, the Taxpayer's commercial domicile is found to be in Virginia.
S1 - Software royalties
During 1990, the Taxpayer transferred software to S1 in exchange for 100% of the stock of S1. No gain or loss was recognized on the transfer pursuant to Internal Revenue Code (IRC) § 351. All software held by S1 was acquired through capital contributions. S1 did not pay the Taxpayer for any software, or reimburse the Taxpayer for any software development costs. The Taxpayer developed the software which was transferred at its various business locations, including those in Virginia.
After transferring software to S1, the Taxpayer entered into a license agreement, thereby agreeing to pay a royalty to S1, based upon a percentage of the Taxpayer's sales. The royalty rate is stated to be 25% of gross receipts, less a portion deducted for customer support. No software is licensed by S1 to third parties, and all royalty income received from S1 was from the Taxpayer.
When asked how the royalty rate was determined, the Taxpayer responded that the rate was determined by an outside party who concluded that the 25% rate was reasonable. When asked to provide evidence that the royalty rate was reasonable, the Taxpayer responded "this rate was determined by our outside accountants, who at the time had reviewed our international royalty rate and based on this and other studies done by them, is [sic] was determined that 25% was an arm's length rate for this transaction." When asked for a written analysis to support this determination, or any other support for the royalty rate, the Taxpayer responded that they had no support other than a verbal indication of what constituted a reasonable rate.
S1 's activities in 1990 through 1992 are minimal. S1 did not license any intangible assets to third parties or receive royalty income from anyone other than the Taxpayer. S1 earned interest income during the taxable year ended September 30, 1992, however, all of this interest was earned from loans made to the Taxpayer.
S1's balance sheet primarily reflects intangible assets and intercompany loans and investments. S1 made significant loans to the Taxpayer. Through September 30, 1992, these loans nearly equal the total net income earned by S1. No written agreement loan agreements exist, although interest is said to be charged at mid-term federal rates.
S1 is stated to have a management service agreement, whereby the Taxpayer "is compensated for any administrative services provided to [S1]." The deduction claimed by S1 for these services appears to be the largest single expense (other than amortization) incurred by S1.
Through September 30, 1992, all of S1's officers and directors were employees of the Taxpayer. Several of S1's officers and directors were employed at the Taxpayer's headquarters in Virginia. S1 issued W-2's to 9 part-time employees in 1991, and to one part-time employee in 1992, which were all resident at S1's "premises" (rented office space) in Delaware. All of S1's employees were also employees of S2.
The Taxpayer provided the following description of S1's function: "[S1] owns the source code of the software sold by [the Taxpayer]. Its purpose is to centralize and improve the infringement monitoring, performance, security, usefulness, and the marketing and licensing potential of the software. There is a distribution agreement in place which designates [the Taxpayer] as the sole marketing representative of such software. For such right, [the Taxpayer] pays a royalty amount to [S1] for all licenses sold."
S2 - Investment income
S2 holds cash and various investments. The investments are primarily loans to, or investments in, related parties. S2 earns dividends and interest income. The majority of the dividend income qualifies for various federal and Virginia subtractions, and is therefore not subject to tax in Virginia. All of the interest income earned by S2 was from loans made to the Taxpayer.
S2's activities in 1989 through 1992 are minimal. S2's balance sheet primarily reflects cash and intercompany loans and investments. S2 made substantial loans to the Taxpayer. The loan balances sometimes equal or exceed S2's cumulative retained earnings. The loans, although substantial, were not evidenced by a written loan agreement. It is stated that interest was charged at the mid-term federal rate.
Through September 30, 1992, all of S2's officers and directors were employees of the Taxpayer. Many (in some years all) of S2's officers and directors were employed at the Taxpayer's headquarters in Virginia. S2 issued W-2's to 8-9 part-time employees for 1990 and 1991, and to one part-time employee in 1992, which were all resident at S2's "premises" (rented office space) in Delaware. S2 has a management service agreement, whereby the Taxpayer "is compensated for any administrative services provided to [S2]."
The Taxpayer provided the following description of S2's function: "[S2's] separate identity allows its activities to be segregated and controlled separately and distinctly from the normal business operations of other members of the affiliated group."
The Taxpayer believes that the department is without authority to consolidate the income of S1 and S2 with the income of the Taxpayer. Furthermore, the Taxpayer believes that because S1 and S2 had no nexus with Virginia, absent any statute requiring consolidation of tax returns, the Tax Commissioner has no authority over S1 or S2.
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- Code of Virginia § 58.1-446 provides, in pertinent part:
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. In all cases mentioned in this paragraph, such other corporations not otherwise liable to taxation under this chapter shall, for the purposes of this chapter, be deemed to be doing business in Virginia through the agency of the corporation liable to taxation under this chapter. (Emphasis added.)
- Code of Virginia § 58.1-446 provides, in pertinent part:
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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 transactions between S1 and the Taxpayer are at an arm's length royalty rate. However, the department does not look only to the royalty rate when examining this type of 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 S1 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 S1 at any time.
In addition, the Taxpayer has transferred a large amount of its "source code" to S1. This source code would apparently constitute a large part of the Taxpayer's product line which can be sold to customers. As such, it would appear difficult to envision that the Taxpayer would ever agree to sell these assets as it would seem to effect their ability to continue as a going concern. Accordingly, it appears unlikely that an arm's length transaction could be structured whereby a third party could purchase, or the Taxpayer would sell, the source code independently of a sale of the entire company.
With respect to the royalty rate, the Taxpayer has presented no objective evidence to support the chosen royalty rate. However, 25% of gross sales is obviously an extremely high rate. By comparison (per their annual report) the Taxpayer's consolidated net income ranges from only 6.5% to 11% of total revenue. Another comparison reveals that the royalties paid by the Taxpayer to S1 are nearly equal to, or in some cases in excess of, consolidated federal taxable income for the group as a whole.
With respect to S2, 100% of the interest income in question was paid by the Taxpayer to S2. Given that S2 basically loans the earnings back to the Taxpayer on an unwritten "open-account" basis, there seems to be little merit to the business purposes cited for the arrangement. The arrangement merely shifts income to S2, and then returns the money to the Taxpayer as a loan.
The department has also reviewed the economic substance of S1 and S2. The corporations are stated to have their own part-time employees. A review of the employment records reveals that of the more than 30 W-2's that were issued for 1990 through 1992, only 8 reflected gross annual salaries in excess of $100 for the year. In fact, 17 W-2's were issued for gross salaries of less than $30 per year. In addition, although the "businesses" of S1 and S2 are supposed to be quite different, during 1992 the only W-2's issued by S1 and S2 were to the same employee, for exactly the same amount of gross wages.
A review of the "duties" of each employee reveals job functions consistent with the maintenance of a shell corporation, such as "Monthly bank reconciliations, Delaware Franchise Tax Reports." From these facts and observations, it appears that S1 and S2 possesses little corporate substance. The books of each company primarily reflect "paper" intercompany transactions. The revenue related activities are primarily limited to the intercompany transactions, and the royalty and interest payments are basically returned to the Taxpayer in the form of intercompany loans.
All of the officers and directors of S1 and S2 were employees of the Taxpayer. Many of these officers and directors were physically present at the Taxpayer's Virginia headquarters, and the rest were involved in the Taxpayer's operational business carried on in Virginia and elsewhere. The officers and directors ultimately control the actions of S1 and S2. These individuals had to act in their capacity as officers and directors on an as-needed basis, and it is unrealistic to believe that they traveled to Delaware each time they were required to do so. Accordingly, the department finds it reasonable to conclude that S1 and S2 were controlled and managed from the Taxpayer's facilities in Virginia and elsewhere.
In addition to the presence of officers and directors in Virginia, S1 and S2 contracted for management services from the taxpayer. These services, which would seem to be fundamental core functions that an independent entity would ordinarily provide for itself, were provided at the Taxpayer's facilities inside and outside of Virginia.
The royalty and interest payments result in the transfer of income from the Taxpayer to S1 and S2. Absent the creation of this arrangement, 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 S1 and S2 in Delaware, where the royalty and interest 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 the court's decision in General Electric Company, it is clear that the department possesses the authority to consolidate the income of S1 and S2 with the Taxpayer. Code of Virginia § 58.1446 provides this authority and VR 6303-446, 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 S1 and S2 and transfer of assets served any significant purpose other than tax planning, and the software transferred does not appear to be clearly severable from the Taxpayer's ability to exist as an independent going concern.
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 finds no basis to reverse the auditor's adjustment, and must deny your request for relief. However, the department has found some minor problems in the manner in which the assessments were computed. These corrections have been made, and the assessments have been adjusted as provided on the attached sheets. The balance due, ***** should be paid within 30 days to prevent the accrual of additional interest. Your payment may be sent to*********c/o Office of Tax Policy, Department of Taxation, P.O. Box 1880, Richmond, Virginia 23282-1880.
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/8124M
Rulings of the Tax Commissioner