Tax Type
Corporation Income Tax
Description
"Taxable income" defined; Noncompete agreement
Topic
Computation of Income
Date Issued
03-06-1995
March 6, 1995
Re: §58.1-1821 Application: Corporate Income Tax
Dear***************
This is in response to your November 17, 1993, letter in which you, on behalf of**********(the "taxpayer"), appeal a corporate income tax assessment for the 1991 taxable year. I apologize for the delay in responding.
FACTS
As the result of an audit, the taxpayer's 1991 return was adjusted and an assessment was issued. You now raise a question unrelated to the audit adjustments. At issue is the correct treatment of the costs associated with a non-compete agreement.
The taxpayer and its wholly owned subsidiary ("S1") are members of an affiliated group of corporations which file a federal consolidated return. The taxpayer files on a separate basis in Virginia, while S1 does not file in Virginia.
Shortly after being purchased by the taxpayer, S1 executed a non-compete agreement with its former owner for a five year period. S1 independently borrowed funds to finance this agreement. In conjunction with the purchase of S1, the taxpayer reorganized the operations of the affiliated group. As a result of this reorganization, S1 ceased to be an operating company. S1 now serves solely as an administrative company for the affiliated group.
S1 still maintains legal ownership of the agreement, however; the taxpayer is the only entity in the affiliated group that benefits from this agreement. The agreement allows the taxpayer to manufacture a certain product with no competition from S1's former owner.
Nevertheless, the taxpayer and S1 do not have a royalty agreement nor does the taxpayer reimburse S1 for the interest costs associated with the loan used to finance the non-compete agreement. The taxpayer and S1 have no reason to establish a royalty or like arrangement, as such an arrangement would simply result in an offset in a federal consolidated filing and thus have no impact on federal income tax liability. The non-compete agreement or the interest costs associated with the agreement were not considered when the taxpayer's 1991 Virginia corporate income tax liability was computed.
You believe the expenses associated with this agreement are related directly to the taxpayer's operation and therefore request a ruling on the proper treatment of this item in computing the taxpayer's Virginia income tax liability.
DETERMINATION
The computation of Virginia taxable income begins with federal taxable income. Therefore, Virginia relies on the amount and character of each item reported on the federal return. However, it is recognized that intercompany charges do not affect the consolidated federal taxable income and federal tax liability. When a taxpayer asserts that an item must be treated differently for Virginia purposes than it was on a federal return, the taxpayer must clearly show that this adjustment is justified. In addition, the taxpayer must show that the alternative treatment does not affect the amount or characterization of any item of federal taxable income.
The department has previously ruled in Public Document (P.D.) 86-5 (12/19185), copy attached, that a taxpayer could properly utilize a loss in determining federal taxable income for Virginia purposes upon furnishing satisfactory evidence that the loss was improperly treated in a federal consolidated filing. In P.D. 90-43 (3/19190), copy attached, the department allowed a corporation filing on a separate company basis to properly report professional fees even though these fees were improperly allocated among the members of a federal consolidated filing.
In the instant case, the non-compete agreement was negotiated by S1 with an unrelated third party at an arms-length price. While S1 maintains ownership and services the debt associated with the agreement, it is clear from the information provided that the taxpayer is the only member of the affiliated group that benefits from this agreement.
Therefore, the department recognizes in the instant case that this item as reported in a consolidated federal return does not properly reflect the separate taxable income of the taxpayer for Virginia purposes. It is also noted that the failure to reflect the proper intercompany charges in the consolidated federal return has no effect on the amount of federal tax liability or characterization of income for federal purposes, so no useful purpose would be served by filing an amended federal return. Accordingly, the department finds basis to justify the inclusion of the costs of the non-compete agreement in the computation of the taxpayer's Virginia tax liability. The taxpayer may amortize the cost of the non-compete agreement over the term of its life and deduct interest costs associated with the agreement in determining Virginia taxable income.
It should be noted that such adjustments on the Virginia return are not "additions" or "subtractions" to federal taxable income as those terms are used in Code of Virginia § 58.1-402. Technically they are adjustments to reconcile federal taxable income for Virginia purposes to federal taxable income actually reported to the Internal Revenue Service.
Based on this above ruling, the taxpayer's outstanding 1991 assessment will be abated in full. Should you have additional questions regarding this matter, please contact*****************.
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- Sincerely,
Danny M. Payne
Tax Commissioner
- Sincerely,
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OTP/7525L
Rulings of the Tax Commissioner