Tax Type
Corporation Income Tax
Description
Price manipulation and intercorporate transactions; Consolidation of income
Topic
Returns and Payments
Date Issued
04-26-1995
April 26, 1995
Re: §58.1-1821 Application; Corporate income taxes
Dear****************
This will reply to your letters of February 23, 1995, and March 22, 1994, in which you apply for correction of additional assessments of corporate income tax to*****************(the "Taxpayer") for the taxable years ended March 31, 1991, and 1992.
FACTS
The Taxpayer was audited by the department, and numerous adjustments were made. You have contested several issues, which shall be addressed separately.
DETERMINATION
Amended Returns: The Taxpayer filed amended returns on February 18, 1994, which report additional adjustments to Virginia taxable income for the taxable years ended March 31, 1991 and 1992 attributable to: i) state taxes not based on, measured by, or computed with reference to net income; ii) an increase to federal taxable income as a result of an Internal Revenue Code ("IRC") § 197 election to amortize intangibles; and, iii) a change to the amount of net income taxes which must be added back to Virginia taxable income as a result of the IRC § 197 election. The audit assessments have been adjusted to reflect these three items.
Taxable year ended March 31. 1990; Amended return: The Taxpayer filed an amended return on November 17, 1993, for the taxable year ended March 31, 1990, to reflect an IRS audit adjustment. The department issued a refund to the Taxpayer attributable to this amended return on July 25, 1994.
When the department's auditor conducted his examination, he was informed that an amended return had not been filed to report the IRS audit adjustment to the year ended March 31, 1990, and consequently adjusted the audit assessment for the same items claimed on the amended return. The auditor's actions generated a second refund attributable to the same adjustments, which was applied to the tax liability for the taxable year ended March 31, 1991. As reflected on the attached schedules, the audit assessment for the taxable year ended March 31, 1990, has been revised for the erroneous duplicate refund, and an additional assessment has been made for a portion of the refund which was both refunded in cash to the Taxpayer, and applied as an overpayment to the taxable year ended March 31, 1991.
Property factor: The Taxpayer has stated that it used an incorrect value for capitalized rented property included in the property factor for the year ended March 31, 1992, when filing its original Virginia return. Although the department's auditor neither made, nor declined to make adjustments for this item, based on the new information provided we have adjusted the audit assessment to reflect the change requested by the Taxpayer.
Consolidation of Subsidiary: One of the adjustments made by the auditor was with respect to a newly formed subsidiary ("S"), incorporated by the Taxpayer during 1990. 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 believe that the department lacks the authority to consolidate the income of S with the Taxpayer.
During 1990, the Taxpayer transferred cash and "intellectual property rights" to S in exchange for 100% of the stock of S. Pursuant to declarations made on the Taxpayer's federal tax return under U. S. Treasury Regulation 1.351-3, the Taxpayer had no tax basis in the intellectual property rights transferred to S, and the value of S's common stock immediately after the transfer of the cash and property to S was to equal to the amount of cash transferred. No gain or loss was recognized on the transfer pursuant to IRC § 351.
After the transfer, the Taxpayer reduced its taxable income by claiming deductions for royalties owed to S. S included the royalty income in its own taxable income, and claimed deductions for "contract services" owed to the Taxpayer. The Taxpayer included the contract service revenue in its own taxable income. The only other activity reported by S during the years under audit was interest income, and amortization of organization expenses.
S is described as having 87 employees. However, the information presented leads to the conclusion that S has no common law employees. It appears that S merely paid "contract services" to the Taxpayer. It is clear from the information presented that S had no royalty income from third parties, did not maintain separate, independent offices from the Taxpayer, and did not incur even the most basic business expenses independently from the Taxpayer.
The Taxpayer believes that because S has no physical presence, business connection, capital or property in Virginia, the department is obligated to respect the structure which it has created.
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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. (Emphasis added.)
- Code of Virginia §58.1 446 provides, in pertinent part:
Virginia Regulation (VR) 630-3446, effective January 1, 1985, 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 Virginia Supreme Court's opinion in Commonwealth v. General Electric Company. 236 Va. 54 (1988) has upheld the department's authority to equitably adjust the tax of a corporation pursuant to Code of Virginia §58.1446 (or its predecessor) where there is an arrangement between two commonly owned corporations in such a manner to improperly, inaccurately, or incorrectly to reflect the business done or the Virginia taxable income.
The Taxpayer has provided no evidence that the transactions between S and the Taxpayer were at an arm's length rate for royalties or services. However, it would not be adequate to simply look to the royalty rate when examining this 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 S 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 S at any time.
The department has also reviewed the economic substance of S. The corporation is stated to have 87 employees. However, a review of S's tax return reveals no payroll expense, payroll taxes, or similar expenses. All of S's "employees" are apparently employees of the Taxpayer that may perform services contracted by S. (It is interesting to note that the Taxpayer made no attempt to reduce the denominator of its own payroll apportionment factor for the "wages" the Taxpayer paid to S's 87 "employees".)
A review of S's balance sheet reveals that its only reported assets are cash and a large receivable from an affiliate. From these facts and observations, it is clear that S possesses little corporate substance. The books of S primarily reflect "paper" intercompany transactions. The revenue related activities of S are limited to the intercompany transactions. The "contract services" provided by the Taxpayer to S for the year ended March 31, 1992, were apparently accrued and unpaid as of the end of the taxable year. 1 he royalty payments were in large part returned to the operational companies in the form of intercompany loans.
The royalty arrangement results in the transfer of income from the Taxpayer to S. Absent the creation of S, 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.
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 authority to consolidate the income of S with the Taxpayer. Code of Virginia §58.1-446 provides this authority and VR 630-3446, 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 S and transfer of intangible assets served any significant purpose other than tax planning. Finally, the "business operations" of S, its facilities, and employees are not able to be distinguished from the Taxpayer's own operations.
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 auditor's adjustment to consolidate S with the taxpayer must be upheld.
Sales factor: The Taxpayer has contested the determination of the denominator of the sales factor. The Taxpayer believes that certain revenue received from S should be included in the sales factor. However, as discussed above, the department has consolidated the income of S with that of the Taxpayer, and determined the sales factor without this intercompany revenue. Accordingly, no adjustment to the auditor's determination of the sales factor is necessary or appropriate.
The assessment shall be adjusted as provided herein and as reflected on the attached schedules. 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.
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- Sincerely,
Danny M. Payne
Tax Commissioner
- Sincerely,
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OTP/7998M
Rulings of the Tax Commissioner