Tax Type
Corporation Income Tax
Description
Price manipulation and intercorporate transactions; Royalty payments to affiliates
Topic
Returns and Payments
Date Issued
10-09-1996
October 9, 1996
Re: § 58.1-1821 Application; Corporate Income Taxes
Dear**************
This will reply to your letter in which you contest the assessment of additional corporate income taxes to *************(the 'Taxpayer") for the taxable years ended December 31, 1989, 1990 and 1991.
FACTS
The Taxpayer was the subject of a field audit by the department. Two adjustments were made, one of which you protest. Relying on Code of Virginia § 58.1-446, the department's auditor disallowed deductions for royalty expenses paid by the Taxpayer to two affiliated corporations ("A1" and "A2") for the use of trademarks owned by these entities.
The Taxpayer is incorporated in Virginia, and is engaged in the manufacture of consumer goods which it wholesales both within and without Virginia. As part of its product line, the Taxpayer manufactures certain goods bearing the trademarks owned by A1 and A2. Both trademarks are very old and well known, having been in existence for most (if not all) of this century. The trademarks were developed by the corporate predecessors of A1 and A2 and are now owned by those corporations as successors in interest, as the result of mergers, to the original owners of those trademarks.
The Taxpayer believes that the department is without authority to disallow its deductions for the royalties paid to A1 and A2. Furthermore, the Taxpayer believes that because the royalty was an "arm's length" agreement with an independent corporate entity the department is obligated to respect the royalty agreements between the Taxpayer and A1 and A2.
DETERMINATION
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.
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- ... 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.)
Virginia Regulation (VR) 630-3-446, 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.
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- 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.)
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 § 58.1-446 (or its predecessor) where an arrangement between two commonly owned corporations operates in a manner to improperly, inaccurately, or incorrectly reflect the business done in Virginia or Virginia taxable income. Generally the department will invoke its authority under Code of Virginia § 58.1-446 if a corporation under common ownership with a taxpayer is found to lack economic substance or the intercompany transactions are not consummated on an arm's length basis.
The department has reviewed the economic substance of A1. Based on the information provided and observations of A1's federal tax returns, it is an active manufacturing company. A1 has substantial assets, employees, and business activity. It manufactures consumer goods under its trademark, which it has owned since the formation of the corporation over 30 years ago. The Taxpayer has clearly demonstrated that A1 has substantial economic substance. In fact, the business activities of A1 in Virginia were such that it filed corporate income tax returns during the periods under protest here.
The Taxpayer has demonstrated that the royalties paid to A1 are reasonable when compared to royalties charged to third parties. During the period under audit, the Taxpayer was able to document that A1 has entered into 45 licensing agreements with unrelated parties for the use of its trademark. All of these agreements were similar to the agreement executed by the Taxpayer and A1, both in terms of royalty rate and the rights and privileges conveyed. Moreover, the Taxpayer and A1 had executed a royalty agreement nearly identical to their current agreement many years prior to the time they became affiliated.
Given the considerable documentation provided, the Taxpayer has demonstrated that the royalties are at an arm's length rate. It is therefore logical to conclude that the trademark is a valuable intangible asset which can be accurately identified, valued, and licensed.
The Taxpayer has also demonstrated that A2 has economic substance. A2 was an active manufacturing corporation until the company was reorganized nearly 15 years ago. At that time, the U.S. manufacturing and marketing operations of A2 were transferred into a newly formed corporation, and the management of international operations was concentrated in A2. A2's international operations consist of more than twenty subsidiaries, and trademark license agreements in about thirty to forty other countries. A2's trademark remained with A2 for this reason.
A review of A2's federal income tax returns shows that it has substantial amounts of investments, which it manages for its own account. The books of A2 primarily reflect actual cash transactions, as opposed to "paper" intercompany transactions. The revenue related activities of A2 are not limited to intercompany transactions, but reflect A2's own investment activity as well as royalties received from the Taxpayer and others. Additionally, A2 incurs such routine business expenses as wages and salaries, rent, and taxes.
The Taxpayer has also documented that the royalty agreement entered into with A2 was at an arm's length. The Taxpayer was able to document that A2 has entered into 29 licensing agreements with unrelated parties for the use of its trademark during the period under audit. All of these agreements were similar to the agreement executed by the Taxpayer and A2, both in terms of royalty rate and the rights and privileges conveyed.
Consequently, as was the case with A1's trademark, the department concludes that A2's trademark is a valuable intangible asset which can be accurately identified, valued, and licensed.
In reaching its decision in General Electric Company. the Virginia Supreme Court cited a fact pattern quite different from the instant case. General Electric had created a Domestic International Sales Corporation ("DISC") to which it shifted income. 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 standards. In General Electric Company the DISC was a paper company which essentially did nothing to earn the income which was shifted to it. The facts in the instant case are not analogous to those in General Electric Company.
The department finds a clear and logical basis to distinguish the instant case from the facts contained in General Electric. Accordingly, the adjustments made to disallow the deduction for the royalty payments made by the Taxpayer have been reversed.
The assessments shall be adjusted as provided herein. A review of the Taxpayer's account indicates the 1989 assessment was paid in full and the 1990 assessment was paid in part. Attached is a schedule showing the revised assessments, and the amount to be refunded. If you have any questions concerning this letter, please contact ********* in the Office of Tax Policy at**********.
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/7610L
Rulings of the Tax Commissioner