Tax Type
Corporation Income Tax
Description
Alternative method of allocation and apportionment; Unitary relationship; Passive investment
Topic
Allocation and Apportionment
Date Issued
10-24-1996
October 24, 1996
Re: § 58.1-1824 Protective Claim: Corporate Income Taxes
Dear*********
This will reply to your letter in which you applied for a refund of corporate income taxes on behalf of*********(the "Taxpayer") for the 1988 taxable year. I apologize for the delay in responding to your request.
PROCEDURAL HISTORY
The Taxpayer sold all of its stock in a wholly-owned subsidiary ("Company A") in 1988. Included in the sales price was an amount paid for a covenant by the Taxpayer not to compete in the business of the subsidiary. The Taxpayer claimed a subtraction from Virginia apportionable income for the income attributable to the covenant, contending that the covenant was unrelated to the Taxpayer's activities in Virginia. This subtraction was disallowed by the department, and the Taxpayer subsequently filed an appeal under Code of Virginia § 58.1-1821. The department upheld its original determination, after which the Taxpayer filed this protective claim.
The Code of Virginia does not provide for the allocation of income other than certain dividends. Accordingly, a taxpayer's entire federal taxable income, adjusted and modified as provided in Code of Virginia §§ 58.1-402 and 58.1-403, less dividends allocable pursuant to Code of Virginia § 58.1-407, is subject to apportionment. The Taxpayer's subtraction of the capital gain has been treated as a request for an alternative method of allocation and apportionment in accordance with Code of Virginia § 58.1-421.
The decision of the U.S. Supreme Court in Allied-Signal, Inc. v. Director, Div. of Taxation, 112 S. Ct. 2551 (1992) made it clear that the payee and payor need not be engaged in the same unitary business as a prerequisite to apportionment in all cases. In the absence of a unitary relationship, apportionment is permitted when the investment serves an operational rather than a passive investment function. The Court also made it clear that the test is fact sensitive.
FACTS
The Taxpayer is a large manufacturing corporation headquartered outside Virginia. During 1979, the Taxpayer acquired 100% of the stock of Company A. In 1988, the Taxpayer sold this stock to a single buyer. For state income tax purposes, the Taxpayer allocated the income attributable to the stock sale (including the covenant not to compete) to its state of commercial domicile.
The Taxpayer financed its acquisition of Company A in part through the issuance of debt. Shortly after the acquisition, the Taxpayer issued additional debt in exchange for debt previously issued by Company A.
During the period the Taxpayer owned Company A's stock, the Taxpayer, as sole shareholder, had the right to elect Company A's entire board of directors. The Taxpayer exercised this right, and elected three members to Company A's board of directors who held seats concurrently on the Taxpayer's board.
In addition to these common directors, several positions in Company A, such as Treasurer, Assistant Treasurer, and Clerk were filled by employees of the Taxpayer. Other than these positions, all management jobs were staffed by Company A employees exclusively. Throughout the Taxpayer's ownership of Company A, no employees of the Taxpayer were reassigned to Company A, and none were reassigned from Company A to the Taxpayer. There were no joint accounting, administrative, or data processing staff. There were no joint training programs and no collective bargaining negotiations which encompassed the employees of both the Taxpayer and Company A. The employees of Company A were eligible to participate in two defined contribution pension plans sponsored by the Taxpayer, as well as a payroll deduction program which allowed Company A employees to purchase shares of the Taxpayer's stock.
The Taxpayer and Company A operated in different sectors of the same general industry throughout their affiliation. As such, there was only limited opportunity for vertical or horizontal integration. There were no common purchasing, selling, marketing, or advertising activities. In 1986, Company A introduced a new product line which incorporated several of the Taxpayer's products as well as the trademarks associated with them. The Taxpayer licensed these trademarks to Company A royalty-free. Intercompany sales comprised less than one-tenth of one percent of the Taxpayer's total sales, and prices charged to Company A were equivalent to those charged to the Taxpayer's other customers. After the Taxpayer sold its holding in Company A, these sales continued the same as before the divestiture. Trademark licensing by the Taxpayer to Company A also continued, although a royalty provision was now implemented.
During the period the Taxpayer owned Company A, all lockbox banks and retail outlet deposits from the Taxpayer, Company A, and other affiliated companies were consolidated daily into a single bank account. This single account comprised the source of funds for the disbursements of the affiliated group. If the account balance was insufficient to fund total disbursements, then the shortfall was borrowed by the Taxpayer through normal credit channels.
When the Taxpayer entered the credit markets, it utilized the assets and credit of the entire affiliated group (including Company A) in obtaining financing for various corporate purposes. While the Taxpayer owned Company A, the Taxpayer expanded its core business through several strategic acquisitions. The Taxpayer also negotiated a stock buy-back agreement with its major shareholder. These activities, as well as capital additions, were funded in part through working capital generated by continuing operations and through the issuance of debt.
The Taxpayer's decision to sell its investment in Company A was made after an evaluation of its strategic plan. The Taxpayer concluded that its resources would better be employed in its core business.
DETERMINATION
The department has examined the evidence provided by the Taxpayer in order to determine if a unitary relationship existed between the Taxpayer and Company A, and to determine if the Taxpayer's activities related to the investment in Company A were in any way connected to the Taxpayer's operational activities.
In considering the existence of a unitary relationship, the Supreme Court has focused on three objective factors: (1) functional integration; (2) centralization of management; and (3) economies of scale. (See Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S., 425 (1980); F.W. Woolworth Co. v. Taxation and Revenue Dept. Of N.M., 458 U.S., 352 (1982); and Allied-Signal.) The Taxpayer has presented evidence regarding each of these factors in clear and objective terms. While there was a flow of goods between the Taxpayer and Company A, the amount was de minimis. The trademark licensing agreement was unambiguous in its intent not to have the Taxpayer and Company A appear affiliated or as part of a unitary relationship. The Taxpayer and Company A operated in different types of businesses, and there was never any attempt to merge the operations of Company A with those of the Taxpayer. No economies of scale were achieved in purchasing, marketing, or manufacturing. Operating decisions were made on an independent basis by Company A. Based on the information provided the department, it does not appear that a unitary relationship existed between the Taxpayer and Company A.
The probative question, therefore, is whether the investment in Company A fulfilled a passive investment function or an operational function. The evidence provided to the department indicated that cash generated by Company A was regularly used to supplement the Taxpayer's working capital, which the Taxpayer could then deploy on behalf of any member of the affiliated group. These funds clearly benefitted the Taxpayer's operational activities in its core business, either through capital expansion or acquisitions. The evidence indicated that funds from Company A were pooled with those from other members of the affiliated group, which determined the amount of borrowing necessary by the Taxpayer. To the extent that Company A's contributions obviated short-term borrowing by the Taxpayer, Company A directly aided the operational activities of the Taxpayer through reduced interest expense and freeing up other resources for use in the Taxpayer's core business.
The Taxpayer incurred significant amounts of debt throughout the period that it owned Company A as a result of capital expenditures, acquisitions, and common stock repurchases. The Taxpayer presented no factual data indicating that its working capital balance was not necessary for, or related to, the operational retirement of scheduled debt service. The presence of long-term debt implies a need to refinance, extend, or renew such financing. Some financing arrangements may require that certain financial ratios be present and maintained; others may be negotiated on a more favorable basis if liquidity and other financial ratios are present. The Taxpayer stated that it handled all borrowing for affiliated companies and that such borrowing was based on the assets and credit of the entire group. The operational benefits of a strong financial position cannot be ignored where there is no evidence that the company can operate effectively without them.
The Taxpayer has not demonstrated by clear and cogent evidence that its ownership of Company A fulfilled a passive investment function. The evidence indicated, to the contrary, that Company A's contribution to the Taxpayer's working capital was directly related to, and therefore enhanced, the operational activity of the Taxpayer. It is logical to conclude that all income attributable to the sale of Company A stock related to the Taxpayer's operational business carried on in Virginia.
In any proceeding relating to the interpretation of the tax laws of the Commonwealth of Virginia, the burden of proof is on the taxpayer. In this particular matter, the Taxpayer must prove by clear and cogent evidence that Virginia's statutory method of allocation and apportionment would result in a tax on income derived from a discrete investment function having no connection with Virginia in violation of the principles set forth in Allied-Signal. Based upon the information provided, it cannot be determined how much, if any, of the Taxpayer's investment in Company A could be fairly characterized as a passive investment. The Taxpayer, therefore, has not met the burden of proof. Accordingly, permission to use an alternative method of allocation and apportionment for the income attributable to the sale of stock in Company A is denied, and consequently, your request for refund cannot be granted.
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/5664G
Rulings of the Tax Commissioner