Tax Type
Corporation Income Tax
Description
Apportionment of income; Capital gain from sale of stock
Topic
Allocation and Apportionment
Date Issued
11-04-1996
November 4, 1996
Re: § 58.1-1824 Protective Claim: Corporate Income Tax
Dear******************
This will respond to your letter in which you request a refund of corporate income taxes on behalf of ************* (the "Taxpayer") for the 1990 taxable year. I apologize for the delay in responding to your request.
PROCEDURAL HISTORY
The Taxpayer sold its 50% ownership in another company ("Company A") during 1990, realizing a capital gain. On a 1990 amended Virginia corporation income tax return, the Taxpayer subtracted this capital gain from income apportionable to Virginia, resulting in a request for refund. The department notified the Taxpayer in a ruling dated June 4, 1993, that its request for refund was denied to the extent it was related to the allocation of the capital gain from the sale of Company A stock. See Public Document (P.D.) 93-137, (6/4/93), copy attached. The denial of this refund constituted an assessment of tax by the department pursuant to Code of Virginia § 58.1-1823.
A protective claim for refund was subsequently requested by the Taxpayer and additional information related to its refund request was submitted. Your protective claim has been resolved based upon its merits pursuant to the authority granted the Tax Commissioner by Code of Virginia § 58.1-1822.
FACTS
The Taxpayer is a large retailing corporation whose commercial domicile is located outside Virginia. In 1983, the Taxpayer acquired 100% of the stock of Company A, a company whose principal product is sold at a significant number of the Taxpayer's retail outlets. The Taxpayer sold 50% of its stock in Company A to a foreign company ("Company B") in 1986, and sold the remaining 50% to Company B in 1990.
During the period from the Taxpayer's initial purchase of Company A until its sale of 50% of Company A's stock in 1986, the Taxpayer maintained complete control of Company A's board of directors. After the 1986 sale, the Taxpayer held three seats on Company A's six member board. The by-laws of Company A were amended such that matters relating to Company A's purchase of raw product from Company B were decided by a three member executive committee, of which two members were appointed by the Taxpayer. Similarly, another three member committee, of which two members were appointed by Company B, handled matters relating to Company A's sale of finished product to the Taxpayer. This arrangement remained in effect until the Taxpayer's complete disposition of Company A stock in 1990.
Throughout the period when the Taxpayer owned 50% of Company A, both corporations maintained separate headquarters with distinct management and support functions. Shortly after the 1986 sale, Company A developed its own capability to provide various legal and financial services which had previously been performed by the Taxpayer on behalf of Company A. Various employee benefits programs, which were administered by the Taxpayer for both itself and Company A, became independently administered by Company A for its own benefit after the 1986 sale. The Taxpayer and Company A also did not share any joint employee training programs, engage in any joint labor negotiations, nor utilize any jointly produced administrative procedures.
The Taxpayer did, however, continue to purchase significant quantities of Company A's principal product after the 1986 sale, and continued to market the product under Company A's brand name. Sales of this product comprised the largest portion of the Taxpayer's total sales over the five year period from 1986 through 1990, generating an average of 21.3% of total sales over that time. The Taxpayer entered into a twenty year purchase agreement with Company A at the time of the 1986 sale, obligating itself to purchase, at a minimum, one-third of its annual product requirements each year. Also in 1986, the Taxpayer and Company A embarked on an aggressive joint marketing campaign, in which Company A's primary trademark was branded at approximately one-third of the Taxpayer's retail outlets. The Taxpayer also accepted Company A's credit card for purchases of Company A's product, as well as other merchandise not sold to the Taxpayer by Company A. Finally, throughout the period following the 1986 sale, the Taxpayer operated a number of retail outlets under another tradename, which was owned by Company A.
In 1987, ownership of the Taxpayer was gained by a private investment group through a leveraged buyout. As a result, the Taxpayer incurred significant amounts of new debt. Pursuant to the financing agreements under which the debt was obtained, the Taxpayer divested several of its operating divisions in 1988 and 1989. These agreements also contained covenants requiring the Taxpayer to maintain specified financial and coverage ratios.
Due partly to higher interest expense caused by this new debt and partly to increased competition, the Taxpayer's results of operations deteriorated significantly after the 1987 buyout. For the five months ended December 31, 1987, the Taxpayer experienced a net loss of approximately $***** million; for the years ending December 31, 1988 and 1989, the Taxpayer lost $*** million and $**** billion, respectively. The Taxpayer's equity in the earnings of Company A for the same periods, however, were $*** million, $** million, and $** million, respectively.
As a result of these negative trends, the credit agreement which financed the leveraged buyout was amended eleven times. The eleventh amendment provided a revised schedule regarding the application of proceeds which were to be derived from the Taxpayer's sale of its remaining stock in Company A. In late 1989, the Taxpayer announced that due to increased competition and lower than expected earnings "available working capital might not be sufficient to meet its principal, interest and other business obligations in 1991." The Taxpayer's stock in Company A was sold three months later, and later in 1990 the Taxpayer filed a voluntary petition for reorganization relief under Chapter 11 of the United States Bankruptcy Code.
The Taxpayer claims that the capital gain realized upon the disposition of the Company A is not subject to apportionment, and instead should be allocated to the Taxpayer's state of commercial domicile pursuant to the decision of the U.S. Supreme Court in Allied-Signal, Inc. v. Director, Division of Taxation (112 S. Ct. 2251 (1992) ). Since the Code of Virginia does not provide for the allocation of income other than certain dividends, 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.
DETERMINATION
The decision of the U.S. Supreme Court in Allied-Signal 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.
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.) Evidence regarding these factors was presented by the Taxpayer in clear and objective terms. Since the Taxpayer seeks to allocate the capital gain from the 1990 sale of Company A stock, the department must determine if those factors existed at the time of the sale and consequently evinced a unitary relationship.
After the 1986 sale, it is clear that the Taxpayer lacked the authority and the ability to unilaterally control the activities of Company A. The Taxpayer held three seats on Company A's six member board; however, a minimum of four votes were required to pass any resolution. In addition, the three member executive committee feature of the by-laws served to severely restrict the ability of either the Taxpayer or Company B to engage in favorable self-dealing with Company A. The Taxpayer also presented objective evidence relating to the lack of any centralized purchasing, training, administrative, or management functions. There was certainly a greater degree of centralized direction and performance of services prior to the 1986 sale. After the 1986 sale, Company A exhibited greater autonomy and functioned essentially as a stand alone, independent entity. In the absence of centralized management of Company A's activities by the Taxpayer, functional integration and economies of scale could not be achieved. The evidence presented, therefore, indicates that the Taxpayer and Company A were not engaged in a unitary relationship at the time of the Taxpayer's sale of Company A stock in 1990.
The determining issue in this case then centers upon whether the Taxpayer's investment in Company A stock fulfilled an operational function or a passive investment function. The Taxpayer contends that the investment cannot be viewed as fulfilling an operational function since the stock was not utilized in a hedging transaction as described in Corn Products Co. v. Commissioner, 350 U.S. 46, 50-53 (1955), nor was it a component of working capital analogous to the short-term bank deposits alluded to in Allied-Signal. The department agrees that the ownership of Company A was not a Corn Products hedge. The department, however, does not agree with the Taxpayer's claim that the Company A stock did not fulfill a working capital function.
As noted above, the Taxpayer's operating results deteriorated significantly after the 1987 leveraged buyout. The financial position of the Taxpayer deteriorated likewise. At December 31, 1989, one month prior to the sale of Company A stock, the Taxpayer exhibited a negative net worth of approximately $*** billion and negative working capital of over $*** million. (Note: the investment in Company A was recorded as a current asset at December 31,1989 due to its sale one month later. The book value of the stock is not included in the $*** million negative working capital determination.) The Taxpayer's quick ratio declined from **** at December 31, 1988 to ***one year later. These facts point to the increasing difficulty of the Taxpayer in maintaining sufficient liquidity to meet its short-term obligations. The Taxpayer's announcement in 1989 concerning the possibility of insufficient working capital and the subsequent bankruptcy filing later in 1990 corroborate this conclusion.
The Taxpayer's claim that its investment in Company A was an illiquid, long-term investment which fulfilled no operational function is unpersuasive when viewed in the context of the severe financial stresses the Taxpayer was experiencing at the time of the sale. The characterization of an investment as short-term or long-term is inconclusive as to whether the investment was operationally related to the Taxpayer's business activities in Virginia. The Taxpayer received cash dividends from Company A during a time when the Taxpayer had a working capital deficit, and the results of Company A contributed favorably to the Taxpayer's efforts to comply with the covenants regarding various financial ratios. Given the Taxpayer's financial position and subsequent bankruptcy, it is probable that the cash infusion from the sale of Company A stock enabled the Taxpayer to prolong its operations without seeking reorganization relief.
The Taxpayer also claims that the investment in Company A did not fulfill an operational function since the sale proceeds were applied to outstanding debt pursuant to the amended credit agreement rather than being used to liquidate operational liabilities. This claim is also unpersuasive. Cash is an extremely fungible commodity, and the sales proceeds undoubtedly made possible the use of the Taxpayer's other limited financial resources in meeting its pressing operational obligations.
The Taxpayer has not demonstrated that the proceeds from the sale of Company A stock were unrelated to the Taxpayer's operational activities carried on in Virginia. To the contrary, the evidence of the Taxpayer's working capital deficit, negative net worth, deteriorating operating results, creditor demands, and subsequent bankruptcy make it clear that the sale of Company A stock was an indispensable component of the Taxpayer's ability to continue its operations, including those in Virginia, prior to the bankruptcy filing. The Taxpayer cannot claim that the investment in Company A should be looked at in a vacuum apart from its overall financial condition for Allied-Signal purposes when the sale of that investment is necessary for the Taxpayer's operational activities to continue.
The department also reiterates its prior determination that the Taxpayer's reliance on the U.S. Supreme Court's decision in ASARCO, Inc. v. Idaho State Tax Commission (102 S. Ct. 3103 (1982)) is misplaced. In P.D. 93-137, the department stated its reasoning as to how the situation in ASARCO differed from the instant case. The major distinction with ASARCO is that Company A has an extensive connection with the Taxpayer's Virginia business activities, while in ASARCO Southern Peru had no connection with ASARCO's Idaho operations. After the 1986 sale, Company A's product and tradename were utilized at a number of the Taxpayer's retail outlets in Virginia. The Taxpayer accepted Company A's credit card for purchases of Company A's product, as well as a limited amount of its own merchandise. The Taxpayer also operated a number of retail outlets in Virginia under a tradename owned by Company A. In addition, Company A assumed operational responsibility for a product terminal in Virginia in which Company A had a 50% ownership interest. These factors clearly indicate an unambiguous relationship, absent in ASARCO, between Company A and the Taxpayer's operational activities 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, the Taxpayer's investment in Company A cannot be fairly characterized as a passive investment. The Taxpayer, therefore, has not met the burden of proof. Permission to use an alternative method of allocation and apportionment for the income attributable to the sale of stock in Company A is therefore denied.
Accordingly, the Taxpayers' protective claim for refund must now be denied. Please be aware this denial does not prevent the Taxpayer from filing suit in circuit court pursuant to Code of Virginia § 58.1-1825; however, the suit must be filed within one year of the date of this letter. The remaining issues raised on your amended return will be processed in accordance with the revisions noted on the attached schedules. The indicated refund will be issued shortly with interest at the statutory rates. Should you have any questions regarding this matter, please contact******at**************.
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/7177G
Rulings of the Tax Commissioner