Tax Type
Corporation Income Tax
Description
Price manipulation and intercorporate transactions; Disallowance of royalties paid to subsidiary
Topic
Returns and Payments
Date Issued
11-06-1996
November 6, 1996
Re: § 58.1-1821 Application: Corporate Income Taxes
Dear**************
This will reply to your letter in which you apply for correction of assessment of additional corporate income taxes to********* (the "Taxpayer") for the taxable year ended August 31, 1992 (the "1991 taxable year"). I apologize for the delay in responding to your request.
FACTS
The Taxpayer was field audited, and an adjustment was made to disallow royalties paid to a wholly-owned subsidiary ("S"). The department's auditor concluded that the royalties were not an arm's length transaction and that S lacked economic substance. You protest the auditor's decision, claiming that the department lacks the authority to disallow the expense.
DETERMINATION
The Taxpayer is a regional manufacturer headquartered outside Virginia. During the 1991 taxable year, the Taxpayer created S by transferring various trademarks to S in exchange for 100% of S's common stock. This transfer was accomplished with no gain or loss to the Taxpayer pursuant to Internal Revenue Code (IRC) § 351.
S licensed the trademarks to the Taxpayer, who paid S a royalty for their use. The royalty rate was determined by an independent appraisal conducted shortly before the incorporation of S. Under the terms of the agreement, royalties are paid by the Taxpayer to S on a quarterly basis.
The stated business purpose of S was to manage and enhance the value of its trademarks. To accomplish this purpose, S hired a staff, opened bank accounts, retained legal counsel, and formed a board of directors. During the 1991 taxable year, S began the process of registering its trademarks in foreign countries. This process culminated in the signing of a trademark licensing agreement with a foreign corporation. Several months after the end of the 1991 taxable year, another licensing agreement was signed for the use of the trademark in an additional overseas operation.
The Taxpayer believes that since S was created for valid business purposes and the royalty rate is indicative of an arm's length transaction, then the department must respect the structure in which the Taxpayer has chosen to conduct its business.
Code of Virginia § 58.1-446 provides in pertinent part:
-
- ... 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.)
The authority of the department to equitably adjust the tax of a corporation pursuant to Code of Virginia § 58.1-446 was upheld by the Virginia Supreme Court in Commonwealth v. General Electric Company, 236 Va. 54 (1988). Pursuant to this decision, the department may equitably adjust tax where there is an agreement between two commonly owned corporations in such a manner to improperly, inaccurately, or incorrectly reflect the business done in Virginia or the Virginia taxable income. Generally, the department will invoke its authority under Code of Virginia § 58.1-446 if a corporation under common ownership with the taxpayer is found to lack economic substance and/or the intercompany transactions were not consummated on an arm's length basis.
In reviewing the operations and structure of S, the department found sufficient business activity to indicate significant economic substance. S had royalty income from an unrelated party. The Taxpayer and S had no common employees. S retained legal counsel independent from that used by the Taxpayer. S opened bank accounts and negotiated agreements in its own name. S incurred substantial expenses in registering its trademarks in foreign countries, which it paid out of its own funds. In addition to those registration expenses, S also had normal operating expenses for items such as payroll and rent. All of these activities were directly related to the achievement of S's stated business purpose.
In determining whether the royalty between the Taxpayer and S constituted an arm's length transaction, the department reviewed the appraisal upon which the royalty rate was based. In order to determine the proper royalty rate for the use of the trademarks, the appraisal distinguished between the value of the trademarks and the other intangible assets of the Taxpayer, such as goodwill. In reaching its conclusions, the appraiser considered the Taxpayer's recent operating performance within industry norms, as well as its own database of other royalty rates derived from previous industry engagements.
The validity of the appraisal was supported by S's execution of two licensing agreements with unrelated parties, one within the 1991 taxable year and one shortly afterward. The first agreement called for the licensing of four trademarks at the exact royalty rate paid by the Taxpayer. In the second agreement, the licensee paid a royalty rate one percentage point below that of the Taxpayer; however, the licensee was only licensed to use one trademark held by S. Based on the trademarks' relative importance, this agreement appears equivalent to that between the Taxpayer and S. Taken together, these agreements support the Taxpayer's claim that the royalties paid to S are reasonable when compared to the rates charged to third parties, and therefore constitute an arm's length transaction.
The facts of this case can clearly be distinguished from those in Public Document (P.D.) 94-179, (6/8/94), copy enclosed, in which the consolidation of a taxpayer and its wholly-owned subsidiary was upheld by the department. In P.D. 94-179, the subsidiary possessed minimal economic substance and undertook no activity to further its stated business purpose. The subsidiary entered into no agreements with third parties which could be utilized to corroborate the arm's length nature of the intercompany royalty payments. The appraisal gave no indication that the value of the trademarks and patents could be readily distinguished from other intangible assets or the intrinsic going-concern value of the company as a whole. Given these factors, the department invoked its authority under Code of Virginia § 58.1-446 to equitably adjust tax.
Accordingly, due to the presence of substantial business activity by S and comparable third party transactions, the auditor's assessment will be revised. The balance due reflected on the enclosed schedule should be paid within sixty days to prevent the accrual of additional interest. Your payment should be sent to*********** , c/o Office of Tax Policy, Department of Taxation, P.O. Box 1880, Richmond, Virginia 23218-1880. If you should have any questions regarding this determination, you may
contact ***********directly at*******.
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/8138G
Rulings of the Tax Commissioner