Tax Type
Corporation Income Tax
Description
Alternate method of allocation and apportionment; Passive investments
Topic
Allocation and Apportionment
Date Issued
11-25-1996
November 25, 1996
Re: §58.1-1821 Application: Corporate Income Tax
Dear**************
This will reply to your correspondence in which you are protesting the assessment of corporate income tax against, ************* (the "Taxpayer"), for taxable years ended December 31, 1989 and December 31, 1990. 1 apologize for the delay in responding to your letter.
FACTS
The Taxpayer was audited and several adjustments were made. One of the adjustments made by the auditor was to consolidate the Taxpayer with its 100% owned subsidiary (S1). The department's auditor found that S1, which had made substantial loans to the Taxpayer, lacked substantial economic substance, consolidated the taxable income of S1 with the Taxpayer, and apportioned the consolidated total to Virginia. You contest this adjustment claiming that S1 does not have nexus and the consolidation does not accurately reflect income from business done in Virginia.
DETERMINATION
Interest paid to subsidiary: During 1987, the Taxpayer contributed proceeds from convertible subordinated debentures to S1, which is located in Delaware. The Taxpayer is the original and current debtor of the debentures. The primary function of S1, as described by the Taxpayer, is to keep the taxpayer's investments separate from provide financing for merger and acquisition activity and foreign working capital an subsidiaries.
S1 uses a bank to maintain physical custody of its assets, monitor the securities, and provide status reports. Prior to 1989, S1 's income was derived from interest from investments with no relationship to the Taxpayer. In 1989, S1 made several loans to the Taxpayer. Copies of written loan agreements consist of three demand promissory notes with a stated interest rate of 11.5% per annum. So in addition to income received from other investment activities, S1 received interest income from the Taxpayer in 1989 and 1990.
S1's balance sheet in 1988 primarily reflects long-term receivables and marketable securities. In 1989 and 1990, the majority of the S1's assets are shifted to trade notes and accounts receivable to reflect the significant loans made to the Taxpayer. All of S1's officers and two of its three directors were employees of the Taxpayer. S1 had no employees and its only expense was for management and corporate services provided by the bank.
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- 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. (Emphasis added.)
- . . . 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.)
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. (Emphasis added.)
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. (Emphasis added.)
The Taxpayer contends that the since S1 has no nexus with Virginia, consolidating it with the Taxpayer distorts income from Virginia sources. However, the interest payments result in the transfer of income from the Taxpayer to S1. Absent of the creation of this arrangement, the interest would not have been expensed from the Taxpayer's taxable income 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 performed at arm's length. Under these circumstances, the department is authorized under Code of Virginia §58.1-446 to determine that income of an affiliate be deemed Virginia income even if the affiliate does not have nexus.
The department has reviewed the economic substance of S1. S1 has no payroll. Its only expense is management and corporate service fees for securing, monitoring and accounting for S1's activities. All of S1's officers and two of its three directors were employees of the Taxpayer. The officers and directors ultimately control the actions of S1. These individuals had to act in their capacity as officers and directors on an as-needed basis, and it is unrealistic to believe that they traveled to Delaware each time they were required to do so. Accordingly, the department finds it reasonable to conclude that S1 was controlled and managed from the Taxpayer's facilities outside the state of Delaware. From the facts and observations presented, it appears that S1 possesses little economic substance.
The substance of the loans themselves lacks substance. The Taxpayer issued bonds, on which it is obligated to pay interest. The Taxpayer transferred the proceeds to S1, which in turn lent money back to the Taxpayer, who now pays interest to S1. In essence, the Taxpayer is paying interest to the bondholders and to S1. In addition, the demand promissory notes held by S1 have no payment schedule, no deadline for the repayment of principle, and not secured by any type of collateral.
Thus, to the extent that the intercompany loans primarily reflect "paper" intercompany transactions, the facts fit that of Commonwealth v. General Electric Company and satisfy 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.
Investments held by S1: 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. In some instances, the department will allow a taxpayer to allocate income other than dividend income. In such instances, this allocation is 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.
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. There was no indication of a flow of goods or of a flow of values between the Taxpayer, S1 and any payors of investment income. Based on the information provided to the department, it does not appear that a unitary relationship existed between the Taxpayer and any payor of investment income, and of S1 and any payor of investment income.
In considering the operational aspects of the investment, the department considered the evidence provided to support the Taxpayer's position. The evidence indicated that S1's investment activity did not complement the Taxpayer's operational activities. Because the investments which produced the investment income were financed directly by the issuance of debenture bonds, and because the activity was conducted independently from the management and investment of necessary working capital balances, the Taxpayer has demonstrated that the investment income of S1 was not generated from the utilization and investment of its operational working capital.
In light of the substantial evidence provided, it does not appear that S1's investment activities were related to the Taxpayer's operational activities. Accordingly, l conclude that S1's investment activities constitute a separate investment function making passive investments that are not of an operational nature.
In any proceeding relating to the interpretation of the tax laws of the Commonwealth, 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, I find that the Taxpayer has demonstrated that an alternative method of allocation and apportionment is appropriate.
Accordingly, the department finds no basis to reverse the auditor's consolidation of S1 with the Taxpayer. However, the department will allow income from unrelated investments held by S1 to be allocated. These corrections have been made, and the assessments have been adjusted as provided on the attached summaries. 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 23218-1880. If you have any questions, you may contact ******* at***********.
Sincerely,
Danny M. Payne
Tax Commissioner
Enclosures
OTP/76640
Rulings of the Tax Commissioner