Tax Type
Corporation Income Tax
Description
Price manipulation and intercorporate transactions; Improper consolidation of affiliated corporation's income
Topic
Returns and Payments
Date Issued
12-10-1996
December 10. 1996
Re: §58.1-1821 Application: Corporate Income Taxes
Dear****************
This will respond to your letter in which you seek correction of assessments of additional corporate income taxes to ************* (the "Taxpayer") for the 1989 and 1990 taxable years. I apologize for the delay in responding to your request.
FACTS
The Taxpayer is a manufacturing corporation headquartered outside Virginia. During the course of a field audit, an adjustment was made to consolidate the taxable income of three subsidiaries ("S1", "S2", and "S3") with the Taxpayer. The department's auditor concluded that the three subsidiaries had limited business activity and no significant economic substance. You protest this adjustment, claiming that the department lacks the authority to consolidate the taxable income of S1, S2, and S3 with the Taxpayer. The facts pertaining to each subsidiary will be addressed separately.
S1
The Taxpayer formed S1 as a wholly-owned subsidiary in 1982 to invest and manage excess funds generated by the Taxpayer. S1 was incorporated in Delaware and initially capitalized with investments owned by the Taxpayer. S1 has no offices, personnel, accounts or other property in Virginia, nor does it have any employees anywhere. The sole business purpose of S1 is to maintain an investment portfolio for the benefit of the Taxpayer.
S1 pays a custodial fee to an unaffiliated financial services company for miscellaneous administrative functions, as well as a fee based on investment income. In addition, another wholly-owned subsidiary of the Taxpayer, ("S4"), assists in the management of S1's investments. S4 is paid a management fee by S1 based on a specified percentage of S1's net assets.
Funds remitted to S1 for investment are accounted for by the Taxpayer as a capital contribution, while distributions of investment earnings by S1 to the Taxpayer are recorded on the Taxpayer's books as a return of capital. At December 31, 1989 and 1990, the Taxpayer's "Investment in Subsidiary" account, which accounts for the cumulative effect of these transactions, exhibited a positive balance. There were no other intercompany transactions between S1 and the Taxpayer during the 1989 and 1990 taxable years.
S1 has four directors, of which three are also directors of the Taxpayer. One of these common directors is also an employee of the Taxpayer. None of S1's four corporate officers are officers of the Taxpayer.
S2
S2, also incorporated in Delaware, is a wholly-owned subsidiary of S1 whose sole business activity consists of factoring the Taxpayer's accounts receivable. The receivables are purchased at a discount equal to the prime interest rate plus three percentage points, multiplied by the average period outstanding. All billing and collection activities are performed by the Taxpayer. There are no other intercompany transactions between the Taxpayer and S2.
S2 utilizes the services of S4 to manage its accounts receivable portfolio, for which S4 is paid a management fee. S2 also engages the same unaffiliated financial services company engaged by S1 to perform general office functions. The directors and officers of S1 also serve as the directors and officers of S2. S2 has no employees anywhere, and no offices, accounts, or other property in Virginia.
S3
S3 is a wholly-owned subsidiary of the Taxpayer which was formed in 1990, whose business activity is limited to holding a partnership interest. S3 has no employees nor any assets apart from this partnership interest. All business activity of the partnership is conducted by the Taxpayer in conjunction with an unaffiliated company.
In 1991, S3 filed a 1990 Virginia corporate income tax return based upon its ownership interest in the partnership. The return, however, indicated a zero Virginia apportionment factor. Returns for subsequent years, which also indicated zero Virginia apportionment factors, were filed by S3 as well.
S3 has three directors, one of whom is a director of the Taxpayer. All of S3's officers are also officers of the Taxpayer.
DETERMINATION
Although Virginia utilizes federal taxable income as the starting point in computing Virginia taxable income and generally respects the corporate structure of taxpayers, Code of Virginia §58.1-446 gives the department the authority to consolidate entities and make adjustments if an agreement between two or more affiliated corporations serves to distort a corporation's income earned from business done in Virginia. This authority was upheld by the Virginia Supreme Court in Commonwealth v. General Electric Company, 236 Va. 54 (1988). The department will generally invoke this authority if the distortion of Virginia taxable income is created by shifting income to an affiliated corporation which lacks economic substance or is accomplished in transactions not conducted at arm's length.
S1
In reviewing the economic substance of S1, the department determined from the consolidated federal return that S1 held significant amounts of cash and securities. This indicates that the transactions engaged in by S1 were substantive, and not merely "paper" transactions. S1's investments generated large amounts of income derived from unrelated parties. S1 also paid substantial amounts for professional services to an unaffiliated third party, as well as fees to an affiliated corporation. S1 was addressed as a separate, independent entity in correspondence reviewed by the department. S1 also had directors and officers who were independent of the Taxpayer. The evidence presented, therefore, indicates that S1 had substantial economic substance.
The department also reviewed the relationship between the Taxpayer and S1. This relationship did not distort the Taxpayer's Virginia taxable income for the 1989 and 1990 taxable years. Unlike the situations described in Public Documents (P.D.s) 94-179 and 95-86, and 4126195, respectively), copies enclosed, the Taxpayer did not attempt to reduce its Virginia taxable income by deducting amounts paid to a subsidiary. The Taxpayer did not deduct as an expense funds transferred to S1 for investment in its computation of federal taxable income; therefore, there was no distortion of the amount of income apportioned and taxed to Virginia.
Absent the creation of S1, the net investment income which had been earned by S1 would have been included in the Taxpayer's federal taxable income. Based on the evidence presented, however, this income and the underlying investments fulfilled a passive investment function similar to that described in P.D. 94-164, (5125194), copy enclosed. The net investment income would therefore not be subject to Virginia taxation pursuant to the U.S. Supreme Court's decision in Allied-Signal v. Director. Div. of Taxation, 112 S.Ct. 2551 (1992). Accordingly, based on the above determination, the auditor's consolidation of S1 with the Taxpayer has been reversed.
S2
The stated business purpose of S2 is to factor the Taxpayer's accounts receivable in order to enhance the balance sheet of the Taxpayer. S2's balance sheets per the consolidated federal return indicate that the assets owned by S2 consist predominantly of significant amounts of accounts receivable purchased from the Taxpayer. S2 also recognized as assets approximately $15,000 in miscellaneous intangibles and prepaid expenses. S2, like S1, paid significant fees to an unrelated party for professional management services, as well as to an affiliated corporation. The evidence presented indicates that S2 possessed sufficient assets and incurred sufficient expenses in order to achieve its valid business purpose. S2, therefore, did not exhibit a lack of economic substance.
The controlling issue regarding the consolidation of S2 with the Taxpayer pursuant to Code of Virginia §58.1-446 then becomes whether the transfer of receivables was accomplished in an arm's length transaction. In determining whether a transaction with a related party is conducted at arm's length, the department will typically inspect similar agreements with unrelated parties to ascertain whether the rates charged and the terms are equivalent. For example, in P.D. 94-66, (3116194), copy enclosed, the department accepted the taxpayer's claim that the royalties payments were arm's length when the taxpayer supplied evidence that the royalty rates charged to both related and unrelated parties were identical.
While the Taxpayer only utilizes S2 to factor its accounts receivable, it did present documentation from unrelated parties regarding the discounts those parties would have charged the Taxpayer to factor accounts receivables. Correspondence from a financial institution indicated that their discount would be equivalent to the prime rate plus three percent, which is equivalent to the rate charged by S2 to the Taxpayer. In addition, the response from the financial institution indicated that the Taxpayer would perform administrative functions pertaining to the receivables, such as billing and collecting. This division of responsibility is also replicated in the arrangement between S2 and the Taxpayer. The financial services company engaged by S1 and S2 also stated, in correspondence reviewed by the department, that their discount would also be equivalent to the prime rate plus three percent.
In reviewing this documentation the department finds that the discount charged by S2 to the Taxpayer is representative of the discount that would be charged by an unrelated party, and therefore the transaction between S2 and the Taxpayer can be characterized as being conducted at arm's length. Consequently, there is no distortion of Virginia taxable income, and no basis to consolidate the Taxpayer with S2 pursuant to Code of Virginia §58.1 -446.
S3
The department has a long-standing policy requiring the inclusion of a corporate general partner's proportion of a partnership's property, payroll, and sales in the respective apportionment factors on the corporation income tax return. This policy was reiterated in P.D. 92-57, (4129192), copy enclosed. Since S3 is a general partner of the partnership in which its holds an ownership interest, its proportionate share of the partnership's property, payroll, and sales is required to be included on S3's corporate income tax return.
In 1990, S3 filed a Virginia corporation income tax return which showed all apportionment factors equal to zero, conclusively indicating that if S3 had any Virginia source income, then that income would not be subject to taxation in Virginia. See P.D. 95-113, (5/11/95), copy enclosed. The department's auditor, in consolidating S3 with the Taxpayer, corroborated this representation. The auditor found that S3 had no property, payroll, or sales attributable to Virginia when including S3's proportionate share of partnership property, payroll, and sales everywhere in the calculation of the Taxpayer's apportionment factors.
As stated above, the Virginia Supreme Court's opinion in Commonwealth v. General Electric Company upheld the department's authority to equitably adjust the tax of a corporation pursuant to Code of Virginia 58.1-446 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. In the instant case, the department finds that the relationship between S3 and the Taxpayer does not distort the Taxpayer's Virginia taxable income. If the partnership, and consequently S3, had income from Virginia sources, this income would have been apportioned and taxed to Virginia on S3's corporate income tax return utilizing the apportionment factors as calculated pursuant to Virginia law and P.D.92-57. Since the partnership had no income from Virginia sources, no shifting of income occurred when the Taxpayer chose to use S3 to hold the partnership interest rather than hold the interest itself.
Consequently, the auditor's consolidation of S3 with the Taxpayer will be disallowed. The inclusion of S3 in the Taxpayer's apportionment factors will also be removed.
Conclusion
Accordingly, based on the determinations above, the consolidation of S1, S2, and S3 with the Taxpayer will be reversed. The balance due as reflected on the enclosed schedules should be paid within sixty days to prevent the further accrual of interest. Your payment should be sent to********* Office of Tax Policy, P.O. Box 1880, Richmond, Virginia 23218-1880. If you have any questions regarding this determination, you may contact********directly at********.
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/7680G
Rulings of the Tax Commissioner