Document Number
96-387
Tax Type
Corporation Income Tax
Description
Property factor; Construction in process; Removal of capitalized interest from denominator
Topic
Allocation and Apportionment
Date Issued
12-26-1996

December 26, 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 1992 and 1993 taxable years. I apologize for the delay in responding to your request.


FACTS


The Taxpayer, a manufacturer headquartered outside Virginia, was field audited, and several adjustments were made. You protest two adjustments, which will be addressed separately.


DETERMINATION


Consolidation with Delaware Holding Company

During 1992 and 1993, the Taxpayer paid royalties for the license of a tradename and technology to a Delaware holding company (the "DHC"), which was exempt from Delaware income taxation pursuant to Delaware Corporation Income Tax Code 1 902(b)(8). The DHC and the Taxpayer were both wholly-owned subsidiaries of another holding company. The department's auditor concluded that the royalty payments were not indicative of an arm's length arrangement and consequently distorted the Taxpayer's Virginia taxable income. The auditor, therefore, consolidated the taxable income of the DHC with the Taxpayer in accordance with Code of Virginia §58.1-446.

You protest the auditor's consolidation, contending that the plain language of Code of Virginia § 58.1 -446 makes the statute applicable to only parent corporations and their subsidiaries, and renders it inoperative in cases involving brother - sister corporations. In the alternative, you contend that the Taxpayer's situation is analogous to that described in Public Document (P.D.) 94-66, (3116194), copy enclosed, in which the department reversed the auditor's consolidation.
    • Code of Virginia §58.1-446 states in pertinent part:

      Any corporation liable to taxation under this chapter and either owned or controlled by or owning or controlling. either directly or indirectly. another corporation may be required by the Department to make a report consolidated with such other corporation .... 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 the instant case, the Taxpayer neither owns nor is owned by the DHC. The Taxpayer does, however, exhibit the ability to control the DHC. Of the DHC's four corporate officers, three are also officers of the Taxpayer. Two of these common officers constitute the DHC's board of directors. One director is also a director of the holding company which owns both the Taxpayer and the DHC. This director also signed the licensing agreement between the DHC and the Taxpayer for both parties. It is clear that this degree of interlocking management permits the Taxpayer to control the activities of the DHC.

The Taxpayer contends that since the decision of the Virginia Supreme Court in Commonwealth v. General Electric Company, 236 Va. 54 (1988) involved the department's consolidation of a parent and its subsidiary, then that decision does not uphold the department's authority to consolidate brother - sister corporations pursuant to Code of Virginia §58.1-446. In General Electric, however, the Court stated that the department may equitably adjust the tax if there is (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. Criterion (2) clearly does not restrict the application of Code of Virginia 58.1-446 to only those cases involving a parent - subsidiary relationship, but rather upholds the department's authority to equitably adjust tax in any instance in which distortion of Virginia taxable income is created by intercorporate transactions between two corporations with common ownership. This criterion is plainly met in the instant case since both the DHC and the Taxpayer are owned by the same entity.

The department utilized this concept of common ownership enunciated in General Electric in Virginia Regulation (VR) 630-3-446, effective for taxable years beginning on or after January 1, 1993, copy enclosed. This regulation provides examples in determining when income from business done in Virginia is distorted by intragroup transactions. A group is defined in VR 630-3-446 as "two or more corporations, which are owned or controlled, directly or indirectly by the same interests." The Taxpayer and the DHC, therefore, clearly constitute a group.

Given that the department has the authority to equitably adjust the tax of brother-sister corporations which engage in transactions that distort the income earned from business done in Virginia, the determining issue in this case then centers upon whether in fact the arrangement between the Taxpayer and the DHC distorted Virginia taxable income. The Taxpayer relies upon the department's ruling in P.D. 94-66 to show that its royalty payments to the DHC did not distort Virginia taxable income. There are several salient distinctions, however, between P.D. 94-66 and the instant case

In P.D. 94-66, the Delaware holding company exhibited viable economic substance as evidenced by the presence of both full- and part-time employees and necessary business expenses. The DHC in this case had no employees in 1992 and no salary expense deducted in the computation of its 1992 federal taxable income. In 1993, the DHC issued 1 Form W-2 for a total of $2,000. The Taxpayer stated that the person receiving this compensation was not even an employee of the DHC. A review of the duties performed by this person reveals job functions consistent with the maintenance of a shell corporation, such as scheduling corporate meetings, safekeeping of corporate records, and filing the annual Delaware franchise tax return. In addition, the DHC did not incur any expenses for rent, telephone, or utilities, indicating that the DHC did not maintain any physical presence in Delaware.

The Delaware holding company in P.D. 94-66 also exhibited substantial business activity by acquiring valuable intangible assets from unrelated third parties. In the instant case, the only assets of the DHC during the audit period were those transferred to it upon formation in an IRC § 351 transfer or loans to the common parent which were funded by the Taxpayer's royalty payments. The Delaware holding company in P.D. 94-66 also paid substantial sums to its parent for the development and maintenance of new and existing technology. These fees were included in the parent's Virginia taxable income. The DHC in this case did not pay any amounts to the Taxpayer for the creation of new intellectual property rights.

The Taxpayer also contends that its situation is analogous to that described in P.D. 94-66 because the DHC in the instant case licensed technology to nine unrelated foreign companies while the Delaware holding company in P.D. 94-66 licensed its technology to 14 unrelated parties. In P.D. 94-66, however, the royalty rates charged to related and unrelated parties were equivalent, and thus indicative of an arm's length transaction. In this case, the unrelated parties were charged fixed fee amounts while the Taxpayer was charged a specified percentage of net sales. While the licensing agreements with these unrelated parties were negotiated prior to the formation of the DHC, and thus prior to the licensing agreement between the Taxpayer and the DHC, their presence alone does not affirm that the agreement with the Taxpayer is conducted at arm's length.

Furthermore, only one of the nine unrelated foreign companies actually renewed its technology licensing agreement. This renewal was executed after the licensing agreement between the Taxpayer and the DHC. The royalty was based on a fixed fee rather than any percentage of sales. In addition, this renewal was signed with the DHC's parent, rather than the DHC. The licensing activities between the DHC and unrelated parties, therefore, are not similar to the licensing activities described in P.D. 94-66, and consequently are not persuasive evidence that the arrangement between the Taxpayer and the DHC is conducted at arm's length.

The distinctions noted above between the instant case and P.D. 94-66 are sufficient to render any comparison between the two inaccurate. The Taxpayer, however, has furnished the department an appraisal which established the royalty rate charged by the DHC. This appraisal, the Taxpayer contends, demonstrates conclusively that the licensing agreement between the Taxpayer and the DHC is indicative of an arm's length transaction.

The appraisal stated that "the fairness of the royalty can be determined by observing how it would affect the company's earning level if the company had to pay the royalty." In determining "fairness", the appraisal tests the Taxpayer's earnings, which are adjusted for the presumed royalty expense, against the earnings of a group of comparable companies. The appraisal then concludes that the anticipated royalty rate is fair since the Taxpayer's adjusted earnings fall within the high and low ranges of the comparable group.

The department tested the actual effect of the royalty payments on the Taxpayer's earnings. For the 1992 taxable year, the Taxpayer's net profit per books, prior to federal income tax, was approximately 1.4% of net sales. Disregarding royalty payments, the margin rose to 4.1%. The appraisal itself stated that " a royalty rate of 25% to 33.3% of anticipated profit is about the average." Yet the royalty actually paid, and deducted by the Taxpayer, is nearly 65% of the net profit margin adjusted for federal taxes [1 - (1.4/4.1)]. In 1993, the Taxpayer incurred negative federal taxable income of nearly $ 4.3 million; disregarding royalty expense, taxable income rose to over $6.8 million. The department feels that no company would willingly enter in a royalty agreement which would diminish its pretax profit margin by two-thirds. Accordingly, the department cannot accept the contention that the royalty rate as determined by the appraisal is indicative of an arm's length arrangement.

Even though the arrangement between the Taxpayer and the DHC improperly reflects the Taxpayer's Virginia taxable income, the department feels that consolidation of the DHC with the Taxpayer is an inappropriate remedy. The DHC did derive interest and dividend income from unrelated parties, which likely would qualify as nonapportionable investment function income pursuant to the guidelines established by the U.S. Supreme Court in Allied-Signal v. Director. Div. of Taxation, 112 S.Ct. 2551 (1992). Consequently, the department feels that a more appropriate remedy in this case is to reverse the auditor's consolidation of the DHC with the Taxpayer, and instead disallow the royalty expense paid to DHC which was deducted by the Taxpayer in computing federal taxable income.

Capitalized Interest

The department's auditor removed capitalized interest from the denominator of the Taxpayer's property factor. You protest this adjustment, contending that the interest capitalized is a cost of constructing property and consequently must be included in the property factor computation.

The Taxpayer computed capitalized interest based upon the average of the amount recorded as construction in progress during the year. The capitalized interest is included in the property factor, according to the Taxpayer, because current year construction in progress becomes placed in service as fixed assets the next year.
    • Code of Virginia §58.1-409 states in pertinent part:

      The property factor is a fraction, the numerator of which is the average value of the corporation's real and tangible personal property owned and used or rented and used in the Commonwealth during the taxable year and the denominator of which is the average value of all the corporation's real and tangible personal property owned and used or rented and used during the taxable year and located everywhere, to the extent that such property is used to produce Virginia taxable income.... (Emphasis added .)
    • VR 630-3-409, effective January 1, 1985, copy enclosed, states in pertinent part:

      Property under construction during the taxable year (except inventoriable goods in process) shall be excluded from the property factor until such property is actually used.
In the instant case, the Taxpayer stated that the construction in progress pertained to items which were placed in service as fixed assets in the subsequent taxable year. Since the capitalized interest related to construction in progress, it cannot be considered part of the Taxpayer's property used during the year. Consequently, the auditor's removal of capitalized interest from the property factor denominator is correct.

Accordingly, the auditor's assessments will be revised to reflect the determinations herein. Please remit the balance due as detailed on the enclosed schedules 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 should have any questions regarding this termination,
you may contact*********** directly at**************.

Sincerely,


Danny M. Payne
Tax Commissioner




OTP/10807G

Rulings of the Tax Commissioner

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