Document Number
96-393
Tax Type
Corporation Income Tax
Description
Taxable income; Modifications to federal taxable income; Royalties; Consolidation with subsidiary
Topic
Computation of Income
Date Issued
12-30-1996

December 30, 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 was field audited, and an adjustment was made to consolidate the taxable income of a wholly-owned subsidiary ("S") with that of the Taxpayer. The department's auditor concluded that the substantial royalty payments from the Taxpayer to S, which were subsequently loaned back to the Taxpayer, resulted in a distortion of the Taxpayer's Virginia taxable income. You protest this conclusion, contending that the licensing and financing arrangements between the Taxpayer and S were conducted at arm's length, possessed substantial economic substance, and served a valid business purpose.


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.

The Taxpayer has demonstrated by objective evidence that S has viable economic substance. S has one employee, whose duties are listed in a position description and who signed an employment agreement. These duties extend beyond those typically associated with the maintenance of a shell corporation to include functions such as monitoring advertising which utilizes the trademark and reviewing customer complaints. S incurred, and paid, ordinary and necessary business expenses such as legal fees, wages, taxes, rent, travel and supplies. In addition, S maintained a physical location separate from corporate headquarters, and had its own telephone listing.

The determining issue in this case then centers upon whether the royalties charged by S were indicative of an arm's length transaction. The Taxpayer has furnished an appraisal which it believes shows that the transactions between itself and S are conducted at an arm's length royalty rate. The appraisal states that "if [the Taxpayer] did not own the tradename, it would be willing to pay an outside party a royalty" for its use. Accepting this logic, it would then follow that the Taxpayer would not transfer its tradename to an outside party without consideration, and then agree to pay a royalty for the use of this same tradename. Yet in the instant case, the Taxpayer transferred the tradename, plus cash, to S, with the only consideration being S's stock, and then paid S a royalty for use of the tradename. Furthermore, if the tradename had been transferred at its fair market value, the gain recognized by the Taxpayer would have been subject to tax by Virginia. Since S is a wholly-owned subsidiary, the Taxpayer never lost the ability to control the transferred intangible assets or the rate and terms of the royalty agreement. The Taxpayer is essentially free to undo the transaction with S at any time. See Public Document (P.D.) 95-229, (916195), copy enclosed.

The appraisal also states that in the Taxpayer's industry "the estimated value of intangible assets must be allocated between customer relationships, the trade name, and other intangibles." The methodology employed by the valuation consultant derived a return on intangible assets by subtracting the return on tangible assets from the return on total assets. Yet the appraisal did not explain the basis for, and the mechanics of, allocating the return on intangible assets among customer relationships, the tradename, and other intangibles. In this respect, the appraisal is similar to the one cited in P.D. 94-179, (618194), copy enclosed. Both appraisals did not present compelling evidence that the tradename could be separately identified and valued apart from the Taxpayer's other intangible assets. Consequently, in the absence of similar transactions with unrelated parties, the department cannot accept the appraisal as conclusive evidence that the royalties paid to S are representative of an arm's length transaction.

S's loans to the Taxpayer of royalty payments made by the Taxpayer to S are also not representative of an arm's length transaction between unrelated parties. At December 31, 1992, S's balance sheet per its separately computed proforma federal tax return indicated a receivable balance exactly equal to the Taxpayer's royalty expense. The net effect of these transactions is that the Taxpayer paid no cash for the use of the tradename, with only a minor amount of cash designated as interest for the payment of S's expenses. At December 31, 1993, the receivable balance increased by an amount nearly equal to the Taxpayer's royalty and interest expense, again with a minimal amount of cash paid to cover S's expenses. The department's auditor concluded that this arrangement served no valid business purpose and was merely an artifice established to reduce the Taxpayer's taxable income in non-unitary states, and therefore was not evident of an arm's length transaction.

The Taxpayer disagrees with this conclusion, stating that the business purposes served by the loan arrangement include providing "an outlet by which [S] may invest idle cash and receive a fair rate of return" and furnishing the Taxpayer with capital "which it may employ in maintaining and growing its business." The department finds the Taxpayer's arguments unpersuasive. The Taxpayer is not receiving cash from a previously untapped capital market, but simply getting its own cash back. S is not investing cash received from unrelated parties. Furthermore, at no point in the chain of transactions is the cash actually beyond the control of the Taxpayer.

In conclusion, the department believes that the arrangement serves no valid business purpose other than tax avoidance. The fact pattern fits that of Commonwealth v. General Electric Company, and satisfies the Court's requirement of (1) an arrangement (2) between two commonly owned corporations (3) in such a manner as to improperly, inaccurately, or incorrectly reflect (4) the business done or the Virginia taxable income earned from business done in Virginia. Consequently, the department possesses the authority under Code of Virginia 58.1-446 to consolidate the taxable income of S with that of the Taxpayer.

Accordingly, the auditor's adjustments are correct. The audit report has been revised, as reflected on the enclosed schedules, to incorporate the results of the Taxpayer's amended return dated September 12, 1995. The balance due is now payable and should be remitted within ninety days to*************Office of Tax Policy, P.O. Box 1880, Richmond, Virginia 23218-1880. If you should have any questions regarding this determination you may contact************at*********.

Sincerely,



Danny M. Payne
Tax Commissioner



OTP/10899G

Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46