Tax Type
Corporation Income Tax
Description
Alternative method of allocation and apportionment; Separate accounting
Topic
Allocation and Apportionment
Date Issued
03-19-1997
March 19, 1997
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 taxable years 1990, 1991, and 1992. I apologize for the delay in responding to your letter.
FACTS
The Taxpayer, a member of an affiliated group, files a separate Virginia corporate income tax return. Pursuant to a field audit, several adjustments were made which resulted in the assessment of additional tax. You protest two of these adjustments, which will be addressed separately below.
DETERMINATION
Consolidation of Taxpayer with Parent
The department's auditor discovered that during the 1990, 1991 and 1992 taxable years the Taxpayer deducted significant amounts paid to its corporate parent (the "Parent"). These amounts were captioned on the Taxpayer's proforma federal income tax returns as management fees. The auditor concluded that these amounts did not represent an arm's length transaction. Consequently, the auditor consolidated the taxable income of the Parent with that of the Taxpayer pursuant to Code of Virginia § 58.1-446. You protest this adjustment, contending that the arrangement between the Taxpayer and the Parent does not result in a distortion of Virginia taxable income.
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 and/or is accomplished in a transaction not conducted at arm's length.
In the instant case, there is no question that the Parent exhibits significant economic substance. The Parent has more than two hundred employees who provide a vast array of essential services to the Taxpayer and six other subsidiaries. The Parent maintains an actual, bona fide physical presence, incurs ordinary and necessary business expenses, and derives income from unrelated third parties. The facts plainly distinguish this case from others where the department has found that the recipient of intercompany charges lacked even the most rudimentary economic substance.
The determining issue regarding the propriety of this adjustment, therefore, is whether the management fee charges were made at terms representative of an arm's length transaction. A closer investigation of the costs grouped under the caption of management fees reveals costs for accounting, tax, cash management, legal, risk management, and human resource services, all of which were provided by the Parent. Also included within the category was the Taxpayer's charge for interest expense on loans obtained by the Parent whose proceeds were utilized on behalf of the Taxpayer.
These charges were allocated to the Taxpayer on the basis of the actual costs incurred by the Parent. There was no intercompany profit incorporated into the overall fee charged by the Parent. Absent this arrangement with the Parent, the Taxpayer would have either engaged an outside firm to perform these essential corporate services or developed its own in-house capability. In either event, the costs incurred by the Taxpayer would have been an allowable deduction in computing federal, and consequently Virginia, taxable income. The department cannot characterize a cost reimbursement arrangement between related parties, without any intercompany profit, as one which distorts Virginia taxable income. The auditor's adjustments consolidating the taxable income of the Parent with that of the Taxpayer, therefore, will be reversed.
Alternative Method of Allocation and Apportionment
The Taxpayer filed its 1992 Virginia corporate income tax return using separate accounting as an alternative method of allocation and apportionment. Permission to utilize separate accounting was neither requested by the Taxpayer nor granted by the department. The auditor consequently recomputed the tax using the statutory three factor formula. The department is treating your protest as a request for permission to use an alternative method of allocation and apportionment in accordance with Code of Virginia § 58.1-421.
You contend that separate accounting is the proper method because the Taxpayer's activity in Virginia during the 1992 taxable year was limited to subletting real property and the income and expenses from the sublease can be clearly segregated. You also believe that separate accounting is appropriate because application of the statutory three factor formula results in a greater portion of the Taxpayer's income being taxed by Virginia than is actually attributable to its Virginia operations. Furthermore, you believe that separate accounting is appropriate because the Taxpayer was merely winding up its Virginia activities and not engaging in its regular course of business.
The department's long standing policy is that the statutory method provides the most equitable means of determining a multistate corporation's income subject to taxation by Virginia. In extraordinary circumstances, however, the department will grant permission to use an alternative method of allocation and apportionment when a taxpayer shows, by clear and cogent evidence, that application of the statutory three factor formula provides an unconstitutional or inequitable result.
Your claim that Virginia taxable income is greater under the statutory method than separate accounting does not constitute "extraordinary circumstances" sufficient to justify permission to use an alternative method. See Department of Taxation v. Lucky Stores. Inc., 217 Va. 121 (1976). In addition, you stated that "Virginia has no basis to tax income from [the Taxpayer's] retail . . . operations which are conducted entirely outside of Virginia." The department does not agree with this assertion. As determined by the U.S. Supreme Court in Mooreman Manufacturing Company v. Bair, 437 U.S. 279. 98 S.Ct. 2340 (1978), as long as each state’s method of allocation and apportionment is rationally related to the business transacted within a state, then each state's tax is constitutionally valid even though there may be some overlap. The department finds that application of the statutory three factor formula is "rationally related" to the Taxpayer's activities in Virginia, and consequently does not produce an unconstitutional result. The mere fact that a taxpayer may be winding up its business affairs in Virginia does not render that finding invalid. Accordingly, permission to use an alternative method of allocation and apportionment is denied.
The auditor's report will be revised in accordance with the determination herein and as reflected on the enclosed schedules. Please remit the balance due within sixty days to*******Office of Tax Policy, Post Office 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/9087N
Rulings of the Tax Commissioner