Tax Type
Corporation Income Tax
Description
Price manipulation and intercorporate transactions; Consolidation resulting from intercorporate transactions
Topic
Returns and Payments
Date Issued
06-26-1997
June 26, 1997
Re: § 58.1-1821 Application: Corporate Income Tax
Dear*********************
This will reply to your letter in which you are protesting the assessment of corporate income tax against ***** (the "Taxpayer"), for taxable years ended August 30, 1992 and August 29, 1993. I apologize for the delay in responding.
FACTS
The department audited the Taxpayer for the taxable years ended August 30, 1992, August 29, 1993 and October 31, 1993. In the first two taxable years, the department's auditor found that a newly formed subsidiary ("S1") lacked substantial economic substance, consolidated the taxable income of S1 with the Taxpayer, and apportioned the consolidated total to Virginia. You contest these adjustments claiming S1 has no nexus with Virginia and had substantial economic substance.
DETERMINATION
In 1992, the Taxpayer transferred title to real estate formerly used in the Taxpayer's operations and interests in several real estate joint ventures in exchange for all of S1's common stock. The Taxpayer recognized no gain or loss on the transfer pursuant to Internal Revenue Code (IRC) § 351. The Taxpayer also arranged for S1 to manage certain other properties owned by the Taxpayer. The primary function of S1, as described by the Taxpayer, was to separate management and more clearly identify the profitability of the properties transferred.
S1 was located in California in offices owned by the Taxpayer. S1 did not lease the office space, but did own office equipment and furnishings for conducting its business. All of the officers of S1 were employees of the Taxpayer. Employees of the Taxpayer performed all the functions of S1.
S1 derived income from renting real estate, selling real estate and the joint ventures in the taxable year ended August 30, 1992. For the taxable year ended August 29, 1993, all of S1's income was received from the joint ventures. S1 had no operating expenses in either taxable year other than some depreciation and amortization. On July 30, 1993, the Taxpayer liquidated S1 in accordance with IRC § 367 and § 332 and merged all the assets back into the Taxpayer.
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.)
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.)
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- 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.)
The Virginia Supreme Court's opinion in Commonwealth v. General Electric Company. 236 Va. 54 (1988) has upheld the department's authority to equitably adjust the tax of a corporation pursuant to Code of Virginia § 58.1-446 (or its predecessor) where an arrangement between two commonly owned corporations exists in such a manner as to improperly, inaccurately, or incorrectly reflect the business done in Virginia or the Virginia taxable income. Generally, the department will exercise its authority if it finds that a transaction, or a party to a transaction, lacks economic substance.
In reviewing the operations and structure of S1, the department found insufficient business activity to suggest significant independent economic substance. In fact, S1 was totally dependent on employees of the Taxpayer to fulfill its stated objectives. Because S1 had no operating expenses, it could not bill the Taxpayer under the property management agreement, which called for a fee equal to expenses plus a percentage. In this light, S1 could not have fulfilled its business purpose of directly supervising the daily activities of the joint ventures without direct and complete control from the Taxpayer.
In addition, the Taxpayer included the joint venture and property transferred to S1 in both beginning and ending property for computing the its property factor for both taxable years. It is unclear if they also included the payroll and sales of the joint ventures in the Taxpayer's apportionment factors. Even if these items were inadvertently included, S1 and the Taxpayer were obviously so closely related that they were essentially operating as one company.
Because the Taxpayer wholly owns S1, the Taxpayer never lost the ability to control the subject assets, or the unrestricted use of the assets. The Taxpayer was free to undo the transaction with S1 at any time and in fact did so in July 1993 when it wanted to use S1's property in a like-kind exchange pursuant to IRC § 1031.
Absent of the creation of the arrangement, S1's income would have been included in 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, Code of Virginia § 58.1-446 authorizes the department to deem income of an affiliate Virginia income even if the affiliate does not have nexus.
From the facts and observations presented, S1 possessed little economic substance and the income received by S1 improperly reflects Virginia taxable income of the Taxpayer. Thus, to the extent that the formation, operation and liquidation of S1 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.
Accordingly, the department finds the auditor was correct in consolidating S1 with the Taxpayer. If you have any questions, do not hesitate to contact********** at *********.
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/10490O
Rulings of the Tax Commissioner