Tax Type
Corporation Income Tax
Description
Price manipulation and intercorporate transactions; Income consolidation
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 correspondence in which you are protesting the assessment of corporation income tax against, ********** (the "Taxpayer"), for taxable year ended January 31, 1991. I apologize for the delay in responding to your letter.
FACTS
The Taxpayer was audited and several adjustments were made. One of the adjustments was ta consolidate the Taxpayer with its parent corporation (the "Parent"). The department's auditor found that the transactions relating to the management and license fees between the Taxpayer and the Parent lacked economic substance, consolidated the taxable income of the Parent with the Taxpayer, and apportioned the consolidated total to Virginia.
The Parent provides management, accounting, marketing and advertising services for its subsidiaries including the Taxpayer. The Parent recognized routine business expenses and maintained separate cash accounts and fixed assets. Management fees are charged to the subsidiaries at a rate equal to the Parent's expenses plus a profit percentage and license fees are charged at a percentage of sales of each retail location. The Taxpayer believes these fees are arm's length transactions. You contest the audit adjustment claiming that the Parent has economic substance and there is no arrangement which causes income from business done in Virginia to be reflected inaccurately.
DETERMINATION
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- 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) 630-3446, 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.)
It has been the department's policy to make determinations based on statutes and regulations in force during the tax period for which the taxpayer is seeking relief. Effective for taxable years beginning on or after January 1, 1993, the department issued expanded regulations related to the application of Code of Virginia § 58.1-446. In 1996, the department's regulations were renumbered and included in the Virginia Administrative Code. Hence, Code of Virginia § 58.1-446 will be regulated by 23 VAC 10-120-360, 361, 362, 363 and 364.
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 there is an arrangement between two commonly owned corporations in such a manner to improperly, inaccurately, or incorrectly reflect the business done 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.
The department has reviewed the economic substance of the Parent. Although, the Parent does maintain fixed assets and recognizes regular expenses, the amount of cash carried on the Parent's books is extraordinarily small (less than $5,000) compared to the multimillions of dollars of recorded income and expenses. Meanwhile, there was considerable activity (thousands of entries according to the Taxpayer) in the intercompany account implying that the Taxpayer actually pays the expenses for the Parent. Also, during the audit period, the management and licence fees from the subsidiaries make up 99.8% (92% from the Taxpayer) of the Parent's income. This income was recorded as other income on the books of the Parent and as negative other income on the books of the subsidiaries. Thus, the income is eliminated even before intercompany consolidating adjustments. The parent never even booked a receivable for this income. These facts and observations make it appear the Parent does not operate independently from its affiliates. Accordingly, the department has determined that the Parent lacks independent economic substance.
Furthermore, the Taxpayer has produced no documents to show that an independent analysis was done to determine the fair market value of the trade name or the services provided to the subsidiaries. The trade name license and the management services are not represented by written agreements. No evidence has been provided to substantiate payments of these fees were made by the subsidiaries to the Parent. Thus, the fee transactions represent nothing more than "paper" accounting entries.
Thus, to the extent that the intercompany fees 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 no basis to reverse the auditor's adjustment, and must deny your request for relief. Please pay the balance due of ********* within 60 days to prevent the accrual of additional interest. Send the payment to **** , c/o Office of Tax Policy, Department of Taxation, P.O. Box 1880, Richmond, Virginia 23218-1880. If you have any questions, you may contact *********at *********** .
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/9460O
Rulings of the Tax Commissioner