Tax Type
Corporation Income Tax
Description
Price manipulation and intercorporate transactions; Royalties paid to affiliates
Topic
Returns and Payments
Date Issued
09-08-1997
September 8, 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 your client, *****(the "Taxpayer"), for taxable year ended September 31, 1992. I apologize for the delay in responding to your letter.
FACTS
The Taxpayer has three main business groups. The two groups which operate in Virginia generally include several national operating divisions of the Taxpayer and numerous regional divisions and wholly owned subsidiaries.
For the taxable year ended September 31, 1992, the Taxpayer and seven subsidiaries filed a combined Virginia income tax return. In computing federal taxable income, the Taxpayer and five subsidiaries, included on the Virginia return, deducted royalties due to two affiliated corporations (A1 and A2) for the use of trademarks. The department's auditor determined the agreements between the Taxpayer and subsidiaries and the two affiliates created an improper reflection of Virginia taxable income and removed the royalty deductions.
You contest these adjustments claiming that the auditor made the adjustment based on reliance of a Virginia regulation which did not become effective until January 1, 1993 and all the transactions between the Taxpayer and subsidiaries and the two affiliates were at arm's length.
DETERMINATION
Affiliate A1:
In the fall of 1991, the Taxpayer and twenty-eight subsidiaries, which make up a business group (Group 1), transferred trademarks to A1 in exchange for all of A1's common stock. The primary function of A1, as described by the Taxpayer, is to aggregate the registration, maintenance, protection and other administration and management of all Group 1's trademarks.
A1 was located in the Delaware offices of an affiliated management corporation (M). A1 did not own or lease any real or personal property. Four of A1's five officers are employed by the Taxpayer or M. Two of A1's three directors are employees and/or officers of the Taxpayer or M. The information provided states the employees of A1 are not employees, officers, or directors of any related party; however, the copies of the Forms W-2 provided show that the salaries were actually paid by M. A1, in fact, had no payroll and thus no employees.
A1's only assets on the balance sheet for the taxable year ended September 30, 1992 were a large amount in intercompany receivables and a small amount of cash. The ending receivable balances are equivalent to the corresponding royalty income on A1's income statement, indicating that royalties are not paid on a periodic basis throughout the year as earned but rather accrued at year-end. In fact, information provided the auditor showed that all royalty billings are done once at year end.
Affiliate A2:
In the fall of 1991, the Taxpayer and ten subsidiaries which make up a business group (Group 2), transferred trademarks to A2 in exchange for all of A2's common stock. The primary function of A2, as described by the Taxpayer, is to aggregate the registration, maintenance, protection and other administration and management of all Group 2's trademarks.
A2 was located in the Delaware offices of M. A2 did not own or lease any real or personal property. Four of A2's five officers are employed by the Taxpayer or M. Two of A2's three directors are employees and/or officers of the Taxpayer or M. The information provided states the employees of A2 are not employees, officers, or directors of any related party; however, the copies of the Forms W-2 provided show that the salaries were actually paid by M. A2, in fact, had no payroll and thus no employees.
A2's only assets on the balance sheet for the taxable year ended September 30, 1992 were a large amount in intercompany receivables, a small amount of cash and an amount called other assets. The ending receivable balances are equivalent to the corresponding royalty income on A2's income statement, indicating that royalties are not paid on a periodic basis throughout the year as earned but rather accrued at year-end. In fact, information provided the auditor shows that all royalty billings are done once at year end.
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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) 630-3-446, 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.)
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 two commonly owned corporations structure an arrangement 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.
The Taxpayer contends that the transactions between A1 and Group 1 and the transactions between A2 and Group 2 are at an arm's length royalty rate. However, the department does not look only to the royalty rate when examining this type of transaction. Two of the Taxpayer's business groups transferred assets to newly created subsidiaries in exchange for stock, in a tax free transaction. If the Taxpayer were dealing with an unrelated third party it would not transfer assets without consideration, and then agree to pay a royalty for the use of these same assets. Because A1 and A2 are 100% owned by the Taxpayer and some of the Taxpayer's wholly owned subsidiaries, the Taxpayer never lost the ability to control the subject assets, the rate or terms of the royalty agreement, or the unrestricted use of the assets. The Taxpayer is essentially free to undo the transaction with A1 and A2 at any time.
The appraisals themselves are incomplete. Estimates of the fair market value of the intangible assets and the royalty rates are based on two companies within each operating group. The appraisal for Group 1 includes two regional companies (one in California and one in New England). Only the two largest divisions of the Taxpayer are used in the appraisal for Group 2. Company history, market share, financial stability, recognition, size and breadth of the market area, and business climate and atmosphere can be drastically different from company to company and region to region. Thus, a complete analysis has not been provided to support the chosen royalty rate or the value of the trademarks for the companies in Group 1 and Group 2 operating in Virginia.
The financial statements also contradict other documentation submitted. According to your letter, the trademarks and tradenames are owned by A1 and A2, yet no trademarks or tradenames are listed on A1's or A2's balance sheet. If A1 and A2 received these assets as a capital contribution, then the assets should have been recorded at their fair market value on A1's and A2's balance sheet. In the alternative, if A1 is the owner of trademarks and tradenames recorded at no fair market value, it is implausible that any royalty should be paid for their use.
The royalty payments result in the transfer of income from the Taxpayer and affiliates to A1 and A2. Absent of the creation of this arrangement, the royalties would not have been deducted from the Taxpayer's and affiliates' 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 equitably adjust the tax of the Taxpayer.
From the facts and observations presented, it appears that A1 and A2 possess little economic substance and the royalty payments improperly reflect Virginia income. Thus, to the extent that the intercompany license 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 the auditor was correct in disallowing royalty expenses charged by A1 and A2. In order to prevent the additional interest charges, please pay the balance due within 60 days. Send your 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/10574O
Rulings of the Tax Commissioner