Document Number
03-73
Tax Type
Corporation Income Tax
Description
Intercompany license fees and interest
Topic
Appropriateness of Audit Methodology
Computation of Tax
Corporate Distributions and Adjustments
Property Subject to Tax
Date Issued
10-15-2003
October 15, 2003



Re: § 58.1-1821 Application: Corporate Income Tax

Dear *****:

This will reply to your letter in which you seek correction of the corporate income tax assessments issued to ******** (the "Taxpayer") for the taxable years ended December 31, 1991 and 1992. I apologize for the delay in the Department's response.
FACTS

In 1990, the Taxpayer transferred all of its trademarks and trade names (the "Trademarks") to a wholly-owned subsidiary ("Subsidiary") in a tax-free exchange under Internal Revenue Code (IRC) § 351 for all of Subsidiary's common stock. The primary function of Subsidiary, as described by the Taxpayer, is to insulate the Trademarks in the event of a lawsuit, protect the Taxpayer in the event of a hostile takeover attempt, provide a centralized system to administer the Trademarks on a worldwide basis, and allow for future licensing of the Trademarks. Subsequently, the Taxpayer entered into a license agreement with Subsidiary entitling the Taxpayer to use the Trademarks for a royalty based on sales.

In computing federal taxable income for the taxable years, the Taxpayer deducted royalties accrued by Subsidiary. The Department's auditor found that Subsidiary lacked substantial economic substance, consolidated the taxable income of S with the Taxpayer, and apportioned the consolidated total to Virginia. The Taxpayer is challenging the Department's assessment on the grounds that Subsidiary has a business purpose and economic substance, and the royalty fee transactions are at arm's length.

DETERMINATION
    • Virginia Code § 58.1-446 provides, in pertinent part::
    • 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.
    • 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, and applicable for the taxable years at issue, provides in pertinent part:
    • 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.)
    • 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) upheld the Department's authority to equitably adjust the tax of a corporation pursuant to Va. Code § 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.

Royalty rate

The Taxpayer contends that the transactions between Subsidiary and the Taxpayer are at an arm's length royalty rate. The Taxpayer has provided a copy of an appraisal to show that the royalty rates and the value of the Trademarks are at fair market value. This appraisal provides a brief description of the methods used to determine the Trademarks' value and royalty rates. The appraisal does not indicate how the royalty rates for the Trademarks stated in the appraisal were derived from the three methods used.

One method used to determine the royalty rates was the "residual profit method." Under this method, the excess of the Taxpayer's margin over the industry standard was considered to be attributable to the Trademarks. This method, however, fails to consider other factors that would have contributed to the Taxpayer's higher than average margin. These factors include the economies of scale in purchasing inventory attained by being one of the largest retailers in its field in the United States, the economies of scale achieved in marketing and advertising through clustering locations in metropolitan areas, the training and experience of employees, the rigorously managed growth philosophy, and the most comprehensive computerized inventory management system in the industry. Without consideration for these other factors, the Department finds that the "residual profit method" is inherently flawed.

Another method used was to review industry rules of thumb by using the "25% rule." Under the "25% rule," the royalty rates were estimated by analyzing a range of 20 to 30% of the pre-tax operating profit margin. The appraisal includes no analysis as to how this rule applies to the Taxpayer's Trademarks and no evidence to document the rates attained from this method.

Finally, the appraiser gave consideration to available market transaction data on actual royalty rates. The appraisal included no documentation to indicate that any market data existed or analysis as to how the Taxpayer's Trademarks compared to such data.

The lack of explanation and documentation raises doubts as to some of the methods used to determine the royalty rates. Accordingly, the Department finds the appraisal inadequate to support the fair market value of the royalty rates.

In 1994, the Taxpayer and Subsidiary entered into an agreement with a foreign corporation ("FC Agreement"), whereby the foreign corporation obtained the exclusive rights to operate and franchise businesses in the foreign country similar to those operated by the Taxpayer in the United States. The FC Agreement allows the foreign corporation access to the Taxpayer's store plans, merchandise presentation, operating procedures and practices, marketing and advertising, and inventory management systems, as well as, some of the Trademarks held by Subsidiary. Keeping this in mind, the royalty fee under the FC Agreement includes a license fee equal to one-fifth the rate charged the Taxpayer by Subsidiary and a percentage of any franchise fees collected by the foreign corporation. Not knowing exactly how much, if any, franchise fee income would be earned by the foreign corporation makes it difficult to directly compare the fee enumerated in the FC Agreement with the royalty rates at issue. However, the foreign corporation is paying for the Taxpayer's whole business concept, of which the Trademarks make up only a part. Thus, it would appear that the actual royalty rate that Subsidiary could charge an unrelated third party is less than the rates included in the license agreement between the Taxpayer and Subsidiary.

Economic substance

Even if the Department were to concede that the royalty rates are representative of those in a fair market transaction, the transactions and Subsidiary are so lacking in economic substance that the possibility of constructing an arm's length arrangement would be impossible.

In reviewing the economic substance of Subsidiary, the Department found that: (1) Subsidiary has no office space or employees; (2) all of Subsidiary's officers and directors are employees, officers or directors of the Taxpayer; and (3) all the transactions between the Taxpayer and Subsidiary consisted entirely of accounting entries. Subsidiary did not have a bank account. The Taxpayer's staff performed all general and administrative functions for the entire affiliated group, including Subsidiary.

These management and administrative services were provided to Subsidiary at no charge. Based on the facts, Subsidiary is clearly an entity that lacks economic substance.

The Taxpayer believes separating intangible assets from the Taxpayer's operations provides a way to organize licensing activities, isolate the Taxpayer's operating assets from any actions by third parties arising from the licensing and use of the Trademarks, and insulate the Trademarks and their royalties from the Taxpayer's creditors. Yet, the Taxpayer has also stated that a bank requested that the Trademarks be put up as collateral for the bank's financing. If the Trademarks are insulated, the Taxpayer's parent could not use the Trademarks to obtain a loan without Subsidiary's permission.

In addition, the Department has reviewed the license agreement between the Taxpayer and Subsidiary. In the agreement, the Taxpayer agrees to assist Subsidiary in any protection of its rights to the Trademarks, and Subsidiary, "if it so desires," may commence or prosecute any claims or suits relating to the infringement of the Trademarks. Because Subsidiary clearly possesses neither the physical resources nor the expertise to protect its own valuable assets, Subsidiary would depend on the Taxpayer to use its resources and knowledge to protect the Trademarks.

The license agreement is also void of any language referring to any quality control standards that must be maintained in order to insure the proper use of the Trademarks. As such, Subsidiary has little control over how the Trademarks are used other than a general statement that the Taxpayer would use the trademarks in a manner that will protect their value. Obviously, the Taxpayer wants to continue as a going concern and, therefore, has a vested interest in maintaining the Trademarks' favorable public image. Without quality standards, Subsidiary is powerless to influence or even approve the Taxpayer's use of the Trademarks. Unlike this agreement, the FC Agreement includes provisions whereby the Taxpayer would be able to monitor how the foreign corporation uses the Trademarks.

Further, the actions of the Taxpayer belie Subsidiary's exclusive rights to the Trademarks. As stated in the FC Agreement, the Taxpayer "desires to cause" Subsidiary to grant to the foreign corporation an exclusive license to use the Trademarks. Also, the Trademarks have been considered as potential collateral in recent bank negotiations involving the Taxpayer's parent corporation. These events clearly indicate that Subsidiary is not in control of the Trademarks.

Conclusion

Based on the foregoing, I find that Subsidiary possesses little economic substance and the Taxpayer's deduction of royalty fees created an improper reflection of Virginia taxable income. Thus, to the extent that the intercompany license fees and interest primarily reflect "paper" intercompany transactions, the facts are consistent with those addressed in 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. Under these circumstances, Va. Code § 58.1-446 authorizes the Department to equitably adjust the tax of the Taxpayer.

The license fees result in the transfer of income from the Taxpayer to Subsidiary. Absent of the creation of these arrangements, the royalties would not have been deducted from 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 penalty or corrective action by the Internal Revenue Service, even where the transactions are not performed at arm's length. In this case, however, I find that consolidating the income of the Taxpayer and Subsidiary would correctly reflect Virginia income. Accordingly, the assessments for the taxable years ended December 31, 1991, and December 31, 1992 are upheld.

Copies of the Code of Virginia sections, regulations, and public documents cited are available on-line in the Tax Policy Library section of the Department of Taxation's web site, located at www.tax.state.va.us. If you have any questions regarding this determination, you may contact ***** in the Office of Policy and Administration, Appeals and Rulings, at *****.
              • Sincerely,


              • Kenneth W. Thorson
                Tax Commissioner


AR/12002B


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46