Tax Type
Corporation Income Tax
Description
Taxpayer did not provide needed information/Royalties
Topic
Out of State Tax Credits
Records/Returns/Payments
Reports
Royalties
Subtractions and Exclusions
Date Issued
04-30-2014
April 30, 2014
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, 2008 through 2010. I apologize for the delay in responding to your request.
FACTS
For the taxable years at issue, the Taxpayer paid royalties to ***** (IHC), an affiliated company, for the use of intangible assets. The Taxpayer filed Schedule 500AB with its 2008 through 2010 Virginia corporate income tax returns listing fifteen states in which IHC filed income tax returns. IHC reported the royalties paid by the Taxpayer and the amount of tax paid based on or measured by net income on the returns. The Taxpayer claimed an exception for 100% of the royalties deducted on its federal income tax returns on the grounds that they were subject to tax in another state. In addition, the Taxpayer claimed deductions for "strategic expense fees" paid to ***** (Corporation A).
On audit, the Department disallowed the amount claimed as an exception to the add-back. The auditor, however, was unable to determine the amount of the royalty expense subject to the add-back exception because the Taxpayer did not provide copies of IHC's out-of-state tax returns. The Department also disallowed the strategic expense fees deductions because the auditor was unable to reconcile the deductions with the rates provided in a transfer pricing study.
The Taxpayer filed an appeal, contending that both IHC and Corporation A had substance and that all transactions were made at arm's length.
DETERMINATION
Valid Business Purpose - Royalties
The Taxpayer contends it should be allowed to exclude the royalties from the add-back requirement because it had a valid business purpose other than the avoidance or reduction of tax. It asserts that IHC had economic substance and the intercompany transactions were at arm's length.
Virginia Code § 58.1-402 B 8 does not provide an exception to the add-back requirement based on the economic substance of the related entities. However, Virginia Code § 58.1-402 A 8 b provides an exclusion for the add-back when the intangible intercompany expenses were incurred through a valid business purpose other than the avoidance or reduction of tax. The statute establishes the specific procedures to follow to claim this exclusion.
In order to apply to the Tax Commissioner for relief based upon the existence of a valid business purpose, a taxpayer must file its Virginia income tax return reporting the addition in accordance with the statute and remit all taxes, penalties and interest due for the taxable year.
A taxpayer may then petition the Tax Commissioner to consider evidence relating to any transactions between it and related members that resulted in its taxable income being increased. The Tax Commissioner may permit the taxpayer to file an amended return if the application demonstrates by clear and convincing evidence that the transactions resulting in such increase in taxable income had a valid business purpose other than the avoidance or reduction of the tax. A questionnaire that provides an example of the type of information a taxpayer must provide to the Department to demonstrate a valid business purpose is enclosed.
If the Tax Commissioner grants the application, the taxpayer may file an amended return that excludes the addition related to the specific transaction or transactions identified in the Tax Commissioner's response. The amended return must be filed within one year of the Tax Commissioner's response.
The Taxpayer's request was not made in accordance with the procedure for claiming the business purpose exclusion from the addition for intangible and interest expenses paid related entities pursuant to Va. Code § 58.1-402 B 8 b. As such, the Taxpayer's request to exclude the add-back of the intangible expenses on the basis that they were incurred for a valid business purpose cannot be considered.
Management Fees
Although Virginia utilizes federal taxable income as the starting point in computing Virginia taxable income and generally respects the corporate structure of taxpayers, Va. Code § 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.]
The Virginia Supreme Court's opinion in Commonwealth v. General Electric Company, 236 Va. 54, 372 S.E.2d 599 (1988), upheld the Department's authority to adjust equitably 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 reflect improperly, inaccurately, or incorrectly 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 or transactions between the parties are not at arm's length.
Based on the information provided, the strategic expense fees resemble management fees. The Department has addressed the issue of management fees in Public Document (P.D.) 97-132 (3/19/1997). In this ruling, the Department recognized that the taxpayer would have had to engage either an outside firm to perform the essential corporate services or develop its own in-house capability. Because no intercompany profit was incorporated into the overall management fee charged by the parent, the Department allowed the deductions. The Department concluded that a cost reimbursement arrangement between related parties, without any intercompany profit, could not be characterized as one that distorts Virginia taxable income. In P.D. 97-290 (6/26/1997), however, the Department disallowed a profit percentage added to a management fee because the parent holding corporation lacked independent economic substance and failed to provide any evidence to show that the profit element of the management fee reflected fair market value.
The audit report concluded the Taxpayer was entitled to deduct the strategic expense fees. However, the auditor was unable to reconcile the amounts the Taxpayer reported on its returns. When the Taxpayer failed to provide computations, the auditor made an adjustment and disallowed a portion of the fees. The Taxpayer has provided additional calculations of the strategic expense fee with its appeal.
CONCLUSION
The statutory provision requiring the addition (and allowing exceptions) specifically states in Va. Code § 58.1-402 B 8 c that "[n]othing in subdivision B 8 shall be construed to limit or negate the Department's authority under § 58.1-446." The latter section authorizes an equitable adjustment when the Department finds that arrangements between affiliated corporations improperly reflect business done in Virginia. The quoted language clearly authorizes the Department to invoke Va. Code § 58.1-446 when it finds that allowing an exception would result in the taxpayer's income improperly reflecting the business done in Virginia.
Even if the Taxpayer qualified for the exception with respect to 100% of the addition for royalty expenses, the situation appears to be similar to that described in P.D. 05-29 (3/7/2005). In those cases, the Tax Commissioner upheld an adjustment under Va. Code § 58.1-446 based upon consolidating the affiliated entities with the taxpayer or disallowing a deduction for amounts paid to the affiliated entity. Under these circumstances the Department may invoke Va. Code § 58.1-446 to make a similar adjustment to the extent that an addition is not made under Va. Code § 58.1-402 B 8. In this case, however, because the Taxpayer qualifies for only a portion of the requested exception, the Department has concluded that any improper reflection of the business done in Virginia is not of sufficient magnitude to require an equitable adjustment under Va. Code § 58.1-446.
In accordance with this determination, the audit will be returned to the auditor in order to review the strategic expense fee computations and the amounts allowed for the add-back exception. The Taxpayer should provide the auditor with copies of IHC's out-of-state tax returns in order to meet the "subject to tax" exception in Va. Code § 58.1402 B 8 a (1). Once the auditor makes the appropriate adjustments, the Taxpayer will receive a revised bill. The Taxpayer should remit payment for the outstanding balance as shown on the revised bill within 30 days from the date of the bill to avoid the accrual of additional interest.
After the audit is revised and the assessment is paid, if the Taxpayer wishes to apply to the Tax Commissioner for relief based upon the existence of a valid business purpose with regard to IHC, it must comply with the statutory time period provided by Va. Code § 58.1-402 A 8 b. The enclosed questionnaire and all other required documentation should be sent to the Virginia Department of Taxation, Appeals and Rulings, P.O. Box 27203, Richmond, Virginia 23260-7203, Attn: *****.
The Code of Virginia sections and public documents cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions section of the Department's web site. If you have any questions regarding this ruling, you may contact ***** in the Office of Tax Policy, Appeals and Rulings, at *****.
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- Sincerely,
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Craig M. Burns
Tax Commissioner
AR/1-5265382926.B
Rulings of the Tax Commissioner