Tax Type
Corporation Income Tax
Description
Price manipulation and intercorporate transactions; Royalty payments to subsidiary shell
Topic
Returns and Payments
Date Issued
10-31-1996
October 31, 1996
Re: § 58.1-1821 Application: Corporate Income Taxes
Dear******************
This will respond to your letter in which you applied for correction of an assessment of additional corporate income taxes to ********** (the "Taxpayer") for the taxable year ended September 30, 1992. I apologize for the delay in responding to your request.
FACTS
The Taxpayer was field audited and an adjustment was made to consolidate the taxable income of a wholly-owned subsidiary ("S") with that of the Taxpayer. The department's auditor based this adjustment on the presence of significant royalties owed by the Taxpayer to S, which the Taxpayer then deducted in computing Virginia taxable income. The auditor found that S lacked substantial economic substance and consequently apportioned the consolidated taxable income to Virginia. You contest this assessment, and assert that the department lacks the authority to consolidate the taxable income of S with that of the Taxpayer.
DETERMINATION
The Taxpayer is a regional corporation headquartered outside Virginia and engaged in the retail sale of various products and commodities. The Taxpayer operates in an industry which is characterized by a high degree of franchised retail operations.
Shortly after the Taxpayer was incorporated, it formed S to facilitate the Taxpayer's entry into the franchising market. S was initially capitalized with a contribution of cash by the Taxpayer in exchange for S's stock. This cash contribution was intended to help defray legal costs involved in gaining trademark protection. After the formation of S, the Taxpayer commenced paying S a royalty for use of a trademark and corresponding tradename. The Taxpayer contends that the department is without the authority to consolidate the taxable income of S with that of the Taxpayer, given what it believes to be S's bona fide business purpose and the presence of an arm's length royalty agreement.
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 a 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).
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- 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.
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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 there is an agreement between two commonly owned corporations in such a manner to improperly, inaccurately, or incorrectly reflect the business done in Virginia or the Virginia taxable income. In general, the department will exercise this authority if it finds that a transaction, or a party to a transaction, lacks economic substance. See Public Document (P.D.) 94-309, (10/11/94), copy enclosed.
In determining the economic substance of S, the department applied various factors discussed in P.D. 94-179, (6/8/94), copy enclosed. The first factor applied was whether the formation of S fulfilled a bona fide business purpose. The Taxpayer stated that the primary business purpose for the formation of S was to facilitate the Taxpayer's entry into the franchising market, yet all franchising fee income is attributed to the Taxpayer, and not S, on the consolidated federal return. In a request by the department for a detailed schedule of S's income, you responded that "the franchisees listed on the schedule are franchisees of [the Taxpayer]." Additionally, the affiliations schedule filed with the 1991 consolidated federal return listed the primary business activity of S as "Investments," but no investments were recorded as assets of S on either the supporting schedule for the consolidated balance sheets filed with the federal return or S's individual balance sheet requested by the department. Likewise, no dividend income and capital gains were attributed to S. The evidence plainly indicates that the formation of S served no bona fide business purpose.
The second factor applied by the department in determining whether S exhibited economic substance regarded S's employees and ordinary business expenses. S's payroll records indicated that S had only three employees who earned a total of $900 in calendar year 1992, with no employee earning more than $450. The duties of these employees were described in general terms as either "Accountant" or "Assistant Secretary, Accountant." Other operating expenses listed in S's income statement were consistent with amounts spent for the maintenance of a shell corporation. For example, S incurred only $600 in rent and $144 in telephone expense for the entire year. The number of employees and insignificant amounts of operating expenses are insufficient to support the stated business purpose for S's creation, and further indicate that S lacked economic substance.
The department next reviewed S's income statement and balance sheet. The balance sheet indicated that approximately 95% of S's total assets consisted of receivables due from the Taxpayer. The ending receivable balances are equivalent to the corresponding royalty income on S's income statement, indicating that royalties are not paid on a periodic basis throughout the year as earned but rather accrued at year--end. The beginning receivable due from the Taxpayer did not appear to be paid, but was instead converted into a note. These transactions are similar to those described in P.D. 95-229, (9/6/95), copy enclosed. The royalties "paid" by the Taxpayer to S are primarily returned as intercompany loans, on which the Taxpayer incurs interest expense. This arrangement essentially creates a revolving door of bookkeeping entries. Given S's minimal employees, operating expenses, and level of activity, there is no bona fide business purpose for these intercompany transactions other than tax avoidance.
S's financial statements also contradicted other documentation submitted by the Taxpayer. The Taxpayer's Form 10-K characterized the trademark and tradename as being owned by S, yet on S's balance sheet no trademark or tradename is listed. If S paid the costs incurred to gain legal protection for the trademark, which was the stated purpose for the initial cash contribution to S upon incorporation, these costs should have been capitalized and amortized for financial accounting purposes by S. If S received these assets as a capital contribution by the Taxpayer, then the assets should have been recorded at their fair market value on S's balance sheet. In the alternative, if ownership of the trademark and tradename was transferred to S and recorded at no fair market value, then it is implausible that any royalty should be paid for their use.
In addition, you stated to the department that "the trademark and tradename are licensed through franchise agreements to individual third-party franchisees of [the Taxpayer]." These agreements are reflected on S's financial statements as income and receivables. This treatment, however, is not reflected on the consolidated federal return. The total royalty income from both the Taxpayer and franchisees reported on S's income statement was eliminated on the return, indicating that none of the royalty income was derived from unaffiliated, third party sources. If in fact royalties were received from unaffiliated, third parties, these amounts should have been included in consolidated federal taxable income. Similarly, the receivable attributable to franchisees on S's balance sheet was completely eliminated in preparing the consolidated balance sheets on the federal return.
The Taxpayer's Form 10-K also stated that numerous services, such as accounting, merchandising and advertising assistance, and supplier selection were provided for franchisees. As described above, S clearly did not have the employees nor incur the level of expenses necessary to provide those services. Given your statement that the franchisees are franchisees of the Taxpayer and the elimination of royalty income in the computation of federal taxable income, it appears to the department that any amounts received from franchisees for the licensing of intangibles is properly the income of the Taxpayer, and is merely assigned to S as royalty income.
Similarly, the absence of the trademark and tradename on S's balance sheet casts considerable doubt on whether those assets are even the property of S. The payment of royalties to S and the corresponding deduction by the Taxpayer, therefore, clearly constitute a distortion of Virginia taxable income.
The fact pattern fits that of Commonwealth v. General Electric Company, and satisfies 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. The department's authority to equitably adjust the tax of the Taxpayer pursuant to Code of Virginia § 58.1-446, therefore, must be upheld. Accordingly, your request for refund is denied. If you should have any questions regarding this determination, you may contact ********* at********** .
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/8584G
Rulings of the Tax Commissioner