Rulings of the Tax Commissioner
Corporation Income Tax
Out-of-state Partnership/Management Fees/Franchise Fees
Partnerships; Royalties; Subtractions and Exclusions; Taxable Transactions
July 19, 2013
Re: § 58.1-1821 Application: Corporate Income Tax
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 January 31, 2005, January 31, 2007, January 31, 2008, and January 31, 2009.
The Taxpayer is an out-of-state partnership that has elected to be taxed as a corporation for federal income tax purposes. It files a separate Virginia corporate income tax return.
The Taxpayer was audited for the taxable years at issue and a number of adjustments were made. In particular, an adjustment was made to disallow deductions for "franchise fees" paid to ***** (the "Parent") for all of the taxable years included in the audit. In addition, the Department limited the amount claimed as an exception to the add-back for intangible expenses by reducing the Taxpayer's intercompany royalty expense to correspond to the amount of the Parent's income from intangibles apportioned to the states in which the Parent paid tax and increased the corresponding net add-back of intangible expense.
The Taxpayer filed an appeal, contending the franchise fees for management services provided by the Parent did not distort the Taxpayer's Virginia taxable income. The Taxpayer also appeals the disallowance of the exception to the add-back, asserting that the add-back is permitted by the plain language of the statute and the Parent had a valid business purpose.
Although Virginia utilizes federal taxable income as the starting point in computing Virginia taxable income and generally respects the corporate structure of taxpayers,
§ 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.]
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
§ 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 franchise 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 auditor disallowed the deduction because the franchise fees were proportionally high compared to the total expenses. The Parent was providing a variety of services to the Taxpayer. As such, the mere fact that the franchise or management fees appeared to be out of proportion with other expenses incurred by the Taxpayer would not be an indication that they create an improper reflection of income done in Virginia.
Because the Parent and the intercompany transactions clearly had economic substance, the Department must analyze whether the services were provided at fair market value. The Taxpayer has provided several independent transfer pricing studies. A review of these studies demonstrates that the rates charged for the services performed by the Parent were reasonable when compared with arm's length transactions between unrelated third parties.
Subject to Tax Exception
§ 58.1-402 B 8 provides several exceptions to the general rule that an add back for certain intangible deductions is required. The exception relevant to the Department's assessment of the Taxpayer states:
This addition shall not be required for any portion of the intangible expenses and costs if one of the following applies: (1) The corresponding item of income received by the related member is subject to a tax based on or measured by net income or capital imposed by Virginia, another state, or a foreign government that has entered into a comprehensive tax treaty with the United States government. (Emphasis added.)
According to the Taxpayer, the plain meaning of the statute entitles it to exclude 100% of its royalty payments from the add back. This interpretation, however, cannot be reconciled with the legislature's use of the limiting words "portion" and "corresponding item." When interpreting statutes "[a] fundamental rule of statutory construction requires that every part of
a statute be presumed to have some meaning, and not be treated as meaningless unless absolutely necessary."
Raven Red Ash Coal Corporation v. Henry Absher
, 153 Va. 332, 149 S.E. 541 (1929). (Emphasis added).
In Public Document (P.D.) 07-153 (10/2/2007), the Department determined that parsing the statutory language of
§ 58.1-402 B 8 shows that the exception is not all inclusive. When considering this statute in its totality, the exception does not apply to the gross amount of payments that a taxpayer made to an affiliate merely because the gross amount is shown on another state's tax return. Instead, the exception is limited to the portion of a taxpayer's intangible expense payments to its affiliate that correspond to the portion of the affiliate's income subjected to tax in other states, as evidenced by the apportionment percentages shown on the affiliate's tax returns filed with other states.
In this case, the Taxpayer incurred intangible expenses for payments to the Parent for the taxable year ended January 31, 2008. The auditor reduced the add-back exception to the portion of the Taxpayer's payments to the Parent that corresponds to the portion of the parent's income subjected to tax in other states.
Valid Business Purpose
The Taxpayer contends it should be allowed to exclude the royalties and the factoring fees from the add-back requirement because the intercompany transactions had a valid business purpose other than the avoidance or reduction of tax. It asserts that the Parent had economic substance and was operated for a valid business purpose and, therefore, was not a "sham" or "shell" company.
§ 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,
§ 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
§ 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.
The statutory provision requiring the addition (and allowing exceptions) specifically states in
§ 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
§ 58.1-446 when it finds that allowing an exception would result in the taxpayer's income improperly reflecting the business done in Virginia.
Based on the foregoing, the audit adjustment disallowing the deduction for franchise fees will be reversed, and the Taxpayer will be permitted a deduction for the franchise fees paid to the Parent for the taxable years under audit. However, the auditor's adjustment to the add-back exception of the intangible expenses for the taxable year ended January 31, 2008 was made in accordance with Department policy and is upheld.
The audit will be returned to the audit staff to be adjusted in accordance with this determination. After the auditor makes the appropriate adjustments, the Taxpayer will receive a revised bill. The Taxpayer should remit its 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.
The Department is currently in litigation regarding the "subject to" add-back exception in
Kohl's Department Stores, Inc. v. Virginia Department of Taxation
, Circuit Court City of Richmond, Case No. 760CL12-1774. In that action, the Petitioner has challenged the Department's policy regarding this exception, and in particular the ruling issued in P.D. 07-153. Pending a decision in the aforementioned litigation, the Taxpayer may be able to file a protective claim pursuant to
§58.1-1824 with respect to any income tax paid as a result of the Department's ruling in P.D. 07-153.
Code of Virginia
sections and public documents cited are available on-line at
in the Tax Policy Library section of the Department's web site. If you have any questions regarding this determination, you may contact ***** in the Office of Tax Policy, Appeals and Rulings, at *****.
Craig M. Burns