Did out-of-state parent and guarantor corporations have Virginia income-tax nexus, and where were lease-guarantee fees sourced?

Subject

Does parent and Guarantor have nexus for income tax purposes; Sales Factor

Plain-English summary

An out-of-state parent, operating company, and guarantor received fees for guaranteeing leases used by related retail businesses, including Virginia stores. The operating company already had Virginia income-tax nexus and also acted as agent for the parent and guarantor.

Virginia found that the parent and guarantor themselves appeared to lack nexus. They had no Virginia employees or property, and their own business activities occurred outside Virginia apart from de minimis activity.

For the operating company's sales factor, the income-producing lease-guarantee work was approval, negotiation, and execution. Those activities occurred at the group's out-of-state headquarters. Under the cited costs-of-performance rule, the fees belonged in the sales-factor denominator but not the Virginia numerator.

Virginia reserved its authority to adjust related-party transactions that distorted Virginia taxable income. Because the request did not provide information about profits included in the guarantee fees, the Department would not issue an advance ruling on whether an intercompany adjustment was required.

What this means for you

• A related company's Virginia stores do not automatically establish nexus for every out-of-state affiliate; each entity's property, employees, and activities matter.
• Under the sourcing rule applied here, the direct activities producing the service fee controlled where the receipt was placed.
• Related-party fee deductions need evidence of pricing, profit, and economic substance to assess possible income adjustments.

Common questions

Did the parent and guarantor have Virginia income-tax nexus?

Virginia said they appeared not to, based on the stated absence of Virginia property, employees, and non-de minimis activity.

Where did the operating company source the guarantee fees?

To the sales-factor denominator only, because approval, negotiation, and execution occurred outside Virginia.

Did Virginia approve the related-party guarantee fees in advance?

No. The Department lacked facts about intercompany profit and said the issue was highly fact-dependent.

Citations and references

• P.L. 86-272 and Wisconsin Department of Revenue v. William Wrigley, Jr. Co., nexus and de minimis activity.
• Va. Code § 58.1-416 and 23 VAC 10-120-230, costs-of-performance sourcing.
• Va. Code § 58.1-446 and 23 VAC 10-120-360 through 10-120-364, intercompany adjustments.
• P.D. 97-132 and P.D. 97-290, cost reimbursements and profit elements in related-party management fees.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 07-116

Original ruling text

July 19, 2007

Re: Request for Ruling: Corporate Income Tax

Dear *:

This will reply to your letter in which you request a ruling as to whether certain related companies have nexus with Virginia for income tax purposes and how to apportion guaranteed lease fees.

FACTS

A parent corporation (the "Parent") owns a group of corporations (the "Group") that in turn own entities that own retail stores and a distribution center located in Virginia. The Group includes an operating company (O) that performs administrative functions on behalf of members of the Group. The Group also included a corporation (G) primarily engaged in providing lease guarantees. G merged with O in 2005. The Parent, O, and G are all located in another state (State A).

Third parties that lease property to the Group require a guarantor for the teases. The Parent and O also guarantee leases on behalf of the Group. In exchange for guaranteeing the leases, members of the Group pay guarantee fees to the Parent, O and G. The Parent, O, and G source these fees to their state of commercial domicile.

In addition to guaranteeing leases on behalf of the Group, the Parent is the primary financial intermediary between the Group and third parties. Specifically, the Parent manages all of the borrowing and lending for the Group and executes other financial instruments on behalf of the Group.

O is responsible for much of the administrative and general management functions of the Group. O performed all of the Group's activities related to the leasing of the property. In regard to the lease guarantees, O acted as an agent for the Parent and G. O has nexus with Virginia for Virginia income tax purposes.

You request a ruling that addresses three questions: (1) Whether the parent and Guarantor have nexus for income tax purposes; (2) If the Parent and G have nexus with Virginia, whether they are required to source the lease guarantee fees into the numerator of their sales factor; and (3) Whether O is required to source the lease guarantee fees into the numerator of its sales factor.

RULING

Nexus

Public Law (P.L.) 86-272, codified at 15 U.S.C.A. §§ 381-384, prohibits Virginia from imposing a net income tax on a foreign corporation when its only contact with Virginia constitutes solicitation of sales. This same protection has been extended by the United States Supreme Court to include activities that are ancillary to solicitation or de minimis in nature. See Wisconsin Department of Revenue v. William Wrigley, Jr. Co., 505 U.S. 214 (1992). Although P.L 86-272 applies to tangible property, the Department's policy has been to extend the "solicitation test" of P.L. 86-272 to situations involving the sales of services.

The Department has a long established policy of narrowly interpreting the provisions of P.L. 86-272. A taxpayer that engages in activities that exceed the protection provided by P.L. 86-272 would be subject to the Virginia corporate income tax. Title 23 of the Virginia Administrative Code (VAC) 10-120-90 G, however, exempts activities that are de minimis in nature. Pursuant to Wrigley , all nonancillary activities are examined to determine if, when considered together, they create more than a de minimis connection to the Commonwealth.

Based on the facts presented, neither the Parent nor G has employees or property located in Virginia. All the Parent's and G's business activities occur outside of Virginia. Because no activities performed by the Parent and G occur within Virginia, other than de minimis activities, it appears neither the Parent nor G has nexus with Virginia for income tax purposes.

Apportionment

Virginia Code § 58.1-416 provides that sales, other than sales of tangible personal property, are in the Commonwealth if:

1. The income-producing activity is performed in the Commonwealth; or

2. The income-producing activity is performed both in and outside the Commonwealth and a greater proportion of the income-producing activity is performed in the Commonwealth than in any other state, based on costs of performance.

Pursuant to Title 23 of the Virginia Administrative Code (VAC) 10-120-230, sales of services from multistate activities are only included in the numerator of the Virginia sales factor if the greater proportion of the income-producing activity is performed in Virginia than in any other state, based on costs of performance. The regulation defines "cost of performance" as the cost of all activities directly performed by the taxpayer for the ultimate purpose of producing the sale to be apportioned. "Income producing activity" is the act or acts directly engaged in by the taxpayer for the ultimate purpose of producing the sale to be apportioned. Indirect expenses such as interest or activities produced by independent contractors are not included.

The income producing activities that generate the guarantee lease fees are approval for providing a lease guarantee, the negotiation of its terms and its execution. These activities occur at the Group's out-of-state headquarters. As such, the lease guarantee fees would not be reported in the numerator of O's Virginia sales factor, but would be included in the denominator only.

Intercompany Transactions

It should be noted that the Department has the authority to adjust the taxable income of two or more corporations in accordance with Va. Code § 58.1-4.46. In the event that the Department finds that transactions between commonly owned businesses improperly reflects Virginia taxable income from business done in Virginia, the Department can, and if necessary will, seek remedies that may include consolidating the accounts of one or more of the corporations. See Title 23 VAC 10-120-360 through 364.

Based on the information provided, the guarantee payments 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.

No information has been provided with regard to the intercompany profits of the guarantee fees. However, because the application of Va. Code § 58.1-446 is highly dependent on the facts and circumstances, the Department cannot issue an advance ruling with respect to these transactions.

This ruling is based on the facts presented as summarized above. Any change in facts or the introduction of new facts may lead to a different result.

The Code of Virginia sections, regulations and public documents cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions regarding this ruling, please contact * in the Office of Policy and Administration, Appeals and Rulings, at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner

AR/1-592718941B