Did an out-of-state parent owe Virginia corporate income tax from licensing intangibles to a related seller whose Virginia activity was solicitation?

Subject

Intangible-license nexus unresolved; no Virginia-source income on stated facts

Plain-English summary

Virginia concluded that the out-of-state parent owed no corporate income tax on the stated facts because it had no Virginia-source income, even though its intangible licensing might create nexus. The parent owned and licensed trademarks, patents, know-how, and other intellectual property to a related seller.

Three manufacturing subsidiaries had no Virginia property, payroll, or sales. The seller had two Virginia employees whose activity was limited to soliciting orders for approval outside Virginia. Virginia treated those subsidiary facts as protected or insufficient for income-tax nexus.

For the parent, Virginia did not rule out nexus from licensing intangibles used in the state. But nexus alone was not enough: a foreign corporation also needed Virginia-source income. The parent had no Virginia property or payroll and incurred no direct Virginia costs for the royalty income. Under the cost-of-performance method described in the ruling, it had no positive Virginia sales factor and therefore no Virginia-source income.

Virginia also reserved its authority to adjust commonly controlled corporations when intercompany transactions improperly reflected Virginia business or income. Because that authority depended heavily on future facts, the Department would not issue an advance ruling that the royalty arrangement could never be adjusted.

What this means for you

• Nexus and Virginia-source income are separate corporate income-tax questions.
• Public Law 86-272 protected only a narrow range of tangible-property solicitation activity.
• Intangible licensing could raise nexus concerns even without physical property.
• The historical cost-of-performance rules placed the royalty receipts outside Virginia on these facts.
• Arm's-length terms and economic substance remain important because Virginia reserved intercompany-adjustment authority.

Common questions

Did Virginia hold that intangible licensing can never create nexus?

No. It expressly allowed that the parent's intangible assets might establish nexus.

Why was no Virginia tax due anyway?

The parent had no positive Virginia property, payroll, or sales factor and therefore no Virginia-source income on the stated facts.

Citations and references

• Va. Code §§ 58.1-400, 58.1-416, and 58.1-446.
• Public Law 86-272, 15 U.S.C. §§ 381-384.
• 23 VAC 10-120-230.
• Wisconsin Department of Revenue v. William Wrigley, Jr., Co., 505 U.S. 214 (1992).
• General Motors Corp. v. Commonwealth, 268 Va. 289, 602 S.E.2d 123 (2004).
• Commonwealth v. General Electric Co., 236 Va. 54 (1988).

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 10-279

Original ruling text

December 22, 2010

Re: Ruling Request: Corporate Income Tax

Dear *:

This is in response to your letter submitted on behalf of your client (the "Taxpayer"), in which you request a ruling regarding corporate income tax nexus.

FACTS

The Taxpayer, a corporation commercially domiciled outside Virginia, is the parent corporation of four subsidiaries (S1, P1, P2, and P3). The Taxpayer has no property or payroll in Virginia. In addition to providing administrative and management functions on behalf of the corporate family, the Taxpayer owns and manages certain intangible assets (trademarks, patents, manufacturing know-how, and other intellectual property) used by members of the corporate family. The Taxpayer licenses intangible assets to S1 for an arm's length royalty fee. S1 uses the intangible assets in connection with the packaging, marketing and sales of its products.

All four subsidiaries are commercially domiciled outside Virginia. P1, P2, and P3 manufacture products that are sold by S1 and have no property, payroll, or sales in Virginia. S1 imports, manufactures, markets, and sells products in the United States, including Virginia. Its activities in Virginia are limited to two employees that solicit orders for S1's products for approval at an office outside Virginia. The Taxpayer requests a ruling that the activities of the corporate family in Virginia are not sufficient to create nexus.

RULING

Subject to Virginia Income Tax

Virginia Code § 58.1-400 imposes income tax "on the Virginia taxable income for each taxable year of every corporation organized under the laws of the Commonwealth and every foreign corporation having income from Virginia sources." Generally, a corporation will have income from Virginia sources if there is sufficient business activity within Virginia to make any one or more of the applicable apportionment factors positive. The existence of positive Virginia apportionment factors establishes income from Virginia sources.

Public Law (P.L.) 86-272, as codified at 15 U.S.C. §§ 381-384, however, prohibits a state from imposing a net income tax where the only contacts with a state are a narrowly defined set of activities constituting solicitation of orders for sales of tangible personal property. The Department limits the scope of P.L. 86-272 to only those activities that constitute solicitation, are ancillary to solicitation, or are de minimis in nature. See Wisconsin Department of Revenue v. William Wrigley, Jr., Co. , 505 U.S. 214 (1992). The Department has a longstanding policy of narrowly interpreting the provisions of P.L. 86-272.

Based on the facts presented, none of the subsidiaries appears to have nexus with Virginia for income tax purposes. The Taxpayer, however, has inquired as to whether S1's use of its intangible assets in Virginia would create nexus for the Taxpayer. 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 sales other than tangible personal property.

In Geoffrey, Inc. v. South Carolina Tax Commission , S.C. Sup. Ct., 437 S.E.2d 13, 114 S Ct. 550 (1993), the South Carolina Supreme Court held that a intangible holding corporation that licensed the use of trademarks and trade names to a related corporation authorized and doing business in the state could be taxed on royalty income it earned from such licensing. The court found that the intangible holding corporation had established sufficient minimum contacts with South Carolina through the licensing of intangible property within the state. Since this decision, a number of states have increased scrutiny of intangible licensing agreements with regard to income tax.

In the case of Virginia, however, even if the Taxpayer's intangible assets were to establish nexus with Virginia, the facts provided raise the question as to whether the Taxpayer would have any Virginia source income. The Taxpayer has no property or payroll in Virginia. In addition, it is likely that the Taxpayer would not have a positive sales factor. Virginia Code § 58.1-416 provides that sales, other than sales of tangible personal property, are deemed in Virginia if:

The income producing activity is performed in Virginia; or

The income producing activity is performed both in and outside Virginia and a greater proportion of the income producing activity is performed in Virginia 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.

In General Motors Corporation v. Commonwealth of Virginia , 268 Va. 289, 602 S. E.2d 123 (2004), the Virginia Supreme Court held that Title 23 VAC 10-120-250 is inconsistent with Va. Code § 58.1-418 when it limits the costs of performance used to apportion income of a financial corporation to direct costs, excluding costs of independent contractors. Because the language defining "cost of performance" and "income producing activity" in Title 23 VAC 10-120-230 is identical to the language in Title 23 VAC 10-120-250, the cost of performance for purposes of sales of intangibles may not be limited to direct costs and may not exclude indirect expenses such as interest or activities produced by independent contractors.

In response to the General Motors decision, the Department issued Tax Bulletin (VTB) 05-3 (4/18/2005). The bulletin explains that financial corporations may elect to file returns prepared in accordance with Title 23 VAC 10-120-250, pending the Department's adoption of policies in response to the General Motors decision. Because the Department administers Va. Code § 58.1-416 in a manner similar to Va. Code § 58.1-418, taxpayers with sales other than tangible personal property may also elect to file returns prepared in accordance with Title 23 VAC 10-120-230 pending the adoption of policies in response to the General Motors decision.

Based on facts presented in your letter, the Taxpayer would incur no direct costs in Virginia in accordance with Title 23 VAC 10-120-230. Thus, the Taxpayer would not have a positive sales factor and have no income from Virginia sources. In other words, if the Taxpayer follows Virginia's regulation, it would not be subject to Virginia income tax even if it did have nexus. Even under the General Motors decision, there would be no costs within Virginia because S1 does not perform services on behalf of the Taxpayer.

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 § 58.1-446. In the event that the Department finds that transactions between commonly owned businesses improperly reflect 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.

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 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. The Department has exercised its authority under Va. Code § 58.1-446 in situations involving the licensing of intangible assets. See Public Document (P.D.) 05-139 (8/23/2005).

In the instant case, S1 licenses intangible assets from the Taxpayer. Based on the facts presented, it appears that neither the Taxpayer nor S1 would be subject to Virginia income tax. As such, the transactions between the Taxpayer and S1 would not appear to affect business conducted in Virginia. 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 tax bulletin cited are available on­line 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, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Linda D. Foster

Deputy Tax Commissioner

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