Did a corporation substantiate 2006-2008 charitable carryovers and related-party interest and factoring deductions?

Plain-English summary

Virginia upheld the related-party factoring add-back and denied the charitable-carryover and interest-expense refund claims for lack of records, while giving the corporation one final 30-day opportunity to substantiate the latter two items. The company filed consolidated federal returns but separate Virginia returns.

Virginia allowed a separate-return filer to use its own share of excess federal charitable contributions, but the amount had to be computed as if a separate federal return had been filed. The taxpayer did not provide that calculation.

The auditor also disallowed interest on a loan from wholly owned affiliate IHCA after finding the affiliate lacked substance and the loan was not arm's length. Virginia requested evidence of economic substance and market terms, but none had been supplied.

For factoring fees paid to IHCB and IHCC, the ordinary subject-to-tax exception covered only the portion corresponding to affiliate income actually subjected to tax elsewhere. The auditor's partial add-back was correct. A valid-business-purpose claim could not be considered because the taxpayer had not used the statute's special pay-first and application procedure.

The refund was denied on the existing record. If the separate-return carryover support and IHCA questionnaire were not provided within 30 days, those audit adjustments would become final.

What this means for you

• Compute consolidated-federal items on a separate-company basis for separate Virginia returns.
• Substantiate related-party loans with evidence of affiliate substance and arm's-length terms.
• Another state's tax return supports only the portion of an add-back exception tied to income actually taxed there.
• Follow the exact statutory process for a valid-business-purpose exception.
• Treat final documentation deadlines as outcome-determinative.

Common questions

Q: Was the charitable carryover automatically allowed through federal conformity?
A: No. The taxpayer still had to calculate and document its separate-return share.

Q: Why was the related-party interest deduction disallowed?
A: The auditor found the affiliate lacked substance and the loan was not arm's length, and the taxpayer supplied no rebuttal evidence.

Q: Did all factoring fees escape add-back because affiliates filed elsewhere?
A: No. Only the share corresponding to affiliate income actually subjected to tax elsewhere qualified.

Q: Was there still a chance for relief?
A: Yes, but only for the carryover and IHCA interest issues if the requested records arrived within 30 days.

Citations and references

• Va. Code §§ 58.1-1824 and 58.1-1821.
• IRC § 170(b)(2) and (d)(2); Va. Code § 58.1-301; 23 VAC 10-120-320 D 1 b.
• Va. Code §§ 58.1-446, 58.1-402 B 8, and 58.1-402 A 8 b.
• Virginia Public Documents 07-153 and 03-56.
• Commonwealth v. General Electric Co., 236 Va. 54, 372 S.E.2d 599 (1988).

Subject

Protective Claim/Charitable Contribution Carryover/Interest Expense

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 13-156

Original ruling text

August 6, 2013

Re: § 58.1-1824 Protective Claim: Corporate Income Tax

Dear *:

This will reply to your letter in which you seek a refund of corporate income tax paid by * (the "Taxpayer") for the taxable years ended December 31, 2006 through December 31, 2008. I apologize for the delay in responding to your letter.

FACTS

The Taxpayer filed consolidated federal and separate Virginia corporate returns for the taxable years at issue. The Department audited the Taxpayer and numerous adjustments were made. The Taxpayer contests several of the adjustments, each of which will be addressed separately below.

DETERMINATION

Protective Claim

Pursuant to the authority granted the Tax Commissioner under Va. Code § 58.1­1824, a protective claim for refund can be held pending the outcome of another case before the courts or the claim may be decided based upon its merits pursuant to Va. Code § 58.1-1821. As permitted by statute, the Taxpayer's request has been treated as an appeal under Va. Code § 58.1-1821.

Charitable Contribution Carryover

The Taxpayer made charitable contributions during the 2001 through 2004 taxable years. Internal Revenue Code (IRC) § 170 allows a taxpayer to deduct charitable contributions up to 10% of its taxable income. See IRC § 170(b)(2). Amounts that exceed the ceiling may be carried over for five years. See IRC § 170 (d)(2). The Taxpayer carried over the deduction to the taxable years at issue for federal income tax purposes.

Pursuant to an audit, the Department recalculated the Taxpayer's net operating loss carry forward and disallowed the carryover of the excess charitable contributions on the basis that the excess charitable contributions reported were not calculated on a separate return basis for Virginia income tax purposes. The Taxpayer contends that excess contribution deductions that were carried over should be allowed because Virginia conforms to the IRC.

Virginia Code § 58.1-301 provides that terminology and references used in Title 58.1 of the Code of Virginia have the same meaning as provided in the Internal Revenue Code (IRC), with certain exceptions, unless a different meaning is clearly required. For corporate income tax purposes, Virginia generally "conforms" to federal law, in that it starts the computation of Virginia taxable income with federal taxable income (FTI).

Title 23 Virginia Administrative Code (VAC) § 10-120-320 D 1 b requires a taxpayer that files a consolidated federal return and a separate Virginia return to compute the federal taxable income of each member of the group as if separate federal returns had been filed. As such, in cases in which a taxpayer files a consolidated return as part of an affiliated group for federal income tax purposes, but files a separate Virginia return for Virginia income tax purposes, the taxpayer may claim its portion of excess charitable contribution carry over provided that it is calculated on a separate return basis.

The Department requested information from the Taxpayer showing the amount of the excess contribution carryover as calculated on a separate return basis. The Taxpayer has not provided the requested information.

Interest Expense

The Department's auditor disallowed interest expense reported by the Taxpayer on an outstanding loan from its wholly owned subsidiary, * (IHCA). The auditor determined IHCA lacked substance and the intercompany loan transactions were not at arm's length. The Taxpayer contends that IHCA was a viable independent company with economic substance, and the subtraction of interest expense should be allowed.

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:

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 therefore, 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 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 requested that the Taxpayer provide information to substantiate its assertions that IHCA had economic substance and that the Taxpayer's intercompany transactions with IHCA were at arm's length. The Taxpayer has not provided the requested information.

Factoring Expense

For the taxable years at issue, the Taxpayer paid factoring fees to * (IHCB) and *** (IHCC). The Taxpayer filed Schedule 500AB with its 2006 through 2008 Virginia corporate income tax returns and claimed an exception for 100% of the factoring fees deducted on its federal income tax returns on the grounds that the sale of the receivables to IHC was subject to tax in another state and had a valid business purpose other than the avoidance of tax.

The auditor limited the amount claimed as an exception to the add back by reducing it to correspond to the amount of the affiliates' factoring income apportioned to each state in which the affiliates paid tax and increased the corresponding net add back of factoring fees. The Taxpayer asserts that the factoring fees paid to IHCB and IHCC qualify for an exception to the add back because they were subject to tax based on or measured by net income imposed by other states.

Virginia Code § 58.1-402 B 8 provides that there shall be added back to the extent excluded from federal taxable income:

the amount of any intangible expenses and costs directly or indirectly paid, accrued, or incurred to, or in connection directly or indirectly with one or more indirect transactions with one or more members to the extent that such expenses and costs were deductible or deducted in computing federal taxable income for Virginia purposes.

The statute provides several exceptions to the general rule that an add back 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 and factoring 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 Va. Code § 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 made factoring payments to IHCB and IHCC. The auditor reduced the add back exception to the portion of the Taxpayer's factoring expenses paid to the two related entities that correspond to the portion of each affiliate's income subjected to tax in other states.

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." Because 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.

If the Taxpayer qualified for the exception with respect to 100% of the addition for royalty and factoring expenses, then the situation would be similar to that described in P.D. 03-56 (8/8/2003). In this case, 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 distortion of the business done in Virginia is not of sufficient magnitude to require an equitable adjustment under Va. Code § 58.1-446.

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.

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 royalties and factor fees on the basis that they were incurred for a valid business purpose cannot be considered.

CONCLUSION

For the reasons set forth above, I find that the auditor properly added back the factoring expense in accordance with P.D. 07-153. If the Taxpayer wishes to apply to the Tax Commissioner for relief with regard to the factoring payments to IHCB and IHCC based upon the existence of a valid business purpose, the Taxpayer must comply with the statutory time period provided by Va. Code § 58.1-402 A 8 b.

Because the Taxpayer has failed to furnish information required by law, I must deny the Taxpayer's request for a refund for the 2006 through 2008 taxable years with regard to the charitable contribution carryforward and audit adjustment resulting from the Taxpayer's transactions with IHCA. I will, however, grant the Taxpayer one final opportunity to provide the information requested to substantiate its claims. The requested documentation and questionnaire with respect to the charitable contribution carryover and the disallowance of the interest expense deduction for interest paid to IHCA must be provided to the Virginia Department of Taxation, Appeals and Rulings Section, P.O. Box 27203, Richmond, Virginia 23261-7203, Attn: *, within 30 days from the date of this letter. If the information requested is not received within the allotted time, the adjustments related to the charitable contribution carryover and the disallowance of the interest expense deduction will be considered valid.

The Code of Virginia sections, regulation, 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 determination, you

may contact * at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1-4585863130.B