Which Virginia corporate audit adjustments survived review for a group with intercompany loans and merchandise sales?

Plain-English summary

Virginia allowed the auditor to inspect older net-operating-loss carryforwards but reversed the challenged intercompany interest, royalty, and related add-back adjustments. The corporate group had changed from consolidated to combined Virginia returns without permission, and the audit recomputed losses from earlier years when correcting the open audit years.

Older NOL years could be examined

The three-year assessment limit did not prevent Virginia from examining net operating losses generated in closed years when those losses affected federal taxable income in open years. Correcting the carryforward was not itself an assessment for the closed year.

Documented intercompany loans were respected

The auditor had disallowed interest tied to three subsidiaries under Virginia's equitable-adjustment authority. On appeal, the taxpayer produced evidence that the entities had economic substance, the loans had significant principal payments, and the interest rates resembled fair-market rates. The Department found the transactions arm's length and allowed the interest deductions.

Merchandise markup was not shown to be a royalty

Another subsidiary designed and sold private-label merchandise and owned related trademarks. It charged the taxpayer cost plus a profit percentage. The Department found the taxpayer was buying tangible inventory, not paying a percentage of its own profits or a designated per-item royalty for trademark use. The royalty add-back was overturned.

Interest was not connected to intangible property

The auditor also treated payments to two former receivables entities as factoring-related add-backs. The evidence showed that during the audited years those entities held debt and received interest but no longer factored receivables. Because they held no intangible property, the cited related-party interest add-back did not apply.

The audit was returned for correction. If a balance remained after recalculation, the taxpayer would receive a revised bill.

What this means for you

• Closed loss years can still be examined when their carryforwards reduce income in an open year.
• Related-party interest deductions need contemporaneous proof of economic substance and arm's-length terms, including loan schedules, principal payments, and market-rate support.
• Ownership of trademarks does not by itself turn a merchandise markup into a royalty; the actual payment terms and what was purchased matter.
• Identify whether a related lender actually holds or is funded by intangible property before applying Virginia's interest add-back.
• Obtain permission before changing Virginia corporate filing status where the regulation requires it.

Common questions

Q: Did the statute of limitations protect the old NOL carryforwards from review?
A: No. Virginia could correct them to determine taxable income for open years without assessing tax for the closed years themselves.

Q: Why were the intercompany interest deductions allowed?
A: The subsidiaries had economic substance, and the records showed principal repayment and interest rates resembling fair-market terms.

Q: Why was the private-label markup not a royalty?
A: The taxpayer bought tangible merchandise at cost plus profit; the payment was not shown to be consideration for permission to use trademarks.

Q: Why did the separate interest add-back fail?
A: The recipient entities held debt but no intangible property during the relevant years, so the cited connection to intangible-property transactions was absent.

Q: What was the outcome?
A: The NOL review remained valid, but the specified intercompany disallowances and add-backs were removed and the audit was remanded for recalculation.

Citations and references

• Va. Code §§ 58.1-1821, 58.1-1812, 58.1-446, and 58.1-402 B 8 and B 9 a.
• 23 VAC 10-120-320.
• Commonwealth v. General Electric Company, 236 Va. 54, 372 S.E.2d 599 (1988).
• Sierra Club, Inc. v. Commissioner of Internal Revenue Services, 86 F.3d 1526 (9th Cir. 1996), as cited in the determination.
• Virginia Public Document 94-154, discussed for review of older NOL carryforwards.

Subject

Adjustments made to combined corporate income tax return with subsidiaries

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 13-213

Original ruling text

November 18, 2013

Re: § 58.1-1821 Application: Corporate Income Tax

Dear *:

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 29, 2005, January 28, 2006, February 3, 2007, and February 2, 2008. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayer filed a combined Virginia corporate income tax return with its subsidiaries for the taxable years at issue. The Department audited the Taxpayer and numerous adjustments were made. The Taxpayer filed an appeal contesting several of the adjustments. Each of the adjustments will be addressed separately below.

DETERMINATION

NOLD Limitation Period

The Taxpayer originally filed consolidated returns for its affiliates that were subject to tax in Virginia. For the taxable years ended January 2004 and thereafter, the Taxpayer began filing combined Virginia corporate income tax returns without receiving permission pursuant to Title 23 of the Virginia Administrative Code (VAC) 10-120-320.

The auditor adjusted the Taxpayer's returns to reflect its consolidated filing status. Pursuant to these adjustments, the auditor recomputed the Taxpayer's net operating loss deductions (NOLDs) for net operating losses (NOLs) incurred for the 2001 through 2003 taxable years.

The Taxpayer contends that adjustments for the NOLDs were made beyond the statute of limitations period. The Taxpayer asserts such adjustments to the NOLDs for the taxable years prior to the taxable year ended January 2005 amount to an assessment of tax for years that are closed under Virginia statute.

Virginia Code § 58.1-1812 provides that the Department must assess omitted taxes within three years of the due date of the return or the actual date that the return was filed, whichever is later. In order to determine the correct federal taxable income for a taxable year, however, the Department has found it proper to examine NOLDs for taxable years outside the limitations period, and make positive or negative adjustments to these amounts. See Public Document (P.D.) 94-154 (5/23/1994). Such adjustments do not constitute assessments prohibited by Va. Code § 58.1-1812; rather, they are the correction of the amount of federal taxable income for taxable years within the statute of limitations.

In auditing the taxable years at issue, the Department must determine the proper federal taxable income. Because the NOLDs affect the taxable income for the taxable years at issue, the examination of an NOLD is appropriate. Positive or negative adjustments to such an NOLD are permitted, if necessary to accurately reflect a taxpayer's federal taxable income.

Interest Subsidiaries

One of the Taxpayer's affiliates paid interest on intercompany loans to * (IHCA), (IHCB), and ** (IHCC). The auditor disallowed the interest expenses claimed by the Taxpayer for the 1996 through 2003 taxable years. The Taxpayer contends the Department could not disallow the interest expense because the statute requiring the add-back of intangible expense was not effective until the taxable year ended December 31, 2004 and thereafter.

The auditor did not add-back interest expense pursuant to Va. Code § 58.1-402 B 9. Instead, the auditor disallowed the interest expense pursuant to Va. Code § 58.1 -­ 446. This statute allows the Department to equitably adjust tax when transactions between commonly owned businesses improperly reflect Virginia taxable income from business done in Virginia. Virginia Code § 58.1-446 was in effect during the 2001 through 2003 taxable years. The auditor made the adjustments in order to calculate the Taxpayer's NOLD carryfoward when the Taxpayer had not provided adequate documentation to substantiate its intercompany loans and factoring transactions.

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 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 Va. Code § 58.1-446 (or its predecessor) where two or more 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.

IHCA, a wholly owned subsidiary of the Taxpayer, held debt owed by one corporation affiliated with the Taxpayer. The evidence provided shows IHCA had economic substance during the taxable years at issue. In addition, a review of the loan schedules and documents shows significant principal payments by the affiliate and the rate of interest on the notes resembles a fair market value interest rate. The documentation regarding the intercompany loans demonstrates that the loans between IHCA and the affiliate were at arm's length.

IHCB was formed to purchase the Taxpayer's receivables, which were used as collateral for investments. IHCB sold the receivables in 1999, but has continued to hold debt owed by related entities. The evidence provided shows IHCB had economic substance during the taxable years at issue. In addition, a review of the loan schedules and documents indicates significant principal payments by the affiliates and the rate of interest on the notes resembles a fair market value interest rate. The documentation regarding the intercompany loans demonstrates that the loans between IHCB and the related entities were at arm's length.

IHCC was formed to purchase and manage customer receivables arising from credit card sales. It also made unsecured loans to the Taxpayer. IHCC sold the receivables in 1999, but has continued to hold debt owed by the Taxpayer. The evidence provided shows IHCC had economic substance during the taxable years at issue. In addition, a review of the loan schedules and documents shows significant principal payments by the Taxpayer and the rate of interest on the loans resembles a fair market value interest rate. The documentation regarding the intercompany loans demonstrates that the loans between IHCC and the Taxpayer were at arm's length.

As such, the Department finds that the intragroup transactions engaged in by IHCA, IHCB, and IHCC fail to satisfy the requirements of the Virginia Supreme Court in General Electric that (1) there was an arrangement; (2) between one or more members of a group subject to Virginia income tax, engaged in one or more intragroup transactions; (3) where the consideration for an intragroup transaction did not accurately reflect the income from business done in Virginia of the participating group members; and (4) the intragroup transaction had the purpose or effect of distorting income from business done in Virginia. As such, the interest deductions made by the Taxpayer and its affiliates for debt owed to IHCA, IHCB, and IHCC will be permitted.

Royalty Expense Add-Back

* (IHCD), a wholly owned subsidiary of the Taxpayer that is commercially domiciled in *** (State A), designed, developed, and sold private label merchandise exclusively to the Taxpayer. IHCD also held all of the trademarks related to the merchandise it sold. The merchandise was sold to the Taxpayer at IHCD's cost plus a profit percentage.

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 related members to the extent such expenses and costs were deductible or deducted in computing federal taxable income for Virginia purposes.

The auditor determined that the percentage above cost paid by the Taxpayer to IHCD was a royalty subject to the add-back requirement of Va. Code § 58.1-402 8. The Taxpayer contends that the profit percentage it paid when purchasing merchandise from IHCD was not a royalty.

In Sierra Club, Inc. v. Commissioner of Internal Revenue Services , 86 F.3d. 1526 (9 th Cir. 1996), the court states:

We can glean that "royalty" commonly refers to a payment made to the owner of property for permitting another to use the property. The payment is typically a percentage of profits or a specified sum per item sold; the property is typically either an intangible property right-such as a patent, trademark, or copyright-or a right relating to the development of natural resources.

In this case, the Taxpayer was purchasing the actual tangible merchandise (inventory) from IHCD. The Taxpayer did not make payments to IHCD based on a percentage of its profits, nor was any specified sum per item sold designated as a royalty. As such, it does not appear that the Taxpayer was paying IHCD for the permission to use IHCD's trademarks.

Interest Expense Addback

In addition to disallowing interest deductions under Va. Code § 58.1-446, the auditor added back payments to IHCB during the 2004 taxable year and paid to IHCC during the 2004 through 2008 taxable years. The auditor reasoned that the entities were engaged in factoring of accounts receivable, which is subject to the addback under Va. Code § 58.1-402 B 8. However, the evidence provided indicates IHCB and IHCC were not engaged in factoring activities during the 2004 through 2008 taxable years, but did hold debt on which they received interest from related entities including the Taxpayer and one of its affiliates.

Virginia Code § 58.1-402 B 9 a requires a taxpayer to add back intercompany interest expenses and costs that are directly or indirectly related or connected to transactions involving intangible property. This generally occurs when intercompany license fees generated by a corporation holding an intangible asset are used to make loans to related corporations. In this case, the affiliate held no intangible property. As such, the Taxpayer was not required to add back interest expense paid to IHCB or IHCC pursuant to Va. Code § 58.1-402 B 9 a.

CONCLUSION

Based on this determination, the auditor was permitted to adjust NOLD carryforwards for taxable years otherwise outside the statute of limitations in order to accurately report federal taxable income for the taxable years at issue. The NOLD adjustments, however, must be corrected to remove the amounts for the disallowance of intercompany transactions between IHCA, IHCB, and IHCC and any related entities. In addition, the addback adjustments related to IHCB, IHCC, and IHCD are overturned.

As such, the audit will be returned to the auditor in order to adjust the audit report in accordance with this determination. Once the auditor makes the appropriate adjustments, the Taxpayer will receive a revised bill if any tax liability remains. The Taxpayer should remit payment for the outstanding balance as shown on the revised bill within 30 days from the date of the revised bill to avoid the accrual of additional interest.

The Code of Virginia sections, regulation and public document cited are available on-line at www.tax.virginia.gov in the Laws, Rules and Decisions 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 ***.

Sincerely ,

Craig M. Burns

Tax Commissioner

AR/1-4757964395.B