Could Virginia still assess related corporations for 2000-2004 royalty transactions when one filed returns and the intangible affiliate did not?

Subject

Nonfiling affiliate remained open to corporate income-tax assessment

Plain-English summary

Virginia distinguished the corporation that filed returns from the related intangible affiliate that apparently did not. If the operating corporation filed its 2000-2004 returns, the ordinary three-year period generally prevented a new royalty adjustment unless the transactions were fraudulent.

Virginia could still examine older net-operating-loss amounts when they carried into an open year because correcting the loss used in the open year was not an assessment for the closed year.

The nonfiling affiliate had no comparable time protection. Virginia law allowed assessment at any time when a corporation failed to file. The Department could review whether related-party royalty income should be treated as Virginia income under its equitable-adjustment authority, even if the affiliate had no positive apportionment factor.

Result: filed years were generally closed subject to fraud and loss-carryforward exceptions, but the nonfiling affiliate's years remained open. The Department would not give an advance answer on the related-party adjustment without complete facts.

What this means for you

• Filing a return starts the ordinary assessment limitations period; nonfiling may leave the year open indefinitely.
• Related-party royalty arrangements require economic substance and arm's-length support.
• Closed-year losses can still be examined when carried into an open year.
• Lack of a positive apportionment factor may not end the analysis under Virginia's equitable-adjustment statute.
• P.L. 86-272 protects only a narrow range of solicitation activities.

Common questions

Q: Did Virginia rule that the affiliate definitely owed tax?

A: No. It said the years remained assessable and that the ultimate related-party treatment required a factual review.

Q: Could Virginia adjust the filing corporation's closed years?

A: Generally not absent fraud, though loss amounts carried into an open year could be corrected.

Citations and references

• Va. Code §§ 58.1-446, 58.1-1812, 58.1-312, and 58.1-400.
• 15 U.S.C. §§ 381-384 (P.L. 86-272).

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 15-143

Original ruling text

June 30, 2015

Re: Ruling Request: Corporate Income Tax

Dear *:

This will respond to your letter in which you request a ruling as to whether the statute of limitations for the assessment of corporate income tax by the Department has expired.

FACTS

Corporation A operated restaurants throughout the United States including Virginia. Corporation B owned and maintained intangible property that included trademarks, trade names, product recipes, and other product intangibles. Corporation B charged Corporation A royalties under a licensing agreement from 2000 through 2008. Beginning in 2005, Corporation A added back intangible expenses in as required by Virginia law.

Corporation A requests a ruling that intercompany royalty expenses would not be required to be added back to federal taxable income for 2000 though 2004 taxable years. In addition, Corporation B seeks a ruling that it would not be subject to income tax for the taxable years at issue.

RULING

Statute of Limitations

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 that the Department may equitably adjust a corporation's income tax liability when an arrangement between related entities is found to reflect improperly business done or the Virginia taxable income earned from business done within the Commonwealth. 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.

In general, Va. 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. Virginia Code § 58.1-312, however, authorizes the Department to assess tax at any time, if a corporation (1) does not file a return, (2) files a false or fraudulent return, or (3) fails to report a change or correction of income by the Internal Revenue Service (IRS). Assuming Corporation A filed Virginia income tax returns for the 2000 through 2004 taxable years, the Department would be prohibited from making an adjustment related to the intercompany royalty transactions unless they resulted from fraudulent activity.

Another exception to the general rule occurs when net operating loss deductions (NOLDs) are carried forward. 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. Instead, they are the correction of the amount of federal taxable income for taxable years within the statute of limitations. The information provided does not indicate whether Corporation A incurred a net operating loss during any of the taxable years at issue. However, if Corporation A is continuing to carry any NOLD from the 2000 through 2004 taxable years forward that may impact taxable periods within the statute of limitations, the Department may make an equitable adjustment to reflect properly the federal taxable income of the corporation.

Nexus

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 clearly establishes income from Virginia sources.

Public Law (P.L.) 86-272, 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. 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 sale of other than tangible personal property. See P.D. 91-33 (3/18/1991) and P.D. 93­-75 (3/17/1993). 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 long-established policy of narrowly interpreting the provisions of P. L. 86-272.

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.

Corporations that do not have a positive apportionment factor are not considered to be subject to Virginia income tax if separate returns are filed. Under appropriate circumstances, however, the Department is authorized under Va. Code § 58.1-446 to determine that income of an affiliate be deemed Virginia income even if the affiliate does not have nexus. See P.D. 96-346 (11/25/1996) and P.D. 10-279 (12/22/2010). 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 intercompany transactions.

As indicated above, Va. Code § 58.1-312 A 1 permits the Department to assess the appropriate tax at any time when a corporation has not filed a return. If Corporation B has not filed returns for the 2000 through 2004 taxable years, the Department would have the authority to review the transactions between Corporation A and Corporation B to determine if the Corporation B's income should be deemed to be Virginia income and issue assessments. The statute also permits such assessments if the Department were to determine that the intercompany royalty transactions were found to be fraudulent.

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 and public documents cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions 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,

Craig M. Burns
Tax Commissioner

AR/1-5861339046.o