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Rulings of the Tax Commissioner

Document Number: 11-162 Tax Type: Corporation Income Tax Brief Description: Taxpayer's request was not made in accordance with Va. Code 58.1-402 B 8 b. Topics: Corporate Distributions and Adjustments; Filing Status; Records/Returns/Payments Date Issued: 09/26/2011

September 26, 2011 Re: 58.1-1821 Application: Corporation Income Tax Dear *****: This will reply to your letter in which you seek correction of the corporate income tax assessments issued to the ***** (the "Taxpayer") for the taxable years ended December 31, 2004 through December 31, 2006. I apologize for the delay in responding to your appeal. FACTS The Taxpayer filed a combined Virginia corporate income tax return and a consolidated federal corporate income tax return for the taxable years at issue. The Taxpayer and an affiliated entity transferred accounts receivable to a related company, ***** (IHC), which was commercially domiciled in ***** (State A). The Taxpayer filed Schedule 500AB with its Virginia combined income tax returns listing one state in which IHC filed income tax returns. The Taxpayer claimed an exception for 100% of the discount on the factoring of the accounts receivable that was deducted on its federal income tax returns on the grounds that IHC was subject to tax in another state. On audit, the Department limited the amount claimed as an exception to the add back by reducing it to correspond to the amount of IHC's income apportioned to the state in which IHC paid tax and increased the corresponding net add-back of the discount. The Taxpayer contends that IHC was a "bankruptcy remote entity" and should be included as part of the combined group on the Taxpayer's combined return. In addition, the Taxpayer contends that the add-back would not be required because the gain from the sales of accounts receivable could be offset by the interest expense

paid to unrelated third-parties. Thus, the Taxpayer believes that IHC had a valid business purpose. DETERMINATION Add Back for Factoring Transactions Virginia Code 58.1-402 B 8 a provides that there shall be added back to the extent excluded from federal taxable income: [T]he 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 direct or 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. Virginia Code 58.1-302 specifically defines "intangible expenses and costs" to include losses related to or incurred in connection with factoring transactions. Several exceptions to the add back requirement are detailed in Va. Code 58.1 402 B 8 a. Based on the facts provided, it does not appear that the Taxpayer qualifies for any of these exceptions. Combined Return The Taxpayer asserts that it should be able to include IHC in the Virginia combined return because the add back failed to account for expenses incurred by IHC. Pursuant to Va. Code 58.1-442, an affiliated group of corporations may elect to file a combined Virginia income tax return. Title 23 of the Virginia Administrative Code (VAC) 10-120-323 provides that a corporation may be included in a Virginia combined return if it is subject to Virginia income tax if a separate return were to be filed, affiliated as defined in Va. Code 58.1-302, and filing using the same taxable year. Public Law 86-272, codified at 15 U.S.C.A. 381-384, 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. 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. Under certain conditions, a corporation may have income from Virginia sources resulting from a positive apportionment factor, but not be subject to tax by virtue of the protections afforded under P.L. 86-272. Further, 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 Public Document (P.D.) 96-346 (11/25/1996). In this case, IHC is a corporation that is both domiciled and conducts all of its operations in State A. The evidence shows that IHC lacked nexus with Virginia and would not have been subject to Virginia income tax if it filed as a separate corporation. As such, IHC cannot be included in the combined return for the 2004 through 2006 taxable years. Valid Business Purpose The Taxpayer contends it should be allowed to exclude the factoring fees from they add-back requirement because the intercompany transactions were made at arm's length and, therefore, 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 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 Commissioner to consider evidence relating to any transactions between it and related members that resulted in its taxable income being increased. The 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. If the 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 Commissioner's response. The amended return must be filed within one year of the 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. Pursuant to Public Document (P.D.) 10-285 (12/22/2010), the sale of receivables to a wholly owned bankruptcy remote entity may have a valid business purpose if the bankruptcy remote entity facilitates the securitization of receivables and is required by unrelated third-party lenders. If the Taxpayer follows the procedures as prescribed under Va. Code 58.1-402 B 8 b within the statute of limitations, the Department will consider whether to permit the Taxpayer to file an amended returns to claim the valid business purpose exception. Until the Taxpayer complies with the statutory requirements, the assessments will be upheld. The Code of Virginia sections 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 ***** in the Office of Tax Policy, Appeals and Rulings, at *****. Sincerely,

Craig M. Burns Tax Commissioner

AR/1-3266811114.B