Could Virginia consolidate a parent with its subsidiary and attribute partnership sales to the parent without proving Virginia destination sales, nexus, or income distortion?

Plain-English summary

A corporation wholly owned a subsidiary that held a 50% general-partnership interest in a joint venture. On audit, Virginia consolidated the subsidiary with the parent, increased the parent's Virginia taxable income, and effectively treated the partnership interest as if the parent held it directly. The Tax Commissioner ordered those adjustments reversed because the audit had not established the necessary facts.

Va. Code § 58.1-446 lets the Department equitably adjust tax when a controlled arrangement improperly reflects Virginia business or taxable income. The auditor cited facts suggesting the subsidiary might lack economic substance -- its officers and directors were parent employees, it reported minimal federal expenditures, and the parent guaranteed its obligations. But the auditor identified no adjustment based on transactions between the parent and subsidiary. An adjustment still had to be rationally connected to an arrangement that distorted income.

The adjustment instead depended on treating the partnership as having Virginia-source income and nexus. The auditor relied on a state-by-state sales detail that included Virginia revenue, but the partnership was not audited and the detail did not establish that those amounts were destination sales into Virginia under Va. Code § 58.1-415. The taxpayer said the partnership sold to an affiliate of the unrelated partner and that the affiliate, not the partnership, made the ultimate Virginia sales.

Nexus was also unresolved. The taxpayer claimed the partnership's Virginia contacts remained within Public Law 86-272's protection for solicitation of orders for tangible personal property. Without examining the partnership, the Department could not determine whether the partnership had Virginia-source income, nexus, or an arrangement that improperly shifted the parent's Virginia income. The challenged consolidation and apportionment adjustments therefore had to be reversed, with revised assessments or refunds as warranted.

What this means for you

Section 58.1-446 adjustments need a rational factual link

Indicators that a subsidiary may be thinly staffed or parent-supported do not by themselves justify any chosen adjustment. The adjustment must address an arrangement that actually distorted Virginia income.

State-labeled revenue is not automatically a destination sale

Virginia sources tangible-property sales to where the purchaser ultimately receives the property. A sales report grouped by state was inconclusive without facts about the actual sales and delivery chain.

Sales-factor presence and nexus are separate questions

Even a positive Virginia sales factor does not itself establish income-tax liability. The entity must also have nexus, subject here to the taxpayer's Public Law 86-272 argument.

Common questions

Did the ruling hold that the subsidiary definitely had economic substance? No. It held that the audit had not rationally connected the consolidation adjustment to an arrangement that improperly reflected Virginia income.

Why was the partnership sales detail insufficient? It showed revenue labeled by state but did not prove that the partnership itself made destination sales ultimately received in Virginia.

What happened to the assessments? The case returned to audit staff to reverse the challenged adjustments and issue revised assessments or refunds as warranted.

Citations and references

• Va. Code § 58.1-446 -- equitable adjustment where controlled arrangements improperly reflect Virginia business or taxable income.
• Va. Code § 58.1-415 -- destination sourcing for tangible-personal-property sales.
• 15 U.S.C. §§ 381-384 -- Public Law 86-272.
• Commonwealth v. General Electric Co., 236 Va. 54, 372 S.E.2d 599 (1988) -- Department authority under § 58.1-446.
• Wisconsin Department of Revenue v. William Wrigley, Jr., Co., 505 U.S. 214 (1992) -- scope of protected solicitation under Public Law 86-272.
• P.D. 96-366 and 92-57 -- partnership income and corporate general-partner apportionment guidance discussed in the ruling.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 20-68

Original ruling text

April 28, 2020

Re: § 58.1-1821 Application: Corporate Income Tax

Dear *:

This will reply to your letter in which you seek correction of the assessments of corporate income tax issued to your client, * (the “Taxpayer”), for the taxable years ended September 29, 2013, and September 28, 2014.

FACTS

The Taxpayer, a * (State A) corporation, wholly owned a subsidiary (the “Subsidiary”). The Subsidiary held a 50% general partnership interest in a joint venture (the “Partnership”). The other 50% interest in the Partnership was held by an unrelated third party entity (“Company B”). The Partnership was formed to sell certain products under the Taxpayer’s brand using Company B’s distribution network.

The Taxpayer filed corporate income tax returns for the taxable years ended September 29, 2013, and September 28, 2014. The Department audited the Taxpayer and made various adjustments to the returns, which included consolidating the Subsidiary with the Taxpayer. The consolidation increased the Taxpayer’s Virginia taxable income and assessments were issued for additional tax due. The Taxpayer appeals, contending that the consolidation was in error because the Subsidiary had economic substance and in any event did not have Virginia source income.

DETERMINATION

Although Virginia utilizes federal taxable income as the starting point in computing Virginia taxable income and generally respects the corporate structure of taxpayers, Virginia 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.

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 Virginia 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 previously addressed similar circumstances in Public Document (P.D.) 96-366 (12/10/1996). The business activity of a wholly owned subsidiary of a parent corporation was limited to holding a general partnership interest. The Department reasoned that if the partnership had had income from Virginia sources, it would have been apportioned and taxed to Virginia on the subsidiary’s corporate income tax return. Because the partnership had no income from Virginia sources, no shifting of income occurred under the arrangement whereby the subsidiary held the partnership interest instead of the parent.

The auditor cited a number of reasons that the Subsidiary lacked economic substance, including that the officers and board members of the Subsidiary were employees of the Taxpayer, the Subsidiary reported minimal expenditures for federal income tax purposes, and the Taxpayer was the guarantor of the Subsidiary’s obligations. The auditor, however, did not make any adjustments that were based on transactions between the Subsidiary and the Taxpayer. While evidence of distortions of income between these two entities would not necessarily be required, an adjustment must be rationally related to an arrangement resulting in an improper reflection of income.

In this case the adjustment resulted from attributing Virginia source income to the Partnership. As such, the consolidation functionally treated the Subsidiary’s joint venture interest as if it were held by the Taxpayer directly. The Virginia source income was reflected in the adjustments to the Taxpayer’s apportionment factors, as if the Taxpayer held the Subsidiary’s general partnership interest in the joint venture directly, in accordance with the Department’s longstanding policy requiring the inclusion of a corporate general partner’s proportion of a partnership’s property, payroll, and sales in its apportionment factors. See P.D. 92-57 (4/29/1992). In assigning Virginia source income to the Partnership, it appears that the auditor concluded that the Partnership had destination sales of tangible personal property into Virginia and nexus to impose income tax on the income attributable to such sales.

The Taxpayer disputes the attribution of Virginia source income to the Partnership. The Taxpayer claims the Partnership made sales to an affiliate of Company B, and it was ultimately that affiliate of Company B that made the destination sales into Virginia. The Taxpayer also argues that the Partnership had no nexus with Virginia.

Virginia Code § 58.1-415 provides that tangible property received in Virginia as a result of a sales transaction is considered a Virginia sale unless the delivery was for transportation purposes. Specifically, Virginia Code § 58.1-415 states:

In the case of delivery by common carrier or other means of transportation , the place at which such property is ultimately received after all transportation has been completed shall be considered as the place at which such property is received by the purchaser [Emphasis added.]

As such, Virginia attributes sales of tangible personal property on a destination basis. In this case, the auditor relied on a sales detail showing the Partnership’s sales revenue by state, including Virginia. This sales detail, however, is inconclusive as to whether such revenue was derived by destination sales made into Virginia. Because the Partnership was not under audit, sufficient facts were not developed in order to reach a conclusion regarding whether such revenue figures were tied to destination sales into Virginia.

Even if a taxpayer has a positive Virginia sales factor, Virginia income tax will not be imposed unless the taxpayer also has nexus. The Taxpayer asserts that the Partnership did not have nexus with Virginia because its contacts with Virginia did not exceed the protections afforded by Public Law (P. L.) 86-272, codified at 15 U.S.C. §§ 381-384.

P. L. 86-272 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 long established policy of narrowly interpreting the provisions of P. L. 86-272.

The Taxpayer asserts the Partnership had no Virginia source income and no nexus with Virginia. If the Partnership had no Virginia source income as it claims, then the facts would resemble those of P.D. 96-366 and no shifting of income would have occurred. Even if the Partnership had Virginia source income, then such source income would have been reflected in the Subsidiary’s apportionment factors and it would have been required to file a Virginia income tax return. See P.D. 92-57.

As stated above, the Partnership was not audited by the Department. Without such an examination, it is impossible to conclude an arrangement existed that improperly reflected Virginia source income of the Taxpayer. Because the auditor failed to establish whether there were any other transactions between the Taxpayer and the Subsidiary or the Partnership that improperly reflected Virginia taxable income, no rational connection has been established between the adjustment and any alleged arrangement to underreport Virginia source income. Accordingly, the case will be returned to the audit staff to reverse the adjustments addressed in this determination and issue revised assessments or refunds as warranted.

The Code of Virginia sections and public documents 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/2092.M

Related Documents

96-366

92-57