Wong Computer Games Inc. (WCG) was incorporated in the state of Illinois in the last decade. The founding shareholder, Mr. Andrew Wong, is an inventor of computer simulation models. His products include a wide variety of computer games as well as some programs which have industrial applications.
Mr. Wong is the controlling shareholder of WCG. His brother owns a minority interest, as does Walter Bends, a long-time associate of Mr. Wong, who often collaborates in the development of new products. All three shareholders are resident in Chicago. In addition to Mr. Wong, the WCG Board of Directors includes George Wolf, who represents the Chicago law firm, which advises WCG, and Tony Aster who represents First National Bank of Chicago, which provides most of the financing for WCG's operations. The Board meets approximately every six months to review financial results, discuss product development and decide on strategic initiatives. The meetings are usually held in the boardroom of George Wolf's law firm.
Two years ago, Mr. Wong achieved an industry breakthrough when he developed his latest game, Super Pilot. Super Pilot is a computer game in which the operator attempts to safely land a disabled airliner. Super Pilot provided special effects which were far beyond those available in any other commercially available product. Although other WCG products were only available in the U.S. market, Wong was convinced that Super Pilot would be a global success. To ensure the competitive advantage would be maintained, Wong Computer Games Inc. took the required legal steps to ensure copyright and patent protection of the program in a variety of countries, including Canada.
By last year, Super Pilot was doing very well in the U.S. market and WCG began to launch the product in other markets. Walter Bends was assigned responsibility for the Canadian market and took a short-term lease on a Toronto apartment in March of last year. WCG established a bank account with a Toronto branch of a Canadian bank. This account was to be used by Bends for promotional expenses and other incidentals. All other expenses, including Bends' salary, continued to be paid from Chicago.
Bends attended a number of Canadian trade shows, exhibiting the Super Pilot program. Prospective purchasers were provided with Super Pilot game cartridges as a promotional item. Bends was given the authority to sign supply contracts which would permit the purchaser a one-month supply of cartridges. At the end of the one month, if the distributor was still interested, a longer-term supply contract would be required. Bends was not permitted, however, to sign any of these long-term agreements without receiving prior approval from the WCG Board. All game cartridges, including promotional cartridges, were supplied from Chicago. If the product began to sell well in Canada, the WCG Board had discussed establishing a Canadian warehouse.
By January of this year, it became obvious that Super Pilot was not going to be a Canadian success. No distributors had requested a long-term supply contract and only one, Pete's Gaming Emporium, had agreed to stock the product for one month. At the end of the month, sales had been so slow that Pete's was not interested in continuing the relationship. Bends returned to Chicago, the bank account was closed, and WCG refocused its marketing efforts on the U.S. market.
REQUIRED
Prepare a memo for the tax person in your firm who will advise WCG on the income tax consequences of these facts. Evaluate in detail the alternatives in the residence issue as they relate to this fact situation during last year and this year. Discuss each possible degree of residence and its tax consequences. State your conclusions on the case after appropriately weighing the significance of the facts considered.