October 30, 2000
Re: § 58.1-1821 Application: Individual Income Taxation
Dear ****
This will reply to your letter in which you contest the assessment of Virginia individual income tax and interest against your clients, * * * (collectively, the "Taxpayers") for the 1997 and 1998 taxable years. Copies of cited authority are enclosed.
FACTS
The Taxpayers received income from a corporation (the "Corporation") that operated in Canada during the 1997 and 1998 taxable years. The Taxpayers reported this income as foreign source income ("FSI") and subtracted it from their Virginia adjusted gross income.
The department disallowed this subtraction and assessed additional income tax and interest. The Taxpayers contest the assessment because they claim that the Taxpayer's Canadian income was erroneously reported as "compensation", when it was actually "dividend" income. In the alternative, the Taxpayers contend that even if the income from the Corporation is considered compensation, it constitutes "technical fees" subject to the FSI subtraction. Finally, the Taxpayers state that disallowing the FSI subtraction would subject it to double taxation, and would violate the nature of the tax treaty between the U.S. and Canada.
DETERMINATION
The Virginia taxable income of a resident individual equals Federal Adjusted Gross Income ("FAGI") along with the modifications enumerated in Code of Virginia § 58.1-322. Code of Virginia § 58.1-322(C)(7) provides a subtraction from FAGI for "any amount included therein which is foreign source income as defined in Code of Virginia § 58.1-302." Code of Virginia § 58.1-302, in pertinent part, defines FSI as: "Dividends, other than dividends derived from sources within the United States; . . . ."
Compensation for services provided by a Virginia resident on behalf of a foreign corporation is not FSI. The Taxpayers contend that the income they received from the Corporation was not remuneration for services. Rather, this income was actually comprised of dividends erroneously characterized as "wages" on their federal and foreign income tax returns.
The evidence shows that the Taxpayers and one other individual were the sole shareholders of the Corporation. The Corporation is a holding company that owns 85% of another holding company, that in turn owns three retail franchises located in Canada. The income that the Taxpayers derived from the Corporation was reported as wages on the Taxpayer's individual federal and Virginia income tax returns. This income was reported as employment income on the Taxpayer's Canadian income tax returns. Finally, the income was reported as management salaries on the Corporation's Canadian corporate income tax return. None of the documentation provided to the department indicates that the income was dividend income.
In the alternative, you state that under Title 23 of the Virginia Administrative Code ("VAC") 10-110-30, that FSI includes technical fees from property located or services performed without the United States, but does not include earned income as defined under Internal Revenue Code ("IRC") 911(b). IRC 911(b) allows individuals to take a deduction up to a certain dollar amount on their individual federal returns for compensation earned outside the United States if they are bona fide residents of a foreign country or are physically present in the foreign country for more than 330 days. You contend that because the Taxpayers are Virginia residents who did not claim the IRC 911(b) deduction, the corporate income must be technical fees eligible for the FSI subtraction.
The mere fact that the Taxpayers did not claim the IRC 911(b) deduction does not mean that the income derived from the services that they provided to the Corporation are technical fees. In order to qualify for the Virginia FSI subtraction, "technical fees" must be derived from services that are incidental to a contract relating to the rental of real property or the licensing of a patent or other like property outside the United States. See Public Document ("P.D.") 91-57, (3/29/91) and P.D. 96-381 (12/20/96). No evidence has been provided to show that the Taxpayer's services to the Corporation were related to the rental licensing income.
Finally, you contend that Virginia's taxation of the income derived from the Corporation constitutes double taxation that violates the nature of the tax treaty between the United States and Canada. This is because Canada and a Canadian province have already taxed this income. Article II(2)(b) of the Convention Between the United States of America and Canada With Respect to Taxes on Income and on Capital (the "Convention"), prior to the Protocol signed March 17, 1995, stated in pertinent part:
- The existing taxes to which the Convention shall apply are . . . in the case of the United States, the Federal income taxes imposed by the Internal Revenue Code. (Emphasis added.)
Pursuant to this article, the Convention applies only to certain taxes imposed at the federal level by the U.S. and Canadian national governments. Taxes imposed by provincial and state governments, including Virginia, are unaffected by the Convention. See P.D. 96-228 (9/9/96). It is also a long established policy that the risk of double taxation does not invalidate a taxing sovereignty's right to tax. See Guaranty Trust Co. of New York v. Commonwealth of Virginia, 305 U.S. 19, 59 S. Ct. 1 (1938).
Accordingly, the additional income tax and interest assessments for the 1997 and 1998 taxable years are upheld. Please remit payment of the tax and updated interest pursuant to the enclosed schedule to * * * at the Office of Tax Policy. Virginia Department of Taxation, P.O. Box 1880, Richmond, Virginia 23218-1880 within 30 days to avoid the accrual of additional interest. If you have any questions regarding this determination, you may contact * * * at * * *
Danny M. Payne
Tax Commissioner