Tax Type
Corporation Income Tax
Description
Manufacturing operations and assessments
Topic
Appropriateness of Audit Methodology
Penalties and Interest
Date Issued
07-01-2002
July 1, 2002
Re: § 58.1-1821 Application: Corporate Income Tax
Dear *****:
This will respond to your letter in which you seek correction of the corporate income tax assessments issued to ***** (the "Taxpayer") for the taxable years ended March 31, 1997 and March 31, 1998. I apologize for the delay in the department's response.
FACTS
The Taxpayer manufactures, sells and services manufacturing equipment. Prior to 1997, the Taxpayer held a 30% interest in an unrelated corporation ("Corporation A") and a 16% interest in another unrelated corporation ("Corporation B"). Corporation A was in the business of purchasing and reselling equipment manufactured by the Taxpayer. Corporation B used the Taxpayer's equipment in its manufacturing operations.
During the 1997 taxable year, the Taxpayer sold its 30% interest in Corporation A and a portion of its interest in Corporation B to unrelated third parties. The remaining interest in Corporation B was sold during the 1998 taxable year. On its Virginia Corporate Income Tax Return for each of those years, the Taxpayer subtracted the gains from these sales as nonbusiness income on the basis that the Taxpayer did not have a unitary relationship with either Corporation A or Corporation B. The department disallowed the subtractions and issued assessments. The Taxpayer contests the assessments claiming the subtractions are nonbusiness income.
DETERMINATION
The Code of Virginia does not provide for the allocation of income other than certain dividends. Accordingly, a taxpayer's entire federal taxable income, adjusted and modified as provided in Code of Virginia §§ 58.1-402 and 58.1-4.03, less dividends allocable pursuant to Code of Virginia § 58.1-407, is subject to apportionment. The Taxpayer's subtraction of the nonbusiness income has been treated as a request for an alternative method of allocation and apportionment in accordance with Code of Virginia § 58.1-421.
In any proceeding with the department, the Taxpayer must bear the burden of showing that the imposition of Virginia's statute is in violation of the standards enunciated by the United States Supreme Court in Allied-Signal, Inc. v. Director. Division of Taxation, 504 U.S.768 (1992). In this matter, the Taxpayer must demonstrate that its investments are not operational assets involved in a unitary business. In considering the existence of a unitary relationship, the Supreme Court has focused on three objective factors: (1) functional integration, (2) centralization of management, and (3) economies of scale. (See Mobil Oil Corp. v Commissioner of Taxes, 445 U.S. 425 (1980); F. W. Woolworth Co. v. Taxation and Revenue Dept., 458 U.S. 354 (1982); and Allied-Signal.)
The decision of the U. S. Supreme Court in Allied-Signal also made it clear that the payee and payor need not be engaged in the same unitary business as a prerequisite to apportionment in all cases. In the absence of a unitary relationship, apportionment is permitted when the investment serves an operational rather than a passive investment function. The Court also made it clear that the test is fact sensitive.
Corporation A
In regard to the unitary business principle, the Taxpayer has presented clear evidence regarding its relationship with Corporation A. The Taxpayer placed a number of directors on Corporation A's board and Corporation A purchased a significant amount of the Taxpayer's products. However, an analysis of all the evidence demonstrates that the operations of the two businesses were not functionally integrated, were not centrally managed, and did not benefit from economies of scale. Based on the information provided, the Taxpayer and Corporation A were not engaged in a unitary business.
The question, therefore, is whether the income arises from an operational function. In this case, the Taxpayer has indicated that the purpose of the Taxpayer's investment was to gain entry into new foreign markets. As a result of the investment, Corporation A began selling the Taxpayer's products in these foreign markets. In fact, Corporation A's operations became heavily dependent on its relationship with the Taxpayer. As much as 40% of Corporation A's purchases were from the Taxpayer. In addition, Corporation A used its relationship with the Taxpayer and the Taxpayer's trademarks to sell the Taxpayer's products. Based on these facts, the department finds that the Taxpayer's investment in Corporation A served an operational purpose. Accordingly, permission to use an alternative method of allocation and apportionment cannot be granted for the income derived from the gain resulting from the sale of Corporation A's stock. In addition, the sales factor has been adjusted to include the net gain attributable to this gain in the denominator.
Corporation B
As with Corporation A, it is clear from the evidence provided that no unitary relationship existed between the Taxpayer and Corporation B. As such, the determining issue for this investment centers upon whether the Taxpayer's 16% ownership interest in Corporation B fulfilled an operational function rather than a passive investment function.
In examining the functional aspects of the investment, the department considered the evidence provided. Unlike the investment in Corporation A, the investment in Corporation B did not result in changes in the Taxpayer's operations. No integration of businesses occurred between the Taxpayer and Corporation, no economies were achieved, and the Taxpayer was not involved in the management of Corporation B.
In light of the evidence provided, it is clear that the Taxpayer did not use its own operational activities to enhance the value of its stock investment in Corporation B, nor did the ownership interest in Corporation B enhance the operational activities of the Taxpayer. Accordingly, the department finds that the Taxpayer has demonstrated that an alternative method of allocation and apportionment is appropriate for the gain recognized on the sale of the Corporation B stock. As such, allocation of the gain resulting from the sale of Corporation B stock out of Virginia apportionable income will be permitted.
Summary
The assessments of corporate income tax and interest for the taxable years ended March 31, 1997 and March 31, 1998 have been adjusted, as reflected on the enclosed schedules. Please remit payment of the tax and interest due to the Virginia Department of Taxation, Office of Policy and Administration, Appeals and Rulings, P.O. Box 1880, Richmond, Virginia 23218, Attention:*****. Payment should be made within 30 days of the date of this letter to avoid the accrual of additional interest.
Copies of the Code sections cited and other public documents are available online in the Tax Policy Library section of the Department of Taxation's web site, located at www.tax.state.va.us. If you have any questions regarding this determination, you may contact ***** at *****.
Sincerely,
Kenneth W. Thorson
Tax Commissioner
AR/27618B
Rulings of the Tax Commissioner