Tax Type
Corporation Income Tax
Description
Capital gain and interest income as a nonapportionable income
Topic
Appropriateness of Audit Methodology
Date Issued
10-06-2002
October 6, 2002
Re: § 58.1-1821 Application: Corporate Income Tax
Dear *****:
This will reply to your letter in which you seek correction of the corporate income tax assessments issued to ***** (the "Taxpayer") for the taxable years ended July 26, 1997 and July 25, 1998. I apologize for the delay in the department's response.
FACTS
The Taxpayer sold its interest in another company ("Company A") in the 1997 taxable year and reported the capital gain as a nonapportionable income subtraction from federal taxable income. In addition, the Taxpayer subtracted certain interest income as nonapportionable income.
Under audit, the department disallowed the subtractions for the capital gain and interest income and assessed additional corporate income tax and interest. The Taxpayer appeals on the basis that both the capital gain and interest income are not apportionable 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 58.1-403, less dividends allocable pursuant to Code of Virginia § 58.1-407, is subject to apportionment. The Taxpayer's subtraction of the capital gain has been treated as a request for an alternative method of allocation and apportionment in accordance with Code of Virginia § 58.1-421. The department will not allow the allocation of capital gains or losses resulting from the sale of affiliated companies by a taxpayer if a unitary relationship exists between the affiliated companies and the taxpayer, or if the taxpayer's ownership of the affiliates fulfills an operational, as opposed to a passive, function.
In considering the existence of a unitary relationship, the United States 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. Of N.M., 458 U.S. 354 (1982); and Allied-Signal, Inc. v. Director, Div. of Taxation, 504 U.S. 768 (1992)).
Further, the decision of the United States Supreme Court in Allied-Signal 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 tests are fact sensitive.
Company A
The Taxpayer and Company A share no services, processes or employees. The Taxpayer owned less than a ten percent share in Company A. The Taxpayer and Company A shared no directors or employees. No board members of either company served on the respective board of the other company. The Taxpayer and Company A did not share any facilities, purchases or supplies, nor did they integrate any employee benefits. The evidence indicates that there was no functional integration, centralization of management or economies of scale between the Taxpayer and Company A. As such, there was no unitary relationship.
Further, the Taxpayer owned less than 10% of Company A and did not exert any control over Company A. In addition, the Taxpayer's operations did not benefit from or change as a result of the investment. As such, the department finds that the Taxpayer's ownership interest in Company A did not serve an operational function. Accordingly, the Taxpayer will be permitted an alternative method of allocation for the gains on the sale of its interest in Company A.
Interest Income
The Taxpayer has significant cash and cash equivalents from which it earns interest income. The cash and equivalents are classified into three main categories: restricted cash, nonrestricted cash managed internally, and nonrestricted cash managed externally. For the taxable years at issue, the Taxpayer classified the interest income from the externally managed cash and a portion of the interest earned on the internally managed nonrestricted cash as nonapportionable income and subtracted these amounts in determining Virginia taxable income.
In this case, the assessment is not based upon an assertion that the Taxpayer and any of the payers of the interest have a unitary relationship. The relevant question, therefore, is whether the income from the cash fulfilled an investment or operational function.
The internally managed nonrestricted cash is available when needed as working capital. The Taxpayer concedes that income generated from working capital is operational in nature and subject to apportionment. The Taxpayer asserts that cash included in this category exceeds the working capital needs of the Taxpayer. As such, the Taxpayer contends that income generated from cash that exceeds its working capital needs does not serve an operational function and should be allocated to its state of commercial domicile.
Externally managed nonrestricted cash accounts are accounts that are managed by unrelated financial services corporations. The Taxpayer contends that none of the interest generated by externally managed nonrestricted cash is operational in nature.
In defense of its position, the Taxpayer has cited Public Document (P.D.) 98-63, (3/25/98). In this ruling, the department granted an alternative method of allocation in a case where the taxpayer reported no long-term debt, cash and accounts receivable sufficient to cover total current liabilities, significant increases in cash provided by operating activities, and investment in fixed assets financed by operations.
The Taxpayer's facts closely resemble those of the taxpayer in P.D. 98-63. In fact, the Taxpayer had no long-term debt during the taxable years at issue. Cash and accounts receivable at the conclusion of taxable years ended July 26, 1997 and July 25, 1998, were sufficient to cover total current liabilities. Cash provided by operating activities was significantly positive during the audit period. The Taxpayer's investment in fixed assets was financed by operations and the financial statements showed increasing revenues and operating income.
On the other hand, the internally managed nonrestricted cash includes both working capital and funds that are invested. In applying the operational function test, it is clear that cash investments from the internally managed nonrestricted cash were functionally integrated with the Taxpayer's working capital. In addition, the facts indicate that the nonrestricted cash managed internally was centrally managed by the Taxpayer's personnel. It is also likely that the Taxpayer benefited from some economies of scale from this centralized management of the internally managed nonrestricted cash.
In order to determine the amount of cash that is considered to be working capital, the Taxpayer's management has estimated the working capital requirements to be equal to two months of recurring, qualifying expenses. Qualifying expenses equal cost of goods sold and total operating expenses, less purchased research and development.
The Taxpayer's determination of its working capital needs is an estimate. Clearly, the liquid nature of cash and cash equivalents can be used for operational purposes if there are unexpected business setbacks or a downturn in the economy. Absent a clear and objective demonstration of the Taxpayer's operational working capital requirements, it is difficult to determine how much, if any, of the Taxpayer's cash fund could be fairly characterized as a passive investment.
Instead, the Taxpayer would need to show that there were, in fact, two separate classes of cash within the nonrestricted cash managed internally category used for different functions. The Taxpayer bears the burden of showing the existence of separate classes of cash, the exact amount of each class, and the income earned from each class. In addition, the Taxpayer would need to show that the investment use of the cash neither provided nor received any benefit from the operational use of the same cash.
In addition, the taxpayer in P.D. 98-63 segregated its investment into midterm municipal securities. As such, the amount of the actual investment income in P.D. 98-63 could be easily determined. The Taxpayer's externally managed cash is segregated in a like manner. Accordingly, the Taxpayer will be permitted an alternative method of allocation with regard to the externally managed cash.
In summary, the department will grant permission to allocate the capital gain from the sale of Company A's stock and the interest income from nonrestricted externally managed cash, but not the interest income from nonrestricted internally managed cash. This determination is limited to the activities described herein for the taxable years ended July 26, 1997 and July 25, 1998, and will not be considered as pertaining to any other taxable year or transaction.
The assessments for the taxable years ended July 26, 1997 and July 25, 1998, have been adjusted according to the enclosed schedules. Please remit payment to the Virginia Department of Taxation, Office of Policy and Administration, Appeals and Rulings, P.O. Box 1880, Richmond, Virginia 23218. Payment must be received within 30 days of the date of this letter to avoid the accrual of additional interest.
If you have any questions regarding this determination, you may contact ***** at *****.
Sincerely,
Kenneth W. Thorson
Tax Commissioner
Rulings of the Tax Commissioner