Tax Type
Corporation Income Tax
Description
Capital gain from the sale of different entities; computing net operating losses.
Topic
Accounting Periods and Methods
Computation of Tax
Penalties and Interest
Date Issued
05-02-2002
May 2, 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 assessment issued to ***** (the "Taxpayer") for the taxable year ended December 31, 1994. I apologize for the delay in the department's response.
FACTS
In 1994, the Taxpayer sold its interest in an electronic publishing company ("Company A"). The Taxpayer also divested itself of a financial information provider ("Company B") and discontinued the operation of a reinsurance company ("Company C"). For state income tax purposes, the Taxpayer allocated the capital gain from the sale of Company A, as offset by the capital losses attributable to the disposition of Company B and Company C, to its state of commercial domicile.
The department's auditor disallowed the subtraction asserting that the net gain on the disposition of the three companies was operational in nature. The Taxpayer contends that there is no unitary relationship with any of the companies at issue and that the acquisition and disposition of the stock was purely an investment decision.
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 investment, function.
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. Of N.M., 458 U.S., 352 (1982); and Allied-Signal, Inc. v. Director. Div. of Taxation, 112 S. Ct. 2251 (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 is a large manufacturing corporation headquartered outside Virginia. In 1968, the Taxpayer purchased Company A. Company A was a subsidiary of the Taxpayer until 1981, when it was merged into the Taxpayer and operated as a division. In 1985, the Taxpayer divested the division and Company A once more became a wholly-owned subsidiary of the Taxpayer.
There is little evidence to show that the Taxpayer and Company A were functionally integrated. Although there was a flow of goods between the two corporations, the Taxpayer and Company A were in different lines of business and their operations were not interdependent. However, the Taxpayer and Company A had integrated a number of administrative functions. These included accounting, finance, and personnel functions. Consequently, the department finds that the Taxpayer and Company A were not functionally integrated with the exception of some shared administrative functions.
The information provided does indicate significant centralization of management by the Taxpayer. The chief executive officer ("CEO") of the Taxpayer was also the CEO and a director of Company A. One of the vice presidents of the Taxpayer was also a director of Company A. In addition, three other members of the Taxpayer's management were officers in Company A. The overlapping officers of the Taxpayer and Company A were involved in finance and tax decisions, both of which are important operational aspects of a business. These activities indicate that the Taxpayer played an active role in managing the operations of Company A.
The Taxpayer also required Company A to submit monthly budget reports and plans. Company A was required to get approval from the Taxpayer's board for any capital expenditures greater than $5 million. These requirements indicate that the Taxpayer had exercised significant control over Company A. As such, there is sufficient evidence to show that Company A was centrally managed by the Taxpayer.
Company A and the Taxpayer also attained considerable economies of scale in a number of operating expenditures through shared service agreements for tax, treasury, risk management and computer functions. Company A contracted with the Taxpayer through a shared service arrangement for financial advice. In addition, Company A was provided general ledger, e-mail, accounts payable, and payroll services though the Taxpayer's mainframe computer. The employees of the Taxpayer and Company A had common welfare benefits, medical and worker's compensation plans and similar bonus/incentive structures. Accordingly, the Taxpayer and Company A achieved economies of scale in a number of operating functions.
Based on the information provided, the relationship between the Taxpayer and Company A indicates a significant degree of centralized management and benefits attained through economies of scale. Accordingly, I find that the Taxpayer had a unitary relationship with Company A.
In addition, it is clear that the Taxpayer and Company A had a long and successful relationship. Because of the involvement of the Taxpayer in Company A's management and the economies of scale achieved through the partnership of a number of administrative functions, the Taxpayer's operations were significantly affected by its relationship with Company A. Therefore, I find that the Taxpayer's investment in Company A served an operational function. Accordingly, the gain on the sale of stock of Company A was properly included in apportionable income by the auditor.
Company B
Code of Virginia § 58.1-421 prohibits the department from granting an alternative method that would result in an increase to the tax due. See Public Document ("P.D.") 97-285 (6/25/97). The Taxpayer claimed a loss on the sale of the stock of Company B. In this case, the allocation of the loss from the sale of Company B's stock would create an increase in the Taxpayer's Virginia tax liability. As such, the department cannot allow the allocation of the net capital loss from the sale of Company B.
Company C
In the late 1980s, the Taxpayer sold Company C to a wholly owned foreign subsidiary holding company ("Holding") and incurred a loss. Because the Taxpayer, Holding and Company C filed as part of a consolidated group, the capital loss on the Taxpayer's sale of Company C was deferred pursuant to federal regulations until Company C left the group in 1994. When Holding sold Company C to an unrelated third party in 1994, the Taxpayer recognized the capital loss for federal income tax purposes.
The computation of Virginia taxable income begins with federal taxable income. Therefore, Virginia relies on the amount and character of each item reported on the federal return. However, it is recognized that intercompany charges do not affect the consolidated federal taxable income and federal tax liability. When a taxpayer asserts that an item must be treated differently for Virginia purposes than it was on a federal return, the taxpayer must clearly show that this adjustment is justified. In addition, the taxpayer must show that the alternative treatment does not affect the amount or characterization of any item of federal taxable income.
The Taxpayer is a member of a Virginia affiliated group that filed a combined Virginia corporate return. Holding and Company C were not members of the Virginia affiliated group. Title 23 of the Virginia Administrative Code ("VAC") 10-120-320 provides that if an affiliated group of companies files a combined return, then each member of the group will compute its federal taxable income as though each member of the group filed separate federal returns. When the Taxpayer's income is computed as if separate federal returns were filed, the capital loss would have been reported from the sale of Company C in the late 1980s when the sale was made to Holding. Therefore, the loss from the sale of Company C must be removed in order to determine the Taxpayer's separate federal taxable income for 1994.
Accordingly, the Taxpayer was correct in making an adjustment to remove the capital loss from the sale of Company C in determining Virginia taxable income. It should be noted that such an adjustment on the Virginia return is not an "addition" or "subtraction" to federal taxable income as those terms are used in Code of Virginia § 58.1-402. Technically the loss on the sale of Company C is an adjustment to reconcile federal taxable income for Virginia purposes to federal taxable income actually reported to the Internal Revenue Service. The audit assessment will be adjusted to reflect the reconciliation between federal consolidated income and separate income for Virginia purposes.
Net Operating Losses
Virginia income tax laws do not address net operating loss deductions ("NOLD's"). However, because the starting point in computing Virginia taxable income is federal taxable income, Virginia allows NOLD's to the extent that they are allowable in computing federal taxable income.
During the course of the review of the Taxpayer's appeal, the department became aware that the Taxpayer had been incorrectly computing net operating losses for Virginia income tax purposes. The department has recalculated the net operating losses for Virginia pursuant to the enclosed schedules.
A schedule that calculates the Taxpayer's Virginia income tax liability is enclosed. Please remit 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, 23218-1880 Attention:*****. Payment must be made within 30 days to avoid the accrual of additional interest.
Copies of the Code of Virginia, regulations and public documents cited 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,
Danny M. Payne
Tax Commissioner
AR/20197B
Rulings of the Tax Commissioner