Tax Type
Corporation Income Tax
Description
Correction of the corporate income tax assessments
Topic
Accounting Periods and Methods
Appropriateness of Audit Methodology
Returns and Payments
Subtractions and Exclusions
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 assessments issued to ***** (the "Taxpayer") and its subsidiaries for the taxable years ended December 31, 1996 and 1997. I apologize for the delay in the department's response.
FACTS
The Taxpayer and its subsidiaries were audited for the 1996 and 1997 taxable years, and numerous adjustments were made resulting in an assessment of additional corporation income tax. The Taxpayer has contested a number of items, each of which will be addressed separately below.
DETERMINATION
Property Factor - Inventory
The Taxpayer maintained inventory on a first-in first-out ("FIFO") basis for accounting purposes. However, it reports inventory on a last-in last-out ("LIFO") basis for federal income tax purposes. In determining its property factor, the Taxpayer reported inventory for both the numerator and the denominator on a FIFO basis.
The auditor reduced inventory in the denominator of the property factor to reflect the LIFO valuation to match the value used on the federal income tax return but was provided no information concerning Virginia inventory under the LIFO method.
The Taxpayer contends that the Virginia inventories should be adjusted to reflect LIFO value so that inventories within Virginia and inventories everywhere are on a comparable basis.
Pursuant to Title 23 of the Virginia Administrative Code ("VAC") 10-120-170(B)(2), the inventories included in the property factor must be valued in accordance with the valuation method used on the federal income tax return. Therefore, the auditor correctly adjusted the denominator to reflect the LIFO inventory valuation. Although the numerator of the property factor should have been adjusted to reflect the LIFO method at the time of the audit, information as to the LIFO value of the inventory was not provided, resulting in no adjustment of the inventory in Virginia. The Taxpayer has now provided information showing the LIFO value of inventory in Virginia for the taxable years at issue. The audit has been adjusted accordingly.
Property Factor - Merger
A wholly-owned subsidiary ("Company A") was merged into the Taxpayer on January 1, 1997. Company A's assets from the beginning of the year were excluded from the computation of the Taxpayer's denominator because they were not included in the Taxpayer's beginning balances reported on its federal income tax return. The Taxpayer contends that Company A's assets and inventory should be included in the beginning property figures because the merger was effective January 1, 1997, and the assets were inadvertently left out of the Taxpayer's beginning balances.
Assets included in the property factor must be valued in accordance with the valuation method used on the federal income tax return. Pursuant to the federal return, the Taxpayer owned all of Company A's assets as of January 1, 1997. As such, Company A's real and tangible personal property should be included in the beginning value of the Taxpayer's calculation of its property factor denominator.
Allocable Income
For the taxable years at issue, the Taxpayer subtracted gains from the sale of an investment in a Limited Partnership (the "LP"). At the time of the audit, the department disallowed the subtraction because it was unable to make a determination as to whether the Taxpayer's relationship with the LP meets the standards for allowing for the allocation of otherwise apportionable income enunciated by the United States Supreme court in Allied-Signal, Inc. v. Director, Division of Taxation, 112 S.Ct. 2251 (1992). The Taxpayer contends that its investment in the LP was a passive investment unrelated to any operational activities, and no unitary relationship existed between the Taxpayer and the LP.
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 department has treated the Taxpayer's amended returns as a request for an alternative method of allocation and apportionment pursuant to Code of Virginia § 58.1-421.
In any proceeding with the department, the taxpayer must show that the imposition of Virginia's statute is in violation of the standards enunciated by the U.S. Supreme court in Allied-Signal. 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. of N.M., 458 U.S., 352 (1982); and Allied-Signal.)
With regard to the LP, the Taxpayer has presented complete and clear evidence regarding these factors. There was no functional integration, centralized management, or economies of scale between the Taxpayer and the LP. As such, the Taxpayer and the LP are not engaged in unitary business.
In the instant case, the Taxpayer and the LP shared no functions. The Taxpayer did not exert any control over the LP. The Taxpayer was a limited partner and owned less than 10% of the LP. The Taxpayer is the manufacturer of tangible personal property. The LP was a venture capital firm. In this case, the Taxpayer's ownership interest in the LP did not serve an operational function. Accordingly, the Taxpayer will be permitted an alternative method of allocation for the gains on the sales of its interest in the LP.
Foreign Source Income Subtraction
The auditor disallowed a foreign source income subtraction taken by the Taxpayer for rents received by two of the Taxpayer's subsidiaries, ("Company B" and "Company C") from property located outside the United States. The rent income was disqualified because it was generated from the lease of tangible personal property. The Taxpayer contends that these rents constitute foreign source income as defined by statute.
Code of Virginia § 58.1-302 defines foreign source income, in pertinent part, as:
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- Rents, royalties, license, and technical fees from property located or services performed without the United States or from any interest in such property, including rents, royalties, or fees for the use of or the privilege of using without the United States any patents, copyrights, secret processes and formulas, good will, trademarks, trade brands, franchises, and other like properties.
Title 23 VAC 10-120-20(3)(a) defines foreign source income as interest, dividends, rents, royalties, license and technical fees and gains, profits and other income from the sale of intangible or real property. A review of the evidence provided indicates that the contested portion of the foreign source income subtractions claimed by Companies B and C are for rental income derived from leasing real estate and cargo ships. Under Virginia law, rent derived from the leasing of real property or tangible personal property located without the United States is foreign source income that is subject to the subtraction.
Based on the foregoing, the assessments for the 1996 and 1997 taxable years have been adjusted according to the enclosed schedules. A refund with applicable interest will be issued as soon as possible.
The Code of Virginia and regulation section cited, along with other reference 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 ***** in the Office of Policy and Administration, Appeals and Rulings, at *****.
Sincerely,
Danny M. Payne
Tax Commissioner
AR/36011B
Rulings of the Tax Commissioner