Document Number
03-28
Tax Type
Corporation Income Tax
Description
Combined Virginia corporate income tax return
Topic
Appropriateness of Audit Methodology
Penalties and Interest
Date Issued
04-01-2003
April 1, 2003


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 December 31, 1993 through 1995.
FACTS

The Taxpayer and its four subsidiaries, ***** ("Company A"), ***** ("Company B"), ***** ("Company C"), and ***** ("Company D"), filed a combined Virginia corporate income tax return for the taxable years at issue. Pursuant to an audit, numerous adjustments to the returns were made, resulting in the assessment of additional tax and interest. You have contested a number of adjustments, which will be addressed separately.
DETERMINATION

Interest Addition

The auditor made an addition for interest to the Taxpayer's foreign source income subtraction for the 1993 taxable year. The Taxpayer contends that no such interest was received during the 1993 taxable year. A review of the audit clearly indicates that the Taxpayer included all interest reported in federal taxable income in determining its Virginia taxable income. Therefore, this adjustment will be removed from the audit.

Foreign Source Income -Technical Fees

The Taxpayer contends that the auditor' disallowed certain income from the foreign source income subtraction for the 1993 taxable year that the Taxpayer classified as technical fees.
    • Va. Code § 58.1-302 defines "foreign source income" and includes:
    • 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.

The words "technical fees from . . . services performed" cannot be taken out of their context to create a subtraction for income earned from the performance outside the United States of any service which can be characterized as technical in nature. The words are incorporated in a subsection dealing with passive income from the rental of real estate and with income from patents, copyrights and other intangible property. See Public Document ("P.D.") 86-209 (11/3/86).

The Department has reviewed the technical fee contracts furnished by the Taxpayer. The contracts provide that the Taxpayer supply technical information and patents to third parties to manufacture certain equipment and to allow the third party to use the Taxpayer's trademarks on the manufactured equipment. The Taxpayer would provide personnel to assist the purchaser in manufacturing the equipment and would provide training to the purchaser's personnel. The purpose of the technical fee contracts was to provide sufficient technical information for the purchaser to manufacture equipment. Services performed by the Taxpayer's employees to implement the contract were used to aid the purchaser in manufacturing the equipment. As such, the services provided by the Taxpayer's employees are incidental to the transfer of the technical information. Based on this information, the technical fees will be included as foreign source income.

Foreign Source Income - Dividends

The Taxpayer and Company A received foreign source dividends from corporations in which the Taxpayer or Company A owned 50% or more of the voting stock for the 1993 through 1995 taxable years. The Department included these dividends in foreign source income eligible for a subtraction pursuant to Va. Code § 58.1-402(C)(8). The Taxpayer contends that because these dividends are eligible for a subtraction under Va. Code § 58.1-402(C)(10), they should not be included in foreign source income subtraction.

The Department has previously ruled in P.D. 93-152 (7/23/93) that when dividends are subject to a separate subtraction, they are not required to be included in the foreign source income subtraction. Expenses related to these dividends are calculated in the same manner as other foreign source income. See P.D. 94-24 (2/18/94). Accordingly, the foreign dividends received from 50% or more owned corporations net of related expenses will be allowed as a separate subtraction.

Foreign Source Income - Related Expenses

In computing the related expenses for the foreign source income subtractions of the Taxpayer, Company A, Company B, Company C and Company D, the auditor included "other definitely allocable expenses" reported on Form 1118. The Taxpayer contends that these expenses were allocated to foreign income derived under Internal Revenue Code ("IRC") § 863(b), which does not qualify for the foreign source income subtraction.

It has been the Department's long-standing policy that the computation of the Virginia foreign source income subtraction (considering expenses related to the income) be determined in accordance with IRC §§ 861 through 863. See P.D. 86-154 (8/14/86). Virginia law requires the use of the federal sourcing rules of IRC § 861 et seq., whether or not the taxpayer believes that certain expenses have any connection to income from foreign sources and regardless of what expenses would be under generally accepted accounting principles.

The provisions of IRC § 861 et seq. contain elaborate detail on assigning income and deductions to particular sources. The provisions differentiate between deductions that are definitely allocable and expenses, which are not definitely allocable. First, definitely allocable deductions that are directly related to a class of income are allocated and then apportioned between foreign and domestic source income. If a deduction is not definitely related to any gross income, the deduction must be apportioned ratably between each class of foreign and domestic source income.

The purpose of Form 1118 is to compute the limitation on the amount of foreign taxes that can be claimed as a credit against federal tax liability. When the procedures of the IRC § 861 et seq. are used to complete Form 1118, the information reported on this form is considered useful and presumed correct and accurate.

On Form 1118, definitely allocable deductions are reported as directly related to rental, royalty, and licensing expenses, expenses related to income from services, and other definitely allocable deductions. These "other definitely allocable deductions" would include expenses directly related to dividends, interest, and other income reported on the Form 1118. The other definitely allocable deductions are generally related ratably to foreign source dividends, interest, and other income unless a taxpayer can show to which classification of income the expenses are directly related.

Under audit, the Department ratably apportioned the other definitely allocable deductions along with not definitely allocable deductions in accordance with the method set forth in P.D. 91-229 (9/30/91). The Taxpayer contends that all of the other definitely allocable deductions were directly related to income under IRC § 863(b), which is not one of the types of foreign source income specified in Va. Code § 58.1-302. See P.D. 86-154 (8/14/86).

To support its contention, the Taxpayer has provided evidence demonstrating that the expenses are definitely related to the IRC § 863(b) income. In addition, the Taxpayer has provided additional information with regard to the not definitely allocable deductions for Company A, Company B, Company C, and Company D for the taxable years at issue. Adjustments have been made pursuant to this additional information and the Form 1118 information attached to the pro forma returns.

Property Factor Denominator - LIFO

For the 1994 taxable year, the Taxpayer, Company A, Company B, and Company C reported inventory on a last-in first-out ("LIFO") basis for federal income tax purposes. However, in determining the property factor, inventory for both the numerator and the denominator was reported using the book 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 values 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 at the time of the audit, resulting in no adjustment of the inventory attributed to Virginia. No information has been provided that shows the LIFO value of inventory in Virginia for the Taxpayer, Company A, Company B, and Company C for the 1994 taxable year. Therefore, the auditor's adjustments are upheld.

Property Factor - Numerator Error

The Taxpayer states that the auditor erroneously used Company C's rent expense from another state in the numerator of the property factor for the 1994 taxable years. A review of the documentation provided indicates that the Taxpayer is correct. Company C's property factor has been adjusted accordingly.

Property Factor - Construction in Progress

The Taxpayer contends that the auditor adjusted the numerator and denominator of the Virginia property factor for Company B and Company D for the 1995 taxable year to include construction in progress. Under 23 VAC 10-120-160(A)(4)(b), property under construction during the taxable year in question must be excluded from the property factor until it is actually used. A review of the audit work papers indicates that construction in progress was removed from the property factor by the auditor. Therefore, no additional adjustment is needed.

Conclusion

The assessments of corporate income tax and interest for the taxable years ended December 31, 1993 through 1995 have been adjusted, as reflected on the enclosed schedules. A refund with the appropriate interest will be issued as soon as possible. Copies of the Code of Virginia sections, regulations and public documents cited, as well as other reference documents, are available online in the Tax Policy Library section of the Department'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,

                • Kenneth W. Thorson
                  Tax Commissioner




AR/29234B

Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46