Document Number
03-60
Tax Type
Corporation Income Tax
Description
Contested Corporate Audit
Topic
Accounting Periods and Methods
Allocation and Apportionment
Appropriateness of Audit Methodology
Computation of Tax
Corporate Distributions and Adjustments
Date Issued
08-08-2003

August 8, 2003


Re: § 58.1-1821 Application: Corporate Income Tax

Dear *****:

This will reply to the letter in which you seek correction of the corporation income tax assessments issued to***** (the "Taxpayer") and affiliates for taxable years ended June 30, 1992 and 1993. I apologize for the delay in responding to your letter.
FACTS

The Taxpayer and its affiliates were audited for the taxable years ended June 30, 1992 and 1993, and numerous adjustments were made resulting in an assessment of additional corporate income tax. The Taxpayer is contesting numerous adjustments made to the returns of the Taxpayer and four of its affiliates (A, B, C and D). Each of the contested items will be addressed separately.
DETERMINATION

Filing Status

Title 23 of the Virginia Administrative Code ("VAC") 10-120-320 provides that in the first year two or more members of an affiliated group of corporations are required to file Virginia income tax returns, the group may elect to file separate returns, a consolidated return or a combined return. All returns for subsequent years must be filed on the same basis unless permission to change is granted by the Department. Absent extraordinary circumstances, permission to change to or from the consolidated filing method is generally not granted by the Department because this change can affect the allocation and apportionment factors and possibly distort the reporting of the portion of business conducted in Virginia.

The Taxpayer was a member of an affiliated group of corporations within the meaning of Va. Code § 58.1-302 prior to the taxable years ended June 30, 1992 and 1993. The Department's records indicate that the Taxpayer and its affiliates initially filed separate returns with the Department, thereby electing the separate filing status for all subsequent years. In accordance with 23 VAC 10-120-320, the members of the group must follow the filing method previously elected by the group.

For the taxable years at issue, the Taxpayer and its affiliates filed Virginia corporate income tax returns that were reported as combined, but were in fact consolidated. The Taxpayer and its affiliates filed these returns without requesting or receiving permission from the Department. Accordingly, the auditor was correct in disallowing the consolidated returns and recomputing each affiliate's taxable income separately.

Federal Audit Adjustments

For the taxable years at issue, the Taxpayer had been audited by the Internal Revenue Service ("IRS"). The Revenue Auditor's Report ("RAR") adjustments with which the Taxpayer agreed were included in the original Virginia audit report. Subsequent to the Virginia audit, the Taxpayer has received the final RAR from the IRS. The Virginia audit assessments have been adjusted accordingly.

Improper Reflection of Income

The auditor made an adjustment to consolidate the Taxpayer with two wholly-owned subsidiaries (IS and PS) pursuant to Va. Code § 58.1-446. The Taxpayer contends that this consolidation was improper because IS and PS have no operations in Virginia.

Code of Virginia § 58.1-446 provides, in pertinent part:
    • When any corporation liable to taxation under this chapter by agreement or otherwise conducts the business of such corporation in such manner as either directly or indirectly to benefit the members or stockholders of the corporation .... by either buying or selling its products or the goods or commodities in which it deals at more or less than a fair price which might be obtained therefor, or when such a corporation . . . acquires and disposes of the products, goods or commodities of another corporation in such manner as to create a loss or improper taxable income, and such other corporation . . . is controlled by the corporation liable to taxation under this chapter, the Department . . . may for the purpose determine the amount which shall be deemed to be the Virginia taxable income of the business of such corporation for the taxable year.
    • . . . In case it appears to the Department that any arrangements exist in such a manner as improperly to reflect the business done or the Virginia taxable income earned from business done in this Commonwealth, the Department may, in such manner as it may determine, equitably adjust the tax. (Emphasis added.)

Virginia Regulation (VR) § 630-3-446, effective for the taxable years at issue, provides in pertinent part:
    • Parent corporations and subsidiaries. When any corporation liable to taxation under this chapter owns or controls . . . another corporation the Department may require the corporation liable to taxation to make a report consolidated with such other corporation and furnish such other information as the Department may require. If the Department finds that any arrangements exist which cause the income from Virginia sources to be inaccurately stated then the Department may equitably adjust the tax of the corporation liable to taxation under this chapter. (Emphasis added.)
    • The conduct or manner in which business is conducted reached by this section is not restricted to the case of improper accounting, to the case of a fraudulent, colorable, or sham transaction or to the case of a device designed to reduce or avoid tax by shifting or distorting income, deductions, credits or allowances. The conduct may be legal or even encouraged by the laws of other jurisdictions, including laws of the United States. The determining factor is whether the conduct of taxpayer's affairs, by inadvertence or design, causes the income from Virginia sources to be inaccurately stated. (Emphasis added.)

The Virginia Supreme Court's opinion in Commonwealth v. General Electric Company, 236 Va. 54 (1988) upheld the Department's authority to equitably adjust the tax of a corporation pursuant to Va. Code § 58.1-446 (or its predecessor) where two commonly-owned corporations structure an arrangement in such a manner as to improperly, inaccurately, or incorrectly reflect the business done in Virginia or the Virginia taxable income. Generally, the Department will exercise its authority if it finds that a transaction, or a party to a transaction, lacks economic substance.

Income of Investment Subsidiary

IS was incorporated in Delaware for the purpose of holding all of the stock of a foreign sales corporation ("FSC"). IS receives all of the deemed dividends of the FSC. In turn, IS makes loans to the Taxpayer. IS has no physical location in Delaware and no employees. Its only annual deductions for the audit period consist of federal and state income taxes and a minute amount of miscellaneous expenses.

The assets of IS include some cash, the investment in the FSC, and a very large receivable due from the Taxpayer. IS had no liabilities during the audit period. Not coincidentally, the annual increase in the note receivable during the audit period almost mirrored IS's annual income. Based on the information provided, IS clearly lacks economic substance.

The Taxpayer contends that the transactions between IS and the Taxpayer are at prevailing interest rates. No evidence has been provided to support the contention that the loan transactions and accrued interest are conducted at arm's length. Inasmuch as the loans are not evidenced by a loan agreement, the Department presumes that the loans were not made pursuant to an arm's length arrangement.

The transactions (commissions and deemed dividends) between a FSC and affiliated corporations are generally little more than accounting entries that do not have to reflect the amount under arm's length pricing guidelines that are relaxed by federal statute. Traditionally, a FSC receives commissions from and transfers deemed dividends to the same affiliate. In this case, the FSC receives commissions on sales made by the Taxpayer, but IS receives the deemed dividends. Because the deemed dividends are merely accounting transfers, IS never actually receives any cash. As such, IS lacks the monetary assets with which to make any loans. Essentially, IS is making loans to the Taxpayer with currency that never left the Taxpayer's bank account. Further, no principal or interest payments were made to IS on the loans during the audit period. In light of these facts, the transactions themselves lack substance.

Therefore, to the extent that the intercompany loans between IS and the Taxpayer primarily reflect "paper" intercompany transactions, the facts fit that of Commonwealth v. General Electric and satisfy the Court's requirement of (1) an arrangement (2) between two commonly-owned corporations (3) in such a manner improperly, inaccurately, or incorrectly to reflect (4) the business done or the Virginia taxable income earned from business done in Virginia. Accordingly, the Department has determined that Virginia income would be correctly reflected by disallowing the Taxpayer's interest deduction related to the transactions between the Taxpayer and IS.

Consequently, I find that the auditor was incorrect in consolidating the taxable income of IS with the Taxpayer. The improper reflection of Virginia income was created by the intercompany transactions at issue. Accordingly, the Taxpayer's interest deduction resulting from its transactions with IS has been disallowed. The audit assessment has been adjusted accordingly.

Income of Patent Subsidiary

According to the Taxpayer, PS was acquired during the taxable year ended June 30, 1992, as a part of the purchase of a business segment from an unrelated third party. PS holds patents and processing rights developed by the unrelated third party for the manufacture of products produced by that business segment. Although the Taxpayer claims that PS incurs expenses to collect the royalties, PS has no physical location, no employees and no apparent means of collection. PS's only annual deductions during the audit period consist of federal and state income taxes and an amount of unidentified miscellaneous expenses.

It is unclear how PS is generating the royalty revenue on the patents. The information provided is silent as to whether the business segment became a subsidiary or division of the Taxpayer. The Taxpayer did not separately state any royalty deductions during the audit period. A large portion of the Taxpayer's other deductions is unidentified miscellaneous expenses. Even if the Department were to presume that another subsidiary of the Taxpayer is responsible for the royalties, these transactions are not evidenced by anything more than accounting entries.

PS does not appear to have a bank account and reported no cash balance on its balance sheet for the audit period. The only asset of PS is a note receivable. PS had no liabilities during the audit period. There is not even an amount for capital stock reported as equity. Not coincidentally, the annual increase in the note receivable during the audit period is exactly the same as PS's annual income. Based on the information provided, PS clearly lacks economic significance and the transactions themselves lack substance.

Further, the Taxpayer reported a significant increase in intangible assets during the taxable year ended June 30, 1992. It appears that the value of the patents is included in the intangibles of the Taxpayer and is not on the books of IS. This raises the question as to what entity actually owns the patents. The Taxpayer appears to be benefiting from an amortization deduction for the patents and either excluding or even deducting the royalties from income.

The Taxpayer has failed to provide any evidence as to the ownership of the patents, any evidence of arm's length agreements between PS and its licensees, or documentation as to the value of the patents and royalty rate. In addition, there is nothing in the information provided that would portray the balances on the accounts on the books of PS as anything other than mere paper transfers. Based on the information provided, the facts fit that of Commonwealth v. General Electric and satisfy the Court's requirement of (1) an arrangement (2) between two commonly-owned corporations (3) in such a manner to improperly, inaccurately, or incorrectly to reflect (4) the business done or the Virginia taxable income earned from business done in Virginia. Because of the lack of clarity of the relationship between the Taxpayer and PS, the Department has determined that consolidating PS with the Taxpayer would equitably reflect Virginia income. Accordingly, the auditor's adjustment is upheld.

Net Operating Loss Deductions

In general, Virginia income tax laws do not address Net Operating Loss Deductions ("NOLDs"). Because the starting point in computing Virginia taxable income is federal taxable income, Virginia allows NOLDs to the extent that they are allowable in computing federal taxable income.

For the taxable years at issue, the Internal Revenue Code ("IRC") § 172 specifies that a NOLD can be carried to the three taxable years prior to and the 15 taxable years subsequent to the taxable year in which the loss was incurred. Effective for NOLDs occurring in taxable years beginning on or after August 5, 1997, a NOLD can be carried to the two taxable years prior to and the 20 taxable years subsequent to the taxable year in which the loss was incurred.

Net Operating Loss Carryforwards of A

The Taxpayer claims the auditor did not incorporate the NOLDs carried forward from the taxable years June 30, 1989 and 1990, in the audit report for the taxable year ended June 30, 1992.

When federal and Virginia income tax returns are prepared on a different basis (federal returns are filed on a consolidated basis), federal taxable income must be computed for Virginia tax purposes as if the federal income tax return was filed on the same basis as the Virginia income tax return (including NOLDs). In computing federal taxable income for Virginia purposes, NOLDs are allowable only if, and to the extent that, they would be allowable on a separate federal income tax return for a corporation filing a separate Virginia income tax return.

The Taxpayer has provided a schedule detailing the NOLDs for the taxable years ended June 30, 1989 and 1990 and their treatment under federal separate return filing rules. The audit assessment has been adjusted accordingly.

Net Operating Loss Carryforwards of D

The Taxpayer requests an explanation of adjustments for the NOLD carried forward to the taxable year ended June 30, 1993, resulting from D's merger with A. This issue concerns the utilization of a NOLD carried forward from a corporation that has merged with a surviving corporation.

Because D files as part of a consolidated group for federal income tax purposes but separately for Virginia, federal taxable income must be computed for Virginia tax purposes as if a separate federal return was filed. D, as the survivor of the merger, will succeed to certain tax attributes of the merged corporations under IRC § 381. That is, any net operating loss deductions of the merged corporations will be available to the surviving corporation. Given the facts in this case, the auditor made an adjustment to use the separate company NOLDs of the merged companies for Virginia tax purposes. Because part of the NOLDs should have been used to offset the taxable year ended June 30, 1992, income of A, the NOLD carryforward and audit assessment have been adjusted in accordance with the attached schedules.

Net Operating Loss Carryforwards of the Taxpayer

The Taxpayer claims the auditor did not adjust its federal taxable income for the NOLD of a wholly owned subsidiary (S) for the taxable year ended June 30, 1992, that was merged with the Taxpayer in December 1991. This issue concerns the utilization of a NOLD carried forward from a corporation that has merged with a surviving corporation. The surviving corporation of a merger that files a separate federal income tax return will succeed to certain tax attributes of the merged corporations under IRC § 381 including any NOLDs of a merged corporation.

The separate proforma information provided at the time of the audit gives no indication of net operating loss incurred by S. The Taxpayer has now provided documentation of the merger between the Taxpayer and S and the net operating loss incurred by S for the taxable year ended June 30, 1992. Based on this additional information, the audit has been adjusted to allow a NOLD by the Taxpayer for Virginia tax purposes based on the federal limitation of the separate NOLD of S.

Virginia Adjustments to Federal Taxable Income

Addition for Taxes Based on Income

For the taxable years ended June 30, 1992 and 1993, the auditor adjusted the federal taxable income of the Taxpayer and D pursuant to a RAR. The Taxpayer contends that RAR adjustments to deductions for foreign income tax were not considered.

Virginia Code § 58.1-402 provides that the amount of income and other taxes that are based on, measured by, or computed with reference to net income are to be added back to federal taxable income in the computation of Virginia taxable income, but only to the extent those taxes were deducted in determining federal taxable income. Under audit, the IRS removed deductions for foreign income taxes. As a result of these RAR adjustments, foreign income taxes were no longer deductible in determining federal taxable income. Accordingly, an adjustment has been made to remove the foreign income taxes to the extent that they were added in computing the Virginia taxable income of the Taxpayer and D. The assessment has been adjusted accordingly.

Subpart F Income and Foreign Dividend Gross-up

The Taxpayer contends that RAR adjustments to the Subpart F income and foreign dividend gross-up of the Taxpayer and D were not considered when the auditor included the RAR corrections to federal taxable income in the audits of the Taxpayer and D.

Virginia Code § 58.1-402 provides subtractions from federal taxable income for amounts included pursuant to IRC § 78 (foreign dividend gross-up) and IRC § 951 (Subpart F income). The RARs include adjustments to increase Subpart F income and foreign dividend gross-up. Because the Code of Virginia allows a subtraction for these types of income, a corresponding adjustment has been made to the Subpart F income and foreign dividend gross-up subtractions of the Taxpayer and D. Accordingly, the audit assessments have been adjusted to allow subtractions for the Subpart F income and foreign dividend gross-up.

Interest from United States Obligations

The Taxpayer's subtraction for interest or dividends on obligations of the United States ("U. S.") for the taxable year ended June 30, 1992, was disallowed by the auditor. The Taxpayer questions why the auditor made this adjustment. In responding to the Department's inquiries, the Taxpayer has indicated that the deduction on its return resulted from interest on tax refunds resulting from IRS audits and look-back interest.

Virginia Code § 58.1-402(C)(1) provides that to the extent included in federal taxable income a deduction is allowed for:
    • Income derived from obligations, or on the sale or exchange of obligations, of the United States and on obligations or securities of any authority, commission or instrumentality of the United States to the extent exempt from state income taxes under the laws of the United States including, but not limited to, stocks, bonds, treasury bills, and treasury notes, but not including interest on refunds of federal taxes, interest on equipment purchase contracts, or interest on other normal business transactions. (Emphasis added.)

This Virginia statute codifies the exempt status of income from obligations of the United States as set forth in 31 U.S.C. § 3124(a). Exempt obligations of the United States have been held not to include federal tax refunds. See Glidden Company v. Glander, 86 N.E.2d 1 (Ohio 1949). This same treatment has been imposed on interest paid on federal tax refunds. American Viscose Corporation v. Commissioner of Internal Revenue, 56 F.2d 1033 (3rd Cir. 1932); Nichols v. Commissioner of Corporations and Taxation, 50 N.E.2d 76 (Mass. 1943). In addition, the U. S. Supreme Court adopted the American Viscose rule in the case of Commissioner of Internal Revenue v. Wodehouse, 337 U.S. 369 (1949) and noted that it extended to both domestic and foreign corporations. As such, the auditor was correct in removing the Taxpayer's deduction for interest on the tax refunds resulting from IRS audits and the look-back interest.

Foreign Source Income

The auditor disallowed the Taxpayer's foreign source income subtraction reported on the Virginia return for the taxable year ended June 30, 1993. The Taxpayer did not file a Form 1118 with the federal income tax returns for the 1993 taxable years and no documentation was provided to the auditor to show how expenses would be allocated to the foreign source income pursuant to IRC §§ 861, 862 and 863. You have contested this adjustment.

Many taxpayers, who claim a Virginia subtraction for foreign source income, will also claim a federal credit for income taxes paid to foreign countries: Thus, the Department considers federal Form 1118 an appropriate starting point to determine foreign source income and expenses. Virginia law, however, does not follow federal law in all respects regarding income from sources without the United States. The federal Form 1118 includes many types of income that do not qualify for the Virginia subtraction. Thus, the fact that a taxpayer does not complete a federal Form 1118 does not preclude the taxpayer from making a foreign source income subtraction, net of expenses pursuant to Treas. Reg. § 1.861-8 et. seq., on its Virginia income tax return.

Because no federal Form 1118 was filed, the Taxpayer must, upon request, provide information to document foreign source income and foreign source expenses allocated against foreign source income as required by 23 VAC 10-120-20. In responding to the Department's request, the Taxpayer has indicated that these foreign source royalties were "originally reported by" a subsidiary of the Taxpayer. From this information, it is unclear whether this royalty income is even included in the Taxpayer's federal taxable income reported on the Virginia return. Because the Taxpayer has failed to provide sufficient documentation to support this deduction, the auditor was correct in eliminating the foreign source income subtraction.

Nonbusiness Income

During the taxable years ended June 30, 1992 and 1993, the Taxpayer subtracted a number of items from federal taxable income, claiming that these items of income are nonapportionable nonbusiness income. The auditor disallowed this treatment for all such subtractions. The Taxpayer contests the Department's right to apportion and tax these items of income.

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 Virginia Code §§ 58.1-402 and 58.1-403, less dividends allocable pursuant to Virginia Code § 58.1-407, is subject to apportionment. The Taxpayer's protest has been treated as a request for an alternative method of allocation and apportionment in accordance with Virginia Code § 58.1-421.

In any proceeding relating to the interpretation of the tax laws of the Commonwealth of Virginia, the burden of proof is on the taxpayer. As such, the Taxpayer must prove by clear and cogent evidence that the imposition of Virginia's statute is a violation of the standards enunciated by the U. S. Supreme Court in Allied-Signal. Inc. v. Director, Division of Taxation, 504 U.S. 768 (1992). In Allied-Signal, the court stated:
    • The existence of a unitary relation between payee and payor is one justification for apportionment, but not the only one. Hence, for example, a state may include within the apportionable income of a nondomiciliary corporation the interest earned on short-term deposits in a bank located in another state if that income forms a part of the working capital of the corporation's unitary business, notwithstanding the absence of a unitary relationship between the corporation and the bank.
    • We agree that the payee and the payor need not be engaged in the same unitary business as a prerequisite to apportionment in all cases. Container Corp. says as much. What is required instead is that the capital transactions serve an operational rather than an investment function. Allied-Signal at 787.

The tests under Allied-Signal that define the limit of a state's authority to tax investment income such as capital gains focus on two issues: (1) the presence or absence of a unitary relationship; and (2) the distinction between a capital transaction that serves a passive investment function versus an operational 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.

Further, the decision of the U.S. 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 income results from an operational rather than a passive investment function. The Court also made it clear that the test is fact sensitive. Accordingly, the Taxpayer must do more than show that the payers are unrelated third parties.

Gain on Sale of Stocks

During the taxable years ended June 30, 1992 and 1993, the Taxpayer realized gains on sales of portions of its stock holdings in two unrelated corporations (E and F). The Taxpayer claimed a nonbusiness deduction on its Virginia income tax returns for these gains on the premise that the Taxpayer did not have a unitary relationship with E and F. The auditor determined that the stock and the transactions surrounding the stock serviced the operational functions of the Taxpayer and disallowed the deduction.

The Taxpayer has provided some evidence concerning the nature of the relationships between E and the Taxpayer, and F and the Taxpayer. This evidence indicates that the essence of the relationship was that of a minority stockholder subsequent to the original transaction. As such, it does not appear that a unitary connection existed between the Taxpayer and either E or F.

In considering the operational aspects of the investment, the Department considered the evidence provided. The Taxpayer asserts that the stocks were purchased with excess cash from operations but has provided no objective evidence to document this claim. In addition, the Taxpayer has significant amounts of long-term debt, and has presented no factual data indicating that its proceeds from the stock sales were not necessary for, or related to, the operational retirement of scheduled debt service or operating expenses. The presence of long-term debt implies a need to refinance, extend, or renew such financing. In addition, the financial statements indicate that substantial cash has been designated to the retirement of long-term debt.

The Taxpayer has also stated that the stock was held as part of a separate investment function but has failed to provide any supporting documentation. To the contrary, the financial statements show that proceeds from the sale of stock of E and F were included in the net cash provided by the operating activity section of the statement of cash flows.

The Taxpayer has cited Public Document (P.D.) 94-154 (5/23/94) as a similar case in which the Department allowed a taxpayer an alternative method of allocation and apportionment for the gain on the sale of stock. In that ruling, the Department determined that the taxpayer had provided objective documentation to show that its stock investment constituted a discrete investment function, having no connection with the operational activities carried on in Virginia. Although the Taxpayer's holdings in the stocks of E and F do bear some similarities to facts contained in P.D. 94-154, the Taxpayer has failed to provide adequate documentation to sustain a similar finding.

Based on the information provided, the Department is unable to determine how much, if any, of the Taxpayer's holdings in the stock of E and F could be fairly characterized as a passive investment. As such, the Taxpayer has not met the heavy burden of demonstrating that the imposition of Virginia's statute is a violation of the standards enunciated by the U. S. Supreme Court in Allied-Signal. Accordingly, permission to use an alternative method of allocation and apportionment for the capital gains realized on the stock of E and F is hereby denied and the auditor's adjustment is upheld.

Gain on Sale of Insurance Stocks

The Taxpayer realized gains on sales of its stock holdings in two corporations (G and H). For the taxable year ended June 30, 1992, the Taxpayer claimed a nonbusiness deduction on its Virginia income tax return for the gain on G's stock on the premise that the Taxpayer did not have a unitary relationship with G and the Taxpayer is not in the insurance business. The auditor determined that the stock and the transactions surrounding the stock serviced the operational functions of the Taxpayer and disallowed the deduction. In the case of H, the Taxpayer did not take a deduction for gain on the stock sale but now claims it is entitled to such for the taxable year ended June 30, 1993, for the same reasons given for G.

G and H were insurance companies formed during an insurance capacity crisis to provide adequate limits of insurance to Fortune 500 companies at a reasonable price. In order to purchase insurance from G and H, a customer was required to become a stockholder. In the mid 1980's, the Taxpayer purchased general and product liability coverage from G and H. During the audit period, public offerings of these insurance companies' stock were approved by the shareholders. In connection with these public offerings, the Taxpayer liquidated its entire holdings in G and H.

While the Taxpayer has provided ample evidence to show that it lacked a unitary relationship with G and H, the information provided clearly shows the operational nature of these stock holdings. Businesses purchase insurance as a hedge against the risk of doing business. The Taxpayer's choice to adequately protect itself against general and product liabilities was a prudent business decision that served its operational functions. Initially, the Taxpayer had to remain a shareholder of G and H in order for coverage to continue. As such, these stock holdings served an operational function by allowing the Taxpayer to maintain coverage against possible general and product liabilities. According to the Taxpayer, when the shareholder restrictions where lifted, all of the shares of the stock of G and H were sold, with the proceeds becoming part of fungible cash used in the operations of the business.

Accordingly, permission to use an alternative method of allocation and apportionment for the capital gains realized on the stock of G and H is denied. The auditor's adjustments with regard to gains on the sale of the stock of G are upheld.

Gain on Sale of Land

For the taxable year ended June 30, 1992, the Taxpayer realized a gain on the sale of a parcel of land. The Taxpayer claimed a nonbusiness deduction on its Virginia income tax returns because the land was not being used for general business purposes and was not located in Virginia. The auditor determined that the land and the transactions surrounding the land serviced the operational functions of the Taxpayer and disallowed the deduction.

The parcel, located near the headquarters of the Taxpayer, was acquired in the early 1980's for the purpose of possible expansion. The intended expansion, however, never materialized and the total acreage was committed to agricultural use. The Taxpayer obtained an agricultural designation for the purposes of real estate tax valuation and rented the land to a farmer for the purpose of grazing cattle. During the taxable year ended June 30, 1992, the Taxpayer sold a portion of the parcel to an unrelated party.

At the time of the purchase, the Taxpayer had made the decision that the parcel was needed for the future operations of the business. When the planned business expansion did not occur, the Taxpayer converted the property to agricultural use and generated revenue from the rental of the land. Thus, instead of being an idle investment, the land was used by the Taxpayer to generate revenue. The Taxpayer knowingly obtained the proper licensing so the land could be used for agricultural purposes. The rents resulting from the lease of the property contributed to the Taxpayer's overall operations. Also, in absence of any evidence to the contrary, the land had been used by the Taxpayer for purposes of inclusion in the denominator of the Taxpayer's property factor for the purposes of determining income apportioned to Virginia.

The fact that the land was not in Virginia has no bearing on whether the income it generates is included in apportionable income. The Taxpayer has numerous operating facilities that do not transact business in Virginia yet have income that is included in the apportionable income of the Taxpayer. By making this argument, the Taxpayer is essentially asking to be allowed to separately account for this land for Virginia income tax purposes. The Department's long-standing policy holds the use of separate accounting in disfavor. See Department of Taxation v. Lucky Stores. Inc., 217 Va. 121 (1976).

The U. S. Supreme Court has recognized that allocation and apportionment of income are an arbitrary process designed to approximate the income from business transactions within a state. As long as each state's method of allocation and apportionment are rationally related to the business transacted within a state, then each state's tax is constitutionally valid even though there may be some overlap. See Moorman Mfg. Co. v. Bair, 437 U.S. 277 (1978).

The Taxpayer has failed to demonstrate that the real estate holding was not an operational asset involved in a unitary business. Accordingly, permission to use an alternative method of allocation and apportionment pursuant to Va. Code § 58.1-421 to allocate the gain on the sale of the land is denied. The auditor's adjustment is upheld.

Interest on Notes

For the taxable year ended June 30, 1993, the Taxpayer accrued interest income on notes receivable from an unrelated corporation (J). The Taxpayer claimed a nonbusiness deduction for this interest on its Virginia income tax return based on the premise that the Taxpayer did not have a unitary relationship with J. The auditor determined that the notes receivable and the interest income serviced the operational functions of the Taxpayer and disallowed the deduction.

In the mid 1980's, the Taxpayer sold one of its facilities to J. As a result of the transaction, the Taxpayer received cash, stock in J, and notes to pay the balance of the sales price. Immediately after the sale, the Taxpayer liquidated its stock holdings in J. The Taxpayer retained the notes receivable and imputed interest.

The Taxpayer has provided adequate evidence to show that it lacked a unitary relationship with J. The information provided reveals, however, that the notes were not part of a separate, discrete investment function. The notes receivable resulted from the Taxpayer financing the sale of its own operating facility to J. It is clear that the transaction surrounding the creation of the notes receivable from J affected the Taxpayer's operations.

The Taxpayer has failed to demonstrate that the interest earned on the notes receivable from J was part of a separate, discrete investment function that meets the standards enunciated in Allied-Signal. Accordingly, permission to use an alternative method of allocation and apportionment pursuant to Va. Code § 58.1-421 to allocate the interest income from J is denied. The auditor's adjustment is upheld.

Income from Rents

For the taxable year ended June 30, 1993, the Taxpayer earned income from the rental of space for a transmission tower at a facility operated by one of its divisions. The Taxpayer claimed a nonbusiness deduction for these rents on its Virginia income tax returns on the premise that the division is not in the business of renting real property and the rental real estate is not located in Virginia. The auditor determined that the land and the rental transactions serviced the operational functions of the Taxpayer and disallowed the deduction.

Although leasing real estate is not its primary business, the division made a business decision to rent space it controlled. The income results from the rental of an operational real estate asset of the division. As such, the Department must conclude that rental income results from the Taxpayer's operations.

As such, the Taxpayer has failed to demonstrate that the rental real estate was not an operational asset involved in a unitary business and resulting income was part of a separate, discrete investment function that meets the standards enunciated in Allied-Signal. Accordingly, permission to use an alternative method of allocation and apportionment pursuant to Va. Code § 58.1-421 to allocate the rental income is denied, and the auditor's adjustment is upheld.

Income from Royalties

For the taxable year ended June 30, 1993, the Taxpayer realized royalty income from licensing patents. The Taxpayer claimed a nonbusiness deduction on its Virginia income tax returns for this royalty income on the premise that the Taxpayer is not in the business of licensing patents. The auditor determined that the patents and the royalty transactions serviced the operational functions of the Taxpayer and disallowed the deduction.

The Taxpayer has provided little information other than the patents were licensed to a company in a similar business. The Department finds it highly unlikely that a business enterprise would or could sever its unitary relationship with its patented products, technologies, and processes without a significant change to its operations. As such, permission to use an alternative method of allocation and apportionment pursuant to Va. Code § 58.1-421 to allocate the royalty income is denied, and the auditor's adjustment is upheld.

Income from Dividends

For the taxable year ended June 30, 1993, the Taxpayer realized dividends from domestic corporations in which it owned less than a twenty percent interest. The auditor adjusted dividend deductions reported on the Taxpayer's Virginia return to match the amount reported on the Schedule C on its federal income tax return. You claim the Taxpayer is entitled to this subtraction because Virginia requires dividends to be allocated to a corporation's commercial domicile.

The Code of Virginia contains several different subtractions that may apply to dividend income. Dividend income included in federal taxable income may qualify for a subtraction as Subpart F income, Section 78 income, foreign source dividend income, or for the subtraction for dividends received from a 50% or more owned corporation. Finally, dividend income remaining in Virginia taxable income after all the statutory subtractions have been claimed may be allocated to the state of commercial domicile.

Virginia Code § 58.1-407 states that dividends "to the extent included in Virginia taxable income are allocable to the state of commercial domicile of the taxpaying corporation." A review of the audit reveals that the auditor included the dividends at issue with various other dividend income in the amount eligible for allocation. As such, these dividends have already been removed in determining the Taxpayer's Virginia taxable income, and the auditor correctly removed the subtraction for these dividends.

Income from Trust Equity

During the taxable years ended June 30 1993, the Taxpayer realized gains on transactions from its holdings in a trust equity fund. The Taxpayer claims these gains are nonbusiness income and should be deducted on its Virginia income tax returns.

According to the Taxpayer, it established a rabbi trust to provide additional retirement compensation for the officers of the corporation. The Taxpayer has provided no explanation as to why earnings from this trust should be considered nonbusiness income. While there appears to be no unitary relationship between the Taxpayer and the trust, the evidence clearly shows that the investment serves an operational function.

By providing for additional retirement compensation of its corporate officers, the Taxpayer is providing an incentive to attract and retain top executives. Inasmuch as attracting and retaining quality corporate officers is an integral part of the operations of any business, the establishment and resulting income of the rabbi trust serves an operational function.

As such, the Taxpayer has not met the heavy burden of demonstrating that the imposition of Virginia's statute is a violation of the standards enunciated by the United States Supreme Court in Allied-Signal. Accordingly, permission to use an alternative method of allocation and apportionment for the gains on transactions from its holdings in a trust equity fund is hereby denied and the auditor's adjustment is upheld.

Foreign Subsidiary Factor Attributes

The Taxpayer contests the exclusion of foreign source items from the apportionment factors of the Taxpayer and D for the taxable years ended June 30, 1992 and 1993. The Taxpayer has provided a document listing wages, rents, property and sales of foreign subsidiaries that you contend should be included in the apportionment factor of the Taxpayer and D.

The Code of Virginia limits the property, payroll and sales included in the apportionment factor to those of the corporation. Title 23 VAC 10-120-160 provides that property is considered in the property factor if it is owned or rented by the taxpayer, used by the taxpayer, and effectively connected with the taxpayer's trade or business within the United States and the income from such trade or business is includable in both Virginia taxable income and federal taxable income. In this case, the property owned, rented or used by the foreign subsidiaries is property that generates income outside the United States for the foreign subsidiary. As such, the property of the foreign subsidiaries is not effectively connected to business of the Taxpayer and D conducted in the United States and cannot be included in their property factors.

Likewise, the sales factor of a corporation is limited to sales of the corporation pursuant to Va. Code § 58.1-414. Title 23 VAC 10-210-210 defines sales as "all gross receipts of the corporation except dividends allocated under § 58.1-407 of the Code of Virginia." As such, the sales that result in income for the Taxpayer and D would not include sales revenue received by their foreign subsidiaries.

In general, the payroll factor includes compensation paid or accrued by a corporation. In P.D. 90-17 (1/11/90), the Department ruled that wages paid by a parent corporation are not included in the payroll factor of a subsidiary, despite bookkeeping allocations by the parent to the subsidiary for a portion of the expense. In the instant case, the facts are similar to those in P.D. 90-17, except that the allocation is from a subsidiary to a parent corporation. This distinction, however, is incidental and does not render the ruling in P.D. 90-17 inapplicable to the current case. The evidence presented clearly shows that the compensation in question was paid or accrued by the foreign subsidiaries of the Taxpayer and D and is, therefore, not includable in the payroll factors of the Taxpayer and D.

The exception to these rules would be when a corporation has income from partnerships, S corporations and other pass-through entities. Such a corporation would, generally, include the factor attributes of the pass-through entities for determining Virginia source income in accordance with the corporate statutory formula set forth in Va. Code §§ 58.1-408 through 58.1-421. No evidence has been provided that would indicate that income from the foreign subsidiaries in this case is passed through or even included in the income subject to Virginia tax of the Taxpayer and D. The auditor was, therefore, correct in excluding the property, payroll and sales of the foreign subsidiaries in the apportionment factors of the Taxpayer and D.

Property Factor Issues

Beginning Property of A

The Taxpayer contends the amount for depreciable assets in Virginia of A for the taxable year ended June 30, 1992 is incorrect. According to the Taxpayer, the auditor included average property instead of beginning property from the Taxpayer's schedule in the amount of total beginning property used to compute the property factor.

In general, Va. Code §§ 58.1-409 through 58.1-411 and 23 VAC 10-120-160 through 180 set forth the requirements applicable to the computation of the average property factor used in apportioning the income of a multistate corporation. Virginia Code § 58.1-409 states:
    • The property factor is a fraction, the numerator of which is the average value of the corporation's real and tangible personal property owned and used or rented and used in the Commonwealth during the taxable year and the denominator of which is the average value of all the corporation's real and tangible personal property owned and used or rented and used during he taxable year and located everywhere, to the extent that such property is used to produce Virginia taxable income and is effectively connected with the conduct of a trade or business within the United States and income therefrom is includable in federal taxable income. (Emphasis added.)

As set forth in both the statute and the regulation, the value used for the property factor is based upon the average value of the property during the taxable year. Based on the information provided, the auditor inadvertently included the average property amount as the beginning value of property. The audit assessment has been adjusted accordingly.

Capitalized Rents of B

The Taxpayer contests the amount for capitalized rent included in the numerator of the property factor of B for the taxable year ended June 30, 1992. According to the Taxpayer, the auditor included total real property rent instead of rent attributable to Virginia in computing the capitalized rent in Virginia.

According to the apportionment factor schedules provided to the auditor for the taxable year ended June 30, 1992, real property rent expense reported in Virginia was less than the total real property rent expense everywhere. The documentation provided to the auditor shows no amount for real property rent expense reported for any other state, locality or foreign country. Because no rent was reported anywhere except for Virginia, the auditor assumed that the total on the work paper belonged in Virginia.

The Taxpayer has not provided documentation to reconcile the difference between the rents reported in Virginia and the total for everywhere. As such, the auditor's adjustment is upheld.

Payroll Factor Issues

The Taxpayer contests the adjustment to the denominator of the payroll factor of B for the taxable year ended June 30, 1993. The denominator of the payroll factor was adjusted based on information reported on the federal income tax return provided during the audit. No other documentation was provided to the auditor.

Pursuant to Va. Code § 58.1-412, the payroll factor is a fraction, the numerator being the total amount of compensation paid or accrued within Virginia during the taxable year by a corporation and the denominator being the total compensation paid or accrued everywhere during the taxable year.

Pursuant to 23 VAC 10-120-20, the Department considers the term "employee" to have the same meaning as used in IRC § 3121(b). As such, the Department will accept the gross amounts reported to the IRS on Form W-2, Form W-3, Form 940 or the accounting records of the corporation, provided that all of the employees of the corporation are included in such reports in determining the total compensation in the denominator of the payroll factor. See P.D. 90-91 (6/12/90).

B used totals from state unemployment tax returns to determine total compensation paid or accrued everywhere. The regulations are specific as to which federal forms may be used to determine the denominator of the payroll factor: only Form W-2, Form W-3, Form 940, or the accounting records of the corporation will be permitted. In absence of such documentation, the auditor adjusted the denominator of the payroll factor to the amount reported on the federal income tax return. Accordingly, the Taxpayer's proposed payroll factors for the taxable year ended June 30, 1993, based on amounts from state unemployment tax returns will not be accepted. The auditor's adjustment to the denominator of B's payroll factor is upheld.

Sales Factor Issues

Location of Sales

The auditor made an adjustment to the denominator of the Taxpayer's sales factor for the taxable year ended June 30, 1992, to remove sales attributed to Washington, D.C. The Taxpayer questions this adjustment.

Under Va. Code § 58.1-415, tangible personal property received in Virginia as a result of a sales transaction is considered a Virginia sale. Sales to the federal government have a history of being classified incorrectly because many federal agencies are located in Virginia, but are invoiced to a Washington, D.C. address. These agencies may have Washington, D.C. addresses, but actually receive purchased goods in Virginia. Thus, Virginia auditors have, in the past, examined U. S. Government sales to verify correct reporting. See P.D. 96-353 (11/25/96). The Taxpayer has had a history of incorrectly reporting sales to Washington, D.C. In prior audits, the Department's auditors had been provided documentation to identify the correct destination of these sales.

For the taxable year at issue, the Taxpayer has provided no documentation to verify the destination of the sales attributed to Washington, D.C. Sales are only included in the sales factor if they are included in Virginia taxable income and are connected with the conduct of a taxpayer's trade or business within the United States. If a taxpayer cannot document the destination of the tangible personal property it sells, the Department must question whether they are connected with the conduct of a taxpayer's business within the United States. Absent such documentation, the auditor's adjustment is upheld.

Returns and Allowances

The auditor reduced the sales factor denominators of the Taxpayer and its affiliates to account for returns and allowances. The Taxpayer questions the inclusion of sales returns and allowances for the taxable years ended June 30, 1992 and 1993. The Taxpayer argues that according to Va. Code § 58.1-414, the sales factor is calculated by dividing total sales in Virginia by total sales everywhere. Sales are defined in Va. Code § 58.1-302 as "all gross receipts of the corporation other than dividends." As such, the Taxpayer claims the Code of Virginia does not provide an adjustment to sales for returns and allowances.

Under 23 VAC 10-120-20, sales of tangible personal property are reduced to account for returns and allowances so that they are in the sales factor only to the extent they are included in federal taxable income. Title 23 VAC 10-120-220 defines when a sale of tangible personal property is considered a Virginia sale. Because returns and allowances follow sales, the Department will consider returns and allowances for inclusion in the Virginia numerator if they can be allocated to Virginia in the same manner as sales as prescribed by 23 VAC 10-120-220. The Taxpayer has provided no such documentation. As such, the auditor's adjustment is upheld.

Other Income

The Department's auditor removed various items included in "other income" on the federal return from the denominator of the sales factor. The Taxpayer contends that these items belong in the sales factor.

Virginia Code § 58.1-302 defines the term "sales" as the gross receipts of the corporation from all sources (except dividends, which are allocated), whether or not such gross receipts are generally considered sales. Virginia relies on the nature of each item reported on the federal return and supporting schedules to determine gross receipts for purposes of computing the sales factor. The adjustments by the auditor were made to reconcile the denominator with the gross receipts shown on the federal return. The Department has previously ruled that receipts of an unknown or unspecified nature may not be included in the denominator of the sales factor. See P.D. 92-45 (4/27/92).

Based on the description on the federal return, these items appear to be unidentified miscellaneous income, reimbursements for expenses, discounts on purchases and various accounting adjustments. The Taxpayer has provided no evidence regarding amounts included in "other income" on the federal return that would demonstrate that they constitute receipts within the meaning of 23 VAC 10-120-210. As such, the auditor's adjustment is upheld.

Nonbusiness Income

In reviewing the audit report of the Taxpayer for the taxable year ended June 30, 1992, the Department found that the auditor disallowed deductions for gains on the sale of stock, but did not include the net gain in the denominator of the sales factor. In addition, the gross proceeds from ordinary gains were not included in the denominator. The sales factor has been adjusted to include these amounts.

Summary

The Taxpayer's request for the abatement of the assessments for the taxable years ended June 30, 1992 and 1993 is denied. The adjusted balances of the assessments for the taxable years at issue have been revised, as shown on the enclosed schedules, in accordance with this determination. Please remit payment to the Virginia Department of Taxation, Office of Policy and Administration, Appeals and Rulings, P.O. Box 1880, Richmond, Virginia 23218, Attention: *****. Payment must be received within 30 days from the date of this letter to avoid the accrual of additional interest.

Copies of the Code of Virginia sections, regulations, public documents cited are available on-line 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 ***** at *****.
                • Sincerely,

                • Kenneth W. Thorson
                  Tax Commissioner



AR/14108B

Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46