Tax Type
Corporation Income Tax
Description
Foreign Source Income Adjustment
Topic
Accounting Periods and Methods
Appropriateness of Audit Methodology
Date Issued
04-01-2004
April 1, 2004
Re: § 58.1-1821 Application: Corporate Income Tax
Dear **************:
This will reply to your letters in which you request correction of the corporate income tax assessments issued to ******** (the "Taxpayer") for the taxable years ended December 31, 1987 through 1989. I apologize for the unusual delay in the Department's response.
FACTS
The Taxpayer was audited for the 1987 through 1989 taxable years. The auditor adjusted the foreign source income subtraction claimed by the Taxpayer for each taxable year by increasing the amount of expenses related to foreign source income.
The Taxpayer contends that audit adjustments for the 1987 through 1989 taxable years overstate definitely allocable expenses attributable to foreign source income. For the 1988 taxable year, the Taxpayer also contends that the Virginia foreign source income adjustment computation improperly included three months of an affiliate's foreign source income that was included on the Taxpayer's federal Form 1118, which was filed on a consolidated basis. The Taxpayer did not file a combined or consolidated Virginia corporate return.
The Taxpayer states that the correct expenses were already listed on Form 1118 as deductions not definitely allocable; therefore, the audit adjustment essentially duplicated expenses already listed. The Taxpayer provided a schedule listing the applicable expenses.
Further, the Taxpayer avers that, for the 1988 and 1989 taxable years, the computation of foreign source income should include the adjustment under Internal Revenue Code ("IRC") § 927(e) for taxpayers receiving income from transactions giving rise to foreign trading gross receipts of a foreign sales corporation ("FSC").
The Taxpayer requests the Department to reverse the auditor's adjustment to the FSC subtractions for the taxable year at issue and allow an additional subtraction for the IRC § 927(e) adjustment.
DETERMINATION
Foreign Source Income of Affiliate
The Taxpayer's 1988 taxable year consolidated federal corporate return included the foreign source income of an affiliate on Form 1118. The Taxpayer filed a separate Virginia corporate return. The Taxpayer states that the auditor's adjustments to the foreign source income subtraction caused a portion of that affiliate's income to be included in the computation of its foreign source income. Based on the information provided, the affiliate's income will be removed from the foreign source income subtraction computation for 1988.
IRC § 927(e)
In 1984, FSC's were established to provide an export incentive by creating certain tax benefits for foreign trade income. See IRC §§ 921 through 927. Under the incentive plan, a percentage of a FSC's income earned from the sale of qualified export property is exempt from federal income tax. Further, corporate FSC shareholders are entitled to a 100% dividend-received deduction on dividends attributable to FSC income. Under the Exclusion Act of 2000 (Public Law 106-519), statutes governing FSCs were repealed effective for transactions after September 30, 2000.
A portion of the foreign trade income of a FSC was treated as foreign source income and is exempt from federal income tax. A FSC's foreign trade income includes profits earned by the FSC from exports, and commissions earned by the FSC from products and services exported by others.
Transfer pricing rules were used to determine the price of transactions involving sales, leases, licenses, services, and commissions between FSCs and a related taxpayer or supplier. The transfer price was determined under an arm's length approach or under one of two administrative pricing methods. Under IRC § 927(e), when an administrative pricing method was used, the related supplier's foreign source income from the transactions with the FSC is limited to a percentage of the income resulting from the transactions.
In this case, all of the Taxpayer's foreign source income resulted from rents, royalties and licensing fees and is subject to the limitation provided under IRC § 927(e). Under Va. Code § 58.1-402(C)(8), the subtraction for foreign source income, is limited to the extent that such income is included in federal taxable income. Because the Taxpayer's income subject to the IRC § 927(e) limitation is included in federal taxable income and meets the definition of foreign source income under Va. Code § 58.1-302, this income is eligible for the Virginia foreign source subtraction.
Foreign Source Income-Related Expenses
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 Public Document ("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 I RC § 861 et seq., contain detailed rules for assigning income and deductions to particular sources. The provisions differentiate between deductions that are definitely allocable and deductions that 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 I RC § 861 et seq., are used to complete Form 1118, the information reported on this form is considered useful and presumed correct and accurate. Such information is an appropriate starting point for computing the foreign source income subtraction allowed on the Taxpayer's Virginia return.
According to the Taxpayer, the auditor made the adjustment to the definitely. allocable deductions for commissions that were already included in deductions not definitely allocable. To support this contention, the Taxpayer has provided evidence demonstrating that the commissions were reported on the Form 1118 as deductions not definitely allocable. Because all the Taxpayer's income reported on Form 1118 for the taxable years at issue meet Virginia's definition of foreign source income under Va. Code § 58.1-302, all the deductions reported were used by the Taxpayer in computing its foreign source income subtraction. Accordingly, the audit assessments will be corrected to remove the adjustments to the definitely allocable deductions.
Summary
The 1987 through 1989 corporate income tax audits have been revised as described above, resulting in abatement of the amounts assessed. Schedules showing the net adjustments are enclosed for your reference.
The Code of Virginia section and public document cited, along with other reference documents, 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 about this determination, you may contact ***** in the Department's Office of Policy and Administration, Appeals and Rulings, at *****.
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- Sincerely,
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- Kenneth W. Thorson
Tax Commissioner
- Kenneth W. Thorson
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AR/17180E
Rulings of the Tax Commissioner