Tax Type
Corporation Income Tax
Description
Commercial domicile, existence of a unitary relationship
Topic
Allocation and Apportionment
Taxability of Persons and Transactions
Taxpayers' Remedies
Date Issued
08-16-2004
August 16, 2004
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 May 31, 1994. I apologize for the delay in responding to your letter.
FACTS
In 1988, the Taxpayer acquired approximately a ten percent interest in an unrelated third party ("Company C"). During the period in which the Taxpayer held the stock, Company C's founder directly and indirectly held at least 85% of the remaining stock. The Taxpayer made the stock acquisition in connection with an agreement granting the Taxpayer exclusive manufacturing rights for one of Company C's products. Almost immediately after the stock purchase, the Taxpayer realized that an operational relationship would not provide a competitive advantage and, as a result, never manufactured any Company C product nor paid any royalties to Company C. The Taxpayer returned part of its stock interest to Company C, thereby reducing the Taxpayer's ownership interest to approximately eight percent by 1990. The Taxpayer had one employee on the Company C Board of Directors from July 1988 to November 1991. Subsequent to that date, the Taxpayer did not seek to fill that seat on the Company C board.
During the taxable year ended May 31, 1994, the Taxpayer sold shares of common stock of Company C. On its Virginia corporate income tax return, the Taxpayer allocated the resulting gain to its state of commercial domicile. Under audit, the Department made an adjustment to include the gain in apportionable income. The Taxpayer has contested the Department's right to apportion and tax the gain on the sale of Company C's stock, maintaining that the income is allocable to its state of commercial domicile.
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 Va. Code § 58.1-402 and § 58.1-403, less allocable dividends pursuant to Va. Code § 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 Va. Code § 58.1-4.21.
The decision of the U. S. Supreme Court in Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768 (1992), 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 test is fact sensitive. The Department has examined the evidence provided to determine if: (1) a unitary relationship existed between the Taxpayer and Company C, and (2) the Taxpayer's activities related to the investment in Company C were in any way connected to the Taxpayer's operational activities carried on in Virginia.
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 New Mexico, 458 U.S. 352 (1982); and Allied-Signal. The Taxpayer admitted that it intended to operate under a product licensing and manufacturing agreement with Company C. Had these operations occurred, a unitary relationship could have developed between the Taxpayer and Company C. This, however, did not take place when the Taxpayer decided the agreement would not provide the competitive advantage it was seeking. Otherwise, the Taxpayer has provided ample evidence to demonstrate that the essence of its relationship with Company C was that of a minority stockholder subsequent to the original transaction. Based on the information provided, it does not appear that a unitary connection ever existed between the Taxpayer and Company C.
In regard to the operational aspects of the Taxpayer's investment in Company C, it is clear the original intent of this stock transaction was to enhance the Taxpayer's operations. The Taxpayer did not, however, pursue the operational aspects of its relationship with Company C. In fact, the Taxpayer's failure to comply with the operational aspects of the agreement caused Company C to take enforcement measures. Under a settlement agreement, the Taxpayer returned a portion of its stock investment to Company C. Accordingly, the initial operational aspects of this investment were never realized.
In addition, the Taxpayer financed the purchase of Company C stock through the issuance of its own stock and maintained a very low ratio of long-term debt during the years it held and disposed of the investment. Cash (excluding investments) and accounts receivable at the conclusion of the 1992, 1993, and 1994 fiscal years were sufficient to cover total current liabilities, and cash provided by operating activities was significantly positive during the audit period to finance investments in fixed assets and other corporate acquisitions. As such, it is the Department's determination that the investment did not serve an operational purpose while it was held by the Taxpayer.
In any proceeding relating to the interpretation of the tax laws of the Commonwealth of Virginia, the burden of proof is on the taxpayer. In this particular matter, the Taxpayer must prove by clear and cogent evidence that Virginia's statutory method of allocation and apportionment would result in a tax on income derived from a discrete investment function having no connection with Virginia in violation of the principles set forth in Allied-Signal. In this case, the Taxpayer has demonstrated by clear and cogent evidence that an alternative method of allocation and apportionment is appropriate. Accordingly, permission is hereby granted to allocate the capital gain on the sale of Company C's stock out of Virginia apportionable income for the taxable year ended May 31, 1994.
Because there was no other tax liability for the taxable year at issue, the assessment has been abated in full. This ruling is limited to the taxable year ended May 31, 1994, and further limited to the transaction described herein, and shall not be considered as pertaining to any other taxable year or transaction.
The Code of Virginia sections and public documents 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 regarding this response, you may contact ***** in the Office of Policy and Administration, Appeals and Rulings, at *****.
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- Sincerely,
Kenneth W. Thorson
- Sincerely,
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AR/11912O
Rulings of the Tax Commissioner