Tax Type
Corporation Income Tax
Description
Subtracted gains on sales of various assets as nonbusiness income
Topic
Allocation and Apportionment
Appropriateness of Audit Methodology
Collection of Tax
Date Issued
08-31-2004
August 31, 2004
Re: § 58.1-1821: 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, 1995 and 1996. I apologize for the unusual delay in the Department's response.
FACTS
For the taxable years ending December 31, 1995 through 1997, the Taxpayer subtracted gains on sales of various assets as nonbusiness income in determining Virginia taxable income. The Department's auditor denied the subtractions, asserting that the gains were operational in nature. The Taxpayer contests the Department's right to apportion and tax these items of income for the 1995 and 1996 taxable years. The Taxpayer contends that the gains were purely investment in nature. Each of the items of income will be addressed separately below.
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 dividends allocable pursuant to Va. Code § 58.1-407, is subject to apportionment. As such, the Taxpayer's protest has been treated as a request for an alternative method of allocation and apportionment in accordance with Va. 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 United States 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 United States 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.
Sale of Common Stock
For the 1995 and 1996 taxable years, the Taxpayer subtracted the net gain from the sales of common stock investments in a number of different corporations. The Taxpayer's ownership in each of the corporations was less than 9 percent. The Taxpayer asserts that these minority interests were not a part of its operational assets and were merely passive investments eligible for treatment as nonbusiness allocable income.
Based on the information provided, it is clear that no unitary relationship existed between the Taxpayer and any of the eight corporations in which the Taxpayer owned a small amount of stock. As such, the determining issue in this case centers upon whether the Taxpayer's investments fulfilled an operational function rather than a passive investment function.
In considering the operational aspects of the investment, the Department considered the evidence provided. The Taxpayer asserts that the gains from these stocks did not arise from operational assets but provides no objective evidence to document this claim. In addition, the Taxpayer's long-term debt decreased significantly during the 1995 and 1996 taxable years despite reporting cash at less than $0 on the balance sheets. The Taxpayer 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.
The Taxpayer has also failed to provide any supporting documentation that the stocks were held as part of a separate investment function. Based on the information provided, the Department is unable to determine how much, if any, of the Taxpayer's holdings in the minority interest in the eight corporations 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 United States Supreme Court in Allied-Signal. Accordingly, permission to use an alternative method of allocation and apportionment for the net capital gains realized on these stock investments is denied and the auditor's adjustment is upheld.
Redemption of Preferred Stock
In 1993, the Taxpayer spun off ***** ("Corporation A") as a dividend to shareholders. The Taxpayer retained a preferred stock interest in Corporation A. The Taxpayer asserts that this transaction was prompted by an extraordinary circumstance and, thus, should be treated as nonbusiness allocable income.
In 1995, Corporation A desired to restructure its balance sheet to improve its financial ratios so that it could improve its chance of borrowing funds. In connection with this restructuring, Corporation A requested that the Taxpayer redeem the preferred stock. The Taxpayer did not own any common stock in Corporation A.
The Taxpayer has provided some evidence concerning the nature of the relationship between Corporation A and the Taxpayer. The preferred stock did give the Taxpayer the right to elect one member of the six members of Corporation A's board of directors. Other than this connection, little interaction occurred between the two corporations. As such, it does not appear that a unitary connection existed between the Taxpayer and Corporation A.
In examining the functional aspects of the preferred stock redemption, the Department considered the evidence provided to support the Taxpayer's position. The evidence indicates that the Taxpayer had no intent to dispose of the stock. The redemption was made at the request of Corporation A. As such, the circumstances surrounding the redemption of the preferred stock investment and the proceeds generated from the investment resulted from activities unrelated to the Taxpayer's operational function. Based on the facts, the Taxpayer has shown that the gain from the redemption of the preferred stock resulted from a passive investment activity. Therefore, the Department will permit the Taxpayer to use an alternative method of allocation and apportionment for the gain realized on the preferred stock of Corporation A for the 1995 taxable year.
Sale of a Subsidiary
***** ("Corporation B"), was a wholly owned subsidiary of the Taxpayer and engaged in business activities similar to the Taxpayer. In 1995, the Taxpayer sold Corporation B because it no longer fit within the Taxpayer's core business.
The Taxpayer has provided some evidence concerning the nature of the relationship between Corporation B and the Taxpayer. As a wholly owned subsidiary, the Taxpayer had the power to elect Corporation B's entire board of directors. Other than certain large capital expenditures, the Taxpayer did not have any approval authority over the operating budget, capital expenditure budget, or individual contracts of Corporation B. During the time when the Taxpayer owned Corporation B, there were no common managers or directors or transfers of personnel or staff. There was no shared or common accounting or administrative staff, transportation services or resources, technology or development, marketing, manufacturing or distribution services and resources. There were also no intercompany loans made or secured between the Taxpayer and Corporation B and no shared ownership and use of any investments, trademarks, patents, or licenses. Employees of the Taxpayer and Corporation B did not belong to the same collective bargaining unit or union. There were no joint management or employee training programs, and no common life, health, annuity or survivor benefit programs, and no common bonus or incentive plans for employees of the Taxpayer and Corporation B. As such, it does not appear that a unitary connection existed between the Taxpayer and Corporation B.
In examining the functional aspects of the sale of the subsidiary, the Department considered all of the evidence provided by the Taxpayer in support of its position. The Taxpayer has provided no evidence to show why it decided to invest in Corporation B. Based on the reasoning given for divesting of this investment, the Taxpayer must have considered Corporation B a part of core business functions at one time. The Taxpayer does state that Corporation B was sold without any negative impact on the Taxpayer's operations. Based on the relationship between the Taxpayer and Corporation B, the more than $100 million in proceeds received from the sale could have more that offset any negative impact. Accordingly, the Taxpayer has not presented sufficient factual evidence to show that the investment in Corporation B did not serve 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 U. S. Supreme Court in Allied-Signal. Accordingly, permission to use an alternative method of allocation and apportionment for the gain realized on the sale of Corporation B is denied and the auditor's adjustment is upheld.
Sale of a Division
The ***** ("Division A"), a division of the Taxpayer, engaged in the manufacture and sale of products for the Taxpayer. Division A's manufacturing facilities were located outside Virginia. In 1995, the Taxpayer sold the entire business operation of Division A. The Taxpayer asserts that, because none of the assets of Division A were located in Virginia, the entire gain was allocated and reported as income to the Taxpayer's state of commercial domicile.
The Taxpayer did not respond to the Department's request for information concerning the relationship between the Taxpayer and Division A. Because a division is not a separate entity, it would normally be considered to be directly related to the day-to-day operations of a corporation and fully integrated into the unitary operations of a taxpayer. This relationship is such that it cannot be characterized as anything other than operational in nature. 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 gain realized on the sale of Division A is denied and the auditor's adjustment is upheld.
Termination of Licensing Rights
In 1984 and 1985, the Taxpayer entered into agreements with an unrelated corporation (Corporation C) whereby the Taxpayer was licensed to make, have made, use, and sell a product developed by Corporation C. In 1995, Corporation C and the Taxpayer entered litigation concerning these licensing agreements. In order to settle the litigation, the Taxpayer and Corporation C entered into an agreement that terminated the licensing agreements. The Taxpayer recognized a gain as the result of the termination of the licensing agreements. The Taxpayer believes the gain was properly allocated and reported to its state of commercial domicile.
The evidence provided by the Taxpayer shows that the license agreements gave the Taxpayer the right to manufacture and sell a product. The evidence also indicates that Corporation C provided technical assistance to the Taxpayer under the agreements. The product licensed from Corporation C was in the same product line as those produced by the Taxpayer. The Taxpayer has provided no evidence that would indicate that the product manufactured and sold under the licensing agreements was not directly related to the Taxpayer's primary business operations. Accordingly, permission to use an alternative method of allocation and apportionment for the gain realized on the termination of the licensing rights is denied and the auditor's adjustment is upheld.
Conclusion
The audit assessment has been adjusted as shown on the enclosed schedules and the audit report revised in accordance with this determination. The Taxpayer should remit its payment within 30 days from the date of this letter to: Virginia Department of Taxation, 3600 West Broad Street, Suite 160, Richmond, Virginia 23230, Attn: ********. Failure to remit full payment within the time allotted may result in the imposition of additional interest and a 20% Amnesty penalty. See the enclosure entitled "Important Payment Information." If you have any questions concerning payment of the assessment, you may contact ***** at *****.
The Code of Virginia sections cited and 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 determination, you may contact ********* in the Office of Policy and Administration, Appeals and Rulings, at *********.
Sincerely,
Kenneth W. Thorson
Tax Commissioner
AR/24533O
Rulings of the Tax Commissioner