Document Number
07-197
Tax Type
Corporation Income Tax
Description
Sales for construction projects included in the numerator of the sales factor
Topic
Appropriateness of Audit Methodology
Assessment
Computation of Tax
Corporate Distributions and Adjustments
Date Issued
11-30-2007


November 30, 2007




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 years ended December 31, 2001 and 2002. I apologize for the delay in responding to your appeal.

FACTS


The Taxpayer and three affiliates (collectively the "Group") file a consolidated corporate income tax return in Virginia. Three members of the Group, including the Taxpayer, are commercially domiciled in ***** (State A). The Taxpayer functions primarily as a real estate company and holds investments in subsidiaries with operations in real estate and construction. The Taxpayer's main subsidiary, ***** (Corporation A) provides preconstruction, construction management, general contracting, trade work, design, build and consulting services. Another subsidiary, ***** (Corporation B) acts as a general and limited partner in real estate investments. ***** (Corporation C) is domiciled in Virginia and is a heavy construction provider.

Each entity's excess cash from operations is combined and invested by an investment management partnership, the ***** (the "Partnership"). The Partnership investments consist of treasury bonds, stocks and limited partnership interests. The Taxpayer allocated interest, dividends and capital gains earned by the Partnership to State A.

The auditor disallowed the allocation of interest, dividends and capital gains on the basis that only dividends may be allocated. The Taxpayer contends that interest, dividends and capital gains earned by the Partnership constituted nonbusiness income that was properly allocated to State A.

In addition, the Taxpayer reported all the sales of Corporation A in the denominator of the sales factor under the cost of performance method. Corporation A is commercially domiciled in State A. It provides job engineering and design, bid development and analysis, ongoing construction cost analysis, gathers and manages all construction related data such as permits and licenses. Actual construction operations are performed by subcontractors.

The auditor included in the numerator of the sales factor the sales of construction projects performed in Virginia. The auditor concluded that the cost of performance for a construction project in Virginia is greater in Virginia than elsewhere. The Taxpayer contends that a vast majority of the work performed by Corporation A occurs at company headquarters in State A.

DETERMINATION


Nonbusiness 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 Va. Code §§ 58.1-402 and 58.1-403, less dividends allocable pursuant to Va. Code § 58.1-407, is subject to apportionment. The Taxpayer's subtraction of the nonbusiness income 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 with the Department, the Taxpayer bears the burden of showing that the imposition of Virginia's statute is in 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 this matter, the Taxpayer must demonstrate that its investments are not operational assets involved in a unitary business. 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.)

The decision of the United States Supreme Court in Allied-Signal also 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 with regard to the relationship between the Group and the Partnership. The Group's operations are focused in the construction industry while the Partnership manages an investment portfolio. Based on the evidence, the Group and the Partnership are not functionally integrated and the Partnership does not contribute to the economies of scale of the Group. Further, decisions regarding the portfolio are made by an investment management committee that includes representatives from each member of the Group. This committee appears to have sufficient independence to administer the portfolio with little centralization of management. The Department, therefore, concludes that the Group and the Partnership do not share a unitary relationship.

Virginia Code § 58.1-391 B (as in effect during the taxable years at issue) provides "[e]ach item of partnership income, gain, loss or deduction shall have the same character for a partner under this chapter as for federal income tax purposes." For Virginia income tax purposes, income retains its character as income from the operations of a partnership in computing Virginia taxable income and is properly included in the apportionable income of the partner. This means that the partners are considered to be operating in the business conducted by the partnership. As such, the Department generally presumes that the income passed through from a partnership to be operational.

In this case, the investment income is recognized in the Partnership's income. The Partnership's operational function is to generate income from investments. Typically, the Department would consider the Group, as a general partner of the Partnership, to be operating as an investment manager in addition to its other operational activities. Under this analysis, the income from the Partnership would be considered apportionable income.

In light of Allied-Signal, however, the Department must consider whether an investment activity was conducted independently from the management and investment of operational working capital balances. See Public Document (P.D.) 94-178 (6/8/1994). In this case, the Partnership was created to separate excess cash from capital needed to conduct the operations of the Group. From these excess assets, the Partnership invested in limited partnerships, stocks, and treasury bonds. Further, the assets and income of the Partnership were not used to supplement or enhance the operations of the Group during the taxable years at issue.

The evidence provided by the Taxpayer supports its position that the income in question was generated through a passive investment with non-unitary payers and, therefore, is not subject to apportionment under the guidelines established in Allied­Signal. Accordingly, permission is hereby granted to allocate the Partnership's investment income (interest and capital gains) passed through to the Taxpayer, Corporation A, Corporation B for the taxable years ended December 31, 2001 and 2002.

Under the standards of Allied-Signal, the nonbusiness income is allocated to the corporation's state of commercial domicile. Corporation C's state of commercial domicile is Virginia. As such, the nonbusiness income passed through to Corporation C from the Partnership would be included in Corporation C's apportionable income.

Cost of Performance

Virginia Code § 58.1-416 provides that sales, other than sales of tangible personal property, are deemed in Virginia if:
    • 1. The income-producing activity is performed in Virginia; or
    • 2. The income-producing activity is performed both in and outside Virginia and a greater proportion of the income-producing activity is performed in Virginia than in any other state, based on costs of performance.

The term "cost of performance" is defined in Title 23 of the Virginia Administrative Code (VAC) 10-120-230 as "the cost of all activities directly performed by the taxpayer for the ultimate purpose of producing the sale to be apportioned."

The auditor included sales for construction projects occurring in Virginia in the numerator of the sales factor on the basis that the costs of performance are greater in Virginia than elsewhere. The Taxpayer has produced evidence that demonstrates that Corporation A performed a majority of its sales-producing activity with regard to each of the Virginia contracts in State A. Therefore, the auditor's adjustment will be corrected.

CONCLUSION


The audit report has been revised in accordance with this determination. Please remit payment of the amount due, according to the enclosed schedule, within 30 days from the date of this letter to avoid the accrual of additional interest. The Taxpayer should remit its payment to: Virginia Department of Taxation, Appeals and Rulings, P.O. Box 27203, Richmond, Virginia 23261-7203, Attention: *****.
    • The Code of Virginia sections and regulation cited are available on-line at www.tax.virginia.gov. If you have any questions regarding this determination, please contact ***** at *****.
                • Sincerely,


                • Janie E. Bowen
                  Tax Commissioner




AR/56253B


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46