Document Number
08-6
Tax Type
Corporation Income Tax
Description
Corporation commercially domiciled in Virginia, filed a consolidated
Topic
Allocation and Apportionment
Appropriateness of Audit Methodology
Corporate Distributions and Adjustments
Nexus
Date Issued
01-11-2008


January 11, 2008




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 assessments issued to ***** (the "Taxpayer") for the taxable years ended October 31, 2001 through October 31, 2003. I apologize for the delay in responding to your appeal.

FACTS


The Taxpayer, a corporation commercially domiciled in Virginia, filed a consolidated Virginia corporate income tax return with a number of its affiliates for the taxable years at issue. In addition, the Taxpayer had three subsidiaries, ***** (Corporation A), ***** (Corporation 13), and ***** (Corporation C), that were commercially domiciled outside Virginia. The Group filed separate Virginia corporate income tax returns for the taxable years at issue.

Under audit, the Department made adjustments to consolidate Corporation A, Corporation B, and Corporation C with the Taxpayer and its affiliates, resulting in the assessment of additional corporate income tax.

The Taxpayer contests the assessment and contends that Corporation A, Corporation B, and Corporation C lacked nexus with Virginia for income tax purposes. The Taxpayer also requests permission to use an alternative method of allocation and apportionment if it is found that Corporation A, Corporation B, and Corporation C must be included in the Virginia consolidated return.

DETERMINATION


Pursuant to Va. Code § 58.1-442, an affiliated group of corporations may elect to file a consolidated Virginia income tax return. If such an election is made, Title 23 of the Virginia Administrative Code (VAC) 10-120-322 provides that, once an election to file a consolidated return is made, a related corporation must be included in the Virginia consolidated return unless it is not affiliated as defined under Va. Code § 58.1-302, exempt from Virginia income tax under Va. Code § 58.1-401, exempt from Virginia income tax under Public Law (P.L.) 86-272, not subject to Virginia income tax if separate returns were to be filed, or using different taxable years.

Virginia Code § 58.1-441 does require every corporation organized under the laws of the Commonwealth to file an income tax return annually with the Department. However, a filing requirement does not subject a corporation to the Virginia tax on its income. Public Document (P.D.) 94-368, (12/12/1994) states that a corporation registered to do business in Virginia, but has not conducted any business in Virginia is not subject to tax in Virginia and is not eligible to be included in a consolidated Virginia return even though it may be required to file a Virginia return. Thus, a business incorporated under the laws of Virginia may be required to file a Virginia return, but may not be subject to the Virginia tax on its income.

Accordingly, a corporation, even one that is incorporated under the laws of Virginia and is required to file a Virginia return, that is not subject to the tax imposed by Virginia on its income cannot be included in an affiliated group for the purposes of filing a Virginia consolidated corporation income tax return. See P. D. 99-34 (3/24/1999).

In order for a corporation to be subject to Virginia income tax, it must have income from Virginia sources. Generally, a corporation will have income from Virginia sources if there is sufficient business activity within Virginia to make any one or more of the applicable apportionment factors positive. For corporations using the three-factor formula, the existence of one positive Virginia apportionment factor clearly establishes income from Virginia sources.

Likewise, corporations that are required to use a single apportionment factor under Va. Code §§ 58.1-417, 58.1-418, 58.1-419 or 58.1-420 are considered to have income from Virginia sources if that single apportionment factor is positive. The same principle is used whether the corporation files a separate return or is affiliated with a group of corporations that files a combined return.

Single apportionment factor corporations that would otherwise be required to be included in a consolidated return, however, must convert to the three-factor formula that includes the property, payroll, and sales of all affiliates. See Title 23 VAC 10-120-326.

This process essentially creates a three-factor formula based on the single-factor formula. Accordingly, single apportionment factor corporations that are otherwise required to be included in a consolidated Virginia income tax return are considered to be subject to Virginia income tax if their single apportionment factor is positive.

Corporation A

Corporation A, a mortgage lender headquartered in New Jersey (State A"), reported a positive sales factor on its separate Virginia return. Corporation A provided mortgages to customers who resided in Virginia. Corporation A derived more than 70% of its gross income from interest and fees to process loans. As such, for Virginia income tax purposes, Corporation A was a financial corporation that was required to apportion income based on cost of performance. See Va. Code § 58.1-418.

Title 23 VAC 10-120-250 defines the "cost of performance" as the cost of all activities directly performed by the taxpayer for the ultimate purpose of obtaining gains or profit, except activities directly performed by the taxpayer for the ultimate purpose of obtaining allocable dividends.

The Taxpayer asserts that even through Corporation A reported positive sales in Virginia on its separate Virginia return; it actually had no sales in Virginia. In addition, Corporation A did not have a positive property or payroll factor. The cost of activities directly performed for the purpose of generating income occurs where employees are working and property is located. Because Corporation A had no property or payroll in Virginia for the taxable years at issue, it is unlikely that it had a positive apportionment factor under Va. Code § 58.1-418.

Based on the evidence, Corporation A lacked any positive apportionment factors and was not subject to Virginia corporate income tax for the taxable years at issue. Accordingly, Corporation A cannot be included in the consolidated return filed by the Taxpayer and its Virginia affiliates.

Corporation B

Corporation B, a mortgage lender headquartered in State A, provided mortgages to customers who resided in Virginia. Corporation B derived more than 70% of its gross income from interest and fees to process loans. Corporation B had an office located in Virginia and employees who worked in that office throughout the taxable years at issue. The purpose of the Virginia office was to take loan applications from customers and forward them to an out-of-state facility for processing. Corporation B did not directly solicit loan applications. Instead, an affiliated corporation that builds homes referred customers to Corporation B.

The Taxpayer asserts that the activities conducted at the Virginia office were ancillary to solicitation and were de minimis. P.L. 86-272, codified at 15 U.S.C. §§ 381-384, prohibits Virginia from imposing a net income tax on a foreign corporation when its only contact with Virginia constitutes solicitation of sales. This same protection has been extended by the United States Supreme Court to include activities that are ancillary to solicitation or de minimis in nature. Although P.L 86-272 applies to tangible property, the Department's policy has been to extend the "solicitation test" of P.L. 86-272 to situations involving the sales of services.

The Department interprets P.L. 86-272 within the context of the decision of the United States Supreme Court in Wisconsin Department of Revenue v. William Wrigley, Jr. Co., 505 U.S. 214 (1992). A taxpayer that engages in activities that exceed the protection provided by P.L. 86-272 would be subject to the Virginia corporate income tax.

The ownership or rental of real estate is not a business activity that is ancillary to the solicitation of sales. As such, the establishment of an office by Corporation B creates a physical presence in Virginia that clearly exceeds the protections of P.L. 86-272.

Title 23 VAC 10-120-90 G, however, exempts activities that are de minimis in nature. Pursuant to Wrigley, all nonancillary activities are examined to determine if, when considered together, they create more than a de minimis connection to the Commonwealth. To determine whether sufficient activity has occurred in Virginia, the Department will analyze the nature, continuity, frequency, and regularity of the activities in Virginia, compared with the nature, continuity, frequency, and regularity of its activities elsewhere.

In this case, Corporation B's office, equipment, and furniture located in Virginia constituted between 10% and 40% of the property factor reported on the separate Virginia tax returns. Likewise, almost 40% of Corporation B's payroll occurred in Virginia. This clearly constitutes more than a trivial level of business activity in Virginia. Accordingly, Corporation B was subject to Virginia income tax for the taxable years ended October 31, 2001 through October 31, 2003.

Further, the presence of property and payroll in Virginia indicate that Corporation B had costs in Virginia that would be included in the numerator of the financial factor under Va. Code 58.1-418. Because Corporation B had a positive financial corporation apportionment factor, it had income from Virginia sources and was subject to Virginia income tax. Accordingly, Corporation B must be included in the consolidated Virginia income tax returns for the taxable years at issue.

Corporation C

Corporation C, headquartered in State A, was in the business of providing title insurance to customers buying homes from an affiliated entity. Corporation C did not directly solicit insurance policies. Instead, an affiliated corporation that builds homes referred customers to Corporation C.

For the taxable years at issue, Corporation C reported Virginia taxable income, but no income subject to Virginia tax after apportionment. Corporation C did not attach the apportionment factor schedule required of multistate corporations. The returns also indicated that Corporation C was incorporated in Virginia.

The auditor concluded that Corporation C was a 100% Virginia corporation that should have been included in the Taxpayer's consolidated returns and attributed all of its property, payroll and sales to Virginia. The Taxpayer asserts Corporation C did not have any property, payroll, or sales in Virginia during the taxable years at issue.

Corporation C conducted minimal business activity during the audit period. In fact, Corporation C reported no sales for the taxable years ended October 31, 2002 and October 31, 2003. Based on the evidence provided, all of Corporation C's property and employees were located in State A and all of its business activities were conducted in State A. There is no evidence that any activities were conducted in Virginia that exceeded P.L. 86-272 protections. Accordingly, Corporation C lacked any positive apportionment factors and was not subject to Virginia corporate income tax for the taxable years at issue. As such, Corporation C cannot be included in the Virginia consolidated return with the Taxpayer for the taxable years at issue.

Consolidated Apportionment Factor

Although Corporation A and Corporation B met the definition of a financial corporation for the 2001 through 2003 taxable years, both corporations filed separate income tax returns using the standard three-factor formula. The auditor, likewise, included the property, payroll, and sales of Corporation A and Corporation B in the consolidated apportionment formula based on the standard three-factor formula.

Virginia Code § 58.1-418 requires financial corporations to apportion income based on cost of performance. As noted above, financial corporations that are included in a consolidated return must convert to the three-factor formula.

Under Title 23 VAC 10-120-326, this conversion is computed by multiplying the financial corporation's property, payroll, and sales that were included in the denominator of the consolidated factor by the percentage derived from its single financial apportionment factor. This process essentially creates a three-factor formula that would apportion the same amount of a corporation's income to Virginia on a separate company basis as the single-factor formula.

In this case, the auditor incorrectly computed the inclusion of Corporation A and Corporation B's factor attributes based on the standard three-factor apportionment formula. The issue with Corporation A is moot because it should be removed from the consolidated return in accordance with this determination. However, Corporation B's portion of the numerator of the consolidated apportionment factors for the audit period must be adjusted in accordance with this determination.

Alternative Method

The United States Supreme Court has recognized that allocation and apportionment of income is an arbitrary process designed to approximate income from business transactions within a state. As long as each state's method of allocation and apportionment is 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. 279 (1978). Thus, the Taxpayer must show that the statutory method of apportionment produces an unconstitutional result.

An apportionment formula used as an approximation of a corporation's income reasonably related to the activities conducted within a taxing state will only be disturbed when the taxpayer has proved by "clear and cogent evidence" that the income attributed to the state is in fact "out of all reasonable proportion to the business transacted . . . in that state," Hans Rees' Sons, Inc. v. North Carolina, 283 U.S. 123, 135 (1931), or has "led to a grossly distorted result," Norfolk & Western R. Co. v. Missouri State Tax Commission, 390 U.S. 317, 326 (1968).

The policies that apply to requests for an alternative method of allocation and apportionment under Va. Code § 58.1-421 are well established. In order for a taxpayer to request an alternative method of allocation and apportionment, the taxpayer must file the return using the statutory method and pay any tax due. Next, the taxpayer is required to file an amended return proposing an alternative method within the time prescribed for filing amended returns claiming refunds. The amended return must include a statement of why the statutory method is inapplicable or inequitable and an explanation of the proposed method of allocation and apportionment. The Department will not grant an alternative method of allocation and apportionment unless it determines that: (1) the statutory method produces an unconstitutional result under the particular facts and circumstances of the taxpayer's situation; or (2) the statutory method is inequitable because it results in double taxation and the inequity is attributable to Virginia, rather than another state's method of apportionment. See Title 23 VAC 10-120-280.

The Taxpayer asserts that using Virginia's statutory apportionment method to include Corporation B in the consolidated return results in an excessive tax burden and is therefore unconstitutional and constitutes double taxation. The Taxpayer contends that the inclusion of Corporation B significantly increases the amount of its income subject to Virginia tax as compared to reported Corporation B's separate returns. The Taxpayer has provided Corporation B's tax returns that were filed in other states in order to demonstrate the additional tax burden created by Virginia's standard apportionment method.

The fact that Virginia taxable income is greater under the statutory method than an alternative method does not constitute "extraordinary circumstances" sufficient to justify permission to use an alternative method. See Department of Taxation v. Lucky Stores, Inc., 217 Va. 121 (1976). Further, even though other states prescribe a different method of apportioning financial companies within and without their jurisdiction, Virginia's statutory formula can still reasonably apportion a corporation's income to its activities conducted within Virginia.

The use of an alternative method is allowed only in extraordinary circumstances where the need for relief has been demonstrated by clear and cogent evidence. Based on the facts presented, you have not demonstrated that the statutory method is unconstitutional or inapplicable, as it would apply to the Taxpayer. Furthermore, the Taxpayer's request is not in accordance with the procedure for requesting an alternative method of allocation and apportionment outlined in Title 23 VAC 10-120-280. Based on the foregoing, I must deny the Taxpayer's request to use an alternative method of sourcing receipts for the Virginia sales factor.

CONCLUSION


Based on the foregoing, the audit will be returned to the audit staff to adjust the assessment as noted above. The auditor will contact the Taxpayer with regard to the cost of performance information for Corporation B. After the auditor makes the appropriate adjustments, the Taxpayer will receive a revised bill. The Taxpayer should remit its payment for the outstanding balance as shown on the revised bill within 30 days from the date of the bill to avoid the accrual of additional interest.

The Code of Virginia sections, regulations and public documents cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions regarding this determination, please contact ***** in the Department's Office of Tax Policy, Appeals and Rulings, at *****.
                • Sincerely,
                  • Janie E. Bowen
                    Tax Commissioner



    AR/1-948504736B


    Rulings of the Tax Commissioner

    Last Updated 08/25/2014 16:46