Rulings of the Tax Commissioner

June 21, 2019

Re:  Appeal of Final Local Determination
       Taxpayer:  *****
       Locality Assessing Tax:  *****
       Business, Professional and Occupational License (BPOL) tax

Dear *****:

This final state determination is issued upon the application for correction filed by you on behalf ***** (the “Taxpayer”), with the Department of Taxation. You appeal an assessment of Business, Professional and Occupational License (BPOL) tax issued to the Taxpayer by ***** (the “County”) for the 2018 tax year. I apologize for the delay in responding to your appeal.

The BPOL tax is imposed and administered by local officials. Virginia Code § 58.1-3703.1 authorizes the Department to issue determinations on taxpayer appeals of BPOL tax assessments. On appeal, a BPOL tax assessment is deemed prima facie correct, i.e., the local assessment will stand unless the taxpayer proves that it is incorrect.

The following determination is based on the facts presented to the Department summarized below. The Code of Virginia sections, regulations and public documents cited are available on-line at www.tax.virginia.gov in the Laws, Rules and Decisions section of the Department’s web site.

FACTS

The Taxpayer, a publicly traded corporation located in the County, acquired, held and managed mortgage-backed securities. Capital to purchase the mortgage-backed securities came from the issuance of common and preferred stock, secured and unsecured debt, short-term repurchase funds and profits. The Taxpayer periodically traded the mortgage-backed securities through registered broker-dealers, but its primary source of income resulted from the interest return on the mortgage-backed securities.

The County audited the Taxpayer for the 2018 tax year and issued an assessment of BPOL tax. The Taxpayer appealed to the County, contending that it was not subject to the BPOL tax, or in the alternative, that its gross receipts were excludable from the tax. In its final determination, the County held that the Taxpayer was subject to the BPOL tax because it operated a licensable business as a dealer of securities and should be classified as a financial service. 

The Taxpayer appealed to the Department, contending it was not exercising a taxable privilege and it was not providing financial services. In the alternative, the Taxpayer asserts that even if it is found to have been engaged in a licensable privilege, its gross receipts were excludable from the BPOL tax because: (1) it was an investment fund; (2) its income was investment income and (3) a portion of the proceeds resulted from the sale of capital assets. 

ANALYSIS

Licensable Privilege

The Taxpayer contends that it was not exercising a licensable privilege because it was merely managing its own money and it did not have any customers. The County asserts the Taxpayer was subject to the BPOL tax because it met the requirement of being engaged in a regular course of dealing for the purpose or earning a profit.

Virginia Code § 58.1-3703.1 A 3 a provides that “the gross receipts included in the taxable measure shall be only these gross receipts attributed to the exercise of a privilege subject to licensure at a definite place of business within [the] jurisdiction.” Generally, gross receipts for license tax purposes exclude any amount not derived from the exercise of the licensed privilege to engage in a business or profession in the ordinary course of business. See Title 23 of the Virginia Administrative Code (VAC) 10-50-70. Further, Virginia Code § 58.1-3700.1 defines “business” as “. . . a course of dealing which requires the time, attention and labor of the person so engaged for the purpose of earning a livelihood or profit. It implies a continuous and regular course of dealing, rather than an irregular or isolated transaction.”  

The Taxpayer cites several regulations and House Doc. No. 59, Joint Subcommittee BPOL Tax Report (1995) to support its contention that it was not exercising a privilege to manage its own money. Specifically, Title 23 VAC 10-500-60 states that “[A]ctivities of a taxpayer that serve only the taxpayer's interest, and no other, do not give rise to gross receipts.”  Because its activities served only its own interests, the Taxpayer believes it does not receive gross receipts, as defined under Title 23 VAC 10-500-10, because the consideration received did not result from transactions with others besides itself. The Taxpayer also asserts that House Doc. No. 59, Joint Subcommittee BPOL Tax Report (1995), Tab 20 at 23 confirms that a taxpayer “cannot create gross receipts by dealing with himself.”

As a publicly traded entity, the Taxpayer was required to file a 10-K report with the Securities and Exchange Commission (SEC). In its 10-K report filed as of December 31, 2017, the Taxpayer describes itself as an investment firm focused on acquiring and holding a portfolio of residential mortgage-backed securities in a manner so as to increase potential returns to shareholders. The Taxpayer has periodically issued both common and preferred stock offerings (most recently in 2019) in order to raise monetary capital so that it would be able to engage in its activities. It also secured capital through debt, retained profits and short-term repurchase agreements for the same purpose. The Taxpayer’s reliance on outside financing to conduct its activities and its emphasis on shareholder returns raises questions as to whether its activities solely served its own interests.

The Taxpayer also believes a business engages in a taxable privilege only when it sells goods or services to customers. The Taxpayer cites Title 23 VAC 10-500-10, which defines “services” as “things purchased by a customer that do not have physical characteristics, or that are not goods, wares, or merchandise.”  The Taxpayer also cites Title 23 VAC 10-500-120, which deals with the classification of businesses based on the nature of goods or services offered to the customers. The Taxpayer asserts that it cannot be classified as a financial service provider because it did not perform a service and services for customers as required under Title 23 VAC 10-500-120 and Title 23 VAC 10-550-380. For the same reason, the Taxpayer asserts it did not satisfy the requirements of a professional service provider under Title 23 VAC 10-500-470 A.  

The Taxpayer particularly relies on commentary from the BPOL Guidelines Draft (10/23/1996) that states “[to] be taxable at all, there must be an actual receipt from a customer for something directly related or ancillary to the licensable privilege.”  This commentary was the opinion of a member of the working group assigned to draft the 1997 BPOL Guidelines, but was not specifically incorporated into the final 1997 BPOL Guidelines, nor the subsequent regulations initially issued in 2008.

For most types of businesses, the identity of the customer is clear. A customer, according to American Heritage Dictionary of the English Language, Fifth Edition, (2011), is an entity “that buys goods or services, as from a store or business.”  A customer can be a consumer purchasing goods from a store, a homeowner hiring a contractor to make a repair, a truck driver getting his tractor repaired by a mechanic, an individual getting a checkup from a doctor, or a business hiring an accountant to prepare financial statements.

In its response to the Taxpayer’s appeal, the County argues the term “services” should be broadly read as a catchall to include all things sold that are not physical. In doing so, the County identifies the uniqueness of the financial sector of Virginia’s economy. The principal products of financial services as defined in Title 23 VAC 10-500-10 (money, credit, securities, or other investments) are fungible assets that can be valued and traded. In transactions involving these products, one party receives cash while the other obtains the opportunity to receive more cash in the future. In some cases, the party in receipt of the cash is the customer (i.e., debtor, investee, insurer, assignee) and in others the customer is the creditor, the investor, the insured, or the account owner. Further, because financial transactions can go through multiple layers, the identification of which party is the provider and which party is a customer in a financial services transaction can become blurred with both parties sharing characteristics of customer and provider in a given transaction.

The mortgage segment of the financial services sector exemplify this dichotomy. An individual or business that receives the proceeds of a mortgage loan is the customer of the financial service provider (i.e., banks, mortgage companies, and other originators). In such cases, the provision of the cash is the service. In return, the loan originator has a loan receivable asset, which entitles it to future cash payments of principal and interest. If the originator chooses to sell the asset, it would traditionally be considered the business selling to a customer. However, because the originator is transferring a loan, it will also be considered to be raising capital (current cash) through the receivable (future cash) in a manner similar to the way its customer borrowed money to buy real estate.

This same uncertainty carries forward to the entity that purchased the mortgage. In most cases, the purpose of the entity is not to collect the mortgage, but to securitize it into a pool with other loans to create bonds or other debt obligations called mortgage- backed securities. According to the United States Securities and Exchange Commission, mortgage-backed securities are “debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property.”  Ultimately, those investing in mortgage-backed securities become holders of debt.

The Taxpayer primarily invested in mortgage-backed securities. Based on this simplistic description, the Taxpayer would appear to have been a customer in a manner similar to any individual making personal investments in the financial markets. As an owner of mortgage-backed debt, however, the Taxpayer was providing current cash to the entity that securitized a pool of loans. In simple terms, the Taxpayer became a creditor whose customers created mortgage-backed securities. Within the realm of the mortgaged-backed securities industry, these entities were the Taxpayer’s customers.

Simply holding a bond, note or debt is not sufficient to create a licensable privilege. Individuals can invest in bonds or provide personal loans to families or businesses without rising to the level of a business. Beyond simply having customers, an enterprise must be engaged in sufficient activities in order to be considered a business as defined in Virginia Code § 58.1-3700.1. Thus, the question becomes whether the Taxpayer’s activities constituted a business.

In 2017, the Taxpayer employed 12 individuals who actively managed its portfolio of securities by hedging to mitigate risks and trading to gain higher yields. In pursuit of these higher yields, the Taxpayer traded its securities, engaging in more than 80 sales transactions while making more than 60 purchases of securities.

As a result of this trading, the County appears committed to the concept that the Taxpayer is engaged as a dealer of securities. The Taxpayer objects to this characterization because it did all of its trading through brokers. Under Virginia Code § 58.1-3700.1, a security dealer is one who meets the definition of a dealer under the Securities and Exchange Act and registers with the Securities and Exchange Commission (SEC). Under 15 USC § 78c (5), a “dealer” is any “person engaged in the business of buying and selling securities . . . for such person’s own account through a broker or otherwise.”  Under this definition, an enterprise would be engaged in the licensable privilege of buying and selling securities on its own account only if it can be defined as a business under Virginia Code § 58.1-3700.1. 

As indicated above, the Department questions whether the Taxpayer is trading on its own account. Further, the Taxpayer argues its sales resulted in a net loss. A dealer is not going to be able to provide a livelihood if it consistently loses more money than it gains. 

While trading resulted in a net loss for 2017, as well as most of the previous years, the Taxpayer also admits that achieving gains on the securities was not the focus of its activities. Instead, securities were analyzed and traded in order to reposition its portfolio. Based on its analysis of the various risks versus potential return associated with a particular securities, the Taxpayer would sell a security at a loss in order to obtain a security that would provide a higher yield.

Although the facts appear to indicate that the Taxpayer did not operate as a dealer, the volume, regularity and dollar amount (approximately $** billion) of the purchases and sales are indicative of activities of an entity engaged in a continuous and regular course that requires substantial time, attention and labor. Further, as indicated above, the Taxpayer was a publicly traded entity that regularly engaged in soliciting capital through issuing stock and various forms of debt. It marketed itself as an investment firm that focused on acquiring and holding a leveraged portfolio of mortgage-backed securities. Finally, the Taxpayer’s portfolio exceeded $** billion at the end of 2017. While this amount may seem small when compared to the total amount of mortgage-backed securities outstanding (roughly $** to $** trillion), a $** billion portfolio is an indicator of more than casual investing.

Classification

The Taxpayer contends that a financial service must be a service provided to a customer for compensation. It asserts that it was not a financial service provider because it traded securities on its own account. The County argues that Virginia Code § 58.1-3700.1 does not require the service be conducted for the benefit of customers asserting that the broker-dealers to whom the Taxpayer sold the securities were customers and that the sales generated a profit.

“Financial, real estate, and professional service businesses” are a separate classification of enterprise under Virginia Code § 58.1-3706. Virginia Code § 58.1-3700.1 defines “financial services” as “the buying, selling, handling, managing, investing, and providing of advice regarding money, credit, securities, or other investments.”  Title 23 VAC 10-500-10 further defines “financial services” as “the buying, selling, handling, managing, and investing money, credit, securities, or other investments for others, as well as providing advice to others on such matters.”  Any person rendering a service for compensation in the form of a credit agency, an investment company, a broker or dealer in securities and commodities, or a security or commodity exchange is providing a financial service. See Title 23 VAC 10-500-380. 

While no longer specifically identified in statute as a type of business subject to local licensure after the passage of the uniform ordinance provisions for Title 58.1 Chapter 37 in 1996, providers of financial services were identified as licensable businesses by the working group assigned to draft the 1997 BPOL Guidelines. Under Title 23 VAC 10-500-380, an entity that renders a service “in the form of a credit agency, an investment company, a broker or dealer in securities and commodities, or a security or commodity exchange is providing a financial service, unless such service is specifically provided for under another section of the BPOL Regulations.”

Title 23 VAC 10-500-390 provides a list of occupations that are classified as licensable financial services subject to the BPOL tax. Again, these activities were compiled by the working group assigned to draft the 1997 BPOL Guidelines and later included in the regulation. The regulation also makes it clear that the provision of financial services is not limited to the businesses listed.

The Taxpayer primarily invested in mortgage-backed securities. These securities consist of bonds that are backed by residential mortgage loans. According to the United States Securities and Exchange Commission, mortgage-backed securities are “debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property.”  Mortgage loans sold by the banks, mortgage companies, and other originators, are collected into a pool and then sold as a security. The Taxpayer received principal and interest payments from the mortgage loans in the pool and hedged its portfolio to mitigate risk by entering into various hedging instruments. The Taxpayer also periodically traded some of its mortgage-backed securities to broker-dealers in order to obtain a higher yield. 

Although, the Taxpayer’s activities are not among the occupations listed, it does share some characteristics of a number of the activities listed. By investing in mortgage-backed securities, the Taxpayer resembles an entity providing working capital financing, which allows brokers, dealers or other entities to securitize mortgage notes. Like other financiers, the Taxpayer is essentially selling cash in hopes of gaining a return from the resulting indebtedness. The entities securitizing the notes become the borrowers or customers because the need the cash the Taxpayer is able to provide.

The list also includes three activities (buying installment receivables, factors, and financing accounts receivable) similar to the Taxpayer’s activity of generating receipts by acquiring evidence of indebtedness originated by another business. Neither the statutes nor the regulations define these activities. A factor, however, has been defined as one who buys accounts receivable at a discount. See Black’s Law Dictionary 630 (8th Ed. 2004). According to Black’s Law Dictionary, “the factor (who buys them) assumes risk of delay in collection and loss on the accounts receivable.”

Generally, factoring can be described as a transaction in which a business sells accounts receivable or invoices in order to secure working capital. Factors purchase accounts receivable but do not have customers to whom they sell goods of services. In many cases, businesses use factoring to manage cash flow or as a means for acquiring financing to meet immediate cash needs. As such, businesses engaged in factoring accounts receivable are considered to be providing financing to others by assuming the risk of collection of collection and credit losses. See Public Document (P.D.) 17-14 (3/10/2017). 

The Taxpayer’s business was similar to that of a factor in that its investment in receivables (mortgage loans) provided working capital for other businesses. Ultimately, converting mortgage loans through a series of transactions and securitization into mortgage-backed securities provided capital lenders with the capital required to make more residential and commercial real estate loans. In addition, like factors, the Taxpayer assumed the risk of receiving a return of its capital through interest and trades of the securities. 

The Taxpayer contends it can be distinguished from factors and purchasers of distressed debt because it passively held securities while factors actively pursue collection. As indicated in the analysis of licensable privilege, the Department disagrees with the Taxpayer’s characterization of its activities. Regardless, the Taxpayer has made no argument as to how it should have been classified if it was found to be a conducting a licensable privilege and its activities appear to have been inseparable from the financial services industry. It conducted financial service activities (investing money in and trading financial instruments) on which it received financial service income (interest) through financial service businesses (security brokers) and financed its trading from financial service obligations (short-term secured debt and long-term unsecured debt) and periodic issuances of financial service securities (common and preferred stock).

Venture Capital Fund Exemption

Virginia Code § 58.1-3703 C 19 prohibits a locality from assessing the BPOL tax against a venture capital fund or any investment fund, except commissions and fees of such funds. Investment companies, however, are subject to the BPOL tax. See Title 23 VAC 10-500-380. The Taxpayer contends that it was a closed-end investment company, which is an investment fund that sells stock to investors and trades on a public exchange. The County asserts that the Taxpayer was a taxable investment company. 

The statutes, regulations, case law and public documents do not define what an investment fund is for BPOL tax purposes. The Taxpayer contends that in accordance with Black’s Law Dictionary 954 (10th ed. 2014), investment means “an expenditure to acquire assets to produce revenue” and fund means “a sum of money or other liquid assets established for a specific purpose”. As such, the Taxpayer argues it was an investment fund because it raised capital, acquired a portfolio and managed the portfolio in order to generate a return. The County asserts that the Taxpayer’s definition would include virtually any corporate entity because all companies raise capital in order to produce revenue. 

By reason of their character as legislative grants, statutes relating to exemptions allowed against a tax liability must be strictly construed against the taxpayer and in favor of the taxing authority. See DKM Richmond Associates, L.P. v. City of Richmond, 249 Va. 401, 407, 457 S.E.2d 76, 80 (1995). Pursuant to City of Lynchburg v. English Constr. Co., 277 Va. 574 (2009), however, taxing statutes must be strongly construed in favor of the taxpayers. The Taxpayer contends that Virginia Code § 58.1-3703 C 19 is a restriction on a locality’s taxing powers, not an exemption. As such, it asserts that if a locality lacks the authority to assess a tax, then taxing statutes must be construed most strongly against the government. The County distinguishes English Const. Co., by arguing the Virginia Supreme Court found that the locality lacked the authority to tax because such authority was implied, not expressly granted by statute. 

The Virginia Supreme Court and the Attorney General have each opined that the subsections of Virginia Code § 58.1-3703 C are tax exemptions. See, for example, Arlington County v. Mutual Broadcasting System, 260 Va. 434, 536 S.E.2d 707 (2000) and Attorney General Opinion 09-043 (8/24/2009). As such, the Department will strictly construe the venture capital fund exemption against the Taxpayer.

The County contends that the SEC refers to companies like the Taxpayer as “closed-end funds” and regulates them as “investment companies” which are subject to the BPOL tax under Title 23 VAC 10-500-380. The Taxpayer asserts that it cannot be an investment company because it managed its own funds. 

In 1996, the General Assembly enacted Senate Bill 587 (1996 Acts of Assembly, Chapter 715), which established Virginia Code § 58.1-3703 C 19. According to the Department’s Fiscal Impact Statement, the purpose of this bill was to codify 1995 Op. Va. Att’y Gen. 250 (6/20/1995). According to this opinion, an investment fund must manage investments as an agent on behalf of its clients in order to be an investment fund. 

The definition of “agency relationship” has been created through case law and applied in both opinions of the Attorney General and rulings by the Department. In City of Alexandria v Morrison-Williams Associates, Inc., 223 Va. 349, 288 S.E.2d 432 (1982), the Virginia Supreme Court established three criteria that must be met if a taxpayer is to establish it has an agency relationship with its clients. These criteria are: (1) contractual relationships exist between the taxpayer and both the client and the contracted third party, and there is a stated relationship between the client and the contracted third party; (2) the taxpayer does not commingle its “agency” funds with other sources; rather it must have a separate accounting system or a fiduciary account where the pass through receipts from its clients are recorded and; (3) the taxpayer does not report these “pass through costs” on its federal income tax returns. See P.D. 01-38 (4/12/2001), P.D. 06-94 (9/28/2006) and P.D. 13-216 (12/12/2013). 

In this case, there was no contractual relationship between the Taxpayer and its shareholders or the mortgagors with regard to the securities it traded. In addition, it did not receive any commissions or fees for managing the securities. The Taxpayer was not an agent of the shareholders or mortgagors and, therefore, does not qualify as an investment fund under Virginia Code § 58.1-3703 C 19. 

Investment Income Exclusion

Virginia Code § 58.1-3732 A 8 provides that gross receipts for BPOL tax purposes exclude:

Investment income not directly related to the privilege exercised by a business subject to licensure not classified as rendering financial services. This exclusion shall apply to interest on bank accounts of the business, and to interest, dividends and other income derived from the investment of its own funds in securities and other types of investments unrelated to the licensed privilege. 

The Taxpayer contends that its income was investment income because it was not financial services. The County asserts that the Taxpayer does not qualify for the investment income exclusion because it was a financial services business and its income was directly related to the exercise of the privilege of engaging in the financial services business. 

In order to claim the exclusion, the interest that a taxpayer earns must not be related to the exercise of a licensable privilege. The Taxpayer’s argument presumes it was conducting a licensable privilege, but not as a financial service provider. As indicated above, the Taxpayer has provided no argument as to how it should have been classified if it was conducting a licensable activity. 

Besides, Virginia Code § 58.1-3732 A 8 provides that the exclusion does “not apply to interest, late fees and similar income attributable to an installment sale or other transaction that occurred in the regular course of business.”  It appears the Taxpayer is asking the Department to permit an exclusion for interest income that resulted from its acquisition, management and holding of mortgage-backed securities, which was its primary activity. 

Capital Asset Exclusion

Virginia Code § 58.1-3732 A 5 provides an exclusion from gross receipts for the return of principal or basis upon the sale of a capital asset. The Taxpayer contends that the proceeds from the sale of its securities was the return of principal or basis upon the sale of capital assets as defined under both federal and Virginia income tax law. The County asserts that income tax law does not apply to the BPOL tax. It argues that that capital assets are those used to raise capital and exclude the Taxpayer’s mortgage-backed security inventory.

The BPOL statutes and regulations do not define capital assets. The BPOL tax is not an income tax. It is a tax that is calculated from the gross receipts that the business earns within that locality. See P.D. 97-432 (10/24/1997).

Capital assets are defined as a long-term asset used in the operation of a business or used to produce goods or services, such as equipment, land, or an industrial plant. Excluded from the definition, are among other things, stock in trade, inventory, and property held by the taxpayer primarily for sale to customers in the ordinary course of trade or business. See Black’s Law Dictionary (8th add.) page 126. As such, in accordance with the Virginia Code and Black’s Law Dictionary, a taxpayer would not be eligible to claim an exemption from the BPOL tax for proceeds from the sale of inventory. 

The County contends that the Taxpayer maintained an inventory of securities that it sold to broker-dealers. The Taxpayer asserts that the securities were not inventory because: (1) it did not have an SEC dealer’s license; (2) the broker-dealers were not customers because transaction fees were paid, and (3) the sale prices of the securities were not published and the securities were not treated as inventory primarily for sale to customers. 

In this case, the Taxpayer argues that its primary purpose was to earn income from the difference between the interest earned on the securities and the interest payable on its debt funding. It states that it periodically bought and sold the securities in order to maximize the yield rate. 

The County, citing 1995 Op. Va. Att’y Gen. 250 and 1984-1985 Op.Va. Att’y Gen. 349 (4/5/1985), argues that the gross receipts of a dealer in securities include the total sales price of the securities. A review of the Taxpayer’s yearly financial statements shows that a majority of its income came from interest, not gains from the sale of its securities. In addition, more than twice as many of the sales of the securities during 2017 resulted in losses than in gains. As indicated above, it appears that the Taxpayer’s primary purpose of acquiring the securities was not to hold them for sale, but to accrue interest. 

DETERMINATION

The Department finds the Taxpayer was engaged in a licensable privilege and was properly classified as a financial service provider by the County for the 2018 tax year. In addition, the Taxpayer was not an investment fund for purposes of the exemption afforded by Virginia Code § 58.1-3703 C 19. Further, the interest earned from the mortgage-backed securities did not qualify for the exclusion of investment income pursuant to Virginia Code § 58.1-3732 A 8.

The Department also concludes the mortgage-backed securities held by the Taxpayer were capital assets. Accordingly, the proceeds from the sale of the mortgage-backed securities through brokers that were a return of principal or basis would be exempt from the BPOL tax under Virginia Code § 58.1-3732 A 5. 

As such, I am remanding the case back to the County to adjust the BPOL tax assessment issued to the Taxpayer for the 2018 tax year to remove those gross receipts attributable to the return of principal or basis from the sales of capital assets. The Taxpayer must provide any documentation requested by the County in order for it to calculate the BPOL tax due.

If you have any questions regarding this determination, you may contact ***** in the Office of Tax Policy, Appeals and Rulings, at *****.

Sincerely,

Craig M. Burns
Tax Commissioner

AR/1836.B