February 18, 2020
Re: Ruling Request: Corporate Income Tax
Dear *****:
This will respond to your letter in which you request a ruling on behalf of ***** (the “Taxpayer”) regarding its eligibility to use the single sales factor for manufacturing companies. I apologize for the delay in responding to your request.
FACTS
The Taxpayer, a subsidiary of a corporation located in ***** (Country A), is headquartered in Virginia and files a consolidated federal return with its subsidiary ***** (Corporation A), but files separate Virginia returns. The Taxpayer holds a 99.9% limited partnership interest in ***** (VLP). Corporation A holds a 0.1% general partnership interest in VLP.
VLP manufactures tangible consumer products in its sole manufacturing plant located in ***** (State A). Corporation A acquires raw materials and then transfers the materials to VLP. All of the manufactured products are then sold to the Taxpayer, which markets and sells the products to unrelated third parties. In addition, the Taxpayer provides all corporate and administrative support functions to VLP. The Taxpayer requests a ruling that it be allowed to utilize the single sales factor for apportionment.
RULING
Virginia Code § 58.1-422 allows manufacturing companies to elect a modified apportionment factor based on sales to determine their Virginia taxable income beginning on or after July 1, 2011. For taxable years beginning on or after July 1, 2014, qualifying corporations that elect to use the modified apportionment formula must use the single factor apportionment method to apportion Virginia taxable income. Once an election is made, it cannot be revoked for three taxable years.
A manufacturing company will be subject to additional tax known as recapture if the average weekly wage of its full-time employees is lower than the state or local weekly wage for its industry or its number of full-time employees do not equal or exceed 90 percent of its base year employment level.
Manufacturing Activities
The Taxpayer believes that it should be eligible to use the single apportionment factor for manufacturers because its employees’ activities would be considered manufacturing. The Taxpayer states that if it is classified as a manufacturer for purposes of apportionment, it would meet the employment and wage requirements.
Virginia Code § 58.1-422 D defines a manufacturing company as “a domestic or foreign corporation primarily engaged in activities that, in accordance with the North American Industrial Classification System (NAICS), United States Manual, United States Office of Management and Budget, 1997 Edition, would be included in Sector 11, 31, 32, or 33.” A business is primarily engaged in manufacturing if either 50 percent or more of the gross receipts are derived from the sale of goods that are manufactured by the taxpayer, or 50 percent or more of the employees are engaged in manufacturing activities. See the Single Sales Factor Election for Manufacturers Guidelines, (the “Guidelines”) issued as Public Document (P.D.) 13-6 (1/7/2013). Pursuant to Black’s Law Dictionary 984 (8th ed. 2004), manufacturing is engaging in the production or assembling of new products.
In this case, the Taxpayer’s NAIC classification is in Sector 42 of the NAIC manual. Neither it, nor any of its employees, engage in the production or assembly of new products. VLP, a separate entity, is classified in Sector 31 of the NAIC manual. It is primarily engaged in manufacturing because all of its gross receipts come from the sale of tangible products and virtually all of its employees are engaged in the manufacturing process.
The Taxpayer asserts that its human resources, finance, payroll, accounting, marketing and management employees are engaged in manufacturing because they are necessary and ancillary to the manufacturing process of VLP. Further, it asserts that employees would not need to be required to be directly involved in the physical process of actually manufacturing the product.
A function is ancillary if it serves no independent business function apart from its connection to the particular activity. See P.D. 95-57 (3/28/1995). It would appear that administrative functions could be performed independently from a businesses’ manufacturing operations.
Regardless as to whether the administrative functions performed by the Taxpayer’s employees are ancillary to manufacturing, however, the Guidelines address whether the activities of one legal entity can be ascribed to a different legal entity. The Guidelines state that “[I]f a manufacturing company is part of an affiliated group consisting of non-manufacturing entities or manufacturing entities that have not elected the modified apportionment method and files a Virginia consolidated return, then the affiliated group must file the mixed apportionment factors method under [Title] 23 VAC 10-120-326.” Thus, manufacturing entities and non-manufacturing entities that are in a consolidated group are recognized as being separate entities. The activities performed by the employees of one legal entity cannot imputed to a related legal entity. As such, the manufacturing activities performed by employees of VLP cannot be attributed to the Taxpayer’s employees.
Pass-Through Entities
In the alternative, the Taxpayer claims VLP’s activities should be imputed or attributed to it because of its 99.9% limited partnership interest. The Taxpayer argues that because each item of partnership income, gain, loss or deduction retains the same character for a partner and that each partner must include its proportionate share of apportionment factors when determining Virginia source income, VLP’s activities should be attributed to the Taxpayer.
Virginia Code § 58.1-390.1 provides that pass-through entities such as limited partnerships, limited liability partnerships, general partnerships, limited liability companies, professional limited liability companies, business trusts or subchapter S corporations are recognized as separate entities for federal income tax purposes, in which the partners, members or shareholders report their share of the income, gains, losses, deductions and credits from the entity on their federal income tax returns. Under Internal Revenue Code (IRC) § 702(b), “[t]he character of any item of income, gain, loss, deduction, or credit included in a partner’s distributive share ... shall be determined as if such item were realized directly from the source from which realized by the partnership or incurred in the same manner as incurred by the partnership.” In addition, each item of pass-through entity income, gain, loss or deduction has the same character for an owner for Virginia income tax purposes as for federal income tax purposes. See Virginia Code § 58.1-391 B.
For federal income tax purposes, the partners are considered the owners of all the pass-through entity’s assets and liabilities. Consequently, the Department regards such owners as having the attributes of the pass-through entities that create nexus and make it subject to Virginia income tax. See P.D. 99-174 (6/30/1999), P.D. 06-85 (8/25/2006), P.D. 07-50 (4/26/2007), P.D. 08-123 (6/26/2008), and P.D. 16-142 (6/27/2016). 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. Id.
The flow-through of tax attributes and activities of pass-through entities to its owners does not mean that the owner is classified as the pass-through entity. For example if a taxpayer owns 1% of a pass-through retailer, 1% of that pass-through entity’s income, gain, loss and deduction will pass through to the owner. Likewise, the owner would be required to include its proportionate share of the pass-through entity’s property, payroll and sales with its own property, payroll and sales for purposes of determining its Virginia apportionment factor unless certain standards are met. See P.D. 95-19 (2/13/1995). However, the Taxpayer would not be classified as a retailer for Virginia income tax purposes.
In this case, VLP’s income, gain, loss and deduction would pass-through to the Taxpayer in proportion to its 99.9% ownership interest. In addition, because the standards set out in P.D. 95-19 would not be met, the Taxpayer would be required to include its proportionate share VLP’s property, payroll and sales with its own property, payroll and sales for purposes of determining its Virginia apportionment factor. The Taxpayer would not be classified as a manufacturer because of its ownership interest in VLP.
CONCLUSION
In accordance with the reasons discussed above, the Taxpayer cannot be classified as a manufacturer in order to elect a modified apportionment factor based on sales pursuant to Virginia Code § 58.1-422. However, if VLP meets the requirement of a manufacturing company, it may elect to use the modified apportionment method. The Taxpayer would then include in their apportionment factors only their share of the VLP’s factor for the applicable taxable year. See. P.D. 13-6.
The Code of Virginia sections and public documents cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions section of the Department’s web site. 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/1896.B