June 2, 2020
Re: Ruling Request: Corporate Income Tax
Dear *****:
This will reply to your letter in which you request a ruling regarding the treatment of bonus depreciation additions and subtractions for ***** (the “Taxpayer”).
FACTS
The Taxpayer is classified as a partnership for federal and Virginia income tax purposes. Six corporations hold an ownership interest in the Taxpayer. ***** (Owner A) holds 100% of the Taxpayer’s common ownership interest. The other five owners collectively hold 100% of the Taxpayer’s preferred ownership interests.
During the 2017 through 2019 taxable years, the Taxpayer put assets into service for which it could claim bonus depreciation. The Taxpayer’s allocation of income and loss among the owners, including fixed date additions and subtractions stemming from claiming bonus depreciation, is in accordance with the Taxpayer’s ownership agreement and federal regulations. Beginning in 2018, the Taxpayer expects that the allocation percentages will change from year to year. As such, the Taxpayer believes that the difference in the 2018 and subsequent year federal tax distributive share percentages, as compared to the prior year percentages, results in a mismatch of the Virginia bonus depreciation addition and subtraction modifications for all owners in future years.
Accordingly, the Taxpayer requests a ruling allowing it to match future bonus depreciation modification subtractions based on the federal distributive share percentages applied to the initial bonus depreciation modification addition. The Taxpayer asserts that the tax benefit rule permits the proposed matching of the addition and subtraction modifications because such allocation would allow for transactional parity. In the alternative, the Taxpayer asserts that Virginia’s alternative method of allocation and apportionment provides a process for matching modification additions and subtractions.
RULING
Bonus Depreciation
Congress enacted bonus depreciation as part of the Job Creation and Worker Assistance Act of 2002, and made it retroactive to taxable year 2001. In response, the 2002 General Assembly enacted a budget amendment to fix the date of conformity to the Internal Revenue Code (IRC) as of December 31, 2001. While the budget was still pending, the Department issued Virginia Tax Bulletin (VTB) 02-2 (3/20/2002), explaining the pending adoption of fixed date conformity and specifically informing taxpayers that bonus depreciation would not be allowed. In 2003, the General Assembly codified fixed date conformity by amending Virginia Code § 58.1-301. While the budget amendments deconformed from all federal changes enacted after December 31, 2001, the amended Virginia Code § 58.1-301 conformed to all changes after that date except for bonus depreciation and some other specific items. This was explained in VTB 03-1 (2/18/2003).
Virginia Code § 58.1-301 provides, with certain exceptions, that terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the Internal Revenue Code (IRC) unless a different meaning is clearly required. Conformity does not extend to terms, concepts, or principles not specifically provided in the Code of Virginia. For Virginia, federal taxable income (FTI) and federal adjusted gross income (FAGI), the starting points for determining income taxable in Virginia for corporations and individuals, respectively, are identical to that as defined by the IRC. For individual income tax purposes, Virginia “conforms” to federal law, in that it starts the computation of Virginia taxable income (VTI) with FAGI. Items of income or deduction properly included in the FAGI of a Virginia resident are subject to taxation by Virginia, unless they are specified as a Virginia modification pursuant to Virginia Code §§ 58.1-322.01 through § 58.1-322.04. For corporate income tax purposes, Virginia “conforms” to federal law, in that it starts the computation of Virginia taxable income with federal taxable income (FTI). Items of income or deduction properly included in the FTI of a Virginia resident are subject to taxation by Virginia, unless they are specified as a Virginia modification pursuant to Virginia Code § 58.1-402.
Since 2003, the General Assembly has enacted legislation to move the fixed-date forward each year. Effective for taxable years beginning on and after January 1, 2016, Virginia’s fixed-date of conformity was advanced from December 31, 2016, to December 31, 2017, with limited exceptions. See VTB 17-1 (2/6/2017). For the 2016 taxable year, Virginia disallowed federal deductions: (1) for bonus depreciation allowed for certain assets under IRC §§ 168(k), 168(l), 168(m), 1400L, and 1400N; (2) related to applicable high yield discount obligations under IRC § 163(e)(5)(F); or (3) related to cancellation of debt income realized in connection with a reacquisition of business debt at a discount after December 31, 2008, and before January 1, 2011 pursuant to IRC § 108(i) (individuals recognizing income during the 2014 through 2018 taxable years as a result of the federal deferral are permitted a fixed-date conformity subtraction on their corresponding Virginia return). In addition, Virginia does not conform to the five-year carry-back allowed under IRC § 172(b)(1)(H).
Taxpayers who claimed one or more of these fixed date conformity items, such as the bonus depreciation allowance, on their federal returns are required to recompute their FTI for Virginia purposes as if none of the bonus depreciation or other fixed date conformity items had been enacted. See VTB 17-1. The difference between the recomputed FTI and the actual amount shown on the federal return is reported as a fixed date addition or subtraction on the taxpayer’s Virginia return. Therefore, if a taxpayer’s total Virginia depreciation calculation is less than its federal deprecation calculation, then the difference must be recognized as an addition to FTI. If a taxpayer’s total Virginia depreciation calculation is greater than its federal deprecation calculation in a particular taxable year, then the difference must be recognized as a subtraction to FTI.
The Taxpayer requests that Owner A be allowed to match “future depreciation modification subtractions based on the federal distributive share percentages applied to the initial bonus depreciation modification as allocated to the Taxpayer and the other owners.” As stated above, the difference between FTI and the amount reported on the federal return stemming from the bonus depreciation allowance is a fixed date conformity addition or subtraction. Fixed date conformity additions and subtractions are not considered Virginia modifications. Rather, these exceptions identified in Virginia Code § 58.1-301 are added to or subtracted from FAGI or FTI.
Pass-Through Entities
Under IRC § 702(b), “The 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. Therefore, the Department regards such owners as having the attributes and conducting the activities of the pass-through entities. Consequently, the tax attributes of a pass-through entity, which may create nexus in a taxing jurisdiction, will be considered to be passed through to the owners. See Public Document (P.D.) 99-174 (6/30/1999), P.D. 06-85 (8/25/2006), P.D. 07-50 (4/26/2007), and P.D. 08-123 (6/26/2008). As such, the Taxpayer would be required to report subtractions stemming from bonus depreciation in accordance with the allocation percentages required by the agreement and federal regulations.
Tax Benefit Rule
The Taxpayer contends that it should be allowed to match future bonus depreciation modification subtractions based on the federal distributive share percentages applied to the initial bonus depreciation modification addition because the tax benefit rule requires the matching of income in one year with certain deductions in a subsequent year to achieve transactional parity.
Virginia Code § 58.1-391 A provides that in determining VTI of an owner, any modification described in §§ 58.1-322.01 through 58.1-322.04 that relates to an item of pass-through entity income, gain, loss or deduction shall be made in accordance with the owner’s distributive share, for federal income tax purposes, of the item to which the modification relates. The Taxpayer contends that the linking of a pass-through entity’s distributive share to the “item to which the modification relates” is consistent with the tax benefit rule.
Virginia conforms to the result of the tax benefit rule only to the extent that it has been employed by the Internal Revenue Service (IRS) or the courts to change FAGI and FTI for federal income tax purposes. See P.D. 98-158 (10/20/1998). In this case, there has been no change to bonus depreciation for federal income tax purposes. Instead, Virginia Code § 58.1-301 requires that FAGI and FTI be recomputed for Virginia purposes with regular depreciation instead of bonus depreciation. While the statute technically requires taxpayers to begin their computation of FAGI or VTI with the recomputed FAGI or FTI required by Virginia Code § 58.1-301, Virginia income tax returns start with FAGI or FTI reported for federal purposes and require an addition or subtraction to reconcile with the recomputed FAGI or FTI pursuant to Virginia Code § 58.1-301. Virginia Code § 58.1-391 A only applies to modifications required by the specified statutes, not the addition and subtraction adjustments to FAGI or FTI required by Virginia Code § 58.1-301.
The Taxpayer has cited several cases in which federal courts and some state courts have applied the tax benefit rule. The tax benefit rule is a judicial doctrine of the federal courts applied in deciding federal income tax cases. The purpose of the tax benefit rule “is to approximate the results produced by a tax system based on transactional, rather than annual, accounting.” Hillsboro Nat’l Bank v. Commissioner, 460 U.S. 370, 381 (1980). The Hillsboro court further held that the rule protects the government and the taxpayer from the adverse effects of reporting a transaction on the basis of assumptions that an event in a subsequent year proves to have been erroneous.
Although the courts of some states have explicitly adopted the tax benefit rule when interpreting provisions of state law, Virginia has not. Even if Virginia had adopted the rule, the circumstances of this case do not support its application. Fluctuations in an owner’s distributive share percentage are not unusual. They occur whenever a person acquires or disposes of an interest in a partnership. They are also affected by changes in the partnership’s ownership structure as other partners are granted additional interests or surrender interests in the partnership. Therefore, at the time that the Taxpayer claimed bonus depreciation on its federal return, and reported an addition on its Virginia return, neither action was based on an assumption that future distributive share percentages would remain static. Therefore, future changes do not support application of the tax benefit rule.
Alternative Method of Allocation and Apportionment
The Taxpayer contends that the Department should allow it to modify its depreciation modifications since Virginia allows for an alternative method of allocation and apportionment. Virginia Code § 58.1-421 allows a taxpayer to request an alternative method of allocating or apportioning its portion of VTI when the statutory methods do not accurately reflect income attributable to business or services within Virginia. As such, Virginia Code § 58.1-421 is limited to the allocation and apportionment of income. In this case, the Taxpayer is requesting for an alternative method to apply subtraction modifications, not an alternative method of apportioning or allocating income.
CONCLUSION
The tax benefit rule cannot be used to match future bonus depreciation modification subtractions based on the federal distributive share percentages applied to the initial bonus depreciation modification addition because it does not affect FTI. In addition, the alternative method of allocation and apportionment allowed by Virginia Code § 58.1-421 is not applicable to Virginia modifications because it only applies to the allocation and apportionment of income.
The Code of Virginia sections, Tax Bulletins, 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 ruling, you may contact ***** in the Office of Tax Policy, Appeals and Rulings, at *****.
Sincerely,
Craig M. Burns
Tax Commissioner
AR/3283.B