Tax Type
Corporation Income Tax
Description
Foreign Source Income
Topic
Computation of Income
Date Issued
03-29-1991
March 29, 1991
Re: §58.1-1821 Application; Corporation Income Tax
Dear*************
This will reply to your letter of July 24, 1990, in which you seek correction of a corporation income tax assessment for*************(the "Taxpayer").
FACTS
The contested assessment arises from the department's most recent audit of the taxpayer. Both of the contested adjustments made during the audit that resulted in additional tax were related to the subtraction claimed for foreign source income. Specifically, you object to the disallowance of certain income amounts classified as "other" on federal Form 1118 and to the manner in which the auditor determined expenses related to the production of the allowable foreign source income.
DETERMINATION
Other Income: The department has previously ruled on the subtraction of foreign source income listed as "other income" on federal Form 1118. See P.D. 90-2 (1/2/90) (copy enclosed).
In the letter accompanying this application, you assert that a majority of the "other" income is technical service fees, which are included in Virginia's definition of foreign source income. Therefore, the taxpayer is entitled to the subtraction.
The department has previously ruled that "the words 'technical fees from . . . services performed' cannot be taken out of their context to create a subtraction for income earned from the performance outside the United States of any service which can be characterized as of a technical nature. The words are incorporated in a subsection dealing with passive income from the rental of real estate and with income from patents, copyrights and other intangible property." P.D. 86-209 (11/3/86).
You fail to explain why the income should be considered technical fees. As the ruling cited above indicates, only particular technical fees qualify for the Virginia foreign source income subtraction. Without more detail explaining the nature of the fees, the subtraction must be disallowed.
Foreign Source Income Expenses: Gross income from sources without the United States must be reduced by definitely allocable expenses and by expenses not definitely allocable, all of which must be computed in the same manner as under Internal Revenue Code (IRC) §861 et seq. P.D. 86-154 (8/14/86) (copy enclosed).
You disagree with this methodology, stating that the federal sourcing rules are used merely to compute a limitation on the amount of foreign taxes which can be claimed as a credit against federal tax liability. In fact, IRC §861 et seq. are definitional sections used for different purposes by several operative sections or regulations. In addition to §904 (foreign tax credit), the federal sourcing rules are used for purposes of §871 (tax on nonresident alien individuals); §881 (tax on foreign corporations); § 936(h)(7) (Puerto Rico and possessions credit); §306(f) and §2104(c).
Virginia law requires use of IRC §861 et seq. whether or not the taxpayer believes certain expenses have any connection to income from foreign sources and regardless of what the expenses would be under generally accepted accounting principles. See P.D. 87-149 (6/8/87) discussion of charitable contributions (copy enclosed). The department allows additional information which may differ from and be more accurate than what is on Form 1118 if, and only if, it is consistent with IRC § 861 et seq. Recognizing the record keeping burden and complexity of the computations required, the department will accept reasonable estimates, ratios and other methods that approximate the result required by federal sourcing rules.
Normally, Virginia relies on the amount and character of each item reported on the federal return and supporting schedules. The department's willingness to accept the supplemental information at variance with federal return information in the previous audit was predicated on statements made in conference that the taxpayer was in an excess credit situation and, therefore, precision in preparing form 1118 was not required. See U.S. Treas. Reg. 1.861-8(c)(1)(vi). No such information has been provided in connection with this audit.
If federal tax liability is affected by the limitation on form 1118, there is a strong presumption that the information on the form is correct. Therefore, any supplemental information must contain an explanation of how it is consistent with IRC §861 et seq. and what, if any, impact the supplemental information would have had on federal tax liability if it had been included on form 1118.
Several of your modifications depart from the rules found in §861 et seq. and the regulations thereunder. You remove interest paid to the Internal Revenue Service from your computation, explaining this has no relation to the production of foreign source income. However, the federal sourcing rules provide that interest expense is attributable to all activities and properties of the taxpayer. Therefore, the interest paid to the IRS, not definitely related to any gross income, must be apportioned ratably among the statutory groupings of gross income and the residual grouping. U.S. Treas. Reg. §1.861-8(c)(2).
You apply stewardship expenses from only those subsidiaries which actually paid a dividend during a particular year. You do this through use of a ratio which compares the dividends and gross-up paid to the amount of foreign profit before tax. The ratio is derived from a seven year average of dividends to earnings and is applied to stewardship expenses to determine that part of stewardship expense which relates to the dividends paid. The federal rules provide no authority for this method, but rather require that stewardship expenses be based on the activities of all subsidiaries, whether or not a dividend was paid. U.S. Treas. Reg. §1.861-8(g).
In your letter, you state that your suggested method to compute related expenses was accepted by the department in the settlement of this issue in a previous audit. We cannot determine if the previous settlement was accepted in error or because the amount involved was deemed immaterial. While prior acceptance of your method is not binding now, in view of the fact that the taxpayer relied on this, and in the interest of closing this audit, the department will accept the supplemental information that you provided regarding the expenses related to the production of qualifying foreign source income. This acceptance is solely for the purpose of settling this audit. All future returns and any other information submitted must be prepared in accordance with the principles of IRC §861 et seq.
Accordingly, the audit will be revised to use the expense figure shown on the taxpayer's return. You will shortly receive an updated bill with interest accrued to date. This bill should be paid within 30 days to avoid the accrual of additional interest. However, to the extent that you can provide the department with detailed information that establishes that the income included as "other" income on Form 1118 qualifies as technical fees under the definition of "foreign source income" under Va. Code §58.1-302, the audit will be revised to remove such income from Virginia taxable income. Any such submission must also include revised expense information as set forth above. If you choose to submit any additional information retailing the nature of the technical fees included as "other" income and the revised expense information, please send it to the department's Technical Services Section, P.O. Box 6-L, Richmond, Virginia 23282, within the next 30 days.
Sincerely,
W. H. Forst
Tax Commissioner
Rulings of the Tax Commissioner