Tax Type
Corporation Income Tax
Description
Foreign Source Income
Topic
Taxpayers
Date Issued
03-29-1991
March 29, 1991
Re: §58.1-1821 Application; Corporation Income Tax
Dear*****************
This will reply to a letter of May 9, 1989, written on behalf of the taxpayer, seeking correction of a corporation income tax assessment for************* (the "Taxpayer").
FACTS
In fiscal year 1986, the taxpayer recognized income from the completion of a long term contract with a foreign government. The contract called for the taxpayer to provide a nationwide electronic data processing and teleprocessing system for the foreign country. Under the terms of the contract, the taxpayer was obligated to deliver a single and complete integrated system for a single fixed price.
In fiscal year 1987, the taxpayer recognized income from an arbitrator's award of damages arising from another foreign government's expropriation and breach of contract. The contract called for the taxpayer to provide systems engineering design, analysis, programming, implementation, management of facilities, training and related technical support services to a company owned by the foreign country. The arbitrator broke down its award into interest (which was allowed as a foreign source income subtraction), technical assistance, and other categories.
The taxpayer claimed a foreign source income subtraction for the two taxable years in question. The auditor disallowed the subtractions and assessed additional tax.
DETERMINATION
on the supporting schedule to the 1987 federal Form 1118 (Computation of Foreign Tax Credit), the income in dispute was classified as "service income." Service income is not one of the types of income allowable for the Virginia foreign source income subtraction. On the supporting schedule to 1986 federal Form 1118, the income recognized from the completed contract was listed under "other income." The department has previously ruled on the subtraction of foreign source income listed as "other income" on Form 1118. P.D. 90-2 (1/2/90) (copy enclosed). Therefore, the auditor properly disallowed the subtractions.
The taxpayer has submitted information with this application, asserting that the income recognized from the completed contract and the settlement agreement was derived from several sources including: (1) the sale of real property; (2) the development and sale of the operating system and computer software programs; and (3) technical assistance in testing the system and training government personnel (technical fees).
Income from the Sale of Real Property: Income from the sale of real property located outside the United States is foreign source income under Va. Code §58.1-302. The taxpayer contends that it sold real property, in the form of facilities used to house the computer systems, to the foreign government, and that the resulting income qualifies as foreign source income.
In this case, it appears that the taxpayer constructed buildings and other structures on the foreign government's property that became part of the real estate. Construction work does not qualify as foreign source income under Virginia law. The facts provided do not state who owned the land on which the construction occurred. "Sale" means conveying title; if a contractor never has title, he does not sell the building - he sells his services in constructing it. Based on the facts provided, income attributable to the facilities constructed to house the computer systems does not qualify as foreign source income.
Income from the Sale of the Operating System and Software Programs: Income from the sale of intangible property located without the United States qualifies as foreign source income under Va. Code §58.1-302. The taxpayer contends that computer software is intangible property, and income from the sale of the software to the foreign government qualifies for the foreign source income subtraction.
In Virginia, computer application software has been classified as intangible property for purposes of the local tangible personal property tax. In addition, "custom" software programs, or programs specifically designed and developed only for one customer, are exempt from the sales and use tax, by excluding it from the definition of tangible personal property subject to the tax. In the absence of an express statutory classification! general principles apply, and the software and operating systems are classified as intangible property for income tax purposes.
However, in this case there is a single contract which provides for the sale of tangible terminals and other hardware (that the taxpayer concedes does not qualify for Virginia's foreign source income subtraction), intangible property, construction of structures on real estate, training and other services. Although the contract called for the transfer of title to most of the software upon completion, it is not possible to identify with certainty the amount of income attributable to the sale of software. Exemptions from taxation are strictly construed and the taxpayer bears the burden of substantiating every detail relating to the exact amount claimed to be exempt from taxation. In addition to the amount of income arising from the sale of software, the taxpayer would have to show the amount of property, payroll, and gross receipts related to the income so that proper adjustments can be made to the denominators of the apportionment factors. In the absence of reliable information no portion of the contract income qualifies for exemption as foreign source income.
It should be noted, however, that this income is clearly income from without the United States under federal law. Although it is included in Virginia taxable income because it does not qualify for Virginia's foreign source income subtraction, Virginia's apportionment procedures ensure that the tax imposed on the taxpayer is limited to the portion of the taxpayer's income attributable to its business activities in Virginia.
Income from Technical Assistance (Technical Fees): The department has previously ruled on the qualification of technical fees as foreign source income. See P.D. 86-209 (11/3/86) and P.D. 87-211 (9/15/87) (copies enclosed). In order for technical fees to qualify as foreign source income, they must be "incidental to a contract relating to the rental of real property or the licensing of a patent, copyright, trademark, trade brand, franchise and other like property for use without the United States."
In this case, the fees were not incidental to the rental of real property or the licensing of intangible property. Instead, the fees were generated from the sale of intangible property, the computer software. Such income does not qualify as "technical fees" eligible for the Virginia foreign source income subtraction under Va. Code §58.1-302. In addition, the department must be satisfied that all "technical fees" are incidental to the software and are not, for example, related to installation of the terminals. The facts presented are not clear as to the true object of the technical assistance and the income, property, payroll, and gross receipts attributable to it.
Accordingly, the assessment is correct and is now due and payable. You will shortly receive an updated bill with interest accrued to date. The bill should be paid within 30 days to avoid the accrual of additional interest.
Sincerely,
W. H. Forst
Tax Commissioner
Rulings of the Tax Commissioner