Tax Type
Corporation Income Tax
Description
Foreign source income; Gross receipts, Consolidated Returns
Topic
Allocation and Apportionment
Appropriateness of Audit Methodology
Corporate Distributions and Adjustments
Date Issued
03-29-1991
March 29, 1991
Re: §58.1-1821 Application; Corporation Income Tax
Dear****************
This will reply to your letters of May 15, 1990, and September 21, 1990, in which you seek correction of a corporate income tax assessment for ********** (Taxpayer #1)************(Taxpayer #2).
FACTS
The taxpayers filed separate returns for 1985 and combined returns for 1986 and 1987. During these years both taxpayers were included in a consolidated federal return with numerous other affiliates. Taxpayer #1 used a standard three factor apportionment formula, and Taxpayer #2 used a one factor business income formula for financial corporations. The returns were audited and numerous adjustments were made, resulting in the assessment of additional tax.
The issues you raise will be addressed separately.
DETERMINATION
Foreign Source Income Subtraction: The auditor disallowed a portion of Taxpayer #1's 1987 foreign source income subtraction and applied the applicable expenses. You contend that the auditor failed to consider all foreign source income in the calculation.
The auditor excluded foreign income contained in the "passive basket," the "financial services basket" and the seven "noncontrolled §902 baskets." The auditor's position was that the income was not the type of income defined in §58.1-302 qualifying for the Virginia foreign source income subtraction.
Internal Revenue Code (IRC) §904(d)(1) provides for the separate application of the limitation of the foreign tax credit with respect to certain categories of income (commonly called "baskets"), including passive income, financial services income, and dividends from each noncontrolled §902 corporation (§78 gross-up). Consequently, income is separated into various "baskets," and a separate federal Form 1118 (Computation of Foreign Tax Credit) is prepared for each "basket" for the purpose of calculating the federal limitation. However, the Virginia subtraction for foreign source income is computed without regard to the limitations contained in IRC §904.
In this case. the income from the various "baskets" is in the form of dividends, dividend gross-up and interest. The fact that this income is included on Form 1118 indicates that the source of the income is "foreign" pursuant to IRC §861 et seq. The amounts representing dividends and interest, which are among the types of income satisfying the Virginia definition of foreign source income, qualify for the foreign source income subtraction under Va. Code §58.1-402(C)(8), net of applicable expenses.
Although all baskets may contain income qualifying for the foreign source income subtraction, the §902 basket is special. All of that income should be §78 gross-up. The department has previously ruled that because gross-up and subpart F income have separate subtractions under Va. Code §58.1-402, and no expense related under generally accepted accounting principles (GAAP), they are not required to have expenses assigned under IRC §861 et seq. P.D. 86-154 (8/14/86).
The auditor also disallowed the portion of the subtraction classified as "other" foreign income. You state that this represents foreign exchange gain on 1982 subpart F income that was remitted in 1987. The distribution of previously taxed earnings of a controlled foreign corporation is not a dividend under IRC §959(d), nor is it subpart F income under IRC § 951 et seq. Although the foreign exchange gain may be related to subpart F income, it is not classified as such under federal law. Therefore, the gain does not qualify for either the subpart F subtraction or the foreign source income subtraction under Virginia law.
Accordingly, the dividend and interest income from the various baskets should be included in the foreign source income subtraction, and the "other income," which represents foreign exchange gain, was properly excluded from the subtraction.
Subsidiary Loss Adjustment: On its 1985, 1986 and 1987 returns, Taxpayer #1 claimed a subtraction for a subsidiary loss adjustment. The amount of the loss adjustment was equal to the income shown on Schedule M-1 of the federal consolidated return. The auditor disallowed the subtraction because there is no provision for it in the Code of Virginia.
Under IRC §1501 an affiliated group of corporations is allowed to file a consolidated federal income tax return. In determining consolidated income, the earnings and losses of each member of the group are taken into account; the losses of one member may be used to offset the gains of another. U.S. Treas. Reg. §1.1502-32(a) provides that each member owning stock in a subsidiary shall annually adjust its basis in the stock by an amount equal to the difference between the earnings and losses of the subsidiary. net negative adjustment reduces the basis of the stock, and any excess of negative adjustment over the basis of the stock is called the member's "excess loss account." In later years this account is increased by negative adjustments, for net losses, and reduced by positive adjustments, for net gains. A member disposing of the subsidiary's stock must include the amount of any excess loss account outstanding in its income for the year of disposition. U.S. Treas. Reg. 1.1502-19(a)(1). If the subsidiary is insolvent at the time of disposition of the stock, the amount of the excess loss account is treated as ordinary income.
At the federal level, the excess loss account was taxed to Taxpayer #1 on the deemed disposition of the subsidiary to recapture losses previously deducted and to collect the tax which had been deferred by the offset against income on the consolidated return. This situation does not exist for Taxpayer #1's Virginia corporation income tax returns. Since Taxpayer #1 never filed consolidated Virginia returns with its subsidiary, the subsidiary's losses were never deducted against Taxpayer #1's Virginia income, and no Virginia tax was ever deferred. The adjustment on the Virginia return is necessary to show the true, separate Virginia taxable income of Taxpayer #1, as required for a combined return under §D.1. of VR 630-3-442.
It should be noted that such adjustments on the Virginia return are not "additions" or "subtractions" to federal taxable income as those terms are used in Va. Code §58.1-402. Technically they are adjustments to reconcile federal taxable income for Virginia purposes to federal taxable income actually reported to the Internal Revenue Service.
Investment Tax Credit: On the 1985, 1986 and 1987 returns; the taxpayers claimed a subtraction for excess state over federal depreciation deduction due to the basis adjustment for the Investment Tax Credit at the federal level. This subtraction was disallowed by the auditor. You contend that additional depreciation expense, based on the original cost of the asset, is required at the state level because Virginia does not allow an investment credit.
It is recognized that the depreciable basis of certain assets is reduced by a portion of the Investment Tax Credit allowed for federal tax purposes, thereby reducing annual depreciation. Virginia does not allow a similar credit and basis reduction. However, there can be no adjustment at the state level to reflect depreciation expense on the full cost of the depreciable assets for state purposes without statutory authority to do so. The Code of Virginia does not provide for such an adjustment; consequently, the subtraction must be disallowed.
Gross Receipts in the Dominator of the Apportionment Factor Financial Corporation: Taxpayer #2 is a financial corporation required to use a single factor apportionment formula based on cost of performance. on its 1985 return, the taxpayer utilized a factor based on the ratio of branch expenses to total expenses and applying that percentage to Virginia generated receipts to determine Virginia cost of performance. The auditor adjusted this factor by applying the percentage to capital and ordinary gains instead of receipts, on the theory that using receipts would distort the apportionment factor. You object to this adjustment.
It is recognized that neither computation is based on a true financial factor as set forth in Va. Code 58.1-418. Since the 1981 amendment to that section, a true financial factor is based on cost of performance, which is defined as "the cost of all activities directly performed by the taxpayer for the ultimate purpose of obtaining gains or profit . . ." Virginia Regulation (VR) 630-3-418. However, the taxpayer is not able to provide state-by-state expense information to support a true financial factor based on cost of performance. Absent detailed information from the taxpayer substantiating its position and meeting its burden of showing its method to be more accurate than the auditor's method, I find that the auditor's method more accurately reflects the taxpayer's cost of performance in Virginia.
The rulings you cite requiring the inclusion of gross receipts in the apportionment factor are limited to sales factor computations and are not applicable to the taxpayer's situation. Taxpayer #2 may not use a sales factor; it is required to use a business factor, based on cost of performance.
Gross Receipts in the Denominator of the Sales Factor: The auditor adjusted Taxpayer 1's sales factor for 1985, 1986 and 1987 by removing gross gains from the computation and including gross receipts. You state that the auditor failed to adjust the denominator to include gross receipts from the sale of marketable securities and from certificates of deposit.
It is a well established policy of the department that since the gross receipts from the sale of marketable securities produce apportionable income, they should be included in the sales factor. Therefore, the gross receipts from the sale of marketable securities will be included in the denominator of the sales factor.
The department has previously ruled on the exclusion from the sales factor of proceeds from certificates of deposit. P.D. 89-155 (5/11/89). Contrary to your claim, this ruling did not change departmental policy; instead, it was the first opportunity the department had to address in a public document a contested assessment raising this issue. The auditor properly excluded these proceeds from the sales factor.
Please note that the law has been changed for taxable years beginning on or after January 1, 1990 (1990 Acts of Assembly, chapter 294), and only the net gain from the sale or disposition of intangible property is included in the sales factor. A disposition of intangible property resulting in a loss is ignored in computing the sales factor.
Accordingly, the assessment will be revised to reflect the principles set forth in this letter. In addition, the assessment of interest based on the refund claimed on Taxpayer #2's amended 1985 return will be corrected and you will shortly receive in updated bill with interest accrued to date. The bill should be paid within thirty days to avoid the accrual of additional interest.
Sincerely,
W. H. Forst
Tax Commissioner
Rulings of the Tax Commissioner