Tax Type
Corporation Income Tax
Description
Foreign source income
Topic
Computation of Income
Date Issued
04-27-1992
April 27, 1992
Re: § 58.1-1821 Application; Corporation Income Tax
Dear ****
This will reply to your letter of May 23, 1991, in which you seek correction of corporation income tax assessments for ***** (the "Taxpayer").
FACTS
The taxpayer was audited and numerous adjustments were made. The taxpayer reported a subtraction for foreign source income for the two years under review. The auditor removed certain income because it did not satisfy Virginia's definition of foreign source income. The auditor also increased expenses related to the foreign source income, thereby reducing the subtraction. You contend that use of federal Form 1118 is improper in computing related expenses and disagree with the auditor's calculations.
DETERMINATION
Methodology: Previous rulings by the department require the Virginia subtraction for foreign source income to be reduced by expenses, determined in accordance with Internal Revenue Code (IRC) § 861 et seq. P.D. 86-154 (8/14/86) (copy enclosed). 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.
You state that the federal sourcing rules are used solely 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).
To support your position that use of Form 1118 is inappropriate in computing expenses related to foreign income, you cite Dana Corporation v. Tax Commissioner, Ohio Bd. of Tax Appeals (March 30, 1990). The court's ruling in that case was based on Ohio law, which does not contain a provision similar to Virginia's that specifically incorporates the federal sourcing rules in determining income and expenses from foreign sources. Therefore, I do not find the case to be persuasive.
You indicate that the taxpayer has adopted a policy of accepting no more than a 5% related expense adjustment to foreign source income comprised primarily of subsidiary dividends. Such a blanket rule is not in accordance with the department's established policy and will not be accepted.
Related expenses: The department has previously ruled on the proper formula for computing nonallocable expenses attributable to foreign source income. See P.D. 91-229 (9/30/91) (copy enclosed). While the auditor properly removed certain income items from the subtraction for foreign source income, a review of the auditor's calculations of related expenses reveals that they are not consistent with the method established in the cited ruling.
For 1988, the auditor included foreign dividend gross-up income in the numerator of the ratio (Virginia source income). The department has previously ruled that this item qualifies for a separate subtraction under Va. Code § 58.1-402 and should not be included in the numerator of the ratio. See P.D. 86-154 (8/14/86). Foreign dividend gross-up income does get some "not definitely allocable" expenses under IRC § 861. However, gross-up (and subpart F) income have separate Virginia subtractions that do not incorporate § 861 allocations; therefore, they are net of expenses, if any, per Generally Accepted Accounting Principles (GAAP). As "deemed income," there are no expenses. Since foreign dividend gross-up income is not subtracted as Virginia foreign source income, it does not belong in the numerator of the expense fraction.
The auditor applied the percentage of expenses relative to foreign source income for 1988 to 1987 foreign source income to determine expenses for that year. This was done because expense information from federal Form 1118 was not available. While this method may be acceptable absent more accurate information, the auditor included foreign dividend gross-up income in foreign source income for Virginia purposes. As stated above, this income should not have been included in Virginia foreign source income.
The audit report will be adjusted to include a separate subtraction for the gross amount of foreign dividend gross-up income, to the extent included in federal taxable income. Expenses relating to foreign source income will be computed in a manner consistent with the principles set forth above, and the audit report will be revised accordingly. Although you requested a conference, this letter has been issued without one. If you still desire a conference, please contact the department within 30 days.
Sincerely,
W. H. Forst
Tax Commissioner
Rulings of the Tax Commissioner