Tax Type
Corporation Income Tax
Description
Alternative allocation method
Topic
Allocation and Apportionment
Date Issued
04-30-1993
April 30, 1993
Re: Ruling Request; Corporate Income Taxes
Dear****************
This will reply to your letter of November 12, 1992 in which you applied for permission to use an alternative method of allocation and apportionment for*********(the "Taxpayer").
FACTS
The Taxpayer is primarily engaged in the business of providing technical services pursuant to government contracts that are awarded to them. The contracts are either on a cost plus fixed fee, firm fixed price, or time and material basis. The Taxpayer agrees to provide personal services to perform specifically enumerated tasks, and revenue is earned under these contracts as these services are provided. Invoices are rendered on the basis of man-hours charged to a specific contract. The Taxpayer has asked permission to determine its sales factor for income apportionment on the basis of direct labor cost for services performed in each state as a percentage of total direct labor costs.
RULING
Review of Statute and Regulations: Virginia Regulation (VR) 630-3-416 provides that the numerator of the sales factor shall include sales, other than the sales of personal property, if:
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- "[the] income producing activity is performed both in and outside Virginia and a greater proportion of the income producing activity is performed in Virginia than any other state, based on costs of performance."
Cost of performance includes the cost of all activities directly performed by the taxpayer for the ultimate purpose of producing the sale to be apportioned. While the direct labor costs of a service organization are certainly an important component of costs of performance, they are not the only costs that must be considered. For example, the cost of a computer center that is integral to the performance of the services under the contract would need to be considered in addition to direct labor costs. Accordingly, direct labor alone cannot be used to determine the cost of performance.
Division (or Allocation) of Individual Contract Revenue:
You objected to the "all or none" concept in determining whether a contract shall be considered as a Virginia sale. You indicate that each contract should be prorated based on the percentage of direct labor performed in a state.
The department does not necessarily treat a contract as an indivisible source of revenue. Where a contract provides for services to be performed on an hourly basis, the amount of the contract price is not fixed, the services are required to be performed both within and without Virginia, and the Taxpayer bills for these services on the basis of man-hours performed, then each man-hour billed will be treated as a separate "sale" for purposes of determining the location of income producing activity, based on costs of performance. If there are no substantial costs of performance associated with the services performed other than man-hours (e.g., computer center time), then the gross receipts factor from each man-hour billed would be included in the numerator of the sales factor if the services were performed in Virginia. The contract revenue resulting from man-hours performed outside of Virginia must be evaluated based on costs of performance, and therefore may also be required to be included in the numerator of the sales factor if substantial costs of performance are present.
Location where Services Performed:
The location at which the services are performed is not necessarily determinative of the treatment for purposes of apportionment. For example, the costs associated with a computer center located in Virginia may exceed the costs associated with man-hours performed outside of Virginia. Where the services performed by the computer center are not separately billed and are integral to the service provided, such costs must be included in costs of performance in determining where a sale will be allocated. If the costs associated with the Virginia situs are material, the contract revenue may be deemed to be a Virginia "sale" even though most man hours are spent outside Virginia. See Example 1 in VR 630-3-416 (D).
Fixed fee Contracts:
A fixed fee contract that does not itemize contract revenue by project, location, or other means would need to be considered in its entirety and treated as a single sale. In no event will a single, indivisible source of revenue be allocated between states based on a percentage of costs incurred within a state. This would be inconsistent with the terms of VR 630-3-416.
Where a contract is a variation between a fixed price contract and an hourly contract, the burden is on the taxpayer to demonstrate that there is a reasonable basis for considering the contract as other than a single sale.
With respect to multi-year fixed fee contracts, revenue derived from such a contract shall be apportioned on an annual basis, based on the costs of performance for such year. Revenue and costs of performance for a given year shall be determined in the same manner and under the same principles that the Taxpayer uses to determine federal taxable income. For multi-year contracts the Taxpayer may determine costs of performance using generally accepted accounting principles or other calculations, where the application of such calculations can be clearly demonstrated to more accurately measure and match cost of performance to related contract revenue. If the Taxpayer determines costs of performance using a method other than that used to determine its federal taxable income, such method must be used for all contracts, and be consistently applied.
Recordkeeping:
The department recognizes that the task of analyzing intangible sales for the purpose of identifying which gross receipts constitute a separate "sale" and which costs of performance are related to producing each separate "sale" requires recordkeeping, analysis and computations that may not be made for any other purpose. As provided in VR 630-3-302:
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- [In] the course of computing income from Virginia sources a corporation may be required to make computations for that purpose or maintain records used only for that purpose. The effects on tax liability of a method used to determine any components of income from Virginia sources and the burden of maintaining records not otherwise maintained and of making computations not otherwise made shall be taken into consideration in determining whether such method is sufficiently precise."
Cost Plus Fixed Fee Contracts:
Where a contract requires the Taxpayer to bill for time and materials, if the "materials" (tangible personal property) are not incidental to the services, the revenue resulting from the billings for materials would be allocated in accordance with VR 630-3-415. Services billed under such contract would be allocated as discussed above.
Alternative Method for Fixed Fee Contracts:
The department has considered your letter as a request to use an alternative method of accounting for fixed fee contracts. The policies which apply to requests for an alternative method under Va. Code §58.1-421 are well established. The Taxpayer has not shown that the statutory method of allocation and apportionment produces an unconstitutional result. The United States Supreme Court has recognized that allocation and apportionment of income is an arbitrary process designed to approximate income from business transactions within a state. As long as each state's method of allocation and apportionment is rationally related to the business transacted within a state, then each state's tax is constitutionally valid even though there may be some overlap. See Mooreman Manufacturing Company v. Blair, 437 U.S. 279, 98 S.Ct. 2340 (1978). I have considered the nature of your business and the portion of it conducted in Virginia and I find that the statutory method is rationally related to the business conducted in Virginia.
After considering the facts set forth, you have not demonstrated by clear and cogent evidence that the statutory method is unconstitutional or inapplicable as applied in your situation. Accordingly, permission to use an alternative method of allocation and apportionment is denied.
Sincerely,
W. H. Forst
Tax Commissioner
OTP/6554M
Rulings of the Tax Commissioner