Tax Type
Corporation Income Tax
Description
Apportionment of income; Financial division of trading company
Topic
Allocation and Apportionment
Date Issued
05-25-1994
May 25, 1994
Re: §58.1-1821 Application: Corporate Income Taxes
Dear**************
This will reply to your letters of May 22, 1992, May 17, 1993, September 9, 1993, and October 25, 1993, in which you request a correction of an assessment of additional corporate income taxes to *********(the "Taxpayer") for the 1990 taxable year.
FACTS
The Taxpayer was the subject of an office audit, resulting in the imposition of additional corporate income taxes. On its 1990 Virginia income tax return, the Taxpayer claimed subtractions for allocable non-business income, and the recovery of an excess loss account adjustment. These subtractions were disallowed by the department, as the Code of Virginia does not provide specific subtractions for these items. You believe that the subtractions should be allowed, and contest the department's determination.
The Taxpayer is a large multi-national corporation, headquartered outside of Virginia, whose principal business activity is the international trade of various products. The Taxpayer is one of the world's largest international importers and exporters, engaged in buying, selling, distributing and marketing a wide variety of commodity, consumer and industrial products in Virginia as well as other states and countries.
The Taxpayer maintains a financial department at its corporate headquarters. This division conducts arbitrage activities, which are separate and apart from its business as a trading company. This division's activities seeks to benefit from the advantageous differential between the cost of issuing short term commercial paper and the yield of floating rate notes. By finding suitable investments that have a rate of return higher than the cost of commercial paper, and then selling commercial paper to raise the capital needed to buy the investments, the company earns a profit. The arbitrage activity is generally accomplished as follows: a manager in the financial department contacts investment bankers and others to try to identify suitable investment vehicles which will provide a return greater than the cost of the commercial paper the Taxpayer can issue. When an investment opportunity is found, the investment vehicle, usually a floating rate note, is purchased and, simultaneously, a corresponding amount of commercial paper is issued to raise the funds necessary to cover the purchase price. None of the Taxpayer's capital is used to accomplish these transactions; the funds used for the purchase of the investments are derived directly from the sale of commercial paper. The purchase price of the investment and the issuance of commercial paper are matched by the finance department. When the investment matures, the amount received is used to repay the commercial paper issued to finance the investment. The Taxpayer benefits from the credit risk it has accepted in purchasing the investment.
The finance department consists of four employees who are solely responsible for finding suitable investments for the arbitrage activities, and for making and monitoring those investments. No other function is performed by this department, and all activities are initiated, consummated, and concluded at its headquarters. This department was separated from other finance activities in 1988 in order to improve the monitoring of the performance of the arbitrage activity. The managerial control of the finance division is also under a different chain of command than other activities of the Taxpayer. The Board of Directors has given direct authorization to the finance division's manager to carry out arbitrage activities for individual transactions of up to******dollars, within certain other conditions. The division does not need day to day approval from the Taxpayer's president, executive vice president, or executive committee.
Financing provided for the import/export trading activities is totally unrelated to the arbitrage activities. The Taxpayer has a separate and distinct department responsible for monitoring, financing and investing working capital balances. The investment of other funds, including excess working capital, is separately accounted for and is not included in and is in no way related to the income earned through the Taxpayer's arbitrage activities. The Taxpayer provides financing services for customers transactions through a separate trade finance department. The income derived from this financing activity is separately accounted for and is not related to the income earned through the Taxpayer's arbitrage activity. The income earned from arbitrage activities is not derived in any respect from any of the Taxpayer's trading activities.
DETERMINATION
The Code of Virginia does not provide for the allocation of income other than certain dividends. Accordingly, a taxpayer's entire federal taxable income, adjusted and modified as provided in Va. Code §§58.1-402 and 58.1-403, less dividends allocable pursuant to Va. Code §58.1-407 is subject to apportionment. The Taxpayer's subtraction of the non-business income has been treated as a request for an alternative method of allocation and apportionment in accordance with Va. Code §58.1-421.
The decision of the U. S. Supreme Court in Allied-Signal, Inc. v. Director, Div. of Taxation, 112 S. Ct. 2551 (1992) made it clear that the payee and payor need not be engaged in the same unitary business as a prerequisite to apportionment in all cases. In the absence of a unitary relationship, apportionment is permitted when the investment serves an operational rather than a passive investment function. The Court also made it clear that the test is fact sensitive.
The department has examined the evidence provided by the Taxpayer in order to determine if a unitary relationship existed between the Taxpayer and payors of the arbitrage income, and to determine if the Taxpayer's activities related to the arbitrage activity were in any way connected to the Taxpayer's operational activities.
In considering the existence of a unitary relationship, the Supreme Court has focused on three objective factors: (1) functional integration; (2) centralization of management; and (3) economies of scale. (See Mobil Oil Corp. v Commissioner of Taxes, 445 U.S., 425 (1980); F. W. Woolworth Co. v. Taxation and Revenue Dept. of N.M., 458 U.S., 352 (1982); and Allied-Signal.) Evidence regarding these factors was presented by the Taxpayer in clear and objective terms. There was no indication of a flow of goods or of a flow of values between the Taxpayer and any payor of arbitrage income. Based on the information provided to the department it does not appear that a unitary relationship existed between the Taxpayer and any payor of arbitrage income.
In considering the operational aspects of the investment, the department considered the evidence provided to support the Taxpayer's position. The evidence indicated that: the arbitrage activity did not complement the Taxpayer's operational activities; no economies were achieved; and, the management of the arbitrage division was separate and distinct from the general management of the Taxpayer and functioned under the direct authority of the board of directors. Because the investments which produced the arbitrage income were financed directly by the issuance of commercial paper, and because the activity was conducted independently from the management and investment of necessary working capital balances,
the Taxpayer has demonstrated that the arbitrage income was not generated from the utilization and investment of its operational working capital.
In light of the substantial evidence provided, it does not appear that the Taxpayer's arbitrage activities were related to its operational trading activities. Accordingly, I conclude that the Taxpayer's arbitrage activities constitute a separate investment function making passive investments that are not of an operational nature. As the Taxpayer's headquarters and management of its arbitrage function was located outside of Virginia, the income recognized by the Taxpayer on the arbitrage activity did not relate to the Taxpayer's operational business carried on in Virginia.
In any proceeding relating to the interpretation of the tax laws of the Commonwealth of Virginia, the burden of proof is on the taxpayer. In this particular matter, the Taxpayer must prove by clear and cogent evidence that Virginia's statutory method of allocation and apportionment would result in a tax on income derived from a discrete investment function having no connection with Virginia in violation of the principles set forth in Allied-Signal. Based upon the information provided, I find that the Taxpayer has demonstrated that an alternative method of allocation and apportionment is appropriate. However, I find that the amount of allocable income claimed by the Taxpayer and the manner in which it was computed does not accurately reflect the net income from arbitrage activities.
The net income from arbitrage activity should be equal to the excess of interest income earned over interest expense paid and related overhead expenses. The Taxpayer has claimed a subtraction equal to interest income earned on arbitrage investments in excess of a prorated amount of the company's total interest expense. However, the Taxpayer's arbitrage investments used to produce the income are directly financed by the simultaneous sale of commercial paper. The Taxpayer's own affidavits state that the arbitrage activities earn a profit by benefiting from advantageous rate differentials. I view the income from the arbitrage activity as only the differential earned on the simultaneous investment and borrowing transactions. Therefore, the amount of allocable income should in no event exceed the excess of the income earned on arbitrage investments over the interest paid on commercial paper issued to finance the investment. Furthermore, a reasonable amount of overhead expenses attributable to the arbitrage activities must also be deducted in determining the net amount of allocable income allowed.
Accordingly, permission is hereby granted to allocate the net arbitrage activity recognized by the Taxpayer, calculated in accordance with this ruling and the attached schedules, out of
Virginia apportionable income. The apportionment factors for 1990 will also be adjusted to remove items attributable to allocable income from the denominator of the respective factors. All other aspects of the Taxpayer's 1990 allocation and apportionment shall be determined in accordance with Va. Code §§58.1-406 through 58.1-420.
This ruling is limited to the 1990 taxable year, and further limited to the activity described herein, and shall not be considered as pertaining to any other taxable year or transaction.
Limitation of allocable income: The gross amount of income which may be considered as allocable income pursuant to this ruling and Va. Code §58.1-407 exceeds the Taxpayer's Virginia taxable income. However, there is no express authority in the Code of Virginia for a Virginia net operating loss. Accordingly, neither the adjustments required in determining Virginia taxable income nor allocable income may be used to create a Virginia net operating loss. The amount of income which the Taxpayer may allocate out of virginia is therefore limited to the sum of its federal taxable income and the adjustments required by Va. Code §58.1-402. Because there is no provision for a Virginia net operating loss, allocable income from the 1990 taxable year cannot be utilized to reduce Virginia taxable income in any other taxable year. See Public Document (P.D.) 84-172 (10/1/84), and a ruling of the Commissioner dated 6/24/83, copies attached.
Excess Loss Account: The Taxpayer claimed a subtraction from Virginia taxable income for "excess loss account" recapture upon disposition of a subsidiary. The "subtraction" claimed by the Taxpayer results from the recapture of an excess loss account upon the disposition of a subsidiary in accordance with U.S. Treasury Regulations. The department has previously ruled that because this income represents the recapture of losses that were never claimed against Virginia taxable income, it is not subject to taxation in Virginia. See P.D. 91-59 (3/29/91), copy attached, for a detailed technical analysis of this issue. Accordingly, the "subtraction" for this item will be allowed as filed.
Sincerely,
Danny M. Payne
Acting Tax Commissioner
OTP/6220M
Rulings of the Tax Commissioner