Tax Type
Corporation Income Tax
Description
Foreign source income; Capital gains
Topic
Allocation and Apportionment
Subtractions and Exclusions
Date Issued
08-15-1994
August 15, 1994
Re: §58.1-1821 Application: Corporate income taxes
Dear This will reply to your letter of July 12, 1994 regarding the application filed on October 30, 1992 for correction of an assessment of additional corporate income taxes to********* (the "Taxpayer") for the 1986 and 1987 taxable years. I apologize for the delay in responding.
FACTS
The Taxpayer was audited for 1986 and 1987 and numerous adjustments were made. The Taxpayer has objected to adjustments made with respect to certain capital gains and interest. The Taxpayer believes that these items should be allocated to its state of commercial domicile, and removed from Virginia apportionable income. The Taxpayer also contests an adjustment made with respect to the Virginia foreign source income subtraction.
The Taxpayer also contests adjustments made to the 1989 taxable year, which affect the net operating loss carryback to 1986.
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 Taxpayer is large multi-national corporation, headquartered outside of Virginia. Among its various activities is the retail sale of merchandise. The Taxpayer has historically purchased stock in the corporations from which it buys material for resale (the "Suppliers"). The Taxpayer has realized gains from the sale of
certain of these stock holdings and interest from installment obligations related to such sales, and seeks to allocate such gain and interest to its state of commercial domicile.
The owned in any particular company varied from approximately 20% to 57% of the outstanding stock.
The department has examined the evidence provided by the Taxpayer in order to determine if a unitary relationship existed between the Taxpayer and the Suppliers, and to determine if the Taxpayer's activities related to the investments in the Suppliers were in any way connected to the Taxpayer's operational activities.
In the existence of a unitary relationship, the department looks to the three factors favored by the courts: (1) functional integration; (2) centralization of management; and (3) economies of scale. The Taxpayer has not presented sufficient evidence to allow the department to reach a definite conclusion with respect to presence or absence of unitary relationships. However, because of the strong operational relationships which existed, the department does not believe that the unitary relationship test is the appropriate measure for this situation.
In considering the operational aspects of the investment, the department considered the evidence provided by the Taxpayer with respect to its stock holdings in and purchases from the Suppliers. The department: finds that the purchaser/supplier relationship between the Taxpayer and the Suppliers creates an unusual and distinct situation.
The Taxpayer's retail operations are large and influential. The Taxpayer represents a very significant retail market, and therefore is an extremely important customer of each of the Suppliers. Information provided to the department indicates that the Taxpayer's purchases from each of the Supplier's varied from approximately 8% to 92% of each Suppliers total output. The Suppliers are fairly sizable companies, and the volume of purchases made by the Taxpayer is significant both in percentage and dollars.
The Taxpayer held significant ownership interests in each of the Suppliers. While the Taxpayer did not necessarily hold a controlling interest in each of the Suppliers, it without question exerted significant influence over each Supplier by virtue of its ownership and significant purchases. It would be unreasonable to conclude that a 20% "passive" stockholder has an equivalent standing to a 20% stockholder who purchases 85% of the Supplier's output. The Taxpayer represents a market for each Supplier that cannot be easily replaced. The fact that the Taxpayer purchases product from the Supplier affects each Supplier's earnings and thus the price of its stock. The influence that the Taxpayer holds can thus affect its relationship both as a customer and as a stockholder. The ability to exercise great control over its source of inventory also enhances the Taxpayer's own earning potential from operational retail activities.
The department does not find that the relationship between the Taxpayer and the Suppliers to be that of a passive investor which relies on the management of the Suppliers for earnings growth and enhanced value. The department believes that there were operational reasons for making the investments, and that there were significant flows of values between the Taxpayer and the Suppliers.
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, the Taxpayer has not met the burden of proof, and has not demonstrated that an alternative method of allocation and apportionment is appropriate. Because of the extraordinary circumstances surrounding the relationship between the Taxpayer and the Suppliers, permission to allocate the capital gains and interest income recognized by the Taxpayer on the sale of Suppliers in 1986 and 1987 must be denied.
1989 Net operating loss carryback. 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 158.1-402. Pursuant to a separate ruling issued to the Taxpayer with respect to the 1989 taxable year, allocable income from the 1989 taxable year cannot be utilized to reduce Virginia taxable income in 1986.
Foreign Source Income: The Taxpayer has contested the adjustment made by the department's auditor with respect to the determination of expenses related to foreign source income. Upon review of the auditor's calculation it appears that the foreign source income subtraction was generally determined in accordance with department policy. However, the subtraction will be adjusted to the extent that expenses have been applied to reduce foreign dividends received from 50% or more owned corporations in accordance with P.D. 93-235 (12/28/93), copy attached.
The assessments will be adjusted as provided herein this letter and as reflected on the attached schedules, and a refund will be issued in due course.
Sincerely,
Danny M. Payne
Tax Commissioner
Rulings of the Tax Commissioner