Tax Type
Corporation Income Tax
Description
Protective Claim
Topic
Allocation and Apportionment
Date Issued
03-15-1994
March 15, 1994
Re: §58.1-1824 Protective Claim: Corporate Income Taxes
Dear**********
This will reply to your protective claim filed August 14, 1992, and to your letters of November 3, 1992, May 24, 1993 and March 7, 1994 regarding the protective claim, for********* (the "Taxpayer") for the taxable years ended December 31, 1986 and 1987.
FACTS
The Taxpayer was field audited, and numerous adjustments were made to the 1986 and 1987 taxable years. In response to an application made pursuant to Va. Code §58.1-1821, the Tax Commissioner issued Public Document (P.D.) 92-60 (5/1/92), copy attached. The Taxpayer has filed a protective claim for 1986 and 1987, contesting the department's right to apportion and tax certain passive income. The Taxpayer believes that such income is allocable to its state of commercial domicile.
RULING
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 protective claim has been treated as a request for an alternative method of allocation and apportionment in accordance with Va. Code §58.1-421.
Because the Taxpayer has contested several different items of income, each will be addressed separately.
Interest income from idle cash: The Taxpayer realized interest income from the investment of idle cash in 1986. The Taxpayer states that such cash was invested in various short-term securities which were acquired, managed and controlled from its headquarters outside Virginia, and that such investments had no connection with the Taxpayer's business which is carried on in Virginia. The Taxpayer seeks to allocate the interest income earned on the idle cash in 1986 to its state of commercial domicile.
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 has cited American Home Products Corp. v. Director, Div. Tax., Ct. 07-14-0285-84-CB, 8/27/90, (New Jersey) in support of its position. Without recognizing or adopting as our own the rationale of the New Jersey court, I have reviewed this matter in light of American Home Products and feel there are several important distinctions between the two cases.
American Home Products Corp. ("AMHP") prevailed in state court with their position stating that income earned on "excess" cash balances could not be apportioned to the taxing state. The cash was a commingled cash fund consisting of various short term investments. The cash fund was managed at the corporate headquarters, located outside the taxing state.
There are several factors in this case that I believe are essential to the holdings of the other state court. During the years contested in this case, AMHP had no significant long-term debt. Throughout this same period, the operating divisions of AMHP were largely profitable and financially self-sufficient, requiring little or no funding from the commingled cash fund. AMHP's commingled cash fund was a separate and distinct account, segregated as excess cash; the operating divisions only deposited cash into the commingled fund that was deemed to be in excess of the operating needs and other anticipated expenses. There was no indication that the invested funds were regularly used to satisfy working capital needs of the operating divisions. In fact, the New Jersey Court was able to conclude that AMHP had sufficient cash flow from its business operations to provide the necessary operating capital for all its business operations and other reasonably anticipated needs without reliance upon the commingled cash fund. The disbursements actually made from the commingled cash fund were generally unrelated to the operational business of AMHP. For example, the commingled fund paid dividends, direct expenses related to headquarters administration, and certain expenses related to all divisions such as taxes, legal fees, and certain insurance policies. The commingled cash fund was administered almost exclusively by a portfolio manager, with little interaction from other corporate officers.
The Taxpayer is large vertically integrated manufacturer, maintaining significant inventories and capital investment in property, plant and equipment. The total operating capital required by the Taxpayer obviously cannot be readily identified as a fixed amount at any given time, and the idle cash may have merely been a temporary investment of working capital. The Taxpayer has not demonstrated how much of the cash balance available at any time was necessary to handle reasonably anticipated cash needs, such as current liabilities, current debt service or balloon payments, or other known cash commitments. The Taxpayer has not demonstrated the "average" or typical amount of working capital which is necessary for a day, week, or any other period, and without such evidence it is impossible to determine how much is reasonably necessary for operational cash flow needs. The Taxpayer has presented no evidence that supports a time period over which the reasonably necessary operational cash flow needs can be measured.
AMHP maintained an extremely liquid position in its passive investment capital due to its desire to maintain a conservative, short-term strategy against volatile interest rates. In contrast, the Taxpayer apparently had a portion of its operational working capital invested in short-term investments. The intent to maximize the return on a temporary cash position does not create a passive investment where the cash is an integral element of the operational activities.
In contrast to AMHP, the Taxpayer has significant amounts of long-term debt, while AMHP did not. The Taxpayer has presented no factual data indicating that its cash balance was not necessary for or related to the operational retirement of scheduled debt service. Also, the presence of long-term debt implies a need to refinance, extend or renew such financing. The need for liquidity becomes more critical when such relationships are present. The absence of long-term debt for AMHP was an important element supporting their position that cash, an extremely fungible commodity, could be viewed as other than an operational asset.
There are also certain intangible aspects to cash balances, such as the impact on operational relationships involving banking and credit. The Taxpayer's position would ignore the operational benefits of intangibles such as a healthy current ratio. As mentioned previously, the presence of long-term debt implies a need to negotiate new or renewed financial relationships. Some financing arrangements may require that certain financial ratios be present and maintained; others may be negotiated on a more favorable basis if liquidity and other financial ratios are favorable. The operational benefits of a strong financial position cannot be ignored where there is no evidence, such as the absence of long-term debt, indicating that the company can operate effectively without them.
The Taxpayer has not demonstrated by clear and cogent evidence that their analysis of the investment income is appropriate, and I find significant differences between their situation and the AMHP case cited. In Allied-Signal, the court stated:
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- "The existence of a unitary relation between payee and payor is one justification for apportionment, but not the only one. Hence, for example, a State may include within the apportionable income of a nondomiciliary corporation the interest earned on short-term deposits in a bank located in another state if that income forms a part of the working capital of the corporation's unitary business, notwithstanding the absence of a unitary relationship between the corporation and the bank."
Based on the information provided, I cannot determine how much, if any, of the Taxpayer's cash could be fairly characterized as a passive investment. 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 bear the heavy burden of demonstrating that the imposition of Virginia's statute is a violation of the standards enunciated by the United States Supreme Court in Allied Signal. Based upon the information provided, I do not find that the Taxpayer met the burden of proof. Accordingly, permission to use an alternative method of allocation and apportionment for interest income earned on idle cash is hereby denied.
Sale of foreign subsidiary: The Taxpayer owned 50% of the stock in a corporation ("Company A") which was organized outside of the United States. An unrelated third party owned the remaining 50% of Company A. The Taxpayer and the unrelated third party are both engaged in the manufacture of similar products. Company A engaged in the manufacture and sale of product outside the United States.
In 1986, the Taxpayer sold its share of Company A to the unrelated third party on the installment basis. The Taxpayer seeks to allocate the interest income received on the installment sale obligation in 1986 and 1987, and the gain recognized during 1987.
During the period of ownership, the Taxpayer did not control or direct Company A. The third party served as the operational partner, and oversaw the daily operations of the business. No approval was necessary by the Taxpayer regarding contractual agreements, capital expenditures, research and development, daily operations, obtaining loans, establishing salaries and bonuses for employees, budgeting, and making capital investments. Company A did not share technical information, marketing services, trademarks, logos, banking services or relationships, purchasing or procurement facilities with the Taxpayer. There were no joint employee training programs, each had its own internal accounting staff, retained different outside CPA's, and independently chose different outside tax advisors. Company A purchased material from the Taxpayer (or the third party) at arm's length prices. The total amount of intercompany sales made between the Taxpayer and Company A during the period of ownership was clearly immaterial to the Taxpayer's sales from this segment of its business. Although two of the Taxpayer's employees served as directors of Company A, the Taxpayer did not control the board of directors. No employee of the Taxpayer served as an officer of Company A. The Taxpayer consistently treated Company A as a nonunitary asset in every respect.
The monetary transactions between the Taxpayer and Company A were limited to purchases of product by Company A at fair market value. Although Company A served as a market for the Taxpayer's products, there is no evidence which indicates that this market source created any special or unique benefit for the Taxpayer. There is no indication that Company A was anything other than a passive investment. The Taxpayer relied on the management of Company A for earnings growth and enhanced value, and no significant relationships of an operational nature existed between the Taxpayer and Company A. The interest income arising from the installment sale obligation constitutes income arising from the sale of a nonunitary asset that is clearly unrelated to the operational activities of the Taxpayer. Based on the information provided, I find that the Taxpayer has demonstrated that an alternative method of allocation and apportionment is appropriate with respect to the interest income arising from the installment sale obligation received by the Taxpayer as a result of the sale of Company A.
Because Company A was incorporated outside the United States, the gain realized on the sale of this intangible asset constitutes foreign source income for purposes of the subtraction allowed pursuant to Va. Code §58.1-402 C 8. Accordingly, the gain recognized in 1987 shall be included as part of the Virginia foreign source income subtraction. Since there is no gain remaining in Virginia taxable income to allocate and apportion, there is no need to address the apportionability of the gain.
Interest income from other notes receivable: The Taxpayer received interest income from various notes receivable from unrelated third parties. Other than general statements regarding the nature of these notes, the Taxpayer has not provided objective evidence indicating that the income arises in the absence of a unitary relationship, or that the income was not operational in nature or did not arise from an operational rather than a passive investment function. Accordingly, permission for an alternative method of allocation and apportionment with respect to this income is denied.
Sale of Preferred stock investment: In 1979, the Taxpayer sold certain assets in exchange for cash and nonvoting, nonconvertible preferred stock of an unrelated third party ("Company B"). The Taxpayer stated in the purchase and sales agreement that it was acquiring the preferred stock for its own investment with no present intention of distributing or reselling the shares or any part thereof, and that they were prepared to bear economic risk of investment for an indefinite period. In 1986 the Taxpayer sold this investment, and seeks to allocate the gain on such sale to its state of commercial domicile.
Company B is a publicly traded corporation. The Taxpayer owned none of the common stock of Company B, and the preferred stock held by the Taxpayer represented only 3.6% of the total outstanding stock of Company B. No officer, director or employee of the Taxpayer served as an officer, director or employee of Company B. The Taxpayer has provided ample evidence indicating that its only relationship with Company B was as a preferred stockholder. The Taxpayer and Company B were unrelated in every other respect.
The Taxpayer has demonstrated that its investment in Company B constitutes a discrete investment function, having no connection with the operational activities carried on in Virginia. Accordingly, the Taxpayer has demonstrated that an alternative method of allocation and apportionment is appropriate with respect to the gain recognized on the sale of Company B in 1986.
Sale of leaseholds: During 1985, the Taxpayer acquired condominium interests in real property located outside Virginia, in addition to space leases to unrelated third parties. The Taxpayer contributed the real property interests to a subsidiary. In 1986, the stock of the subsidiary and the third party leases were sold at a net gain. The Taxpayer seeks to allocate part of this gain to its state of commercial domicile.
Part of the real estate sold was occupied by the Taxpayer, and used as its corporate headquarters. Accordingly, the gain would be operational in nature to the extent that it related to its corporate headquarters. However, the Taxpayer has demonstrated that the net amount of gain it seeks to allocate results solely from the sale of third party leases. The space leased to third parties was physically separated from the Taxpayer's headquarters, and was street level retail space. The space occupied by the Taxpayer was office space located in upper floors of the building. The Taxpayer was in the process of moving its headquarters, and was able to take advantage of a soaring real estate market as a result of its long-term lease for space at a rental that was well below fair market value. The party selling the property to the Taxpayer in 1985 was truly captive to the Taxpayer's long-term bargain rate lease, and could not otherwise realize the potential of its assets. The Taxpayer took advantage of its position, and consequently realized a large, short-term gain.
The Taxpayer has apportioned the portion of the gain realized with respect to its corporate headquarters to Virginia, and paid the resulting Virginia tax. The Taxpayer seeks to allocate gain relating to the sale of third party leases, determined in accordance with the sales agreement executed when the Taxpayer sold the assets
The Taxpayer has demonstrated that the sale of third party leases at a substantial gain constituted a discrete investment function, having no connection with the operational activities carried on in Virginia. Accordingly, the Taxpayer has demonstrated that an alternative method of allocation and apportionment is appropriate with respect to the gain recognized on the sale of third party leases during 1986.
Royalties: The Taxpayer receives royalties from third parties for the right to extract minerals and oil from property owned by the Taxpayer. The Taxpayer contends that such royalties are unrelated to the Taxpayer's operations carried on in Virginia, and therefore should be allocated to the states in which such real property is located.
The Taxpayer is one of the largest vertically integrated manufacturers in the world. The Taxpayer holds millions of acres of land, from which it extracts natural resources used in manufacturing its products. The Taxpayer also extracts resources such as timber from its lands, which is sold for lumber.
The Taxpayer, through its mineral division, is engaged in oil, gas and hardrock mineral programs. The Taxpayer has millions of acres of fee mineral holdings. The Taxpayer engages in its own oil and gas drilling programs, invests in drilling programs of third parties, and acquires proven reserves. The hardrock mineral program focuses on developing the Taxpayer's lands through leasing or joint venturing with third parties.
The Taxpayer clearly uses its real estate holdings as an operational asset, involved in a unitary manufacturing business. In fact, the Taxpayer's annual reports to stockholders stress its image as one of the world's largest natural resource companies.
The Taxpayer has cited the decision of the California State Board of Equalization in Appeal of the Masonite Corporation, 87-SBE-018, March 3, 1987. Masonite Corporation manufactures hardboard, and other wood based building materials. Masonite owned approximately 544,000 acres of timberlands, which it acquired to establish a secure source of raw materials. Masonite received royalties from oil reserves discovered on its land in Mississippi. The California court found that the royalty income constituted nonbusiness income unrelated to the actual operation of Masonite's unitary hardboard business. Again, without formally recognizing the other state's decision, I have reviewed this matter in light of Masonite and again, I find several important distinctions between that case and the Taxpayer's situation.
The primary difference is the extent that the Taxpayer utilizes its land holdings in its unitary business. The Taxpayer fully exploits its land holdings to extract natural resources. The Taxpayer uses some of these natural resources as a source of supply for its manufacturing process, and harvests others for direct sale. The Taxpayer regularly and systematically profits from the extraction of oil and other minerals from its land, either through its minerals division or through third parties. Masonite held a relatively insignificant land interest, which it intended to utilize as a source of supply. There is little comparison between the extent to which Masonite and the Taxpayer utilize their land holdings in their operational activities. The Taxpayer is clearly in the business of harvesting natural resources from land holdings.
Another point which makes Masonite a poor comparison is the difference in California's taxing statute. Whereas California provides for the allocation of nonbusiness income by statute, the issue in the instant case is whether the principles set forth in Allied-Signal would deem the royalties to be a discrete business investment unrelated to the Taxpayer's operational activities.
I find the significant differences between Masonite and the Taxpayer leave little support for the Taxpayer's comparison to the California decision.
A better comparison may be from the decision of the Oregon Tax Court in Willamette Industries, Inc. v. Department of Revenue, Or. Tax Ct., Oct. 6, 1992, 12 OTR 291. In that case, the Oregon Tax Court found that oil and gas royalties received by a timber company, engaged in the unitary business of forest management, logging and the production of various wood and paper products, could be apportioned to Oregon even though the real property was located in other states. The Oregon court held that the California State Board of Equalization erred in its decision in Masonite, and stated:
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- "What is determinative here is that the income arises from plaintiffs' business assets. If plaintiffs invested in oil lands devoid of timber with no relation to plaintiffs' trade or business, the income would be nonbusiness income and subject to allocation. Here, however, the timberland is acquired, managed and used in plaintiffs' trade or business. The oil and gas royalties are simply incidental business income arising from this business property."
In this particular matter, the Taxpayer must do more than show that the payors of the royalties are unrelated third parties, or that the real property is located outside Virginia. Rather, the Taxpayer must bear the heavy burden of demonstrating that the imposition of Virginia's statute is a violation of the standards enunciated by the United States Supreme Court in Allied-Signal. In Allied-Signal, the court stated
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- "We agree that the payee and the payor need not be engaged in the same unitary business as a prerequisite to apportionment in all cases. Container Corp. says as much. What is required instead is that the capital transaction serve an operational rather than an investment function."
The real question therefore, is whether the royalty income arises from an operational function. The income in question arises from the exploitation of land holdings for their various natural resources. As the U. S. Supreme court made clear in Corn Products Co. v. Commissioner, 350 U. S. 46, 50-53 (1955), capital transactions can serve either an investment function or operational function. In the instant case, the land holdings clearly relate to the Taxpayer's unitary business operations. Based upon the information provided, I do not find that the Taxpayer met the burden of proof with respect to their claim. Accordingly, permission to use an alternative method of allocation and apportionment for royalty income is hereby denied.
Other items: On its tax return and in its protest, various sundry items have been claimed as allocable income. The Taxpayer has not met the burden of proof with respect to these items. Accordingly, permission to use an alternative method of allocation and apportionment for royalty income is hereby denied.
Accordingly, your protective claim will be adjusted as provided herein, and as reflected on the attached schedules. In addition, appropriate adjustments will be made to the sales factor with respect to the income allowed to be allocated out of Virginia. Your refund, with interest calculated at statutory rates, includes the effect of the adjustments agreed to in the department's ruling of May 1, 1992. It will be mailed to you in due course.
Sincerely,
Danny M. Payne
Acting Tax Commissioner
OTP/6370M
Rulings of the Tax Commissioner