Tax Type
Corporation Income Tax
Description
Apportionment of passive income
Topic
Allocation and Apportionment
Date Issued
03-24-1994
March 24, 1994
Re: §58.1-1821 Application: Corporate Income Taxes
Dear****************
This will reply to your letter of June 11, 1993, in which you have applied for correction of assessments of additional corporate income taxes to ********** (the "Taxpayer") for the taxable years ended December 31, 1988 and 1989.
FACTS
The Taxpayer was the subject of an office audit for the 1989 taxable year, and an assessment was made as a result of that audit. The Taxpayer was later field audited, and numerous adjustments were made to the 1988 and 1989 taxable years. The Taxpayer has contested 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. The Taxpayer also believes that certain computational errors were made by the department's auditor.
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 §§8.1-402 and 58.1-403, less dividends allocable pursuant to Va. Code §58.1-407 is subject to apportionment. The Taxpayer's protest 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.
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 1988.
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.
Sale of stock investment: In 1989, the Taxpayer sold shares of the stock of an unrelated third party ("Company s"). The Taxpayer had acquired the shares in 1974 and 1975. The Taxpayer had executed a stock repurchase agreement with the Company, which provided for the repurchase of a fixed number of shares of stock by 1989. Pursuant to this agreement, certain shares were repurchased by Company B in 1980 and again in 1986. In 1989 the Taxpayer sold the final shares of stock pursuant to this agreement, and seeks to allocate the gain on such sale to its state of commercial domicile.
Prior to the 1989 sale, the Taxpayer owned a 45% equity interest in Company B, and after the sale the stock held by the Taxpayer represented only 3% of the total equity of Company B. The Taxpayer and Company B did not use common in-house legal counsel, accountants or auditors. Company B independently chose its outside legal counsel, accountants, tax advisors and auditors. Company B did not receive any tax advice from the Taxpayer or from any inside department of the Taxpayer. Only one employee of the Taxpayer served as a director on the eleven member board of Company B. No employee, officer or director of the Taxpayer served as an officer of the Taxpayer, and no officer, director or employee of Company B served as an officer, director or employee of the Taxpayer. There were no joint employee training programs between the Taxpayer and Company B. Company B did not participate in any pension plans, stock options plans, employee benefit plans, or health or life insurance plans in common with the Taxpayer. There was no sharing of technical information, marketing services, trademarks, logos, banking service or relationships, purchasing or procurement facilities. Company B established its own employment practices and determined the salary, wages, and bonuses to be paid to its employees, officers and directors. Other than through minority representation on the board of directors, the Taxpayer did not impose any limits on contractual agreements, capital expenditures, research and development, daily operations, loans, establishing salaries and bonuses for employees, hiring and firing of officers and employees, use of outside legal counsel and budgets. All sales between the companies were at arm's-length negotiated prices reflecting fair market value.
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 1989.
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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- "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."
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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.
Rental income, Permits and other income: On its tax return and in its protest, various items such as rent, rights to hunt and fish on land holdings, and geophysical exploration permits have been claimed as allocable income. Like the royalties discussed above, the income arises in connection with the acquisition the timberland, which has been acquired, managed and used in the Taxpayer's trade or business. The income in question is simply incidental business income arising from this business property. The Taxpayer has not demonstrated by clear and cogent evidence that this income is unrelated to their operational activities.
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 rents and other types of income earned is hereby denied.
Interest income from other sources: The Taxpayer received imputed interest income in 1989 from the sale of a division of a foreign corporation in which the Taxpayer held a 51% stock interest. 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.
Accordingly, the assessment will be adjusted as provided herein, and as reflected on the attached schedules. The duplicate assessment made pursuant to the 1989 office audit will be abated. In addition, appropriate adjustments will be made to correct the computational errors made by the auditor. The balance due including interest,************* must be paid within 30 days to prevent the accrual of additional interest.
Sincerely,
Danny M. Payne
Acting Tax Commissioner
OTP/6013M;7077M
Rulings of the Tax Commissioner