Tax Type
Corporation Income Tax
Description
Taxable income; Modifications to federal taxable income; Foreign source income expenses
Topic
Computation of Income
Date Issued
11-25-1996
November 25, 1996
Re: §58.1-1821 Application: Corporation Income Tax
Dear***************
This will reply to your letter, in which you protest assessments of corporation income tax against ******** (the "Taxpayer") for the 1991 taxable year. I apologize for the delay in responding to your letter.
FACTS
The Taxpayer was audited by the department for its 1990, 1991, and 1992 taxable years, and numerous adjustments were made. As a result of this audit, the department issued a refund for 1990 and an assessment for 1991. No changes were made for 1992.
You contest three adjustments that impact the 1990 and 1991 taxable years. Each of these issues will be addressed separately.
Determination
Sales Factor
The auditor increased the numerator of the sales factor in both years to include
15% of sales attributed by the Taxpayer to Washington, D.C. The Taxpayer believes these sales were properly attributable to Washington, D.C. It is clear from Code of Virginia § 58.1-415, that tangible personal property received in Virginia as a result of a sales transaction are considered Virginia sales. Sales to the federal government have a history of being classified incorrectly because many agencies are located in Virginia, but are invoiced to a Washington, D.C. address. These agencies may have Washington, D.C. addresses, but actually received purchased goods in Virginia. Thus, Virginia auditors have in the past examined U. S. Government sales to verify correct reporting. It is clear from the information provided that there were sales attributed to Washington, D.C. that were actually delivered to the customer in Virginia.
The Taxpayer disagrees with the method used to determine the amount of Washington, D.C. sales included in the Virginia numerator. The auditor performed an audit on the U. S. Government sales attributed to Washington, D.C. using a one-month sample. Based on an analysis of the test month, it was determined that U. S. Government sales destined for Virginia made up approximately 15% of sales attributed to Washington, D.C. This percentage was applied to annual sales attributed to Washington, D.C.to determine the amount of sales to be included in the Virginia numerator.
A review of the documentation in this case does not support the auditors conclusion that 15% of sales attributed to Washington, D.C. should be included in the Virginia numerator. In fact, the documentation provided indicates that sales delivered in Virginia, but attributed to Washington, D.C., were a very small percentage of the total. The department has therefore determined that the sales delivered in Virginia but attributed to Washington, D.C. would have an immaterial effect and the sales factor will be adjusted to remove the 15% of sales attributed to Washington, D.C.
Based on the above, the auditor's adjustment to the sales factor is reversed.
Foreign Source Income Subtraction
The Taxpayer reported a subtraction for foreign source income for two of the years under review. The auditor increased expenses related to the foreign source income, thereby reducing the subtraction for 1991. You contend that the use of federal Form 1118 is improper in computing related expenses and believe the auditor's expense calculation is excessive. The department has previously ruled on this issue in Public Document (P.D.) 91-229 (9/30/91), and 86-154 (8114186), copies attached.
The department requires the Virginia subtraction for foreign source income to be reduced by expenses, determined in accordance with Internal Revenue Code (IRC) §§ 861, 862 and 863. The provisions of IRC § 861 et seq. contain elaborate detail on assigning income and expense to particular sources. The provisions differentiate between expenses which are definitely allocable and expenses which are not definitely allocable. The latter, such as legal and accounting fees of the taxpayer, are apportioned to items of income on the basis of a percentage of the taxpayer's total receipts. Virginia law requires use of IRC §861 et seq. whether or not the taxpayer believes certain expenses have any connection to income from foreign sources and regardless of what the expenses would be under generally accepted accounting principles. In this case, the rent and royalty expense is directly allocable to the gross rent and royalty income reported on the parent's Form 1118 and were correctly allocated by the auditor. The remaining expenses do not appear to be directly allocable and are therefore subject to apportionment.
The proper method of computing the nonallocable expenses attributable to foreign source income is to multiply the total nonallocable expenses by a ratio, the numerator of which is total Virginia foreign source income and the denominator of which is total income from without the United States per federal Form 1118. You contend that all royalties and interest received for the Taxpayer for 1991, are included in the numerator, and that income should only be included in the numerator to the extent that it is derived from activities carried on in Virginia. For purposes of determining expenses apportioned to foreign source income, Virginia foreign source income means income that would be included in taxable income if it did not meet the definition of foreign source income under IRC § 861 et seq. Thus the auditor correctly included interest, rents, and royalties as they appeared on the parent Form 1118 in the numerator. Since Virginia law allows a separate subtraction for foreign dividend gross up and subpart F income, they are not included in Virginia foreign source income but are included in total foreign source income for purposes of calculating apportionable foreign expenses. Thus, the auditor correctly included interest, rents, royalties, and foreign dividend gross up as they appeared on the parent Form 1118 in the denominator.
Based on the evidence presented, the auditor computed expenses in accordance with the department's established policy. Accordingly, the audit adjustments to the foreign source income subtraction are correct. The prescribed method for computing the foreign source subtraction as demonstrated by the auditor should be used in future tax filings for Virginia.
Sale of common stock investment
The Taxpayer also has contested the department's right to apportion and tax certain capital gains. The Taxpayer believes that such income is allocable to its state of commercial domicile.
During 1989, the Taxpayer acquired shares of common stock of an unrelated third party ("Company C") in exchange for the taxpayer's 82% ownership in a subsidiary. The Taxpayer valued the Company C stock received at fair market value, and reported the gain resulting from the sale of the subsidiary as apportionable income on its 1989 Virginia income tax return. A portion of the Company C stock was sold in 1989 and 1990 with the gains resulting from these sales being included in apportionable income on its 1989 and 1990 Virginia income tax returns. In 1991, the Taxpayer sold the remaining shares and sought to allocate the gain on such sale to its state of commercial domicile.
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 Code of Virginia§§ 58.1-402 and 58.1-403 less allocable dividends pursuant to Code of Virginia 1 58.1-407 is subject to apportionment. The Taxpayer's subtraction of the capital gain has been treated as a request for an alternative method of allocation and apportionment in accordance with Code of Virginia §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 Company C, and to determine if the Taxpayer's activities related to the investment in Company C were in any way connected to the Taxpayer's operational activities carried on in Virginia.
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. Evidence affecting these factors was provided by the taxpayer in clear and objective terms. The Taxpayer has indicated that a minimal flow of goods at less than arms length transpired between the taxpayer and Company C. Other than flow of goods, the Taxpayer has provided ample evidence indicating that the essence of its relationship with Company C was as a minority stockholder subsequent to the original transaction. Based on the information provided to the department, it does appear that a unitary connection did exist between the Taxpayer and Company C.
In considering the operational aspects of the investment, the department considered the evidence provided. The initial exchange of stock clearly affected the operations of both the Taxpayer and Company C. Divesting an 82% owned subsidiary involved a conscience choice to change the operations of the Taxpayer. You have indicated that Company C (a computer software company) was not engaged in the "CAE business" until after the exchange of stock. It is reasonable to conclude that sale of the subsidiary to Company C contributed to its capacity to expand into a new business function which had a direct effect on the investment held by the Taxpayer.
There is also evidence that the investment was not separate from the Taxpayer's operations. The gains from sales of Company C stock were considered operational in nature in both 1989 and 1990 and were included in apportionable income for those years. No objective documentation has been provided indicating that the Taxpayer has a discrete investment function, having no connection with the operational activities carried on in Virginia, which handled the investment in Company C.
You have indicated that proceeds from the sales were reinvested. A review of the investing activities on the statements of cash flows for 1989,1990 and 1991 reveals out flows of cash under investing activities for the purchase of property, plant and equipment, cost of business acquisitions and investments, and other. Purchases of property, plant and equipment are considered to be operational and the cost of business acquisitions and investments and other could be either. However, out flows for the cost of business acquisitions and investments and other in investing activities totaled well less than the proceeds from the sale of long term investments in 1991. This leads to the assumption that the proceeds were either used to finance operating activities or included in the ending cash balance.
Thus, the operations of the Taxpayer were affected by the transaction in which the Taxpayer obtained the stock of Company C, the stock was not handled as a part of a discrete investment function, and the proceeds from the sales were primarily used to enhance the Taxpayer's operational activities. Accordingly, the department concludes that the Taxpayer's investment in Company C did relate to the Taxpayer's operational business carried on in Virginia.
Summary
The audit will be adjusted in accordance with this ruling. The attached schedule reflects the changes made to the audit and the effects of Forms 500 NOLD filed for 1993 and 1994. A refund with applicable interest will be issued. If you have any questions regarding this ruling, you may contact*******at*******.
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/8461 O
Rulings of the Tax Commissioner