Document Number
96-363
Tax Type
Corporation Income Tax
Description
Taxable income; Modifications to federal taxable income; Additions and subtractions
Topic
Computation of Income
Royalties
Date Issued
12-09-1996


December 9, 1996



Re: §58.1-1821 Application: Corporate Income Taxes



Dear**************

This will reply to your letter in which you request a correction of assessments of additional corporate income taxes to****** (the "Taxpayer") for the 1991, 1992, and 1993 taxable years. I apologize for the delay in responding to your request.


FACTS


The Taxpayer was field audited, and numerous adjustments were made. The Taxpayer protested several of these adjustments, which will be addressed separately.


DETERMINATION


Net Operating Loss Deduction (NOLD)

The Taxpayer files a consolidated return for federal purposes and a separate Virginia corporate income tax return. The Taxpayer liquidated two wholly-owned subsidiaries ("S1" and "S2") in tax-free transactions pursuant to Internal Revenue Code (IRC) §332 on January 3, 1992 and December 31,1992, respectively. The Taxpayer utilized the total net operating loss carryover of S1 as a deduction against federal taxable income for the 1992 taxable year on the Taxpayer's consolidated federal return, and did likewise with S2's net operating loss carryover for the 1993 taxable year. The Taxpayer, however, added back these NOLDs to federal taxable income in computing Virginia taxable income for the Taxpayer's separate Virginia corporate income tax return. The department's auditor made no adjustment regarding the NOLDs for either year. The Taxpayer now asserts that the addition of the NOLDs to federal taxable income was in error, and requests that the department eliminate this addition in its assessments of additional corporate income taxes.

Virginia law has no separate provision for a NOLD. A NOLD, therefore, is allowable for Virginia purposes only to the extent that the NOLD is allowable as a deduction in computing federal taxable income for Virginia purposes, i.e., as if federal returns had been filed on the same basis as Virginia returns for all affected years.

IRC § 381 requires that a successor corporation in corporate acquisitions pursuant to IRC §§ 332 and 361 acquire various tax attributes of the predecessor. The use of these attributes by the successor, however, may be limited. In the case of net operating loss carryovers, the successor's use of the predecessor's net operating loss carryover for the first taxable year ending after the acquisition date is limited to the successor's taxable income after the acquisition. Treasury Regulation §1.381 (c)(1)-1 defines this limitation as the successor's taxable income for the entire year (determined without regard to any NOLD) multiplied by a ratio. This ratio is the number of days from the acquisition date to the end of the taxable year, divided by the total number of days in the successor's taxable year. Treasury Regulation §1.381(c)(1)-1 is also clear in that is necessary to apply the provisions of IRC§ 172 in accordance with the limitations imposed by IRC§ 381(c)(1).

In the instant case, the Taxpayer liquidated S1 and S2 during the 1992 taxable year, thereby acquiring their respective net operating loss carryovers. Since both acquisitions were accomplished by means of IRC § 332 liquidations, IRC § 381 is applicable. Treasury Regulation§ 1.381(c)(1)-1 thus limits the Taxpayer's use of S1's and S2's net operating loss carryovers for the first taxable year ending after the acquisition date. The Taxpayer contends it is entitled to utilize the entire net operating loss carryovers of S1 and S2 in the first taxable years ending after their respective acquisition dates in computing Virginia taxable income. Since Virginia allows a NOLD only to the extent it is allowable in computing federal taxable income for Virginia purposes, the NOLDs for the 1992 and 1993 taxable years must be computed in accordance with Treasury Regulation §1.381(c)(1)-1 and IRC § 172.

The NOLD for S1 is computed by determining the number of days after January 3, 1992 (the acquisition date) to the end of the Taxpayer's taxable year. This is then divided by the total number of days in the Taxpayer's 1992 taxable year. This ratio is multiplied by the Taxpayer's federal taxable income computed on the same basis it uses for Virginia purposes to determine the limitation on the use of the predecessor corporation's net operating loss carryover.

Since the acquisition date of S2 was December 31, 1992, the first taxable year ending after that date is December 31, 1993. Pursuant to Treasury Regulation 1.381 (c)(1)-1, the net operating loss carryover of S2 is allowed in full, unless otherwise limited by I RC § 172, for the 1993 taxable year.

Applying the provisions of IRC §172 and Treasury Regulation § 1.381(c)(1)-1 to the Taxpayer's situation results in the full net operating loss carryovers of S1 and S2 being allowed as a deduction against federal taxable income for the 1992 and 1993 taxable years. Accordingly, the auditor's report will be adjusted to remove the NOLD addition from the computation of Virginia taxable income.

Dividends Received From Puerto Rican Corporation

The Taxpayer held a 5% direct ownership interest in a Puerto Rican corporation ("PRC") during the 1991 and 1992 taxable years. The Taxpayer claimed foreign source income subtractions for dividends received from PRC on its 1991 and 1992 Virginia corporate income tax returns. These subtractions were disallowed by the department upon audit. The department's auditor concluded that since Puerto Rico was a possession of the United States, then income from Puerto Rican sources was not foreign source income. The Taxpayer disagreed with this conclusion, and contends that the dividends from PRC constitute foreign source income.

"Foreign source income" is defined by Code of Virginia § 58.1-302, which states in pertinent part:

    • In determining the source of "foreign source income," the provisions of §§861, 862, and 863 of the Internal Revenue Code shall be applied....

IRC§ 862(a)(2) defines foreign source dividends as those dividends which are not considered as sourced from within the United States pursuant to IRC § 861(a)(2). IRC § 861 (a)(2)(B) states that dividends from a foreign corporation are U.S. source income unless less than 25% of all the foreign corporation's gross income for a three year period prior to the dividend declaration date is effectively connected with a trade or business conducted in the United States. Utilizing these sourcing rules, dividends from PRC constitute foreign source income if: 1) PRC is a foreign corporation; and 2) PRC's source of income falls within the criteria specified in IRC §861(a)(2)(B).

IRC § 7701 defines a foreign corporation as one not organized under the laws of the United States or any State. Definitions of "United States" and "State" within IRC§ 7701 do not include Puerto Rico or other U.S. possessions. A corporation organized under the laws of Puerto Rico, therefore, is a foreign corporation. Since PRC was organized under the laws of Puerto Rico, PRC is a foreign corporation.

The Taxpayer has stated that none of the gross income received by PRC was effectively connected with the conduct of a trade or business in the United States. The Taxpayer paid taxes to Puerto Rico on all dividends received from PRC. The income was incorporated into the form 1118 filed with the Taxpayer's consolidated federal return, and was never reclassified by the Internal Revenue Service as domestic income. Accordingly, the dividend income received by the Taxpayer from PRC constitutes foreign source income within the definition of Code of Virginia § 58.1-302. The audit report, therefore, will be adjusted to reflect the dividends received from PRC in the foreign source income subtraction.

Royalties Paid by Foreign Licensees via Domestic Subsidiary

During the 1992 and 1993 taxable years, the Taxpayer received royalties for the use of various intellectual and industrial property rights which were licensed to foreign subsidiaries. These subsidiaries were also licensed to use patents which were owned by another subsidiary ("S") of the Taxpayer. S was incorporated and located in the United States.

The Taxpayer originally owned all patents and other intellectual property rights, namely trademarks, copyrights, and technology, which it licensed for use overseas by foreign subsidiaries. Royalties paid by the licensees qualified as income eligible for the Virginia foreign source income subtraction. In 1992, the Taxpayer transferred to S ownership of all patents, while retaining the intellectual property rights. The Taxpayer assigned to S all licensing agreements with foreign subsidiaries. S and the Taxpayer then entered into an agreement whereby S would remit to the Taxpayer a specified portion of the royalty fee. That agreement states in pertinent part:
    • [S] agrees to pay to [the Taxpayer] a portion of the license fee which [S] obtains from the said International Subsidiaries under the respective licenses in payment for a license by [the Taxpayer] to [S] in all trademarks, copyrights and Technology....

The Taxpayer included these royalties in the foreign source income subtractions on its Virginia corporate income tax returns. The department's auditor, upon discovering that the royalties were received directly from a domestic corporation, concluded that the royalties were not foreign source income. The Taxpayer protested this conclusion, asserting that the royalties were foreign source income pursuant to the sourcing rules in IRC §861 et seq. The Taxpayer also referred to Revenue Ruling 72-232 as support for its position.

As stated above, Virginia law requires that the source of foreign source income be determined in accordance with IRC §§ 861, 862, and 863. The definition of foreign source income in Code of Virginia§ 58.1-302 directly incorporates the language of IRC § 862(a)(4) by declaring that foreign source income includes "rents, royalties, or fees for the use of or the privilege of using without the United States any patents, copyrights, secret processes and formulas, trademarks, trade brands, franchises, and other like properties." Pursuant to this statute, the place where the property is used is the controlling factor in determining whether the income is derived from foreign sources, not from where payment is received.

In Revenue Ruling 72-232, royalties paid to a nonresident alien individual by a domestic corporation for books printed in the U.S. and sold exclusively in a foreign country under that country's copyright were considered income from foreign sources pursuant to IRC § 862(a)(4). The nonresident alien, as an independent contractor, contracted with the publisher to prepare the manuscript. The publisher, in turn, paid to the individual the royalties which the publisher received from overseas sales.

A similar fact pattern is present in this case. The fact that the Taxpayer granted a license to S for the intellectual property rights, which were in turn sublicensed to foreign subsidiaries, is similar to the indirect relationship between the author in Revenue Ruling 72-232 and the foreign payers of the royalties. In these transactions, S acted only as a conduit by which the royalties paid by the licensees were remitted to the Taxpayer. When S received the total share from the licensees, it recorded the Taxpayer's portion as a liability. The Taxpayer's share of the royalties received by S were not recorded as income to S under tax accounting principles, nor were the royalties passed along to the Taxpayer recorded as expenses by S.

Based on the determination that the royalties received by the Taxpayer were for property which was used outside the United States, the royalties in question constitute foreign source income as defined by Code of Virginia §58.1-302. The royalties, net of expenses, will therefore be included in the foreign source income subtraction on the revised audit report.

Foreign Source Income Not Included on Federal Form 1118

The Taxpayer claimed a subtraction for foreign source interest income on its Virginia corporate income tax returns for the 1992 and 1993 taxable years. This interest income was not included on the respective forms 1118. The department's auditor disallowed this subtraction by utilizing only the amounts included on the form 1118. The Taxpayer contested this omission.

Since many taxpayers who claim a foreign source income subtraction on their Virginia income tax returns will also claim a foreign tax credit on their federal returns, federal form 1118 provides a useful starting point for audit purposes. Not all income on the form 1118, however, is eligible for the Virginia foreign source income subtraction, nor is there a requirement that all Virginia "foreign source income" be reported on the form 1118. The statutory definition in Code of Virginia § 58.1-302 in conjunction with the sourcing rules in IRC § 861 et seq. provide the correct basis for determining what constitutes foreign source income.

The evidence presented by the Taxpayer indicates that the income is from foreign sources and is of a type which meets the criteria in Code of Virginia § 58.1-302. Such income, therefore, is eligible for the Virginia foreign source income subtraction.

Environmental Tax

On its pro forma federal income tax returns for the 1991, 1992 and 1993 taxable years, used to calculate federal taxable income for Virginia income tax purposes, the Taxpayer claimed a deduction for environmental taxes. These taxes were not added to federal taxable income when computing Virginia taxable income. The department's auditor added these taxes to federal taxable income in accordance with Code of Virginia §58.1 -402 B.4. The Taxpayer contends that the amount of the addition is incorrect because it was not based on the separate company environmental tax as calculated on the separate company proforma federal form 4626.

Code of Virginia §58.1-402 B.4 provides that the amount of income and other taxes which are based on, measured by, or computed with reference to net income are to be added back to federal taxable income in the computation of Virginia taxable income, but only to the extent those taxes were deducted in determining federal taxable income. In Public Document (P.D.) 91-87, (5129191), copy enclosed, the department ruled that an environmental tax was computed with reference to net income, and therefore fell within the scope of Code of Virginia §58.1-402 B.4. P.D. 91-87 was also clear in stating that the tax could only be added back to the extent it was actually deducted in determining federal taxable income.

In the instant case, the Taxpayer submitted a pro forma federal corporate income tax return with the Virginia return for each taxable year. The pro forma federal returns detailed the computation of federal taxable income, which became the starting point in computing Virginia taxable income. During the field audit, the department's auditor obtained a schedule of taxes which agreed with the total taxes reported on line 17 of the pro forma 1120, and deducted in determining federal taxable income. Included on this schedule was an amount labeled "environmental." This amount formed the basis for the auditor's adjustment in each taxable year.

The Taxpayer asserts that the environmental tax deducted on the proforma 1120 is actually calculated on a consolidated basis and therefore is not the proper amount to be added back to federal taxable income. The Taxpayer states that it pays the consolidated environmental tax, and is reimbursed by the subsidiaries for their share in the subsequent year. Since the Taxpayer files a separate return for Virginia purposes, the Taxpayer contends the addition for environmental taxes must be calculated on a separate company basis.

When a taxpayer asserts that an item must be treated differently for Virginia purposes than it was on a federal return, the taxpayer must clearly show that this adjustment is justified. In addition, the taxpayer must show that the alternative treatment does not affect the amount or characterization of any item of federal taxable income. Because the environmental tax was computed on a consolidated basis, federal taxable income, on a separate company basis, was understated. The auditor's adjustment for the consolidated amount removed all environmental taxes from Virginia taxable income, which is the effect of Code of Virginia § 58.1-402 B.4, and essentially corrected federal taxable income. The amount by which the consolidated tax exceeded the separate company tax is better characterized as a receivable than as an expense of the separate company.


Based on the information presented, the Taxpayer has not shown that an alternative treatment of environmental taxes is justified. Accordingly, there is no basis to reverse the auditor's adjustments.

The audit report will be adjusted to reflect the determinations herein. A refund, calculated in accordance with the enclosed schedules, will be issued with interest at statutory rates in due course. If you have any questions regarding this determination, you may call********** at*********.

Sincerely,





Danny M. Payne
Tax Commissioner







(OTP/9701G

Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46