Document Number
97-207
Tax Type
Corporation Income Tax
Description
Taxable Income; Modifications to Federal Taxable Income; Foreign source income reduced to zero
Topic
Computation of Income
Date Issued
04-28-1997

April 28, 1997


Re: § 58.1-1821 Application: Corporate Income Tax


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

This will reply to your letter in which you are contesting the assessment of corporation income tax against your client, ********(the "Taxpayer"), for taxable years ended December 31, 1991 and 1992. I apologize for the delay in responding to your letter.

FACTS


The department audited the Taxpayer for the 1991 and 1992 taxable years, and made numerous adjustments resulting in an assessment of additional corporation income tax. Because you have contested a number of issues, each issue will be addressed separately.

DETERMINATION


Interest Income of subsidiary

In computing federal taxable income for 1991 and 1992, the Taxpayer deducted interest due to a subsidiary (S1). The department's auditor removed the interest deductions after determining the loan agreements between the Taxpayer and S1 lacked economic substance and created an improper reflection of Virginia taxable income.

S1 was formed to provide funds to satisfy working capital needs of the Taxpayer and affiliates. The Taxpayer has not indicated where S1 obtained the assets to supply the funding needs of the affiliated group. S1's assets on the balance sheet for the taxable years include cash, trade receivables and other investments. The large balance in other investments appears to be intercompany loans. Based on S1's stated purpose, it received all the interest income from affiliated companies. S1 had substantial interest income for both taxable years with minimal expenses. S1 had no employees and no tangible assets.

Code of Virginia § 58.1-446 provides, in pertinent part:
    • When any corporation liable to taxation under this chapter by agreement or otherwise conducts the business of such corporation in such manner as either directly or indirectly to benefit the members or stockholders of the corporation, . . by either buying or selling its products or the goods or commodities in which it deals at more or less than a fair price which might be obtained therefor, or when such a corporation . . . acquires and disposes of the products, goods or commodities of another corporation in such manner as to create a loss or improper taxable income, and such other corporation . . . is controlled by the corporation liable to taxation under this chapter, the Department . . . may for the purpose determine the amount which shall be deemed to be the Virginia taxable income of the business of such corporation for the taxable year.
    • . . . In case it appears to the Department that any arrangements exist in such a manner as improperly to reflect the business done or the Virginia taxable income earned from business done in this Commonwealth, the Department may, in such manner as it may determine, equitably adjust the tax. (Emphasis added.)

Virginia Regulation (VR) 630-3-446, effective January 1, 1985, provides in pertinent part:
    • Parent corporations and subsidiaries. When any corporation liable to taxation under this chapter owns or controls . . . another corporation the department may require the corporation liable to taxation to make a report consolidated with such other corporation and furnish such other information as the Department may require. If the department finds that any arrangements exist which cause the income from Virginia sources to be inaccurately stated then the department may equitably adjust the tax of the corporation liable to taxation under this chapter. (Emphasis added.)
    • The conduct or manner in which business is conducted reached by this section is not restricted to the case of improper accounting, to the case of a fraudulent, colorable, or sham transaction or to the case of a device designed to reduce or avoid tax by shifting or distorting income, deductions, credits or allowances. The conduct may be legal or even encouraged by the laws of other jurisdictions, including laws of the United States. The determining factor is whether the conduct of taxpayer's affairs, by inadvertence or design, causes the income from Virginia sources to be inaccurately stated. (Emphasis added.)

It has been the department's policy to make determinations based on statutes and regulations in force during the tax period for which the taxpayer is seeking relief. Effective for taxable years beginning on or after January 1, 1993, the department issued expanded regulations related to the application of Code of Virginia § 58.1-446. In 1996, the department's regulations were renumbered and included in Title 23 of the Virginia Administrative Code (VAC). Hence, Code of Virginia § 58.1-446 will be regulated by 23 VAC 10-120-360, 361, 362, 363, and 364.

The Virginia Supreme Court's opinion in Commonwealth v. General Electric Company, 236 Va. 54 (1988) has upheld the department's authority to equitably adjust the tax of a corporation pursuant to Code of Virginia § 58.1-446 (or its predecessor) where an arrangement exists between two commonly owned corporations in such a manner to improperly, inaccurately, or incorrectly reflect the business done in Virginia or the Virginia taxable income. Generally, the department will exercise its authority if it finds that a transaction, or a party to a transaction, lacks economic substance.

The Taxpayer contends that the transactions between S1 and the Taxpayer are at an arm's length interest rate. However, the department does not look only to the interest rate when examining this type of transaction. Unfortunately, the Taxpayer has not provided the additional information requested by the department's letter on September 20, 1996, concerning this issue.

In the absence of this documentation, the department has assumed the Taxpayer transferred cash assets to a newly created subsidiary in exchange for stock. Had the transfer to S1 not occurred, the Taxpayer, presumably, would not have been compelled to borrow funds to satisfy its working capital needs. Because S1 is a subsidiary, the Taxpayer never lost the ability to control the cash, the rate or terms of the loans, or the unrestricted use of the cash. The Taxpayer is essentially free to undo the transaction with S1 at any time.

The department has determined that the interest payments result in the transfer of income from the Taxpayer and S1. Absent of the creation of this arrangement, the interest would not have been deducted from the Taxpayer's taxable income apportioned and taxed in Virginia. The federal tax laws affecting corporate transfers and consolidated returns allow this action to be taken without adverse federal tax consequences, even where the transactions are not performed at arm's length. Under these circumstances, Code of Virginia § 58.1-446 authorizes the department to equitably adjust the taxable income of a corporation to properly reflect business done in Virginia.

You have stated that S1 was a distinct autonomous operation. However, S1 has no tangible assets or employees to run the operation. As such, S1 could not have negotiated an arm's length agreement and lacks the resources to enforce the loan agreements with the Taxpayer.

From the facts and observations presented, it appears that S1 possesses little economic substance and the interest expense creates a distortion of Virginia income. Thus, to the extent that the intercompany loan agreements primarily reflect "paper" intercompany transactions, the facts in this case are consistent with Commonwealth v. General Electric Company and satisfy the Court's requirement of (1) an arrangement, (2) between two commonly owned corporations, (3) in such a manner as to improperly, inaccurately, or incorrectly reflect, (4) the business done or the Virginia taxable income earned from business done in Virginia. Accordingly, the department finds the auditor was correct in disallowing interest expenses due to S1.

The auditor disallowed interest expenses equal to the total interest income of S1. The Taxpayer has provided documentation that S1 earned interest income from affiliated corporations other than the Taxpayer. The interest attributable to the affiliates has been removed from the audit.

1991 State Income Tax Adjustment

The Taxpayer's federal taxable income for 1991 included state income refunds as a result of federal audit adjustments of prior years. The Taxpayer failed to exclude these refunds in determining Virginia taxable income. Based on the documentation provided, the department has made the adjustment you requested.

1992 Foreign Source Income

The Taxpayer has provided documentation concerning its 1992 foreign source interest income. This information identifies additional foreign source interest income not reported on the 1992 return. As this information was submitted with other information regarding the expenses related to foreign source income, this income will be considered with the Taxpayer's expenses related to foreign source income.

Expenses Related to Foreign Source Income

The auditor reduced the subtraction allowed pursuant to Code of Virginia § 58.1-402(C)(8), (Foreign Source Income) by expenses allocable and apportionable to such income. Because the allocated and apportioned expenses exceeded income qualifying for the subtraction, the auditor reduced the Taxpayer's subtraction for foreign source income to zero. You contend that the method used in the audit distorts expenses related to foreign source income.

The statutory requirement that the subtraction for foreign source income be computed net of related expenses is found in Code of Virginia § 58.1-402(C), which provides:
    • [There] shall be subtracted to the extent included in and not otherwise subtracted from federal taxable income: . . .
    • [8.] Any amount included therein which is foreign source income as defined in Sec. 58.1-302. (Emphasis added.)

23 VAC10-120-20 further provides the "federal procedure in Treasury Reg § 1.861-8 is applied to allocate and apportion expenses to income derived from U.S. and foreign sources."

Previous rulings of the department require the Virginia subtraction for foreign source income to be reduced by expenses, determined in accordance with Internal Revenue Code (IRC) §§ 861, 862 and 863 (see P.D. 91-229, 9/30/91, copy attached.) The department has clearly defined its policy in this area. Virginia law requires the use of the federal sourcing rules of IRC § 861 et seq. whether or not the taxpayer believes that certain expenses have any connection to income from foreign sources and regardless of what expenses would be under generally accepted accounting principles.

The department considers federal Form 1118 an appropriate starting point to determine foreign source income and expenses. The department realizes, however, that U. S. Treasury regulations do not require a high degree of precision in allocating and apportioning expenses on Form 1118 when federal tax liability will not be affected. The Taxpayer has provided the department with additional information regarding its foreign source income and the related expenses.

The information provided by the Taxpayer for 1991 and 1992, reports more income as coming from foreign sources than appears on the Forms 1118. The reports reveal the Taxpayer's only sources of foreign income were dividends, interest, and royalties. Income from interest and royalties qualify for the Virginia foreign source income subtraction. The reports also allocate and apportion expenses to the foreign source income in accordance with IRC § 861 et seq. Based on these reports, expenses far exceed the income reducing foreign source income eligible for the Virginia subtraction to zero. As such, the auditor was correct in removing the Taxpayer's foreign source income subtraction.

Returns and Allowances

The auditor reduced the sales factor denominator to account for returns and allowances as prescribed by Title 23 VAC 10-120-20. At the time of the audit, the Taxpayer could not document returns and allowances directly attributable to Virginia.

Title 23 VAC 10-120-220 defines when a sale of tangible personal property is considered a Virginia sale. Since returns and allowances follow sales, the department will consider returns and allowances for inclusion in the Virginia numerator if they can be allocated to Virginia in the same manner as sales as prescribed by Title 23 VAC 10-120-220.

The Taxpayer has provided documentation to determine the amount of returns and allowances directly attributable to Virginia. The attached work paper details the amount of returns and allowances directly attributable to Virginia. These returns and allowances will be deducted from the sales factor numerator.

Fully Depreciated Assets

The auditor adjusted the property factor in accordance with schedules provided by the Taxpayer. Title 23 VAC 10-120-160 provides that property is considered in the property factor if it is owned or rented by the taxpayer, used by the taxpayer, and effectively connected with the taxpayer's trade or business within the United States and the income from such trade or business is includable in both Virginia taxable income and federal taxable income. Once used or available for use, property shall remain in the property factor until its withdrawal is established by an identifiable event. The fact that property is no longer used by the Taxpayer does not necessarily mean that the property should be removed from the property factor.

The auditor appropriately relied on the Taxpayer's schedules as a starting point. However, the Taxpayer has now presented new information regarding fully depreciated assets. These assets have been written off the Taxpayer's books, but are still owned and in use. The Taxpayer has provided evidence such as property tax return schedules which demonstrate that property is still owned by the Taxpayer. The fully depreciated property was included the Taxpayer's ending 1991 schedules and 1992 schedules. Accordingly, the property factor has been adjusted to include this property in the beginning of 1991.

Interest Included in Sales Factor

The Taxpayer has asserted that interest income was understated in the 1992 sales factor. However, based on the additional information provided to document foreign source income, interest income included in both the 1991 and 1992 sales factors was overstated.

Code of Virginia § 58.1-302 defines the term "sales" as the gross receipts of the corporation from all sources (except dividends, which are allocated), whether or not such gross receipts are generally considered sales. The sales factor includes all gross receipts included in Virginia taxable income and connected with the conduct of the taxpayer's trade or business within the United States.

A corporation claiming a subtraction for foreign source income will adjust its apportionment factors in accordance with Title 23 of the Virginia Administrative Code (VAC) 10-120-150 (B)(2)(b). This regulation, effective for taxable years beginning after January 1, 1985, provides in pertinent part;
    • The property, payroll and sales of a corporation which are used to produce income qualifying for the subtraction for . . . foreign source income shall not be included in the denominator of the fractions.

Title 23 VAC 10-120-20, effective for taxable years beginning on or after January 1, 1990, further provides;
    • All income and expenses included in foreign source income and property or other activity associated with such income and expenses shall be excluded from the factors in the Virginia formula for allocating and apportioning Virginia taxable income to sources within and without Virginia.

Pursuant to these regulations, to the extent a taxpayer has foreign source income, this income will be excluded from the denominator of the sales factor. Thus, the sales factors for both 1991 and 1992 have been adjusted to remove foreign source interest income based on the additional information submitted to show foreign source income with more precision than that shown on Form 1118.

Partnership Income

During 1991 and 1992, one of the Taxpayer's affiliates and an unrelated third party were partners in a partnership. Income from this partnership was inadvertently included on the federal income tax return as income of the Taxpayer. Because the Taxpayer files a separate Virginia income tax return, the partnership income has been removed from the Taxpayer's Virginia taxable income.

Amended Returns

In August 1995, the Taxpayer filed amended Virginia corporation income tax returns for 1989, 1990, and 1991, to report the results of a federal audit. For 1991, the Taxpayer apportioned income to Virginia based on the three factor formula on its original return instead of the formula as adjusted by the auditor in 1994. Consequently, the audit assessment will be adjusted to reflect the tax due on the 1991 amended return based on the apportionment factor as revised by this determination.

Summary

The department has made the adjustments as provided in this letter. The revised work papers are attached. Please remit the balance due within 60 days to prevent the accrual of additional interest to ************* c/o Office of Tax Policy, Department of Taxation, P.O. Box 1880, Richmond, Virginia 23218-1880. If you have any questions, you may contact ****** at *********.


Sincerely,




Danny M. Payne
Tax Commissioner


OTP/9002O

Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46