Tax Type
Corporation Income Tax
Description
Taxable income-modifications to federal taxable income; Environmental tax
Topic
Computation of Income
Date Issued
06-27-1997
June 27, 1997
Re: § 58.1-1821 Application: Corporation Income Tax
Dear*************
This will reply to your letter in which you are protesting the assessment of corporation income tax against your client, ******* (the "Taxpayer") for the taxable years ended January 31, 1993, 1994 and 1995 (the "taxable years").
FACTS
The department audited the Taxpayer and made several adjustments. On its Virginia returns for the taxable years in question the Taxpayer claimed a subtraction of gross income from foreign sources. The auditor reduced the subtraction by expenses related to the gross income claimed as a subtraction. The Taxpayer contends that the subtraction should include only gross foreign source income since the definition under Code of Virginia § 58.1-302 does not indicate a net calculation.
In determining the addition for net income and other taxes based on income, the Taxpayer subtracted an amount called "accrued income tax" from state income tax expense. The auditor determined that the "accrued income tax" was improperly reported and removed it from the addition. The Taxpayer contends that the "accrued income tax" was an adjusting entry to correct the balance of the state and local income tax expense and adjustment to the balance sheet accrual.
DETERMINATION
Code of Virginia § 58.1-302 is merely a definitional section. The provision permitting the subtraction for foreign source income is Code of Virginia § 58.1-402(C), which states:
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- "[There] shall be subtracted to the extent included in and not otherwise subtracted from federal taxable income: . . .
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- [8.] Any amount included therein which is foreign source income as defined in § 58.1-302." (Emphasis added).
In computing federal taxable income, expenses reduce gross income. Thus, any income removed from gross income must also be reduced by related expenses.
Title 23 of the Virginia Administrative Code (VAC) 10-120-20 provides that 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." Because Code of Virginia § 58.1-302 explicitly requires the use of the federal provisions in determining the source of "foreign source income", both the gross income and the expenses included in federal taxable income are used when computing the Virginia subtraction. Thus, definitely allocable and not definitely allocable expenses must reduce gross income from sources without the United States.
Previous rulings of the department require the reduction of the Virginia subtraction for foreign source income by related expenses, 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 souring rules of IRC § 861 et seq. whether or not the taxpayer believes that certain expenses have any connection to income from foreign sources and no matter what expenses would be under generally accepted accounting principles.
The provisions under IRC § 861 et seq. contain elaborate detail on assigning income and expense to particular sources. The provisions differentiate between expenses that are definitely allocable and expenses that 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.
Many taxpayers who claim a Virginia subtraction for foreign source income will also have claimed a federal credit for income taxes paid to foreign countries. Thus, the department considers federal Form 1118 an appropriate starting point to determine foreign source income and expenses. Virginia law does not follow federal law in all respects regarding income from sources without the United States because, federal form 1118 includes many types of income that do not qualify for the Virginia subtraction.
For example, gains, profit and other income arising from the sale of tangible personal property are not included in the list of specified types of income qualifying for the Virginia subtraction. As already noted, foreign dividend gross up and Sub-part F income are not included in computing the Virginia subtraction for foreign source income. Also, amounts reported on form 1118 may be affected by limitations contained in IRC § 904 while the Virginia subtraction is computed without regard to such limitations.
For the taxable year ended January 31, 1993, the auditor properly reduced foreign source income by ratably apportioning the expenses not definitely allocable on the federal form 1118. For the taxable year ended January 31, 1994 and 1995, the expense information from federal Form 1118 was not available. Since Virginia foreign source income remained fairly constant over the period of the audit, the auditor used the same apportioned deductions for the two succeeding taxable years.
The auditor also reduced Virginia foreign source income by allocable foreign taxes in each of the taxable years. Because foreign taxes are not used in reducing gross income for computing federal taxable income, they are not used to reduce Virginia foreign source income. Accordingly, the department will remove the foreign tax adjustment from the audit.
In addition, the auditor determined that not definitely allocable expenses did not include any interest expense on the federal form 1118. Because the Taxpayer had a large interest deduction on its federal income tax return, the auditor used part of the interest deduction to reduce foreign source income to zero. The allocation and apportionment of interest are governed by U. S. Treasury Regulation § 1.861-9T which states "except as otherwise provided, the aggregate of deductions for interest in all cases shall be considered related to all income producing activities assets of the taxpayer and, thus, allocable to all the gross income." As such, the audit will be adjusted to reflect interest apportioned to foreign source income based on the percentage of foreign source to total gross income.
Net income and other taxes based on income
The Taxpayer has provided evidence that the "accrued income tax" was an error in presentation on the income tax return detail. Accordingly, the Taxpayer reported the correct amount of state and local income taxes on its Virginia return.
On its federal return, the Taxpayer reported a deduction for the amount of environmental tax paid. The auditor adjusted the taxpayer's income by adding the amount of the environmental tax to the taxpayer's income, in accordance with Code of Virginia § 58.1-402(B)(4).
Code of Virginia § 58.1-402(B)(4) provides that any net income taxes or other taxes which are based on, measured by, or computed with reference to net income, imposed by Virginia or any other taxing jurisdiction and deducted in determining federal taxable income shall be added to Virginia taxable income.
Based on the attached revision summaries, the assessment has been abated in full. If you have any questions, you may contact ******** at*********.
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/11764O
Rulings of the Tax Commissioner