Tax Type
Corporation Income Tax
Description
Taxable income; Modifications to federal taxable income; Adjustments
Topic
Computation of Income
Date Issued
09-18-1997
September 18, 1997
Re: § 58.1-1821 Application: Corporate Income Tax
Dear*********
This will reply to your letter in which you contest the assessment of corporation income tax against ********* (the "Taxpayer"), for taxable years ended December 31, 1991 through 1993. I apologize for the delay in responding to your letter.
FACTS
As a result of an audit, the department made numerous adjustments to the Taxpayer's corporation income tax returns for the 1991 through 1993 taxable years. Because you have contested a number of issues, each issue will be addressed separately.
DETERMINATION
Addition to Virginia Taxable Income - State Income Taxes
The auditor adjusted the addition for net income and other taxes based on income to reflect the amount of state income taxes included as a deduction on the federal return for each of the taxable years.
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 will be added to federal taxable income in determining Virginia taxable income.
The auditor reconciled amounts reported as state and local income taxes on the supporting schedule to taxes deducted on the federal return. You contend that a portion of the amount reported on the federal return as state and local income taxes represents franchise taxes based on capital, interest expense from a tax assessment, and a royalty payment incorrectly coded to the income tax account. You contend that these miscoded items should not be included in the addition for state and local income taxes.
Virginia relies on the amount and character of items reported on the federal return and supporting schedules. When a taxpayer alleges an item should be treated differently on a Virginia return than it was on a federal return, the taxpayer must clearly show why different treatment is required.
Based on the information provided, you have provided sufficient documentation to show these amounts were improperly included in the addition for state and local income taxes on the federal return. Accordingly, the addition for state and local income tax will be adjusted.
Addition to Virginia Taxable Income - Franchise Tax Based on Income
The auditor made an addition for franchise tax computed based on income. You claim that these taxes were included in the addition for each respective year and these adjustments result in a double addition of these taxes.
The audit adjustment was based on state tax schedules provided by the Taxpayer. These schedules show balances of state income taxes roughly equivalent to the addition on the Taxpayer's original return. Franchise taxes based on income were included in a separate balance. Further review of these schedules show that they were prepared prior to the Taxpayer's year end. As such, these balances do not reflect any year end adjustments reflective of the actual taxes due on the various state, local and other returns. The Taxpayer has provided detailed schedules showing the year end adjustments to these balances. As a result the adjustment for franchise tax computed based on income will be revised.
Addition to Virginia Taxable Income - Texas Franchise Tax
The auditor made an addition for franchise tax paid to the state of Texas. You claim that the Texas tax is not based on income and is, therefore, not subject to the addition required by Code of Virginia § 58.1-402(B)(4).
Texas Tax Code § 2-171.002 imposes a franchise tax on corporations, including S corporations, operating in the state. In 1991, the Texas legislature restructured the franchise tax to include two component parts retaining the base of taxable capital, but adding a net taxable earned surplus component.
The earned surplus component is basically federal taxable income with several modifications. Thus, the earned surplus tax is based on net income and must be added back for Virginia purposes in accordance with Code of Virginia § 58.1-402(B)(4). The net capital tax is based on stated capital plus surplus, and is not required to be added back in determining Virginia taxable income. The tax based on earned surplus is paid only if it exceeds the net capital tax. Since the earned surplus tax is only an addition to the net capital tax, a taxpayer will always pay at least the net capital tax. Accordingly, Virginia will only consider the Texas "tax" to be based on earned surplus to the extent that it is added to the net capital tax. The Taxpayer has provided documents to show how the Texas franchise tax was calculated for the years under audit. The department will adjust the addition for income taxes accordingly.
Expenses Related to Foreign Source Income
Based on the Forms 1118 for the taxable years, the auditor reduced the subtraction for foreign source income allowed pursuant to Code of Virginia § 58.1--402(C)(8), by expenses allocable and apportionable to such income. You contend that the method used by the auditor 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:
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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 Sec. 58.1-302. (Emphasis added.)
Title 23 of the Virginia Administrative Code (VAC) 10-120-20 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 (I.R.C.) § 861, 862 and 863. See Public Document (P.D.) 91-229, 9/30/91, copy attached. The department has clearly defined its policy in this area.
Virginia requires the use of the federal sourcing rules of I.R.C. § 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 Taxpayer reduced Virginia foreign source income by a corporate coordination expense directly attributable to foreign dividends and using a flat percentage of Virginia foreign source income to apportion expenses not definitely allocable. The auditor applied expenses to foreign source income in accordance with l.R.C. § 861et seq.
The Taxpayer asserts that the method used to apportion related expenses for the 1991 through 1993 taxable years is consistent with their method used for the 1988 through 1990 taxable years. The Taxpayer claims their method was accepted in the audit of the Taxpayer's 1990 taxable year and subsequent amended returns for 1988 and 1989. The foreign source income subtraction calculations attached to the 1988 and 1989 amended returns do not provide sufficient detail as to how the related expenses were computed. The fact that the department processed these unaudited amended returns does not mean the department agrees with the Taxpayer's method used to calculate its foreign source income subtraction. Thus, the auditor was correct in adjusting the foreign source income subtraction.
Foreign Source Income - Technical Services
For the 1992 taxable year, the Taxpayer included amounts characterized as technical services in the Virginia foreign source income subtraction. The department's auditor concluded that these amounts did not qualify as foreign source income pursuant to Code of Virginia § 58.1-302, and consequently reduced the amount of the subtraction. You protest the auditor's conclusion, contending that these amounts are eligible for the Virginia foreign source income subtraction.
Code of Virginia § 58.1-302 defines foreign source income, in pertinent part, as:
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- Rents, royalties, license, and technical fees from property located or services performed without the United States or from any interest in such property, including rents, royalties, or fees for the use of or the privilege of using without the United States any patents, copyrights, secret processes and formulas, good will, trademarks, trade brands, franchises, and other like properties.
The department has previously ruled that the words "technical fees from . . . services performed" cannot be taken out of their context to create a subtraction for income earned from the performance of services outside the United States for any service which can be characterized as of a technical nature. See P.D. 86-209, 11/3/86 and P.D. 92-44, 4/27/92, copies enclosed. In order to qualify for the Virginia foreign source income subtraction, "technical fees" must be incidental to a contract relating to the rental of real property or the licensing of a patent or other like property outside the United States. See P.D. 91-57, 3/29/91, copy attached.
In a case such as this, the Taxpayer must prove by clear and cogent evidence that the technical services are incidental to a contract relating to the rental of real property or the licensing of a patent or other like property outside the United States. The Taxpayer has indicated that they have no additional information other than what was provided to the auditor. Accordingly, the auditor's adjustment is correct.
Other Income in Sales Factor
The department's auditor removed various items included in "other income" on the federal return from the denominator of the sales factor. The Taxpayer contends that these items belong in the sales factor.
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.
Virginia relies on the amount and character of each item reported on the federal return and supporting schedules to determine gross receipts for purposes of computing the sales factor. The adjustments by the auditor were made to reconcile the denominator with the gross receipts shown on the federal return. The department has previously ruled that receipts of an unknown or unspecified nature may not be included in the denominator of the sales factor. See P.D. 92-45 (4/27/92), copy attached.
The Taxpayer has provided evidence regarding receipts included in "other income" on the federal return, and demonstrated that some of these constitute receipts within the meaning of Title 23 VAC 10-120-210. Accordingly, these items will be included in the sales factor for the 1991 through 1993 taxable years. The remaining items of unidentified miscellaneous income, reimbursements for expenses, and various accounting adjustments will not be included. The attached schedule lists the items of other income the department considers receipts and the items that are not.
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,
Janie E. Bowen
Assistant Tax Commissioner
Office of the Commissioner
OTP/11846O
TO WHOM IT MAY CONCERN
Under the authority of Section 58.1-1 of the Code of Virginia, I hereby delegate to Janie E. Bowen, Senior Executive Assistant, the authority to sign for me any and all documents, including, but not limited to, affidavits, warrants, rulings, appeals, offers in compromise and sales tax revocations.
This authority shall not extend to matters or documents related to my service on any statutorily created board or commission, including, but not limited to, the Compensation Board, the Local Debt Commission, and the Treasury Board.
This authority will continue until revoked. The delegation of authority dated March 1, 1994, is hereby revoked and replaced.
Done at Richmond, Virginia this third day of June, 1994.
Danny M. Payne
Tax Commissioner
Rulings of the Tax Commissioner