Tax Type
Corporation Income Tax
Description
Interest income and stock sale proceeds.
Topic
Allocation and Apportionment
Date Issued
12-29-1997
December 29, 1997
Re: § 58.1-1821 Application: Corporate Income Tax
Dear**************
This will reply to your letter in which you make an application for the correction of an assessment for additional corporate income taxes to************* (the "Taxpayer") for the 1992 taxable year. I apologize for the delayed response.
FACTS
The Taxpayer is a corporation headquartered outside of Virginia. In addition to dividend income, the Taxpayer realized a capital gain on the sale of numerous stocks acquired at various times through an unrelated investment advisor. The Taxpayer also recognized interest income on miscellaneous investments which included federal government agency and bank issued instruments. These activities occurred throughout the 1992 taxable year at the discretion of an investment advisor. Also during the same year, the Taxpayer realized a gain on the sale of real property located outside of Virginia.
The Taxpayer claimed a subtraction for certain "nonbusiness income" on its 1992 Virginia corporate income tax return. The Taxpayer was the subject of an audit, and an adjustment was made to disallow the subtraction.
In its revised protest, the Taxpayer concedes that the gain from the sale of real property resulted from the sale of part of its unitary business assets and consequently should be apportioned to all taxing jurisdictions. The Taxpayer does, however, contest the portion of the assessment related to the disallowance of its subtraction for income derived from interest, dividends, and the sale of marketable securities based on the belief that such income is allocable investment function income and should be removed from Virginia apportionable income.
DETERMINATION
Virginia law does not require or permit the subtraction or allocation of "nonbusiness income." The Code of Virginia only provides for the allocation of 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 dividends allocable pursuant to Code of Virginia § 58.1-407, is subject to apportionment. The Taxpayer's subtraction 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 United States 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 the payors of the income, and to determine if the Taxpayers activities related to the investments were in any way connected to the Taxpayer's operational activities.
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. (See Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S., 425 (1980); F.W. Woolworth Co. v. Taxation and Revenue Dept. of N.M., 458 U.S., 352 (1982); and Allied-Signal.) The Taxpayer has presented evidence regarding each of these factors in clear and objective terms. There was no indication of a flow of goods or a flow of values between the Taxpayer and the payors of the income.
Based on the information provided to the department, it does not appear that a unitary relationship existed between the Taxpayer and the payors of the income. In Allied-Signal, however, the Court stated:
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- The existence of a unitary relation between payee and payor is one justification for apportionment, but not the only one. Hence, for example, a State may include within the apportionable income of a nondomiciliary corporation the interest earned on short-term deposits in a bank located in another state if that income forms part of the working capital of the corporation's unitary business, notwithstanding the absence of a unitary relationship between the corporation and the bank.
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- We agree that the payee and the payor need not be engaged in the same unitary business as a prerequisite to apportionment in all cases. Container Corporation says as much. What is required instead is that the capital transaction serve as an operational rather than an investment function.
Accordingly, the Taxpayer must do more than show that the payors are unrelated third parties. The determining issue in this case, therefore, centers upon whether the Taxpayer's investments fulfilled an operational function rather than a passive investment function.
The department previously addressed this issue in Public Documents (P.D.) 94-58 (3/15/94) and 96-320 (11/04/96), copies enclosed. In P.D. 94-58, the department analyzed the taxpayer's position relative to American Home Products Corp. v. Director, Div. Tax., Ct. 07-14-0285-84-CB, 8/27/90, (New Jersey). Based on the facts presented, the department concluded that the Taxpayer's investment in various short-term securities did not create a passive investment where the cash was an integral element of its operational activities. In P.D. 96-320, the department similarly ruled that an investment, whether classified as short-term or long-term, will be considered related to an operational function when certain financial conditions exist, such as a working capital deficit, a negative net worth, or deteriorating operating results.
In the instant case, an analysis of the financial statements for the 1990, 1991, 1993, and 1994 periods shows that the Taxpayer continually sustained low or negative operating income. During the same period, cash flows attributable to net earnings from operating activities were correspondingly low or negative, and the Taxpayer maintained little or no cash balances. These trends in the Taxpayer's operations were not isolated incidences but, rather, they occurred on a recurring basis.
The Taxpayer's statement of cash flows for the 1991 taxable year indicates that bank loan borrowing considerably increased. In 1992, when the transactions in question occurred, the Taxpayer reported a significant decrease in cash caused by a change in operating assets and liabilities. Also in 1992, the Taxpayer made a substantial principal payment on its outstanding debt. In addition to the financial trends previously noted, these activities and circumstances reveal that the cash provided by the transactions in question were an indispensable component of the Taxpayer's operations.
The Taxpayer has not shown by clear and cogent evidence that the interest income and proceeds from the stock sales were a passive investment function unrelated to its operational activities. Further, the Taxpayer has not demonstrated that sufficient working capital was available to handle reasonably anticipated cash needs. Instead, the documentation presented indicates that the operations of the Taxpayer were clearly and necessarily affected by the 1992 transactions.
In any proceeding relating to the interpretation of the laws tax laws of the Commonwealth of Virginia, the burden of proof is on the taxpayer. In this particular matter, the Taxpayer must show that the imposition of Virginia's statutory method of allocation and apportionment would result in a tax on income derived from a discrete investment function having no connection with Virginia in violation of the principles set forth in Allied-Signal. Based upon the information provided, l do not find that the Taxpayer has met the burden of proof with respect to its claim.
Accordingly, permission to use an alternative method of allocation and apportionment is hereby denied. The assessment will be adjusted, however, to allocate the dividend income out of Virginia taxable income pursuant to Code of Virginia § 58.1-407. A copy of the revised audit report and adjusted assessment is enclosed for your convenience. Interest has been accrued through the date of this letter. The balance due should be paid in full within 30 days to avoid the accrual of additional interest. Please remit your payment to the attention of ***** , Virginia Department of Taxation, Office of Tax Policy, P.O. Box 1880, Richmond, Virginia 23218-1880. Should you have any questions about this ruling, please contact ***** at ***** .
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/7676M
Rulings of the Tax Commissioner