Tax Type
Corporation Income Tax
Description
Technical Services Fees
Topic
Collection of Tax
Date Issued
11-12-1999
November 12, 1999
Re: Sec. 58.1-1821 Application: Corporate Income Tax
Dear***
This will reply to your letters in which you protest the assessments made against ***** (the "Taxpayer') for the taxable years ended December 31, 1991 through 1993. I apologize for the delayed response.
FACTS
For the taxable years of 1991 through 1993, the Taxpayer included amounts characterized as technical services fees 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 Sec. 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.
The Taxpayer also subtracted gains from the sale of stock in a foreign corporation ("C') as income allocable to the Taxpayer's state of domicile for the 1992 and 1993 taxable years. The auditor denied the subtraction asserting that the gain on the sale of the stock of C was operational in nature rather than an investment. The Taxpayer contends that there is no unitary relationship with C and that the purchase and sale of the stock was purely an investment decision.
DETERMINATION
Foreign Source Income - Technical Services Fees
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 contends that the income was mislabeled as "technical service fees.' The Taxpayer states that the income is derived from royalty payments made by four wholly owned foreign subsidiaries to the Taxpayer for the subsidiaries' use and responsibility of patents, patent applications, and trademarks.
The Taxpayer has provided copies of the licensing agreements that produced the income at issue. It is clear from the terms of the agreements that the fees in question were royalty payments for the use of the Taxpayer's patents, patent applications, and trademarks. As such, "technical service fees' will be reclassified as royalties for the purposes of computing the Taxpayer's foreign source income subtraction.
Nonapportionable Income
The Code of Virginia does not provide for the allocation of income other than certain dividends. Accordingly, a taxpayer's entire federal taxable income, adjusted and modified as provided in Code of Virginia Secs.58.1-402 and 58.1-403, less dividends allocable pursuant to Code of Virginia Sec. 58.1-407, is subject to apportionment. The Taxpayer's protest has been treated as a request for an alternative method of allocation and apportionment in accordance with Code of Virginia Sec. 58.1-421.
The decision of the United States Supreme Court in Allied-Signal, Inc. v. Director, Div. of Taxation. 112 S. Ct. 2251 (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 foreign corporation, and to determine if the Taxpayer's 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 foreign corporation. There is also no evidence of any centralization of management between the two corporations.
Based on the information provided to the department, it does not appear that a unitary relationship existed between the Taxpayer and the payers of the income. In Allied-Signal. however, the Court stated:
In examining the functional aspects of the investment, the department considered the evidence provided. The 14% ownership in C was an asset of a corporation acquired in 1986. The Taxpayer borrowed funds for the acquisition. Since the purchase was made, the Taxpayer has deducted the interest paid on the borrowed funds in determining apportionable Virginia income. The Taxpayer's operations have clearly benefitted from tax deductions for the interest on the funds borrowed for the purchase that included the stock of C.
While the Taxpayer asserts that its operations did not benefit from the sale of its interest in C, the cash flow and income statements on the Taxpayer's annual reports for 1992 and 1993 categorize the proceeds from the sale of the stock of C as a reduction in operating expenses. In addition, there is no evidence that the proceeds were invested in nonoperating assets. The Taxpayer has also failed to show that this investment was part of separate and distinct investment function. Therefore, the department must conclude that the proceeds from the sale of the stock in C were used in the operational function of the Taxpayer's business.
In any proceeding relating to the interpretation of the 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 the Allied-Signal case. Based upon the information provided, I do not find that the Taxpayer has met the burden of proof with respect to its claim.
As such, the assessments against the Taxpayer will be adjusted in accordance with the attached schedules. The balance should be paid in full within 30 days to avoid the accrual of additional interest. Please forward your payment to the attention of ***** at the Department of Taxation, Office of Tax Policy, Post Office Box 1880, Richmond, Virginia 23218-1880. If you have any questions, please contact ***** at *****
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/9862G
Re: Sec. 58.1-1821 Application: Corporate Income Tax
Dear***
This will reply to your letters in which you protest the assessments made against ***** (the "Taxpayer') for the taxable years ended December 31, 1991 through 1993. I apologize for the delayed response.
FACTS
For the taxable years of 1991 through 1993, the Taxpayer included amounts characterized as technical services fees 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 Sec. 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.
The Taxpayer also subtracted gains from the sale of stock in a foreign corporation ("C') as income allocable to the Taxpayer's state of domicile for the 1992 and 1993 taxable years. The auditor denied the subtraction asserting that the gain on the sale of the stock of C was operational in nature rather than an investment. The Taxpayer contends that there is no unitary relationship with C and that the purchase and sale of the stock was purely an investment decision.
DETERMINATION
Foreign Source Income - Technical Services Fees
-
Code of Virginia Sec. 58.1-302 defines foreign source income, in pertinent part, as:
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.
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 contends that the income was mislabeled as "technical service fees.' The Taxpayer states that the income is derived from royalty payments made by four wholly owned foreign subsidiaries to the Taxpayer for the subsidiaries' use and responsibility of patents, patent applications, and trademarks.
The Taxpayer has provided copies of the licensing agreements that produced the income at issue. It is clear from the terms of the agreements that the fees in question were royalty payments for the use of the Taxpayer's patents, patent applications, and trademarks. As such, "technical service fees' will be reclassified as royalties for the purposes of computing the Taxpayer's foreign source income subtraction.
Nonapportionable Income
The Code of Virginia does not provide for the allocation of income other than certain dividends. Accordingly, a taxpayer's entire federal taxable income, adjusted and modified as provided in Code of Virginia Secs.58.1-402 and 58.1-403, less dividends allocable pursuant to Code of Virginia Sec. 58.1-407, is subject to apportionment. The Taxpayer's protest has been treated as a request for an alternative method of allocation and apportionment in accordance with Code of Virginia Sec. 58.1-421.
The decision of the United States Supreme Court in Allied-Signal, Inc. v. Director, Div. of Taxation. 112 S. Ct. 2251 (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 foreign corporation, and to determine if the Taxpayer's 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 foreign corporation. There is also no evidence of any centralization of management between the two corporations.
Based on the information provided to the department, it does not appear that a unitary relationship existed between the Taxpayer and the payers of the income. In Allied-Signal. however, the Court stated:
-
"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 Corp. says as much. What is required instead is that the capital transaction serve as an operational rather than an investment function...
"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.' Allied Signal at 2263.
In examining the functional aspects of the investment, the department considered the evidence provided. The 14% ownership in C was an asset of a corporation acquired in 1986. The Taxpayer borrowed funds for the acquisition. Since the purchase was made, the Taxpayer has deducted the interest paid on the borrowed funds in determining apportionable Virginia income. The Taxpayer's operations have clearly benefitted from tax deductions for the interest on the funds borrowed for the purchase that included the stock of C.
While the Taxpayer asserts that its operations did not benefit from the sale of its interest in C, the cash flow and income statements on the Taxpayer's annual reports for 1992 and 1993 categorize the proceeds from the sale of the stock of C as a reduction in operating expenses. In addition, there is no evidence that the proceeds were invested in nonoperating assets. The Taxpayer has also failed to show that this investment was part of separate and distinct investment function. Therefore, the department must conclude that the proceeds from the sale of the stock in C were used in the operational function of the Taxpayer's business.
In any proceeding relating to the interpretation of the 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 the Allied-Signal case. Based upon the information provided, I do not find that the Taxpayer has met the burden of proof with respect to its claim.
As such, the assessments against the Taxpayer will be adjusted in accordance with the attached schedules. The balance should be paid in full within 30 days to avoid the accrual of additional interest. Please forward your payment to the attention of ***** at the Department of Taxation, Office of Tax Policy, Post Office Box 1880, Richmond, Virginia 23218-1880. If you have any questions, please contact ***** at *****
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/9862G
Rulings of the Tax Commissioner