Document Number
05-157
Tax Type
Corporation Income Tax
Description
Taxpayer contends the Department's position violates the Due Process Clause
Topic
Allocation and Apportionment
Appropriateness of Audit Methodology
Nexus
Date Issued
10-06-2005


October 6, 2005


Re: § 58.1-1821 Application: Corporate Income Tax

Dear *****:

This will reply to your letter in which you seek correction of the corporate income tax assessment issued to your client, ***** (the "Taxpayer"), for the taxable year ended June 30, 2001. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayer is a multinational corporation that is domiciled outside of Virginia and has numerous subsidiaries. The group files a consolidated corporate income tax return for federal purposes. A Virginia affiliated group that includes the Taxpayer files a combined return for Virginia income tax purposes.

***** ("Corporation A") is domiciled outside Virginia but operates in Virginia. Corporation A is solely owned by ***** ("Corporation B"), a holding company that is domiciled outside Virginia. Corporation B is solely owned by the Taxpayer. In December 2000, Corporation A's stock was sold to a foreign corporation. Company B, in concert with the foreign corporation, elected to treat the transaction as an asset sale under Internal Revenue Code ("IRC") § 338(h)(10). The gain from this sale was subtracted as nonbusiness income on the Virginia combined income tax return.

The Taxpayer was audited and numerous adjustments were made. One adjustment was to disallow the subtraction of nonbusiness income reported on the combined return. The Taxpayer contests the disallowance of the subtraction, contending the Department's position violates the Due Process Clause because it requires that the gain be recognized by an entity that lacked Virginia nexus. The Taxpayer also maintains that the proceeds from the sale constituted investment income rather than operational income. In addition, the Taxpayer asserts that even if the Department properly included the gain in apportionable income, it erroneously excluded the gain in the sales factor denominator. Finally, the Taxpayer requests that an alternative method of allocation and apportionment be granted if the gain is included in apportionable income.

DETERMINATION

Virginia's conformity to federal law is set forth in Va. Code § 58.1-301. This section states that, except as otherwise provided, the terms used in the Virginia income tax statutes will have the same meanings as used in the Internal Revenue Code ("IRC"). Therefore, federal taxable income ("FTI") for corporations is identical to that as defined by the IRC. As such, Virginia's treatment of the IRC § 338(h)(10) election will mirror federal treatment as closely as possible, while ensuring that any Virginia tax accurately reflects the business activity in Virginia.

An election under IRC § 338 allows a purchaser of stock in a target corporation to obtain a stepped up basis in the target's assets as if there had been a direct purchase of the assets. In order to avoid potential double taxation, IRC § 338(h)(10) allows the purchaser and seller to make a joint election, provided that the target and seller are part of an affiliated group of corporations that file a consolidated federal return. The result of the election is that a series of fictitious steps are deemed to have occurred:

· The target is deemed to have sold its assets, recognizing gain or loss that must be included in the selling group's consolidated federal return;
    · The target is deemed to have distributed all its assets in a complete liquidation to which IRC § 332 applies;

    · Any gain or loss on the sale of target stock incurred by the selling group is ignored.

    In all cases, if the seller, target, purchaser or any combination thereof are Virginia taxpayers, the IRC § 338(h)(10) election actually made on a federal return will be recognized exactly as it is for federal purposes. See Public Document ("P.D.") 91-317 (12/30/91). To the extent that any gain or loss is deemed to be recognized for federal purposes by any party, it will be similarly recognized by the applicable entity for Virginia purposes. Because Virginia follows the federal treatment of the IRC § 338(h)(10) election, Corporation A is deemed to have sold its assets, and must recognize the gain.

    Due Process

    The operation of the Due Process Clause as a limitation on the taxing power of the states usually involves one of two basic issues. First, the relationship between the state exercising taxing power and the object of that exercise of power, and second, whether the degree of contact is sufficient to justify the state's imposition of a particular obligation. The Department recognizes that if the gain were considered as the sale of stock by Corporation B, the income would not be subject to Virginia income tax. It is also clear that under an asset sale by Corporation A, a portion of the gain would be within Virginia's jurisdiction to tax.

    The Taxpayer contends that following the IRC § 338(h)(10) election violates due process because the sale is in fact a stock sale. As such, the Department is barred from taxing any of the gain on what in fact and substance is the sale of an intangible asset by Corporation B. Under this reasoning, the Taxpayer asserts that the Department cannot use the Taxpayer's election to circumvent the protections of the Due Process Clause. If this were the case, then Virginia's conformity to IRC § 338(h)(10) would fail the constitutional standard in every instance the election is made.

    The Taxpayer argues that the United States Supreme Court (the "Court") has held that due process scrutiny requires looking past the formal language of the statute to its practical effect. In particular, the Taxpayer cites two cases, Kraft General Foods, Inc. v. Iowa Dept of Rev. & Finance, 505 U.S. 71 (1997) and Lunding v. New York Tax Appeals Tribunal, 505 U.S. 285 (1998) to support its argument. The Court ruled in Kraft that the mirroring of the federal tax system does not shield a state's tax laws from Commerce Clause scrutiny. The Court ruled in Lunding that following federal law does not protect a state's law from the Privileges and Immunities Clause.

    In Kraft, Iowa's tax law followed federal tax law in that it taxed dividends a corporation received from its foreign subsidiaries, but not dividends from domestic subsidiaries. Federal law, however, provides relief for foreign dividends in the form of a tax credit. Iowa statutes provided no such relief. The Court held that the Iowa statute, on its face, violated the Commerce Clause because it discriminated against foreign commerce. The Taxpayer contends that Kraft demonstrates that a state tax statute must be evaluated on its practical effect regardless that the statute follows the federal treatment.

    In Lunding, the New York Tax Appeals Tribunal argued that New York tax law reflected the federal law that disallows nonresident aliens from deducting alimony paid to residents. The Court disregarded the New York Tax Appeals Tribunal argument on the basis that it was irrelevant to the Privileges and Immunities Clause. The Privileges and Immunities Clause places the burden on the state to demonstrate that there is a substantial reason for the difference in treatment of individuals and that the discrimination bears a substantial relationship to the state's objective. The Court held that the New York statute violated the Privileges and Immunities Clause because the New York Tax Appeals Tribunal could not produce a substantial reason for the different treatment of nonresidents for purposes of the alimony deduction.

    In the instant case, the practical effect is the gain from the sale of Corporation A is treated as a sale of assets by Corporation A for tax purposes and a sale of stock by Corporation B for financial accounting purposes. The IRC § 338(h)(10) election was voluntarily made by the parties involved for their mutual benefit with regard to federal income taxation. The election allowed the parties to change the means by which the gain was realized and by whom. Because Corporation A and Corporation B elected to have Corporation A report the gain, the gross income on Corporation A's federal tax return increased by the amount of the gain, precisely as if it had sold its assets and produced income in Virginia. The Taxpayer's gross income was correspondingly reduced, as if it had never sold its Corporation A stock.

    Corporation B was not required to make the election under IRC § 338(h)(10). As noted earlier, if Corporation B had not made the election, the stock sale would have been treated differently for Virginia income tax purposes. If the Taxpayer had wanted to have the gain treated as the sale of stock, the election to treat the transaction as an asset sale should not have been made. Because the Taxpayer controlled how the gain would be taxed, the Department's conformity with IRC § 338(h)(10) does not violate due process. Additionally, because Corporation A sold assets that were located in Virginia, a sufficient relationship exists for Virginia to exercise its power to tax the gain recognized by Corporation A.

    Accordingly, the Taxpayer's argument that Corporation B lacked nexus with Virginia is not persuasive because the gain is recognized by Corporation A. Because Corporation A recognizes the gain from the sale under IRC § 338(h)(10), the gain is properly included in Corporation A's Virginia taxable income and apportioned in accordance with Virginia statutes.

    Allocation

    The Taxpayer contends that even if the gain is recognized on the Virginia combined return, it is not apportionable to Virginia and must be allocated to the Taxpayer's state of commercial domicile. The Taxpayer asserts that it did not have a unitary relationship with either Corporation A or Corporation B, and the investment in these entities had ceased to serve an operational function.

    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 Va. Code §§ 58.1-402 and 58.1-403, less dividends allocable pursuant to Va. Code § 58.1-407, is subject to apportionment. The Taxpayer's subtraction of the capital gain has been treated as a request for an alternative method of allocation and apportionment in accordance with Va. Code § 58.1-421. The Department will not allow the allocation of capital gains or losses resulting from the sale of affiliated companies by a taxpayer if a unitary relationship exists between the affiliated companies and the taxpayer, or if the taxpayer's ownership of the affiliates fulfills an operational, as opposed to a passive, function.

    In considering the existence of a unitary relationship, the United States 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. 354 (1982); and Allied-Signal, Inc. v. Director, Div. of Taxation, 504 U.S. 768 (1992).

    Further, the decision of the United States Supreme Court in Allied-Signal 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 tests are fact sensitive.

    The question as to the relationship and function of the investment in Corporation A to other members of the Taxpayer's affiliated group is irrelevant to this case. Corporation A is deemed to have sold its own assets and the gain is recognized in Corporation A's separately computed Virginia taxable income included in a Virginia combined return. Clearly, Corporation A had a unitary relationship with its operating assets (both tangible and intangible). Accordingly, the gain is properly included in the apportionable income of Corporation A.

    Apportionment

    The Taxpayer contends that the auditors failed to follow established policy for including the gain in Corporation A's sales factor in accordance with P.D. 91-317 (12/30/91).

    Virginia Code § 58.1-302 provides that "sales" means all gross receipts of the corporation not allocated, except the sale or disposition of intangible property includes only the net gain realized from the transaction. Pursuant to Title 23 of the Virginia Administrative Code ("VAC") 10-120-323 A, the Virginia taxable income for a combined return is separately allocated and apportioned for each eligible corporation using each corporation's commercial domicile and apportionment factors.

    The selling group's consolidated sales factor must include the deemed gross proceeds arising from the deemed sale of the target's assets. The numerator must include the gross proceeds attributable to (1) real or tangible property located in Virginia on the day of the transaction and (2) intangible property if the target's headquarters is in Virginia. In any event, the selling group's consolidated sales factor numerator or denominator will not include any deemed sales proceeds or proceeds from the sale of target stock if the target is not subject to Virginia tax.

    In the instant case, Corporation A's headquarters were located outside Virginia. As such, the sales factor numerator should not have included the gain from the sale of any of Corporation A's intangible property. The Taxpayer has provided the Department with a revised sales factor calculation reflecting the removal of intangible sales from the numerator. Pursuant to the information provided by the Taxpayer, the Department has adjusted the assessment in accordance with P.D. 91-317 (see enclosure).

    Alternative Method

    Finally, the Taxpayer contends that the taxation of the proceeds from the sale of Corporation A exceeds Corporation A's presence in Virginia, and therefore the Taxpayer is entitled to an alternative method of apportionment under Va. Code § 58.1-421.

    The Taxpayer requests an alternative method of allocation and apportionment that would essentially allow the gain to be allocated outside Virginia. In support of this argument, the Taxpayer cites Commonwealth Edison Co. v. Montana, 453 U.S. 609 (1981), which addresses the fourth prong of the test set forth in Complete Auto Transit v. Brady, 430 U.S. 274 (1977). In Commonwealth Edison, the Court held
      • when the measure of a tax bears no relationship to the taxpayers' presence or activities in a state, a court may properly conclude under the fourth prong of the Complete Auto Transit test that the state is imposing an undue burden on interstate commerce.

    The Taxpayer contends that it is subject to more than a just share of state tax burden under Virginia's standard method of apportionment because the proceeds of the sale had no connection to the Taxpayer's or Corporation A's day-to-day business activities in Virginia.
      • Virginia Code § 58.1-421 provides:
      • If any corporation believes that the method of allocation or apportionment hereinbefore prescribed as administered by the Department has operated or will so operate as to subject it to taxation on a greater portion of its Virginia taxable income than is reasonably attributable to business or sources within this Commonwealth, it shall be entitled to file with the Department a statement of its objections and of such alternative method of allocation or apportionment as it believes to be proper under the circumstances with such detail and proof and within such time as the Department may reasonably prescribe. If the Department concludes that the method of allocation or apportionment theretofore employed is in fact inapplicable or inequitable, it shall redetermine the taxable income by such other method of allocation or apportionment as seems best calculated to assign to the Commonwealth for taxation the portion of the income reasonably attributable to business and sources within the Commonwealth, not exceeding, however, the amount which would be arrived at by application of the statutory rules for allocation or apportionment.

    The Taxpayer asserts that the Department's method of apportioning the gain attributable to intangible assets creates an unconstitutional distortion because the gain should be attributable to Corporation A's management outside Virginia and the proceeds were actually received by Corporation B outside Virginia.

    The U.S. Supreme Court has recognized that allocation and apportionment of income is a process designed to approximate income from business transactions within a state. As long as each state's method of allocation and apportionment is rationally related to the business transacted within a state, then each state's tax is constitutionally valid even though no single formula apportions income perfectly. See Moorman Manufacturing Co. v. Bair, Director of Revenue of Iowa, 437 U.S. 267 (1978).

    Corporation A had substantial property, payroll, and sales in Virginia. According to the Taxpayer's argument, these assets and employees made no contribution to the overall value of Corporation A that resulted in the intangible asset at the time it was sold. I disagree. Corporation A's activities in Virginia were clearly a vital part of its operations and made significant contributions to its value.

    The Taxpayer also contends that the gain from the intangible assets would be treated differently under Virginia's apportionment method for financial corporations. The Taxpayer argues that the transaction from the sale of stock of a financial corporation would be attributed to the locations of the cost of performance associated with the sale under Va. Code § 58.1-418. Because Corporation A is required to apportion income using the standard three-factor formula pursuant to Va. Code § 58.1-408, a portion of the gain is attributed to Virginia creating an unconstitutional result.

    Again, I must disagree. First, the transaction is not a sale of stock because the Taxpayer elected not to have it treated as such. Second, the standard three-factor formula makes accommodation for the sale of intangible assets by using the cost of performance associated with such sales within the formula. See Va. Code § 58.1-416.

    In this case, the gain from Corporation A's intangible assets were included only in the denominator of the sales factor. Likewise, the salaries of Corporation A's management and the assets they used to transact the sale were included only in the denominator of the payroll and property factors, respectively. Although it may be imperfect, I find the statutory method is rationally related to Corporation A's activities conducted within Virginia.

    CONCLUSION

    Because Corporation A is deemed to have sold its assets, the gain is within Virginia's jurisdiction to tax. Virginia's apportionment method fairly estimates the portion of the gain included in Corporation A's income subject to tax. As such, Virginia's treatment of the gain from the sale of Corporation A does not violate the Commerce Clause or Due Process Clause.

    The Department has corrected the apportionment formula based on additional information provided by the Taxpayer; however, the request of an alternative method is denied. A revised bill, with interest accrued to date, will be sent to the Taxpayer. No additional interest will accrue provided the outstanding balance in paid within 30 days from the date of the bill. The Taxpayer should remit its payment to: Virginia Department of Taxation, 3600 West Broad Street, Suite 160, Richmond, Virginia 23230, Attention: 88888. If you have any questions concerning payment of the assessment, you may contact ***** at *****.

    The Code of Virginia sections, regulation and public documents cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions regarding this determination, you may contact ***** in the Office of Policy and Administration, Appeals and Rulings, at *****.
                      • Sincerely,

                      • Kenneth W. Thorson
                        Tax Commissioner




    AR/52609B


    Rulings of the Tax Commissioner

    Last Updated 08/25/2014 16:46