Tax Type
Corporation Income Tax
Description
Affiliates lacked positive apportionment factors/Taxpayer has not provided necessary documentation
Topic
Allocation and Apportionment
Filing Status
Nexus
Records/Returns/Payments
Reports
Royalties
Date Issued
05-06-2014
May 6, 2014
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 assessments issued to ***** (the "Taxpayer") for the taxable years ended October 31, 2005 and 2006.
FACTS
The Taxpayer filed consolidated federal and separate Virginia corporate returns for the taxable years at issue. The Department audited the Taxpayer and numerous adjustments were made. The Taxpayer contests several of the adjustments, each of which will be addressed separately below.
DETERMINATION
Disregarded Entity
Virginia Code § 58.1-442 allows corporations to elect to file returns as separate, combined, or consolidated entities regardless of how the corporations file their federal income tax returns. Title 23 of the Virginia Administrative Code (VAC) 10-120-320 provides that in the first year two or more members of an affiliated group of corporations are required to file Virginia returns, the group may elect to file separate returns, a combined return, or a consolidated return. When a corporation ceases to be a member of an affiliated group, however, it may no longer elect a filing status and is required to file a separate Virginia corporate income tax return pursuant to Va. Code § 58.1-441.
Treas. Reg. § 30,1.7701-1 et seq., otherwise known as the "check the box" regulations, allow business entities to choose a federal classification or be classified under the regulation's default provisions. The default election for a single member limited liability company is treatment as a disregarded entity. A disregarded entity whose single member is a corporation would be treated as a division of such corporation for federal and Virginia income tax purposes. See Public Document (P.D.) 97-343 (8/28/1997).
The Department has made several requests for the Taxpayer to provide documentation to support its claim. To date, the Taxpayer has not provided any documentation showing that ***** (Company A) was a disregarded entity and that its income was include twice in the auditor's adjustment.
Nexus
The Department consolidated the income of ***** (Company C), ***** (Company D), ***** (Company E), ***** (Company F), ***** (Company G), ***** (Company H), and
***** (Company I), collectively (the "Affiliates"). The Taxpayer contends that none of these affiliated corporations were subject to Virginia income tax because they did not have any positive apportionment factors.
Virginia Code § 58.1-400 imposes the income tax "on the Virginia taxable income for each taxable year of every corporation organized under the laws of the Commonwealth and every foreign corporation having income from Virginia sources." Generally, a corporation will have income from Virginia sources if there is sufficient business activity within Virginia to make any one or more of the applicable apportionment factors positive. The existence of positive Virginia apportionment factors clearly establishes income from Virginia sources.
Public Law (P.L.) 86-272, codified at 15 U.S.C. §§ 381-384, prohibits a state from imposing a net income tax where the only contacts with a state are a narrowly defined set of activities constituting solicitation of orders for sales of tangible personal property. Although P.L. 86-272 applies to tangible property, the Department's policy has been to extend the "solicitation test" of P.L. 86-272 to situations involving the sale of other than tangible personal property. See Public Document (P.D.) 91-33 (3/18/1991) and P.D. 93-75 (3/17/1993). The Department limits the scope of P. L. 86-272 to only those activities that constitute solicitation, are ancillary to solicitation, or are de minimis in nature. See Wisconsin Department of Revenue v. William Wrigley, Jr., Co., 505 U.S. 214 (1992). The Department has a long-established policy of narrowly interpreting the provisions of P. L. 86-272.
Under certain conditions, a corporation may have income from Virginia sources resulting from a positive apportionment factor, but not be subject to tax by virtue of the protections afforded under P.L. 86-272. See Public Document (P.D.) 94-175 (6/8/1994). Further, corporations that do not have a positive apportionment factor are not considered to be subject to Virginia income tax if separate returns are filed, Under appropriate circumstances, however, the Department is authorized under Va. Code § 58.1-446 to determine that income of an affiliate be deemed Virginia income even if the affiliate does not have nexus. See P.D. 96-346 (11/25/1996).
A review of the documentation available indicates that none of the Affiliates had nexus with Virginia or positive Virginia apportionment factors. Further, the Department finds that the transactions between the Taxpayer and the Affiliates did not improperly reflect Virginia income. As such, the Affiliates were not subject to Virginia income tax for the taxable years ended October 31, 2005 and 2006.
Royalty Add-back
For the taxable years at issue, the Taxpayer paid royalties to two affiliated entities, ***** (IHCA) and ***** (IHCB). On its income tax returns, the Taxpayer listed six states in which the affiliated entities filed income tax returns and claimed an exception for all of the royalty deductions on the grounds that they were subject to tax in another state.
On audit, the Department disallowed the entire amount claimed as an exception to the add-back. The Taxpayer contends that the full royalty deduction is permitted by the plain language of the statute. The Taxpayer asserts that the Virginia add-back statute violates the Commerce and Due Process clauses.
Subject to Tax Exception
Virginia Code § 58.1-402 B 8 provides several exceptions to the general rule that an add-back for certain intangible deductions is required. The exception relevant to the Department's assessment of the Taxpayer states:
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- This addition shall not be required for any portion of the intangible expenses and costs if one of the following applies: (1) The corresponding item of income received by the related member is subject to a tax based on or measured by net income or capital imposed by Virginia, another state, or a foreign government that has entered into a comprehensive tax treaty with the United States government. (Emphasis added.)
According to the Taxpayer, the plain meaning of the statute entitles it to exclude 100% of its royalty payments from the add-back. This interpretation, however, cannot be reconciled with the legislature's use of the limiting words "portion" and "corresponding item." When interpreting statutes "[a] fundamental rule of statutory construction requires that every part of a statute be presumed to have some meaning, and not be treated as meaningless unless absolutely necessary." Raven Red Ash Coal Corporation v. Henry Absher, 153, Va. 332, 149 S.E. 541 (1929). (Emphasis added).
In Public Document (P.D.) 07-153 (10/2/2007), the Department determined that parsing the statutory language of Va. Code § 58.1-402 B 8 shows that the exception is not all inclusive. When considering this statute in its totality, the exception does not apply to the gross amount of payments that a taxpayer made to an affiliate merely because the gross amount is shown on another state's tax return. Instead, the exception is limited to the portion of a taxpayer's intangible expense payments to its affiliate that correspond to the portion of the affiliate's income subjected to tax in other states, as evidenced by the apportionment percentages shown on the affiliate's tax returns filed with other states.
In this case, the Taxpayer paid royalties to two affiliated entities. The auditor disallowed the add-back in its entirety. Accordingly, the add-back must be adjusted to correspond to the portion of the affiliates' income subjected to tax in other states where the affiliates file returns.
Due Process and Commerce Clauses
The Taxpayer contends the add back statute violates the Due Process and Commerce clauses of the United States Constitution. In order to determine if a tax violates the Commerce Clause by placing an undue burden on interstate commerce, the U.S. Supreme Court has developed a four prong test. Complete Auto Transit Inc, v. Brady, 403 U.S. 274, 279 (1977). A state tax will overcome a Commerce Clause challenge if it "(1) is applied to an activity with a substantial nexus with the taxing State, (2) is fairly apportioned, (3) does not discriminate against interstate commerce, and (4) is fairly related to the services provided by the State." Id.
The add-back statute is fairly apportioned. In fact, the amount added back is apportioned twice. First, the law allows an exception to the add-back for the portion of intangible expenses on which the affiliated recipient has been subject to tax. Second, the amount added back is then allocated and apportioned with the rest of the Taxpayer's income to determine the portion subject to Virginia tax.
Requiring an add back does not discriminate against interstate commerce. The Commerce Clause requires that a taxing scheme be internally consistent. A taxing "formula must be such that, if applied by every jurisdiction, it would result in no more than all of the unitary business income being taxed." Oklahoma Tax Comm'n v. Jefferson Lines, Inc., 514 US 159 (1983). The add-back statute only requires the taxpayer to add back royalties deducted to the extent that the affiliate's income from those royalties it is not apportioned to another taxing jurisdiction. The amount is further allocated and apportioned under Virginia law. Thus, if every state adopted the same the add-back statute, and had the same allocation and apportionment statute as Virginia, it would not result in taxing more than all of the unitary business income of the taxpayer.
Apportionment Factor
The Taxpayer contends that ***** (Company B) and certain other subsidiaries are financial corporations, and the auditor erred by adjusting their apportionment factors to the three-factor formula.
Virginia Code § 58.1-418 requires financial corporations to apportion income based on cost of performance. Virginia Code § 58.1-418 defines a "financial corporation" as one that derives more than 70% of its gross income from (1) fees for financial services, (2) gross profits from securities trading, (3) interest, and (4) dividends to the extent included in Virginia taxable income. Title 23 VAC 10-120-250 defines the "cost of performance" as the cost of all activities directly performed by the taxpayer for the ultimate purpose of obtaining gains or profit, except activities directly performed by the taxpayer for the ultimate purpose of obtaining allocable dividends.
The Department has made several requests for the Taxpayer to provide documentation to support its claim. To date, the Taxpayer has not provided any documentation showing that Company B was a financial corporation and that its income was included twice in the auditor's adjustment.
CONCLUSION
Based on the information provided, the Taxpayer has failed to show that Company A was a disregarded entity whose income was reported twice in the return or that Company B and certain other subsidiaries were financial corporations. The Department finds that the Affiliates lacked positive apportionment factors and that their exclusion from the Taxpayer's consolidated return did not distort Virginia taxable income. Finally, the Taxpayer was required to add-back the royalty expense generated from its intercompany transactions with IHCA and IHCB. However, it was entitled to claim an exception from the add-back for that portion of the expenses that correspond to the affiliate's income subjected to tax in other states.
The case will be returned to the auditor in order to adjust the audit report and assessments in accordance with this determination. The auditor will contact the Taxpayer to set a mutually agreeable time to review documentation with regard to the disregarded entity and the financial corporations. If the Taxpayer is unable to provide such documentation within the time provided by the auditor, these adjustments will be considered to be correct. The auditor will also make adjustments to remove the Affiliates from the audit and reduce the royalty add back to allow an exception for the six states in which the IHCA and IHCB filed income tax returns. Once the auditor makes the appropriate adjustments, the Taxpayer will receive a revised bill. The Taxpayer should remit payment for the outstanding balance as shown on the revised bill within 30 days from the date of the revised bill to avoid the accrual of additional interest.
The Code of Virginia sections, regulation, and public documents cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions section of the Department's web site. If you have any questions regarding this ruling, you may contact ***** in the Office of Tax Policy, Appeals and Rulings, at *****.
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- Sincerely,
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Craig M. Burns
Tax Commissioner
AR/1-4696329086.B
Rulings of the Tax Commissioner