July 27, 2021
Re: Ruling Request: Corporate Income Tax
Dear *****:
This will reply to your letter in which you request an alternative method of allocation and apportionment on behalf of ***** (the “Taxpayer”).
FACTS
The Taxpayer, a real property contractor operating in Virginia, also operated a farm located in ***** (State A). In 2014, the Taxpayer’s sole owner passed away. Through the owner’s will, the State A property owned by the Taxpayer was passed directly to one of the owner’s children. For income tax purposes, the distribution of the property resulted in a gain.
The Taxpayer contends the gain was not the result of a business sale, but to fulfill the wishes of the owner. Under these circumstances, the Taxpayer requests permission to allocate the gain from the sale of the farm property to State A.
RULING
For Virginia income tax purposes, a corporate taxpayer’s entire federal taxable income, adjusted and modified as provided in Virginia Code §§ 58.1-402 and 58.1-403, less dividends allocable pursuant to Virginia Code § 58.1-407, is subject to apportionment in accordance with Virginia Code §§ 58.1408 through 58.1-421.
Alternative Method of Apportionment
The United States Supreme Court has recognized that allocation and apportionment of income is an arbitrary 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 there may be some overlap. See Moorman Mfg. Co. v. Bair, 437 U.S. 267, 98 S. Ct. 2340 (1978). Thus, the Taxpayer must show that the statutory method of apportionment produces an unconstitutional result.
An apportionment formula used as an approximation of an entity’s income reasonably related to the activities conducted within a taxing state will only be disturbed when the taxpayer has proved by “clear and cogent evidence” that the income attributed to the state is in fact “out of all reasonable proportion to the business transacted . . . in that state,” Hans Rees' Sons, Inc. v. North Carolina, 283 U.S. 123, 135 (1931), or has “led to a grossly distorted result,” Norfolk & Western R. Co. v. Missouri State Tax Commission, 390 U.S. 317, 326 (1968).
Recently, the Virginia Supreme Court’s decision in Corp. Exec. Bd. Co. v. Va. Dep't of Taxation, 297 Va. 57, 822 S.E.2d 918 (2019) found that Virginia’s apportionment method did not violate the Due Process or Commerce clauses of the United States Constitution or Virginia Code § 58.1-421 and did not create a distorted result because the tax imposed on services rested upon the labor of employees in Virginia. Recognizing the United States Supreme Court’s decision in Moorman Mfg., 437 U.S. at 274, Virginia’s highest court acknowledged that the existence of double taxation does not, by itself, violate the United States Constitution. Further, it conceded the inevitability of states devising different schemes of taxation and apportionment. Corp. Exec. Bd., 297 Va. at 72, 822 S.E.2d at 925 Thus, states are granted wide latitude in adopting apportionment formulas. See Moorman Mfg., 437 U.S. at 274.
Title 23 of the Virginia Administrative Code (VAC) 10-120-280 goes even further by permitting taxpayers an alternative method when the statutory method of allocation and apportionment is inequitable. Under the standards of the regulation, a statutory method can be found to be inequitable if: (1) it results in double taxation of the income, or a class of income, of the taxpayer; and (2) the inequity is attributable to Virginia, rather than to the fact that some other state has a unique method of allocation and apportionment.
The Department’s long-standing policy holds the use of separate accounting in disfavor. See Department of Taxation v. Lucky Stores, Inc., 217 Va. 121, 225 S.E.2d 870 (1976), ), Public Document (P.D.) 85-61 (3/18/1985), P.D. 86-88 (4/30/1986), P.D. 92-85 (6/1/1992), P.D. 06-13 (2/7/2006), P.D. 07-75 (5/18/2007), P.D. 11-138 (7/28/2011) and P.D. 13-86 (6/10/2013). The Taxpayer has not provided any evidence that demonstrates the statutory apportionment method is inequitable. The fact that separate accounting produces a different result from the statutory method is not sufficient to show the statutory apportionment method is inequitable.
In addition, the Taxpayer has not followed the established procedure for requesting an alternative apportionment method. The policies that apply to requests for an alternative method of allocation and apportionment under Virginia Code § 58.1-421 are well established. In order for a taxpayer to request an alternative method of allocation and apportionment, the taxpayer must file the return using the statutory method and pay any tax due. Next, the taxpayer is required to file an amended return proposing an alternative method within the time prescribed for filing amended returns claiming refunds. The amended return must include a statement of why the statutory method is inapplicable or inequitable and an explanation of the proposed method of allocation and apportionment. The Department will not grant an alternative method of allocation and apportionment unless it determines: (1) the statutory method produces an unconstitutional result under the particular facts and circumstances of the taxpayer's situation; or 2) the statutory method is inequitable because it results in double taxation and the inequity is attributable to Virginia, rather than another state’s method of apportionment. See Title 23 VAC 10-120-280.
In the context of a ruling request, when a taxpayer does not provide the Department with the opportunity to examine the records underlying the claim, the taxpayer cannot demonstrate that Virginia’s factor formula produces an unreasonable or distorted result. Further, because constitutional apportionment is designed to approximate income from business transactions within a state and not result in actual income from business transactions within a state, a taxpayer’s argument that Virginia's statutory method does not reflect actual income in Virginia cannot be accepted.
The use of an alternative method is allowed only in extraordinary circumstances where the need for relief has been demonstrated by clear and cogent evidence. Based on the facts presented, the Taxpayer has not demonstrated that the statutory method is unconstitutional or inapplicable as it would apply to the Taxpayer. Furthermore, the Taxpayer’s request is not in accordance with the procedure for requesting an alternative method of allocation and apportionment outlined in Title 23 VAC 10-120-280. Based on the foregoing, I must deny the Taxpayer’s request to use an alternative method of allocating and apportioning income.
Nonbusiness Income
Not withstanding the general rule, the Department will allow an alternative method of allocation and apportionment if a taxpayer can show that the imposition of Virginia’s statute is in violation of the standards enunciated by the United States Supreme Court in Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768, 119 L.Ed.2d 533 (1992) and Meadwestvaco Corporation v. Illinois Department of Revenue, 553 U.S. 16, 128 S.Ct. 1498 (2008). In order to meet the standards set by the Supreme Court, a taxpayer must demonstrate that its investments are not operational assets involved in a unitary business.
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 decision of the United States Supreme Court in Allied-Signal also 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 Meadwestvaco supra at 29, 128 S.Ct. 1507, the Supreme Court clarified that the decision in Allied-Signal did not create “a new ground for the constitutional apportionment of extrastate values in the absence of a unitary business.” Still, it opined the operational function analysis in Allied-Signal could be influential to the finding that an asset was a unitary part of a business being conducted in the taxing jurisdiction. Accordingly, the form of an entity’s business and the purpose of its investments are both relevant in determining if an asset was a unitary part of the business conducted by such entity.
According to the Taxpayer, the farm was used strictly for farming purposes and the farming activity had slowly been diminishing prior to the distribution. The facts as stated, however, indicate the Taxpayer owned the farm assets and was operating the farm as a going concern. Thus, it appears the Taxpayer’s unitary business included both contracting and farming up until the distribution of the property.
Further, the Taxpayer argues that the gain only resulted from the execution of the owner’s will and was not the result of a business decision. Without clear documentation as of the intent of the owner, the Department cannot speculate as to the owner’s reasons for separating the businesses upon her death.
What the Department is able to surmise of the facts presented is that the Taxpayer conducted a unitary business that included farming in State A and contracting in Virginia and that the assets of the farm were being used in the operation of the Taxpayer’s farming business until the time of the distribution. Under these circumstances, the Department would not consider the gain to be nonbusiness income eligible for allocation to the Taxpayer’s state of commercial domicile.
In addition, under the standards of Allied-Signal, nonbusiness income is allocated to the entity’s state of commercial domicile. Because the primary ongoing activity was its contracting operations, it appears the Taxpayer was commercially domiciled in Virginia. As such, if the gain were treated as nonbusiness income, it would be allocated to Virginia. Virginia Code § 58.1-421, however, expressly prohibits allowing an alternative method of allocation and apportionment if the alternative method increases the tax liability of a taxpayer. In the case presented, allocating the gain to Virginia would likely increase the Taxpayer’s Virginia income tax liability. Accordingly, the gain from the distribution of the farm property could not be treated as allocable income.
The Code of Virginia sections, regulations, 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 Department’s Office of Tax Policy, Appeals and Rulings, at *****.
Sincerely,
Craig M. Burns
Tax Commissioner
AR/596o