Tax Type
Corporation Income Tax
Description
Apportionment of income; Sale of common stock investment
Topic
Allocation and Apportionment
Date Issued
05-23-1994
May 23, 1994
Re: §58.1-1821 Application: Corporate Income Taxes
Dear****************
This will respond to your letters of April 29, 1992, July 6, 1993 and April 8, 1994, in which you have applied for a correction of an assessment of additional corporate taxes to *********** (the "Taxpayer") for the 1987 and 1988 taxable years.
FACTS
The Taxpayer was field audited, and numerous adjustments were made to the 1987 and 1988 taxable years. The Taxpayer has contested the department's right to apportion and tax certain capital gains. The Taxpayer believes that such income is allocable to its state of commercial domicile. The Taxpayer has also protested adjustments made with respect to a net operating loss carryover from the 1985 taxable year.
RULING
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 protest has been treated as a request for an alternative method of allocation and apportionment in accordance with Va. Code §58.1-421.
The Taxpayer has contested two different transactions which will be addressed separately.
Sale of common stock investment: During 1986, the Taxpayer sold certain assets in exchange for cash, common stock, and warrants to acquire common stock of an unrelated third party ("Company B"). The Taxpayer valued the Company B stock and warrants received at fair market value, and reported the gain resulting from the sale of the assets as apportionable income on its 1986 Virginia income tax return. In 1987 the Taxpayer sold this investment, and seeks to allocate the gain on such sale to its state of commercial domicile.
Company B is a publicly traded corporation. The common stock owned (or purchasable) by the Taxpayer represented approximately 11% of the total outstanding stock of Company B. The Taxpayer stated as part of the purchase and sales agreement that it was acquiring the stock and warrants for its own account for the purpose of investment, with no present intention of distributing or reselling the shares. No officer or director of the Taxpayer served as an officer or director of Company B. Pursuant to an agreement signed in 1986 when the Company B stock was first acquired, the Taxpayer agreed to vote its shares for management's nominees to the Board of Directors, and for other routine operating matters in accordance with a majority of the Board of Directors. The Taxpayer also agreed to certain restrictions as to the sale of its Company B stock, and further agreed not to acquire a greater than 15% voting interest in Company B.
The Taxpayer valued its initial investment in Company B at the closing price per the New York Stock Exchange as of the date it received its shares. The Taxpayer sold the stock on the open market, less a standard commission. The Taxpayer has provided evidence which documents that the traded price of Company B stock, per the New York Stock Exchange, appreciated dramatically from the date of acquisition through the date of sale.
The Taxpayer has provided ample evidence indicating that its only relationship with Company B was as a minority stockholder. The Taxpayer and Company B were unrelated in every other respect.
The Taxpayer has provided objective documentation indicating that its investment in Company B constitutes a discrete investment function, having no connection with the operational activities carried on in Virginia. Accordingly, the Taxpayer has demonstrated that an alternative method of allocation and apportionment is appropriate with respect to the gain recognized on the sale of Company B in 1987.
Sale of subsidiary: During 1985, the Taxpayer transferred three major lines of business from one of its divisions to a newly created corporation ("Company C") in exchange for cash, 100% of the preferred stock, and 49% of the common stock of Company C. The balance of Company C stock was acquired by a management group as part of a leveraged buy-out. The transaction was structured as an I.R.C. §351 transfer, whereby a majority of the gain realized by the Taxpayer on the transfer was not recognized for federal income tax purposes. A portion of the assets transferred to Company C were located in Virginia. In 1987, an unrelated third party acquired 100% of the common and preferred stock of Company C. The Taxpayer seeks to allocate the gain recognized from the sale of Company C stock to its state of commercial domicile.
The division transferred to Company C in 1985 was a part of the Taxpayer's unitary business immediately prior to the transfer. After the transfer, a significant amount of operational connections between the Taxpayer and Company C remained. Company C retained a large number of the Taxpayer's employees, and Company C agreed to become liable for and make contributions to certain multi-employer benefit plans maintained by the Taxpayer on behalf of such employees. Other benefit plans provided by the Taxpayer were amended to provide that service with Company C increased an employee's benefits and vesting under the plan. The Taxpayer also agreed to administer benefit plans established by Company C which were similar to their own for a period of time after the transfer.
The Taxpayer and Company C had entered into a supply and distribution agreement, whereby Company C was required to purchase from the Taxpayer, and the Taxpayer was required to sell to Company C, 100% of the output of certain of the Taxpayer's manufacturing plants. After the first year of the agreement, the required sale/purchase amount decreased to 90% of production for the next 12 months, and 80% thereafter. The agreement provided the manner in which prices would be determined, and restricted the price at which the Taxpayer could sell product to third party. The agreement also required the Taxpayer to maintain comprehensive product liability insurance with a company satisfactory to Company C. In addition to the supply and purchase agreement, Company C also purchased a significant amount of other materials from the Taxpayer. During the period that the Taxpayer held Company C's stock, Company C acquired in excess of 25% of its total material purchased for sale from the Taxpayer.
The Taxpayer had an agreement with Company C to provide specific general and administrative services. In addition, the Taxpayer provided other services not covered by the agreement.
The Taxpayer, and the other common stockholders of Company C, were subject to an extensive stockholders agreement which, among other things, restricted the free transferability of Company C's stock.
In this particular matter, the Taxpayer must do more than show that the payor of the income is an unrelated third party. Rather, the Taxpayer must bear the heavy burden of demonstrating that the imposition of Virginia's statute is a violation of the standards enunciated by the United States Supreme Court in Allied-Signal, Inc. v. Director, Division of Taxation (112 S. Ct. 2251 (1992)). In Allied-Signal, 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 a 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 Corp. says as much. What is required instead is that the capital transaction serve an operational rather than an investment function.
The business divisions transferred to Company C by the Taxpayer constituted an integral part of the Taxpayer's unitary business. After the transfer, the Taxpayer's relationship with these divisions (Company C) did not undergo an abrupt transformation. The Taxpayer maintained a significant ownership interest in Company C; such ownership was restricted from the type of free transferability normally associated with an independent investor. The Taxpayer was required by contract to utilize Company C as a market for its product, and Company C was required to buy this product. Company C purchased a material amount of product from the Taxpayer. The Taxpayer continued to provide significant administrative services to Company C. In large part, the initial employees and management of Company C came from the Taxpayer, and the Taxpayer and Company C integrated certain employee benefit plans for these employees.
Where an asset (or group of assets) was once a part of a taxpayer's unitary business, or was once clearly of an operational nature, there is a particularly heavy burden of proof. In the instant case, the Taxpayer has not provided objective evidence demonstrating that its unitary relationship with the assets transferred changed significantly after the transfer. However, even if a unitary relationship had ceased to exist at a moment prior to the sale, there were a significant number of operational connections after the transfer of assets to Company C.
Finally, the transfer of assets to Company C was accomplished in a tax free transaction pursuant to I.R.C. §351. The amount of gain recognized by the Taxpayer on the ultimate sale of Company C stock a short time later was roughly equivalent to the gain deferred on the initial 351 transfer. Had the Taxpayer sold the assets to Company C in 1985 in a taxable transaction, the gain would have clearly been apportionable. The fact that assets were transferred to a corporation should not change this result unless the Taxpayer can demonstrate by objective evidence the moment in time that their objective and purpose for holding the investment changed.
There was clearly a flow of values between the companies from the initial transfer in 1985 through the time of sale in 1987. The importance to the parties of the supply and purchase arrangement entered into by the parties was evidenced by the fact that it was a legally binding obligation, and by the significant value of the transactions which resulted from this agreement. In summary, this does not appear to be a passive investment in which the Taxpayer relied on the management of Company C for earnings growth and enhanced value, and for which there were no operational reasons to select, acquire, manage or dispose of the investment.
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 bear the heavy burden of demonstrating that the imposition of Virginia's statute is a violation of the standards enunciated by the United States Supreme Court in Allied Signal. Based upon the information provided, I do not find that the Taxpayer met the burden of proof. Accordingly, permission to use an alternative method of allocation and apportionment for the gain realized on the sale of the subsidiary is hereby denied.
Net Operating Loss Carryforward: The Taxpayer files a consolidated federal return, and a separate Virginia return. Accordingly, the Taxpayer is required to determine its federal taxable income for Virginia purposes as if a separate federal income tax return had been filed. During 1985, the Taxpayer incurred a federal net operating loss on a separate company basis. This loss was carried forward to the 1987 taxable year, and claimed as a deduction in determining federal taxable income on a separate company basis for 1987.
The Taxpayer discovered that it had failed to properly determine its 1985 federal net operating loss on a separate company basis. The department's auditor refused to adjust the 1985 loss because the statute of limitations for amending the 1985 return had expired.
In auditing the 1987 taxable year, the department must determine the proper federal taxable income on a separate company basis. Because the 1985 net operating loss affects 1987 taxable income, it is proper to examine the amount of this deduction, and if appropriate, make positive or negative adjustments to this amount.
When the Taxpayer originally determined its 1985 net operating loss for Virginia purposes, it failed to account for a consolidating item on the federal return. The federal return was properly filed, and the change that the Taxpayer has requested does not involve an amendment to the 1985 federal return.
The item at issue is an element of the 1987 federal taxable income determined on a separate company basis, and the statute of limitation for amending the 1987 return had not expired at the time the Taxpayer requested the change. Accordingly, the corrected 1985 net operating loss amount shall be allowed, and the department shall allow the effect that this adjustment may have on carryovers to subsequent taxable year to flow through to such years.
The assessment shall be adjusted as provided herein this letter, and as reflected on the attached schedules.
Sincerely,
Danny M. Payne
Acting Tax Commissioner
OTP/6141M
Rulings of the Tax Commissioner