Tax Type
Corporation Income Tax
Description
Assessments for additional income taxes
Topic
Appropriateness of Audit Methodology
Basis of Tax
Date Issued
03-25-1994
March 25, 1994
RE: §58.1-1821 Application: Corporate income taxes
Dear*************
This will reply to your letter dated August 20, 1992 in which you have applied for correction of assessments for additional income taxes to ********* (the "Taxpayer") for the taxable years ended December 31, 1987, 1988 and 1989. I apologize for the delay in responding.
FACTS
The Taxpayer was the subject of a field audit, and numerous adjustments were made. The Taxpayer is protesting adjustments made with respect to several items, which will be addressed separately.
DETERMINATION
Research and Development Credit Expense Exclusion. In computing federal taxable income, a corporation's deduction for certain research expenses is reduced by 50% of the amount of the federal research credit determined with respect to those expenses. The Taxpayer claimed the disallowed federal expenses as a subtraction in determining its Virginia taxable income. The department's auditor disallowed this subtraction.
The Taxpayer believes that because Va. Code §58.1-402 C 6 allows a Virginia subtraction for salary and wage expense not deductible on the federal tax return on account of the federal Targeted Jobs Credit, a similar Virginia subtraction should be allowed for research expenses disallowed on account of the federal research credit.
Virginia taxable income is defined in Va. Code §58.1-402 as federal taxable income, as provided in subsections B, C, and D there under. There is no specific adjustment, exclusion, or subtraction provided for research expenses in the Code of Virginia. The General Assembly has enacted specific adjustments with respect to federal credits when it has deemed it appropriate to do so; there are Virginia modifications required for ESOP credit adjustments and wages eligible for the federal Targeted Jobs Credit. In this instance, the General Assembly has not enacted a specific adjustment for amount of research expenses disallowed on account of the federal research credit. (Note: Legislation which will allow such a subtraction in post 1994 taxable years was introduced and passed by the Virginia House and Senate during the 1994 General Assembly. These Acts, Senate Bill 285 and House Bill 1298, are expected to be signed into law the Governor.)
Without statutory authority, I can not allow a subtraction for this item. Therefore, the adjustment made by the department's auditor with respect to this issue is upheld.
Property Factor Issue. The department's auditor made an adjustment to the Taxpayer's property factor for the taxable year ended December 31, 1989. The auditor included software development costs capitalized for financial accounting purposes as property for purposes of determining the property apportionment factor.
VR 630-3-409 defines property as "all real and tangible personal property including land, mineral rights, buildings, machinery, inventory, and any other real or tangible personal property in which the corporation has any right of use or possession." Although the capitalized amounts are property for financial accounting purposes, the amounts clearly do not fall within the definition of tangible personal property for purposes of determining the property apportionment factor. Therefore, the auditor's adjustment to the property factor for capitalized software will be reversed.
Foreign Source Income. The Taxpayer claimed a subtraction for foreign source income, which was disallowed by the department's auditor. The Taxpayer believes that the income it receives from the licensing of computer software to foreign persons outside the United States, providing technical assistance and maintenance incidental to such licenses, and sales of custom computer software to foreign persons, including modifications of licensed software for foreign persons for use outside the United States, should be considered as foreign source income for purposes of the Virginia subtraction.
Licensing computer software. The department has previously ruled that for purposes of the Virginia foreign source income subtraction, the sale of software created by a taxpayer subject to a license agreement is considered to be income earned pursuant to such license agreement. See Public document (P.D.) 94-36 (3/7/94), copy attached. Where the use of the software subject to the license agreement is without the United States, such income qualifies for the Virginia foreign source income subtraction. Accordingly, the Taxpayer's income from the license of software used outside the United states is one of the types of income that qualifies for the Virginia foreign source income subtraction.
Technical assistance and maintenance. In addition to selling computer software abroad, the Taxpayer also provides technical assistance with respect to the software that it sells, in the form of "maintenance services" for periods commencing after the software is purchased. Pursuant to the maintenance agreements, the Taxpayer provides the following services: (i) telephone consultation during normal business hours; (ii) computer program code to correct errors that may cause the software to deviate materially from the software specifications when originally purchased; and (iii) all enhancements to the software which are developed by the Taxpayer and generally made available at no charge to other licensees of the software. The Taxpayer believes that this income should constitute a "technical fee" eligible for the subtraction in accordance with P.D. 91-57 (3/29/91), copy attached.
It is the long standing policy of the department that the words "technical fees from ... services performed" cannot be taken out of their context to create a subtraction for income earned from the performance of services outside the United States for any service which can be characterized as of a technical nature. See P.D. 92-44 (4/27/92) and P.D. 86-209 (11/3/86), copies attached.
In P.D. 91-57, a foreign source income exclusion (for Virginia income tax purposes) is permitted for "technical fees" if such fees are "incidental to a contract relating to the rental of real property or the licensing of a patent . . . franchise and other like property for use without the United States.
In the instant case, the maintenance services provided pursuant to the agreement provide for consultation for a reasonable amount of time by telephone, and the resolution of problems. The agreement provides that the Taxpayer will investigate and correct suspected errors at their offices to the extent possible. The standard license agreement used by the Taxpayer for its software shows that its maintenance service agreements are in fact incidental to the licensing of its software. However, the agreements clearly provide that such services will be performed at the Taxpayer's offices and by telephone where possible.
The performance of services does not generally qualify as a technical fee, except where those services are incidental to licensing a patents, franchise or similar asset. However, where services that otherwise qualify as technical fees are actually performed, such services must be performed outside the United States and classified as income from without the United States under the federal sourcing rules. The Taxpayer has not demonstrated that the services in question are performed outside the United States. The agreements specifically provide otherwise. Accordingly, the technical assistance is not eligible for subtraction as a technical fee eligible for the Virginia foreign source income subtraction.
Sale of custom software and modifications of licensed software. As previously stated, the department views income arising from the licensing of software as income arising from the underlying license agreement. The department does not view the resale of prewritten software as the sale of an intangible asset. The department generally views the purchase and sale of prewritten software, which is developed and licensed by someone other than the reseller, as wholesale and retail activity which does not qualify for the foreign source income subtraction.
Where software is created or customized by a taxpayer for a customer, the department will generally consider the income arising from such activity to be a sale of personal services unless the custom software or programming is actually subject to a license agreement between the taxpayer and the customer. Finally, the performance of programming services will not usually qualify as a technical fee eligible for the foreign source income subtraction unless such services are incidental to a license agreement, and are performed outside the United States.
The Taxpayer has not demonstrated that such custom modifications are subject to a license agreement for use outside the United States, or that the programming services otherwise qualify as technical fees performed outside the United States. Accordingly, sales of customized software and modifications of licensed software do not qualify for the foreign source income subtraction.
In summary, the income from licensing software for use without the United States will be allowed as part of the foreign source income subtraction. The subtraction will be determined net of related expenses in accordance with P.D. 93-235 (12/28/93), copy attached. Finally, the denominator of the sales factor must be reduced to the extent of any foreign source license income qualifying for the foreign source income subtraction.
The assessment will be adjusted as provided herein and in accordance with the attached schedules. The balance due, ********** including interest should be paid within 30 days to prevent the accrual of additional interest.
Sincerely,
Danny M. Payne
Acting Tax Commissioner
Rulings of the Tax Commissioner