Did fees from foreign consulting contracts qualify for Virginia's foreign-source-income subtraction as incidental technical fees?

Plain-English summary

The taxpayer did not establish that its foreign consulting fees qualified for Virginia's foreign-source-income subtraction. Virginia's definition included specified rents, royalties, license fees, and technical fees connected with property or services outside the United States. The Department's stated policy limited "technical fees" to fees incidental to a contract for foreign real-property rental or licensing a patent or similar property.

The company described itself as a global management and technology consulting provider. Its sample agreement called for consulting services and custom deliverables incorporating the company's intellectual property. The Department found that the contract's primary purpose was services: the company used its expertise to create client-specific systems and invoiced anticipated fees and expenses instead of charging rent or royalties for an existing asset.

The Department twice requested contracts supporting the claimed foreign technology and trademark licenses, but the taxpayer supplied no objective substantiation. Because an assessment was presumed correct and the taxpayer bore the burden of proving error, the Department upheld the assessments for years ended August 31, 2006 through 2008.

The taxpayer received one final opportunity to submit the requested documentation within 30 days of the ruling. Otherwise, the assessments would be deemed correct and collection would resume.

What this means for you

• Foreign performance of technical work did not by itself create the subtraction under the Department's interpretation.
• Contract substance mattered: a services agreement producing custom deliverables was not treated as a license of preexisting intellectual property.
• Taxpayers needed objective contracts and records supporting the claimed licensing income.
• The ruling's assessments were upheld but included a final 30-day substantiation window.

Common questions

Q: Why did the sample agreement fail?
A: Its primary purpose was consulting services and custom deliverables, billed through anticipated fees and expenses.

Q: Could technical fees ever qualify?
A: Under the policy stated in the ruling, only when incidental to qualifying foreign property rental or licensing arrangements.

Q: Was the taxpayer given another chance?
A: Yes. It had 30 days from the ruling date to provide the requested documentation.

Citations and references

• Va. Code §§ 58.1-205, 58.1-219, 58.1-302, and 58.1-1826.
• Virginia Public Documents 86-209 (November 3, 1986) and 91-57 (March 29, 1991).

Subject

Disallowance of foreign source income subtractions

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 12-198

Original ruling text

December 6, 2012

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 August 31, 2006 through 2008. I apologize for the delay in responding to your letter.

FACTS

The Taxpayer was audited by the Department for the taxable years at issue and numerous adjustments were made. One of the adjustments made by the auditor was to eliminate the foreign source income (FSI) subtraction claimed by the Taxpayer. The auditor determined that the Taxpayer performed services for foreign clients that were not incidental to the rental of real property or the licensing of intangible assets. The Taxpayer appeals the disallowance of the FSI subtractions, contending it primarily licensed intellectual property to its overseas customers and any technical services provided were incidental.

DETERMINATION

Virginia Code § 58.1-302 defines foreign source income, in pertinent part, as:

Rents, royalties, license, and technical fees from property located or services performed without the United States or from any interest in such property, including rents, royalties, or fees for the use of or the privilege of using without the United States any patents, copy rights, secret processes and formulas, good will, trademarks, trade brands, franchises, and other like properties.

Pursuant to the Department's long-standing policy, the words "technical fees from property located or 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 that can be characterized as of a technical nature. See Public Document (P.D.) 86-209 (11/03/1986). In order to qualify for the Virginia FSI subtraction, "technical fees" must be incidental to a contract relating to the rental of real property or the licensing of a patent or other like property outside the United States. See P. D. 91-57 (3/29/1991).

The Taxpayer states that it is a global provider of management and technology consulting services. These services include a wide range of solutions to enable a business or government to perform more efficiently. To support its position, the Taxpayer provided a copy of a "Consulting Servicing Agreement". Under the agreement, the Taxpayer agrees to perform services and create deliverables that incorporate its intellectual property.

In reviewing the sample agreement provided by the Taxpayer, the Department finds that primary purpose of the contract is to provide services to which the deliverables are the resulting product. The agreement begins by stating, "[W]hereas, Client desires to obtain services from [the Taxpayer] from time to time, and [the Taxpayer] desires to provide services to Client . . . ." Under the description of services, the Taxpayer is required to perform consulting services and create deliverables in accordance with a separate statement of works document. In a typical licensing agreement, a business would be providing an asset that had already been created. In this case, the Taxpayer is using its expertise and know-how to create systems designed specifically for its clients. Further, instead of charging a royalty or rent for the deliverables, the Taxpayer invoices its clients based on anticipated fees and expenses it will incur.

By correspondence dated July 12, 2012 and August 22, 2012, as well as a telephone conversation, the Department requested copies of contracts pertaining to technology and trademark licenses outside of the United States in order to fully consider the facts in this case. As of the date of this letter, the Taxpayer has provided no objective evidence to substantiate its claim that the services provided to foreign clients were incidental technical fees.

The Department has the authority to investigate any books and records of a taxpayer in order to ascertain the proper tax liability. See Va. Code § 58.1-219. Further, Va. Code § 58.1-205 provides that in any proceeding relating to the interpretation of the tax laws of Virginia, an "assessment of a tax by the Department shall be deemed prima facie correct." As such, the burden of proof is on the Taxpayer to show that the assessment is incorrect.

In addition, Va. Code § 58.1-1826 precludes a court from granting relief to taxpayers seeking correction of erroneous state tax assessments in cases in which the assessment was attributable to the taxpayer's willful failure or refusal to provide the Department with necessary information as required by law.

Because the Taxpayer has failed to furnish information requested, the Department's assessments for taxable years ended August 31, 2006 through 2008 are upheld. I will, however, grant the Taxpayer, one final opportunity to provide the information requested to substantiate his claim. The documentation must be provided within 30 days from the date of this letter. Otherwise, the assessments will be deemed correct and collection action will resume.

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

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1-5025182752.B