Could Virginia residents claim an income-tax credit for the District of Columbia Unincorporated Business Franchise Tax paid on sole-proprietor income?

Plain-English summary

Virginia denied resident taxpayers a credit for the District of Columbia Unincorporated Business Franchise Tax paid on sole-proprietor income. Virginia's credit applies to a broad-based income tax comparable to Virginia's individual income tax. The D.C. tax was a franchise tax and did not tax all of an individual's income, so it was specifically outside that definition even though income helped measure it.

The Department also rejected the taxpayers' Commerce Clause argument. It reasoned that the double taxation resulted from the interaction of two different, internally consistent tax structures, not discrimination built into Virginia's own system. The assessment was upheld.

Common questions

Does a tax qualify merely because it is measured partly by income? No. Virginia law excludes certain franchise and license taxes that do not tax all individual income.

Did paying the D.C. tax as a sole proprietor change the classification? No.

Did the Department find unconstitutional double taxation? No. It found no Commerce Clause violation under the internal-consistency analysis.

Citations and references

• Va. Code §§ 58.1-332 A and 58.1-332.2 A-B
• U.S. Const. art. I, § 8, cl. 3
• Comptroller of the Treasury v. Wynne, 135 S. Ct. 1787 (2015)
• Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977)
• People of State of New York ex rel. Cohn v. Graves, 300 U.S. 308 (1937)
• P.D. 11-92 (June 2, 2011) and P.D. 12-108

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 18-166

Original ruling text

September 26, 2018

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will reply to your letter in which you seek correction of the individual income tax assessment issued to * (the “Taxpayers”) for the taxable year ended December 31, 2013.

FACTS

The Taxpayers filed a Virginia resident income tax return for the 2013 taxable year, claiming a credit for the payment of the Unincorporated Business Franchise Tax (UBFT) to the District of Columbia. Under review, the Department disallowed the credit and issued an assessment. The Taxpayers appeal, contending they were eligible to claim credit for the UBFT because it was a tax based on income and denial of the credit would result in double taxation.

DETERMINATION

Classification of Tax

Virginia Code § 58.1-332 A allows Virginia residents a credit on their Virginia return for income taxes paid to another state provided the income is either earned or business income. The Department has ruled that the UBFT does not qualify for the credit. See Public Document (P.D.) 11-92 (6/2/2011). In addition, Virginia Code § 58.1-332.2 A defines an “income tax” as a term of art that refers to a specific type of tax levied on all of a resident’s earned and unearned income, and all income of a nonresident from sources within the jurisdiction, which is similar to the income tax that Virginia imposes on resident and nonresident individuals. Virginia Code § 58.1-332.2 B includes examples of taxes that do not qualify for the credit, even though they may be measured, in part, by income. Taxes do not qualify because (i) they are labeled as a franchise or license tax, and (ii) they do not tax all income of the individual. Examples of taxes that do not qualify for the credit pursuant to Virginia Code § 58.1-332.2 include the UBFT, the Texas Margin Tax, and the Ohio Commercial Activity Tax. See P.D. 12-108.

Pursuant to Virginia Code § 58.1-322.2 and in accordance with the Department’s longstanding policy, the UBFT does not qualify for the credit under Virginia Code § 58.1-322. The fact that the Taxpayers paid the UBFT on business income as a sole proprietor does not alter the eligibility of a tax as characterized under Virginia Code § 58.1-332.2.

Commerce Clause

The Taxpayers contend that the decisions of the United States Supreme Court, most recently Comptroller of the Treasury v Wynne, 135 S. Ct. 1787, 191 L. Ed. 2d 813 (2015), prohibit the double taxation of income of an individual or business. It is well established, however, that a state may tax all the income of a resident, even income from outside the taxing jurisdiction. In People of State of New York ex rel. Cohn v. Graves , 300 U.S. 308 (1937), the United States Supreme Court explained “[t]hat the receipt of income by a resident of the territory of a taxing sovereignty is a taxable event is universally recognized.” In Wynne , the Supreme Court also recognized that a state's taxation of a resident's income may be subject to constitutional scrutiny under the Commerce Clause of the United States Constitution.

The Commerce Clause grants Congress power to “regulate Commerce . . . among the several States.” Art. I, § 8, cl. 3. Although the Clause is framed as a positive grant of power to Congress, the Court has consistently held this language to contain a further, negative command, known as the dormant Commerce Clause. Wynne , 135 S. Ct. at 1794. The dormant Commerce Clause prohibits state taxation discriminating against interstate commerce, even when Congress has failed to legislate on the subject. Id . To help identify state tax schemes that discriminate against interstate commerce, the Court uses something known as “the internal consistency test.” Id . at 1803. The United States Supreme Court first adopted the “internal consistency test” in Complete Auto Transit, Inc. v Brady, 430 U.S. 274 (1977). The test “looks to the structure of the tax at issue to see whether its identical application by every State in the Union would place interstate commerce at a disadvantage as compared with commerce intrastate.” Wynne , 135 S. Ct. at 1803 (citations and internal quotation marks omitted).

Accordingly, a state is within its authority to impose income tax on all of the income of a resident of that state. A state need only ensure that the income tax, to the extent that it substantially affects interstate commerce, does not discriminate against such commerce. While granting a credit against a resident’s income tax may cure an otherwise discriminatory tax, the Supreme Court in Wynne did not order that. In fact, the Court noted that alternative remedies existed, one of which would be for the state to refrain from taxing nonresidents on certain income. Wynne , 135 S. Ct. at 1806.

Critically, not all situations of double taxation are a result of discriminatory tax schemes. The Court explained:

By hypothetically assuming that every State has the same tax structure, the internal consistency test allows courts to isolate the effect of a defendant State’s tax scheme. This is a virtue of the test because it allows courts to distinguish between (1) tax schemes that inherently discriminate against interstate commerce without regard to the tax policies of other States, and (2) tax schemes that create disparate incentives to engage in interstate commerce (and sometimes result in double taxation) only as a result of the interaction of two different but nondiscriminatory and internally consistent schemes...The first category of taxes is typically unconstitutional; the second is not.

Id . (citations omitted).

If a court were to subject Virginia’s credit to the internal consistency test it would assume that all states, including the District of Columbia, imposed a broad- based income tax like Virginia’s and would not analyze the actual taxes imposed by each of the other states. Under that assumption, Virginia would grant the credit for income taxes imposed by the other states and no discrimination would be found to exist that could be attributed to Virginia’s tax structure. The fact that a credit has been denied for the UBFT is attributable to the fact that District of Columbia has imposed taxes that are significantly different from Virginia’s income tax. This situation fits into the second type of result of the internal consistency test, which does not violate the Commerce Clause of the United States Constitution.

CONCLUSION

Under Virginia statutes, the Taxpayers were not eligible to claim a credit for the Unincorporated Business Franchise Tax imposed by the District of Columbia because such tax is not a broad-based income tax for which Virginia allows a credit. In addition, contrary to assertions by the Taxpayers, the denial of the credit in this case does not violate the Commerce Clause of the United States Constitution.

Accordingly, the assessment is upheld. The Taxpayers will receive an updated bill with accrued interest to date. The Taxpayers should remit the balance within 30 days of the date of this letter to avoid the accrual of additional interest and further collection actions.

The Code of Virginia sections 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 determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1703.A