How did Virginia correct a corporation's foreign-source-income expenses, foreign partnership loss, and currency amounts in its sales factor?

Plain-English summary

Virginia sent the corporation's foreign-source-income subtraction back to the auditor for review of newly supplied separate-company pro forma expense information. Virginia used the federal IRC §§ 861 through 863 sourcing rules to allocate deductions related to foreign income. When a separate Form 1118 was unavailable, prior Department rulings allowed allocation from consolidated information, but the taxpayer had now supplied pro forma data for the auditor to test.

The corporation also handled its foreign limited partnership loss incorrectly in the sales factor. As the general partner, it should not place the ordinary loss itself in the factor. It needed to include its proportionate share of the partnership's property, payroll, and sales, except attributes used to produce income already removed through specified foreign-income subtractions.

Finally, all foreign-currency exchange amounts had to be removed from both the numerator and denominator. Currency conversion was a change in the form of money, not itself a sale producing gross receipts. After the auditor reviewed the pro forma expenses and made the required factor changes, Virginia would issue revised bills or refunds.

Common questions

Could the auditor use consolidated foreign expenses? Yes when separate information was unavailable, but the taxpayer's new pro forma separate-company data had to be reviewed.

Could an ordinary partnership loss be placed in the sales factor? No. The corporation had to use its proportionate share of partnership factor attributes instead.

Were all partnership factor attributes included? Not those used to produce income qualifying for specified foreign-income subtractions.

Were foreign-exchange gains and losses sales? The ruling removed all foreign-currency exchange amounts because currency conversion itself was not a sales transaction.

Citations and references

• Va. Code §§ 58.1-302 and 58.1-402 C 8
• IRC §§ 861-863
• Va. Code §§ 58.1-408 through 58.1-421
• 23 VAC 10-120-120 and 10-120-150 B 2 b
• Va. Code § 58.1-1821

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 18-188

Original ruling text

October 30, 2018

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 assessment issued to * (the “Taxpayer”) for the taxable years ended December 31, 2009 and 2010. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayer filed consolidated federal and separate Virginia corporate income tax returns for the taxable years at issue. Under audit, the Department adjusted the foreign source income subtraction the Taxpayer claimed by increasing the amount of related expenses. The Taxpayer appeals, contending that the Department used consolidated rather than separate foreign source income expenses for its adjustments.

The Taxpayer also asserts that the auditor erroneously disallowed negative foreign exchange amounts and foreign partnership income in the sales factor. The Taxpayer requests that negative foreign exchange income and negative income passed through from * (FLP), a foreign limited partnership, be removed from the denominator of its sales factor.

DETERMINATION

Foreign Source Income

Virginia Code § 58.1-402 C 8 provides a subtraction for foreign source income as defined in Virginia Code § 58.1-302, to the extent included in federal taxable income. The computation of the Virginia foreign source income subtraction (considering expenses related to the income) is determined in accordance with Internal Revenue Code (IRC) §§ 861 through 863. See Public Document (P.D.) 86-154 (8/14/1986). Virginia law requires the use of the federal sourcing rules of IRC § 861 et seq. , whether or not the taxpayer believes that certain expenses have any connection to income from foreign sources and regardless of what expenses would be under generally accepted accounting principles.

The provisions of IRC § 861 et seq. , contain detailed rules for assigning income and deductions to particular sources. The provisions differentiate between deductions that are definitely allocable and deductions that are not definitely allocable. First, definitely allocable deductions that are directly related to a class of income are allocated and then apportioned between foreign and domestic source income. If a deduction is not definitely related to any gross income, the deduction must be apportioned ratably between each class of foreign and domestic source income.

The Department has previously ruled that the proper method of computing non-allocable expenses attributable to foreign source income is to multiply total non-allocable expenses by a ratio, the numerator of which is gross Virginia foreign source income and the denominator of which is gross income from without the United States per the Form 1118. See P.D. 91-229 (9/30/1991). Items that qualify for separate subtractions under other provisions of Title 58.1 of the Code of Virginia , such as IRC § 78 gross-up, Subpart F income, and dividends from corporations in which the taxpaying corporation owns 50% or more of the voting stock, are not subtracted again as foreign source income. Accordingly, they are not included in the numerator of the ratio, but are included in the denominator to the extent included on Form 1118.

The Taxpayer states that the auditor used the expenses from the consolidated Federal Form 1118 in making the adjustments. It asserts that these expenses include those of affiliated corporations. In P.D. 96-365 (12/9/1996), the Department found that when information to prepare a pro forma Form 1118 on a separate company basis was unavailable, it was appropriate to utilize an allocation of expenses based on a corporation’s relative share of consolidated foreign source income. A similar method was permitted in P.D. 92-184 (9/10/1992). As a part of its appeal, the Taxpayer has provided pro forma information concerning its foreign source expenses.

Sales Factor

In general, the sales factor is a fraction, the numerator of which is total sales in Virginia during the taxable year, and the denominator of which is total sales of the corporation everywhere during the taxable year. See Title 23 of the Virginia Administrative Code (VAC) 10-120-120 A. The term “sales” is defined as all gross receipts of the corporation except dividends allocated under Virginia Code § 58.1-407. See Virginia Code § 58.1-302 and Title 23 VAC 10-120-120 B.

Foreign Partnerships

The Taxpayer, the general partner of FLP, reported an ordinary loss from the partnership. Under the Department’s longstanding policy, a corporation, which holds a general partnership interest in a partnership, must include its proportionate share of partnership property, payroll and sales in its own factors for purposes of apportioning Virginia taxable income. See P.D. 88-226 (7/29/1988). Likewise, in P.D. 95-19 (2/13/1995), the Department ruled that a corporate limited partner is required to include its proportionate share of the partnership’s property, payroll and sales with its own property, payroll and sales for purposes of determining its Virginia apportionment factor unless certain standards are met.

In cases where a p artnership passes property, payroll and sales through to a corporation, the factor attributes would be determined as provided in Virginia Code §§ 58.1-408 through 58.1-421. The property, payroll and sales that are used to produce income qualifying for the subtraction for foreign dividend gross up, subpart F income and foreign source income, however, are not included in the denominator of the apportionment factor. See Title 23 VAC 10-120-150 B 2 b and P.D. 03-65 (8/19/2003). Thus, any income that passed through from FLP that was also included in one of these subtractions would be removed from the Taxpayer’s apportionment formula.

Foreign Currency

The Taxpayer indicates that the negative foreign exchange amounts it reported in the denominator of the sales factor result from the recognition of exchange rate fluctuations from the settlement of specific currency transactions when exchange rates are different from when a transaction is initiated, and the recognition of distributions of certain pretax book income attribution to the change in exchange rates between the tome of the previous inclusion in United States taxable income and the time of actual distribution to the United States.

The conversion of foreign currency into United States dollars, however, is not a transaction producing gross receipts, but rather a mere change in the form of the money involved. See P.D. 85-1 (1/7/1985). Gross receipts in such transactions result only from a difference between the amount of United States dollars originally converted to foreign currency and the amount of United States dollars subsequently received in re-conversion.

CONCLUSION

Based on the above analysis, the Taxpayer incorrectly included the ordinary loss from FLP in its sales factor. Instead of the loss, a proportionate share of FLP’s sales should have been included in the Taxpayer’s sales factor. In addition, because currency transactions are not considered to be sales for the purpose of Virginia Code § 58.1-407, all foreign currency exchange amounts must be removed from the numerator and denominator of the sales factor.

The case will be remanded back to the auditor to review the accuracy of the information of the pro forma foreign expenses submitted and adjust the audit in accordance with this determination. Once the adjustments are made, updated bills or refunds will then be issued for the 2009 and 2010 taxable years. The Taxpayer should remit payment of any remaining liability within 30 days of the date of the revised bills to avoid the accrual of additional interest.

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

Sincerely,

Craig M. Burns

Tax Commissioner

AR/557.B