Were retained arbitration proceeds foreign-source income when they arose from selling stock in a U.S. corporation?

Plain-English summary

Virginia upheld the denial of a foreign-source-income subtraction for arbitration proceeds. The taxpayer sold stock in a United States corporation but negotiated the right to retain proceeds from that corporation's pending foreign contract arbitration.

When the matter settled, the taxpayer reported the proceeds federally as gain. Virginia found that the rights had become part of the consideration for the domestic stock sale. The foreign corporation—not this taxpayer—had performed the technical services abroad, so the taxpayer could not recharacterize its stock-sale gain as foreign technical fees.

The Department said this result followed both federal conformity and substance over form. The earlier determination in P.D. 17-3 remained.

Common questions

Did the foreign court proceeding make the proceeds foreign-source income? No. Virginia looked to the transaction from which this taxpayer obtained the proceeds.

Could a federal return item ever receive different Virginia treatment? The ruling says the taxpayer must clearly show why state law requires it; that showing was not made here.

Citations and references

• Va. Code §§ 58.1-402 C 8, 58.1-302, and 58.1-301
• 23 VAC 10-20-165 F 1 a
• P.D. 17-3 and P.D. 97-376
• Gregory v. Helvering, 293 U.S. 465 (1934)
• Frank Lyon Co. v. United States, 435 U.S. 561 (1978)

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 18-72

Original ruling text

May 2, 2018

Re: § 58.1-1821 Application: Corporate Income Tax

Dear *:

This will reply to your letter in which you seek reconsideration of the Department's determination letter issued as Public Document (P.D.) 17-3 (1/19/2017) to * (the “Taxpayer”) for the taxable year ended January 31, 2011. I apologize for the delay in responding to your request.

FACTS

In P.D. 17-3, the Department determined that the proceeds from an arbitration settlement were not foreign source income because the gain was not derived from the sale of intangible property outside the United States and the proceeds were not technical fees. The Taxpayer seeks reconsideration of that determination, contending that the Department relied on the form and not the substance of the transaction.

DETERMINATION

Virginia Code § 58.1-402 C 8 permits a taxpayer to subtract foreign source income from federal taxable income (FTI) to the extent it is included in and not otherwise subtracted from FTI. Under Virginia Code § 58.1-302, “foreign source income” includes “[G]ains, profits, or other income from the sale of intangible or real property located without the United States”.

The Taxpayer reported an arbitration award granted to * (Corporation A) as a gain in accordance with the Internal Revenue Service (IRS). Because Corporation A was an American corporation, the Department determined in P.D. 17-3 that the gain was not foreign source income. The Taxpayer contends that the Department's determination is erroneous because it puts form over substance. It argues that the proceeds from the arbitration were in substance foreign source income because they were derived from a contract dispute in *** (Country A), and the dispute was resolved in that country's court system.

The Taxpayer has cited the United States Supreme Court cases Gregory v. Helvering , 293 U.S. 465, 55 S.Ct. 266 (1934), Helvering V. Lazarus , 308 U.S. 252, 60 S.Ct. 209 (1939) and Frank Lyon Co. v. United States , 435 U.S. 561, 98 S.Ct. 1291 (1978) for the principle of substance over form. It also contends that the Department has allowed substance over form in numerous public documents that addressed the foreign source income subtraction. See P.D. 86-209 (11/3/1986), P.D. 91-57 (3/29/1991), P.D. 96-381 (12/20/1996), P.D. 99-292 (11/12/1999), P.D. 03-28 (4/1/2003), P.D. 03-65 (8/19/2003), P.D. 06-19 (2/7/2006) and P.D. 14-8 (1/24/2014).

The Gregory and Frank Lyon Co . cases both addressed whether a particular transaction had substance or was a sham. Lazarus dealt with whether a transaction was a long-term lease or a mortgage loan. None of these court cases are applicable to the Taxpayer's case because they do not address statutory reporting requirements.

All the public documents cited by the Taxpayer addressed whether particular items in contracts and agreements qualified as foreign source income for purposes of the subtraction. None involved any item being treated differently than what was reported on a federal return as mandated by the IRC.

The Taxpayer in essence argues that even though the Department is required to conform to federal tax law when calculating FTI, it should disregard this requirement when a particular item reported on a federal return is substantively different from what is reported. The Department, however, relies on the amount and character of each item reported on the federal return and supporting schedules. When a taxpayer alleges an item should be treated differently on a Virginia return than it was on a federal return, the taxpayer must clearly show why different treatment is required. See P.D. 97-376 (9/18/1997).

As indicated in P.D. 17-3, the Taxpayer sold its stock ownership of * (Corporation A), a corporation based in the United States, to an unrelated third party. Prior to the sale, Corporation A had contracted with (Corporation B), headquartered in ** (Country A), to provide telecommunications services. When it negotiated the sale of Corporation A's stock, the Taxpayer had negotiated a provision by which it would retain the rights to proceeds from an arbitration proceeding pending in a Country A court between Corporation A and Corporation B. When the arbitration was settled, the Taxpayer reported the proceeds from the settlement as a gain on its federal income tax return and on its 2010 Virginia corporate income tax return. In its request for redetermination, the Taxpayer has not argued the facts set forth in P.D. 17-3 were misstated by the Department, which is one of the grounds for a reconsideration pursuant to Title 23 of the Virginia Administrative Code (VAC) 10-20-165 F 1 a.

Based on these facts, the Department must disagree with the Taxpayer's characterization of the substance of the transaction. The proceeds from the arbitration received by the Taxpayer resulted from its transaction to sell the stock of Corporation A. It was Corporation A, not the Taxpayer, which had a contract with Corporation B to provide technical services in Country A. If Corporation A had reported the proceeds from the court settlement on its Virginia return, it may have qualified for the foreign source income subtraction. Conversely, when the Taxpayer negotiated the right to retain the proceeds with the unrelated third party, it became part of the sales price of Corporation A's stock. Thus, by ruling the proceeds must be treated as a gain from the sale of stock, it not only conformed to the Internal Revenue Code as required under Virginia Code § 58.1-301, it also correctly applied the doctrine of substance over form.

Because the substance of the transaction from which the proceeds were derived was the sale of stock in a United States based corporation, the Department correctly disallowed the Taxpayer's the subtraction of the proceeds from the arbitration settlement as foreign source income for the taxable year ended January 31, 2011. This case has been returned to the auditor to adjust the Taxpayer's 2010 in accordance with the Department's determination in P.D. 17-3.

The Code of Virginia sections, regulation 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 Department's Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1200.B