Can a corporation support its Virginia foreign-source-income subtraction with Virginia-only amended Form 1118s without amending its federal returns?

Plain-English summary

Virginia corporations may subtract foreign source income to the extent it's in federal taxable income (Va. Code Sec. 58.1-402 C 8; defined in Va. Code Sec. 58.1-302). But the subtraction is figured net of related expenses, and those expenses must be assigned using the federal sourcing rules of IRC Sec. 861 et seq. -- not the taxpayer's own view of which expenses relate to foreign income (P.D. 86-154). Those rules distinguish deductions definitely allocable to a class of income (allocated, then apportioned between foreign and domestic source) from those not definitely allocable (apportioned ratably).

The corporation had assigned all related expenses to the 'not definitely allocable' category on the Form 1118s filed with its federal returns. The auditor adjusted the Virginia subtraction to match those federal Form 1118s, reducing it and assessing more tax. On appeal, the corporation provided amended Form 1118s allocating the expenses to royalty and installment-sale income, arguing this was the correct IRC Sec. 861 result and that it shouldn't have to amend its federal returns because the change didn't affect federal tax.

The Commissioner agreed and adjusted the assessments:

• Form 1118 is normally the federal foreign-tax-credit limitation form, and when completed under IRC Sec. 861 its figures are a presumed-correct starting point for the Virginia subtraction (P.D. 94-54). But the Department accepts supplemental information prepared under IRC Secs. 861-863 -- including Form 1118s prepared specifically for Virginia (P.D. 87-149).
• A taxpayer is not required to file a federal amended return to amend a Virginia return (P.D. 92-135). So not amending the federal returns didn't stop the Department from using the Virginia-purpose amended Form 1118s.

The Department reviewed the supplemental information, reallocated the expenses to royalty and installment-sale income as appropriate, and revised the 2014-2016 assessments.

What this means for you

Corporations claiming the foreign-source-income subtraction

The expense allocation that limits your subtraction must follow the federal IRC Sec. 861 sourcing rules, but you can document the correct allocation with Virginia-specific supplemental Form 1118s -- you don't have to reopen your federal return to do it.

Federal and Virginia amendments are decoupled

When a change affects Virginia tax but not federal tax, Virginia lets you amend the Virginia return on its own (P.D. 92-135). Keep the supporting IRC Sec. 861 computation.

The federal Form 1118 is a starting point, not a ceiling

The as-filed federal Form 1118 is presumed correct, but a properly supported reallocation under the same federal rules can change the Virginia result.

Common questions

Do I have to amend my federal return to fix the Virginia subtraction? No -- Virginia accepts supplemental or Virginia-only amended Form 1118s prepared under IRC Sec. 861 (P.D. 87-149, 92-135).

Can I just allocate expenses however I think is fair? No. The allocation must follow the federal IRC Sec. 861 et seq. sourcing rules, regardless of your own view of the connection.

What happened to the assessments? They were adjusted -- the Department reallocated the expenses to royalty and installment-sale income and issued revised bills.

Citations and references

• Va. Code Sec. 58.1-402 C 8 and Va. Code Sec. 58.1-302 -- foreign-source-income subtraction and definition.
• IRC Sec. 861 et seq. -- federal rules for sourcing income and allocating/apportioning deductions.
• P.D. 86-154, 94-54 -- use of the federal sourcing rules and Form 1118 as the starting point.
• P.D. 87-149 -- supplemental/Virginia-purpose Form 1118s accepted.
• P.D. 92-135 -- no federal amended return required to amend a Virginia return.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 20-90

Original ruling text

May 27, 2020

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 December 31, 2014 through 2016.

FACTS

The Taxpayer claimed subtractions for foreign source income pursuant to Virginia Code § 58.1-402 C for the taxable years at issue. It assigned all of its related expenses to those not definitely allocable on its Federal Form 1118s. The Department’s auditor adjusted the Taxpayer’s foreign source income related expenses to the amounts reported by the Taxpayer on the Form 1118s filed with its federal returns, resulting in a reduction of the subtraction and assessments of additional tax.

The Taxpayer provided the Department with amended Form 1118s for purposes of the audit that allocated the expenses to royalty and installment sale income. The Department did not adjust the expenses because the Taxpayer’s federal returns were not amended.

The Taxpayer appealed, contending that the related expenses were properly allocated to the royalty and installment sale income, and it should not be required to amend its federal returns because the change in the allocation of expenses does not affect its federal income tax liability.

DETERMINATION

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 purpose of Form 1118 is to compute the limitation on the amount of foreign taxes that can be claimed as a credit against federal tax liability. When the procedures of IRC § 861 et seq ., are used to complete Form 1118, the information reported on this form is considered useful and presumed correct and accurate. Such information is an appropriate starting point for computing the foreign source income subtraction allowed on the Taxpayer’s Virginia return. See P.D. 94-54 (3/14/1994).

The Taxpayer contends that the amended Form 1118s that it provided to the Department properly reflect the allocation of the expenses related to the foreign source income subtraction in accordance with IRC § 861 et seq . In P.D. 87-149 (6/8/1987), the Department determined that supplemental information prepared in accordance with IRC §§ 861 through 863 will be accepted. Such supplemental information would include Form 1118s that are prepared specifically for Virginia corporate income tax purposes.

Further, in P.D. 92-135 (8/6/1992), the Department acknowledged that a taxpayer is not required to file a federal amended return in order to amend a Virginia income tax return. As such, the fact that the Taxpayer did not amend its 2014 through 2016 federal returns does not preclude the Department from considering the amended Form 1118s in order to calculate the proper amount of the subtraction for foreign source income.

In accordance with this determination, the Department has reviewed the supplemental information and allocated the related expenses to royalty and installment sale income as appropriate. Therefore, the assessments for the taxable years ended December 31, 2014 through 2016 have been adjusted based on the enclosed schedules. The Taxpayer will receive updated bills which will include accrued interest to date. It should remit the balance due within 30 days of the bill date to avoid the accrual of additional interest.

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/2198.B

Related Documents

85-154

87-149

92-135

94-54