The Department disallowed our manufacturing parent's single sales factor election by looking only at its Virginia operations, adjusted our sales factor using our own public financial data without explanation, and disallowed our research-expense and jobs-credit subtractions with no stated reason -- can all of that really be upheld?

Plain-English summary

A corporate group filed consolidated federal returns and combined Virginia corporate income tax returns for 2015 and 2016. The parent company used Virginia's modified single sales factor apportionment method for manufacturers, while the group's other affiliates used the standard three-factor formula. On audit, the Department made three separate adjustments: it disallowed the parent's manufacturer election and switched it to the standard formula; it increased the sales and services income sourced to Virginia for purposes of the sales factor; and it disallowed subtractions the parent claimed for qualified research expenses and Targeted Jobs Credit wages. The taxpayer appealed all three.

The manufacturer election: a nationwide test, not a Virginia-only one. Virginia Code § 58.1-422 lets qualifying manufacturing corporations use a single sales factor instead of the standard three-factor apportionment formula. A company qualifies as a "manufacturing company" if 50% or more of its gross receipts come from goods it manufactures, OR 50% or more of its employees work in manufacturing (evaluated under NAICS sectors 11, 31, 32, or 33; see the Guidelines, P.D. 13-6). The Department found the auditor had wrongly applied this test using ONLY the parent's Virginia operations -- but the manufacturing-company test looks at the company's ENTIRE business, wherever conducted, not just its Virginia footprint (the separate 90%-base-year-employment RETENTION requirement, by contrast, is Virginia-specific, but that's a different requirement from the manufacturing-company threshold test itself). Evaluated correctly against the parent's nationwide operations, it qualified as a manufacturing company and was eligible for the single sales factor method for both years.

The sales factor: unsupported estimates don't survive. The auditor had increased both the total sales and the Virginia-sourced services income used in the sales factor, partly based on trends observed in the company's own PUBLICLY AVAILABLE financial data rather than its actual tax records. The Department found the estimated sales figures were never reconciled to the company's federal returns or any other records provided -- without corroborating evidence, the sales factor's denominator cannot be pushed above what the company actually reported on its Virginia return. On the numerator (services sourced to Virginia), the audit report cited only general statutory and regulatory language, with no explanation of the reasoning or documentation behind the specific adjustment. An audit adjustment lacking any supporting explanation or documentation cannot be upheld.

The subtractions: another undocumented adjustment. Virginia allows corporations to subtract qualified/basic research expenses (§ 58.1-402 C 14) and Targeted Jobs Credit wages (§ 58.1-402 C 6) that couldn't be deducted federally because of IRC § 280C. The parent claimed both subtractions on its 2016 return; the audit report disallowed them without explaining why. As with the sales factor, an adjustment with no stated rationale cannot stand.

Outcome. All three sets of adjustments were reversed: the manufacturer election was reinstated, the sales factor adjustments were undone, and the research-expense and jobs-credit subtractions were restored. This resulted in abatement of most, though not all, of the originally assessed amounts (a portion was not in dispute and remained due), with a revised bill to follow.

What this means for you

Multi-state manufacturing corporations electing Virginia's single sales factor method

The manufacturing-company qualification test (50% of gross receipts or employees in manufacturing) is measured against your ENTIRE business, not just your Virginia operations -- an audit that evaluates eligibility using only your Virginia footprint is applying the wrong test.

Any business facing a sales-factor or subtraction adjustment based on estimates or unexplained reasoning

An audit adjustment must be reconciled to your actual returns/records and supported by an explained rationale -- estimates drawn from public financial data alone, or a bare disallowance with no stated reason, cannot be upheld on appeal.

Corporations claiming subtractions for research expenses or Targeted Jobs Credit wages tied to IRC § 280C

These subtractions exist precisely because IRC § 280C denies the federal deduction for amounts also claimed as a federal credit -- if an audit disallows the Virginia subtraction, insist on a stated explanation, since a bare disallowance is vulnerable to reversal.

Common questions

Q: An audit disallowed our manufacturer's single sales factor election by looking only at our Virginia operations -- is that the right test?
A: No, based on this ruling. The manufacturing-company qualification test looks at your entire nationwide business, not just Virginia operations (though the separate 90% base-year-employment retention requirement IS measured in Virginia specifically).

Q: The auditor increased our reported sales using our own public financial statements rather than our tax records -- can that adjustment stand without more?
A: Not without reconciliation to your actual returns or records, and a documented explanation. Unsupported estimates, and adjustments with no stated rationale, are vulnerable to reversal on appeal.

Q: Our research-expense or Targeted Jobs Credit subtraction was disallowed on audit with no explanation -- do we have to just accept that?
A: Not necessarily. This ruling reversed exactly that kind of unexplained disallowance -- push for the Department's stated reasoning if none was given.

Citations and references

Statutes:

• Va. Code § 58.1-422 -- manufacturers' single sales factor apportionment election; manufacturing company defined by NAICS sector and the 50% gross-receipts/employee tests (applied to the ENTIRE company, not just Virginia operations)
• Va. Code § 58.1-402 C 14 -- subtraction for qualified/basic research expenses not deducted federally due to IRC § 280C(c)
• Va. Code § 58.1-402 C 6 -- subtraction for wages/salaries eligible for the federal Targeted Jobs Credit, not deducted federally due to IRC § 280C(a)

Guidance the Department relied on (described here, not linked): Single Sales Factor Election for Manufacturers Guidelines, issued as P.D. 13-6 (1/7/2013) -- the manufacturing-company qualification tests.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 24-33

Original ruling text

March 21, 2024

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, 2015, and December 31, 2016. I apologize for the delay in responding to your letter.

FACTS

The Taxpayer filed consolidated federal corporate income tax returns and combined Virginia returns for the 2015 and 2016 taxable years. * (the “Parent”) used the modified apportionment method for manufacturing companies. The other affiliates included in the combined returns used the standard three factor formula.

Under audit, the Department disallowed the modified apportionment method and adjusted the returns to reflect the general three factor formula. The Department also increased both the total amount of sales income and the amount of income from services apportioned to Virginia, for purposes of computing the Parent’s sales factor. In addition, the Department disallowed the subtraction claimed on the Taxpayer’s 2016 return for qualified or basic research expenses and wages or salaries eligible for the federal Targeted Jobs Credit.

The Taxpayer appeals, contending that the Parent met all the requirements to use the modified apportionment method for manufacturing companies. In addition, the Taxpayer asserts that the Department incorrectly adjusted the Parent’s sales factor and improperly disallowed the subtraction for qualified or basic research expenses and wages and salaries eligible for the federal Targeted Jobs Credit.

DETERMINATION

Manufacturing Apportionment Factor

Virginia Code § 58.1-422 allows manufacturing companies to elect a modified apportionment factor based on sales to determine their Virginia taxable income. For taxable years beginning on or after July 1, 2014, qualifying corporations that elect to use the modified apportionment formula are required to use the single factor apportionment method to apportion Virginia taxable income. Once an election is made, it cannot be revoked for three taxable years. The single factor formula is calculated by multiplying Virginia taxable income less dividend income allocated without Virginia by the sales factor.

Virginia Code § 58.1-422 D defines a manufacturing company as “a domestic or foreign corporation primarily engaged in activities that, in accordance with the North American Industrial Classification System (NAICS), United States Manual, United States Office of Management and Budget, 1997 Edition, would be included in Sector 11, 31, 32, or 33.” A business is primarily engaged in manufacturing if either 50% or more of the gross receipts are derived from the sale of goods that are manufactured by the taxpayer, or 50% or more of the employees are engaged in manufacturing activities. See the Single Sales Factor Election for Manufacturers Guidelines (the “Guidelines”), issued as Public Document (P.D.) 13-6 (1/7/2013).

In this case, the audit staff appears to have applied the requirements of the election without regard to any operations that were conducted outside of Virginia. This was incorrect. Although taxpayers are required to maintain at least 90% of their base year full-time employment level in Virginia to remain qualified to use the modified method, the tests to be considered a manufacturing company encompass the company’s entire operations, not just those in Virginia. Based on its activities conducted throughout the United States and an evaluation of the documentation provided, the Parent was a manufacturing company for the taxable years at issue and was eligible to use the modified apportionment method.

Sales Factor

The Taxpayer contests the auditor’s adjustments to the total amount of sales and the amount of sales from services that were sourced to Virginia. The Taxpayer claims that these amounts were properly reported on its Virginia returns for the taxable years at issue. The auditor adjusted the reported sales based in part on trends reported in the Taxpayer’s publicly available financial data.

The estimated sales amounts were not reconciled to the amounts reported on the federal returns or any other records provided by the Taxpayer. Absent corroborating evidence from the Taxpayer’s records, the denominator of the sales factor cannot be adjusted to exceed the amount reported on its Virginia income tax return.

With regard to the numerator, the audit report provided to the Taxpayer only cites general statutory and regulatory information concerning sales of other than tangible personal property without providing any explanation of the rational for or the documentation used to support the adjustments. Without a supporting explanation or documentation, an audit adjustment cannot be upheld.

Subtractions

Pursuant to Virginia Code § 58.1-402 C 14, corporations are allowed to subtract the amount of qualified research expenses and basic research expenses that were eligible for deduction for federal purposes, but which were not deducted on account of the provisions of § 280C(c) of the Internal Revenue Code (IRC). Similarly, Virginia Code § 58.1-402 C 6 allows corporate employers to subtract the amount of wages or salaries eligible for the federal Targeted Jobs Credit which was not deducted for federal purposes on account of the provisions of IRC § 280C(a).

On its 2016 Virginia income tax return, the Parent claimed subtractions under these code sections for amounts it claims it could not deduct on its federal return on account of IRC § 280C. The subtractions were disallowed in the audit. The audit report fails to explain the reason for these adjustments. Without an explanation for the adjustment, it cannot be upheld.

CONCLUSION

Based on this determination, the Parent was eligible to use the modified manufacturer’s apportionment method to compute its Virginia apportionment factor for the taxable years at issue. Further, the adjustments to the Parent’s sales factor will be reversed. Finally, the Department’s adjustment to the subtractions for the amount of qualified or basic research expenses eligible for deduction for federal purposes and for the amount of wages or salaries eligible for the federal Targeted Jobs Credit, but which were not deducted on account of the provisions of IRC § 280C, is reversed.

This determination will result in an abatement of most of the amount of the assessments. A portion, however, was not in dispute. The Department will adjust the assessments in accordance with this determination and the attached schedule. The Taxpayer will receive an updated bill that will include accrued interest to date. The Taxpayer should remit the balance due within 30 days of the bill date to avoid the accrual of additional interest and possible collection actions.

The Code of Virginia sections, regulations and public document 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 (804) ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/3250.B

Related Documents

13-6