Could an investor exclude a Virginia hotel's factors and use separate accounting through an advance ruling request?

Subject

Request is not in accordance with procedure for requesting a change in method

Plain-English summary

An out-of-state company invested through multiple LLC tiers in a Virginia hotel. It asked in advance to omit the hotel's apportionment factors and separately account for the hotel, arguing that the hotel was a passive investment managed by an unrelated company.

Virginia denied the request. Federal tax attributes and the hotel's business activity flowed through the LLC tiers, so the investor had to include the hotel's income or loss and its property, payroll, and sales factors. An alternative method requires an extraordinary showing and the procedure in 23 VAC 10-120-280: file using the statutory method, pay the tax, and timely claim a refund on an amended return with evidence. The advance request supplied neither that procedural record nor clear and cogent proof of unconstitutional distortion or Virginia-caused double taxation.

What this means for you

• Virginia generally disfavors separate accounting as a substitute for its statutory apportionment formula.
• A different result under separate accounting does not itself prove the statutory formula is inequitable.
• Build the claim through a completed return and amended refund request so the Department can examine the underlying records and sources of profit.

Common questions

Did outside management make the hotel merely a passive investment?

No. The ruling said the operating hotel's characteristics flowed through the pass-through entities to the investor for Virginia tax purposes.

Can a taxpayer obtain advance approval of an alternative apportionment method?

The Department called that impractical here because distortion and profit sources could not be tested before the taxable period closed and the records were complete. It directed taxpayers to the return-and-refund procedure.

Citations and references

• Va. Code § 58.1-421 and 23 VAC 10-120-280, alternative apportionment standards and procedure.
• Va. Code § 58.1-391(B), character of pass-through entity items.
• P.D. 97-343, cited for treating an owner as holding a share of pass-through entity assets and liabilities.
• Department of Taxation v. Lucky Stores, Inc., cited for Virginia's disfavor of separate accounting.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 07-118

Original ruling text

July 19, 2007

Re: Request for Ruling: Corporate Income Tax

Dear *:

This will reply to your letter in which you request an alternative method of allocation and apportionment on behalf of your client, * (the "Taxpayer").

FACTS

The Taxpayer is a limited liability company commercially domiciled in * (State A). The Taxpayer's primary business is investing in various types of commercial and residential real estate through a multi-tiered series of limited liability companies. One such investment includes *** (Company B), which owns a hotel located in Virginia.

The hotel is administered and controlled by the unrelated property management company that is a minority shareholder of Company B. The management company is responsible for all day-to-day operations of the hotel. It is responsible for all staffing decisions, market research, pricing policies, maintenance and repair. Company B maintains detailed books of account that record the income and expenses related to the hotel.

The Taxpayer contends that it should not be required to include the hotel's apportionment factors in its Virginia corporate income tax calculation. The Taxpayer asserts that the use of separate accounting would more accurately reflect the income subject to Virginia tax. The Taxpayer requests permission to use an alternative method of allocation and apportionment.P. D.

RULING

The United States Supreme Court has recognized that allocation and apportionment of income is an arbitrary process designed to approximate income from business transactions within a state. As long as each state's method of allocation and apportionment is rationally related to the business transacted within a state, then each state's tax is constitutionally valid even though there may be some overlap. See Moorman Mfg. Co. v. Bair , 437 U.S. 279 (1978). Thus, the Taxpayer must show that the statutory method of apportionment produces an unconstitutional result.

An apportionment formula used as an approximation of a corporation's income reasonably related to the activities conducted within a taxing state will only be disturbed when the taxpayer has proved by "clear and cogent evidence" that the income attributed to the state is in fact "out of all reasonable proportion to the business transacted . . . in that state," Hans Rees' Sons, Inc. v. North Carolina , 283 U.S. 123, 135 (1931), or has "led to a grossly distorted result," Norfolk & Western R. Co. v. Missouri State Tax Commission , 390 U.S. 317, 326 (1968).

The policies that apply to requests for an alternative method of allocation and apportionment under Va. Code § 58.1-421 are well established. In order for a taxpayer to request an alternative method of allocation and apportionment, the taxpayer must file the return using the statutory method and pay any tax due. Next, the taxpayer is required to file an amended return proposing an alternative method within the time prescribed for filing amended returns claiming refunds. The amended return must include a statement of why the statutory method is inapplicable or inequitable and an explanation of the proposed method of allocation and apportionment. The Department will not grant an alternative method of allocation and apportionment unless it determines that: (1) the statutory method produces an unconstitutional result under the particular facts and circumstances of the taxpayer's situation; or (2) the statutory method is inequitable because it results in double taxation and the inequity is attributable to Virginia, rather than another state's method of apportionment. See Title 23 of the Virginia Administrative Code (VAC) 10-120-280.

In the context of a ruling request, when a taxpayer does not provide the Department with the opportunity to examine the records underlying the claim, the taxpayer cannot demonstrate that Virginia's factor formula produces an unreasonable or distorted result. Further, even assuming the existence of double taxation, a corporation's argument that Virginia's statutory method (rather than another state's method) causes an unconstitutional result will not be accepted without documentation revealing the sources of the corporation's profits. This cannot be done until after a corporation has fully accounted for and prepared its financial statements after the close of a taxable period. Consequently, it is impractical for the Department to issue an advanced ruling with regard to allocation and apportionment. The procedures set forth under Title 23 VAC 10-120-280 were designed for this purpose.

The Taxpayer avers that under Container Corp. v. Franchise Tax Board , 463 U.S. 169 (1983), there must be a sharing of value or exchange of value beyond the mere flow of funds arising out of a passive investment in order for formula apportionment to be a reasonable method of taxation. The Taxpayer also contends that Allied-Signal, Inc. v. Director, Division of Taxation , 504 U.S. 768 (1992) prohibits the apportionment of any investment income that is unrelated to any operational activities carried on in the state. The Taxpayer contends that apportionment is not applicable in the instant case because the hotel is a passive investment and is not part of a single unitary business in Virginia.

Virginia Code § 58.1-391 B provides:

Each item of pass-through entity income, gain, loss or deduction shall have the same character for an owner under this chapter as for federal income tax purposes. Where an item is not characterized for federal income tax purposes, it shall have the same character for an owner as if realized directly from the source from which realized by the pass-through entity or incurred in the same manner by the pass-through entity.

For federal income tax purposes, attributes and activities of the hotel will flow through the multi-tiers of limited liability companies to the Taxpayer. Further, the Department considers a taxpayer to be the owner of a share of the pass-through entity's assets and liabilities. See Public Document (P.D.) 97-343 (8/28/1997). In this case, the characteristics of Company B as the operator of a hotel business will flow through to the Taxpayer. Therefore, the Taxpayer will include income or loss of the hotel in determining Virginia taxable income and the appropriate amount of the hotel's property, payroll and sales in determining income apportioned to Virginia.

The Taxpayer also contends that separate accounting of the hotel most accurately allocates income tax liabilities to each state. The Taxpayer supports this argument by stating that the hotel is its only investment in Virginia and there are separate books and records for the hotel's operation. The Taxpayer also avers that it reports its investment activity for all other states, but one, on a separate basis. The Taxpayer has cited administrative decisions from other states that allow for separate accounting in analogous situations. Finally, the Taxpayer has provided letters from two other states that allow it to use separate accounting in lieu of apportionment.

The Department's long-standing policy holds the use of separate accounting in disfavor. See Department of Taxation v. Lucky Stores, Inc ., 217 Va. 121, 225 S.E.2d 870 (1976). The fact that separate accounting produces a different result from the three-factor formula is not sufficient to show the statutory apportionment method is inequitable.

CONCLUSION

The use of an alternative method is allowed only in extraordinary circumstances where the need for relief has been demonstrated by clear and cogent evidence. Based on the facts presented, you have not demonstrated that the statutory method is unconstitutional or inapplicable as it would apply to the Taxpayer. Furthermore, the Taxpayer's request is not in accordance with the procedure for requesting an alternative method of allocation and apportionment outlined in Title 23 VAC 10-120-280. Based on the foregoing, I must deny the Taxpayer's request to use an alternative method of allocating and apportioning income.

The Code of Virginia section, regulations and public documents cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's website. If you have any questions regarding this ruling, please contact * in the Department's Office of Policy and Administration, Appeals and Rulings, at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner

AR/1-893640297B