How did Virginia treat gain and net operating losses after a corporate group made an IRC § 338(h)(10) election for a subsidiary sale?

Subject

Deemed asset-sale gain was apportionable in the Virginia combined return

Plain-English summary

Virginia followed the federal IRC § 338(h)(10) election and treated the subsidiary as selling its own assets. The transaction was not treated for Virginia purposes as a simple stock gain that the parent could subtract as nonbusiness income.

Because Corporation A was deemed to sell assets used in its own operations, the gain entered Corporation A's separately computed Virginia taxable income within the combined return. Virginia found the gain apportionable and denied the request to allocate it to the parent's state of commercial domicile or use an alternative method.

The Department separately reviewed net operating losses. It corrected the group's 1998-2006 NOL deductions to account for Virginia combined-return modifications and federal Revenue Agent's Report changes, and adjusted the assessment accordingly.

What this means for you

• Virginia generally follows the federal substance of an actual § 338(h)(10) election.
• The target's deemed asset gain is recognized by the target for Virginia purposes.
• Gain from operating assets can remain apportionable even when the legal transaction involved stock.
• Combined-return NOLs require member-level calculations and Virginia modifications.
• Alternative apportionment is fact-sensitive and is not granted merely because a taxpayer prefers allocation elsewhere.

Common questions

Did Virginia treat the transaction as a stock sale?

No. It recognized the federal deemed asset sale.

Could the gain be allocated to the parent's commercial domicile?

No. Virginia kept it in Corporation A's apportionable income.

Was the assessment unchanged?

No. The gain treatment remained, but the Department adjusted NOLs and federal audit changes.

Citations and references

• Va. Code §§ 58.1-301, 58.1-402, 58.1-403, 58.1-407, and 58.1-421.
• IRC §§ 338(h)(10), 332, and 172.
• 23 VAC 10-120-325(D).
• P.D. 05-157 and P.D. 91-317.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 08-188

Original ruling text

October 17, 2008

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 year ended January 2, 2004.

FACTS

The Taxpayer is a multinational corporation that is domiciled outside of Virginia and has numerous subsidiaries. The group files a consolidated corporate income tax return for federal purposes. A Virginia affiliated group that includes the Taxpayer files a combined return for Virginia income tax purposes.

* ("Corporation A") is domiciled outside Virginia but operates in Virginia. Corporation A is solely owned by the Taxpayer. In March 2003, Corporation A's stock was sold to an unrelated third party. The Taxpayer, in concert with the unrelated third party, elected to treat the transaction as an asset sale under Internal Revenue Code (IRC) § 338(h)(10). The gain from this sale was subtracted as nonbusiness income on the Virginia combined income tax return.

The Taxpayer was audited and numerous adjustments were made. One adjustment was to disallow the subtraction of nonbusiness income reported on the combined return. The Taxpayer contests this adjustment because the transaction was a sale of stock. The proceeds were primarily used to retire the debt of Corporation A, and were not used in the Taxpayer's operations. In the alternative, the Taxpayer requests that an alternative method of allocation and apportionment be granted.

In connection with its appeal, the Taxpayer provided information that net operation loss deductions (NOLDs) were not carried forward to the taxable years at issue by the auditor. In addition, the Taxpayer submitted amended returns reflecting Revenue Agent's Report (RAR) adjustments.

DETERMINATION

IRC § 338(h)(10) Election

The Department has previously addressed this issue in Public Document (P.D.) 05-157 (10/06/05). Virginia's conformity to federal law is set forth in Va. Code § 58.1­301. This section states that, except as otherwise provided, the terms used in the Virginia income tax statutes will have the same meanings as used in the IRC. Therefore, federal taxable income (FTI) for corporations is identical to that as defined by the IRC. As such, Virginia's treatment of the IRC § 338(h)(10) election will mirror federal treatment as closely as possible, while ensuring that any Virginia tax accurately reflects the business activity in Virginia.

An election under IRC § 338 allows a purchaser of stock in a target corporation to obtain a stepped up basis in the target's assets as if there had been a direct purchase of the assets. In order to avoid potential double taxation, IRC § 338(h)(10) allows the purchaser and seller to make a joint election, provided that the target and seller are part of an affiliated group of corporations that file a consolidated federal return. The result of the election is that a series of fictitious steps are deemed to have occurred:

The target is deemed to have sold its assets, recognizing gain or loss that must be included in the selling group's consolidated federal return;

The target is deemed to have distributed all its assets in a complete liquidation to which IRC § 332 applies; and

Any gain or loss on the sale of target stock incurred by the selling group is ignored.

In all cases, if the seller, target, purchaser or any combination thereof are Virginia taxpayers, the IRC § 338(h)(10) election actually made on a federal return will be recognized exactly as it is for federal purposes. See P.D. 91-317 (12/30/91). To the extent that any gain or loss is deemed to be recognized for federal purposes by any party, it will be similarly recognized by the applicable entity for Virginia purposes. Because Virginia follows the federal treatment of the IRC § 338(h)(10) election, Corporation A is deemed to have sold its assets, and must recognize the gain.

Allocation and Apportionment

The Taxpayer contends that even if the gain is recognized on the Virginia combined return, it is not apportionable to Virginia and must be allocated to the Taxpayer's state of commercial domicile. The Taxpayer asserts that it is entitled to "fair apportionment".

The Code of Virginia does; not provide for the allocation of income other than certain dividends. Accordingly, a taxpayer's entire federal taxable income, adjusted and modified as provided in Va. Code §§ 58.1-402 and 58.1-403, less dividends allocable pursuant to Va. Code § 58.1-407, is subject to apportionment. The Taxpayer's subtraction of the capital gain has been treated as a request for an alternative method of allocation and apportionment in accordance with Va. Code § 58.1-421. The Department will not allow the allocation of capital gains or losses resulting from the sale of affiliated companies by a taxpayer if a unitary relationship exists between the affiliated companies and the taxpayer, or if the taxpayer's ownership of the affiliates fulfills an operational, as opposed to a passive, function.

In considering the existence of a unitary relationship, the United States Supreme Court has focused on three objective factors: (1) functional integration; (2) centralization of management; and (3) economies of scale. See Mobil Oil Corp. v. Commissioner of Taxes , 445 U.S. 425 (1980); F. W. Woolworth Co. v. Taxation and Revenue Dept. of N.M. , 458 U.S. 354 (1982); and Allied-Signal, Inc. v. Director, Div. of Taxation , 504 U.S. 768 (1992).

Further, the decision of the United States Supreme Court in Allied-Signal made it clear that the payee and payor need not be engaged in the same unitary business as a prerequisite to apportionment in all cases. In the absence of a unitary relationship, apportionment is permitted when the investment serves an operational rather than a passive investment function. The Court also made it clear that the tests are fact sensitive.

The question as to the relationship and function of the investment in Corporation A to other members of the Taxpayer's affiliated group is irrelevant to this case. Corporation A is deemed to have sold its own assets and the gain is recognized in Corporation A's separately computed Virginia taxable income included in a Virginia combined return. Clearly, Corporation A had a unitary relationship with its operating assets (both tangible and intangible). Accordingly, the gain is properly included in the apportionable income of Corporation A.

Because Corporation A is deemed to have sold its assets, the gain is within Virginia's jurisdiction to tax. Virginia's apportionment method fairly estimates the portion of the gain included in Corporation A's income subject to tax. As such, Virginia's treatment of the gain from the sale of Corporation A is fairly proportioned.

Net Operating Losses

In general, Virginia income tax laws do not address NOLDs. Nonetheless, Va. Code § 58.1-301 provides, with certain exceptions, that terminology and references used in Title 58.1 of the Code of Virginia have the same meaning as provided in the IRC, unless a different meaning is clearly required. Because the starting point in computing Virginia taxable income is federal taxable income, Virginia allows a NOLD to the extent that it is allowable in computing federal taxable income. For the taxable years at issue, I.R.C. § 172 specifies that a NOLD can be carried to the two taxable years prior to and the 20 taxable years subsequent to the taxable year in which the net operating loss (NOL) is incurred.

Under Virginia combined return accounting, each member's taxable income is computed as if it were filing a separate return. As such, if a member of a combined group incurs an NOL on a separate return basis for a taxable year, no NOLD carried from another taxable year is allowed.

Title 23 of the Virginia Administrative Code (VAC) 10-120-325 D provides the methodology that a Taxpayer must use to calculate the NOLD carrybacks and carryforwards for purposes of a Virginia combined return. Under these rules, a Virginia NOLD modification must be determined for the taxable year an NOL occurred. This Virginia NOLD modification must be carried back and forward in the same manner as the NOLD. In a combined return in which multiple members are carrying back and forward NOLDs, one member's Virginia NOLD modification for a particular taxable year may be affected by carrybacks and carryovers of other members.

In this case, the Taxpayer's schedules computed its NOL carrybacks and carryforwards without regard to the Virginia NOLD modifications. Based on the information available, the Department has adjusted the Taxpayer's NOLDs for the 1998 through 2006 taxable years, accounting for Virginia NOLD modifications and RAR adjustments.

CONCLUSION

The Taxpayer's assessments will be adjusted to reflect the corrected NOLDs and the RAR changes in accordance with the enclosed schedules. The Taxpayer should remit its payment to: Virginia Department of Taxation, 3600 West Broad Street, Suite 160, Richmond, Virginia 23230, Attn: *. If you have questions concerning payment of the assessment, you may contact at **.

The Code of Virginia sections, regulation and public documents cited are available on-line at www.tax.virginia.gov in the Tax Policy Library 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,

Janie E. Bowen

Tax Commissioner

AR/1-1048631891.B