Could a corporation allocate stock-sale gains outside Virginia apportionable income because the investee was not part of a unitary business?

Subject

No clear and cogent evidence that an alternative method of allocation and apportionment is appropriate

Plain-English summary

Virginia denied the refund and kept the stock-sale gains in apportionable income. The taxpayer owned no more than 27% of Corporation A, shared no facilities, staff, management, benefit plans, or centralized functions with it, and had only limited board overlap. Virginia agreed the companies were not a unitary business.

That did not end the analysis. Income can still be apportionable when an investment serves an operational function. The taxpayer granted Corporation A an exclusive technology license in exchange for restricted stock rather than cash royalties and provided technical assistance, training, start-up, testing, fabrication, modeling, quality-control, and reliability support.

Corporation A used investment proceeds to build a plant and its revenue grew sharply. Virginia found the taxpayer's active support contributed to the stock's value. The taxpayer also had substantial long-term debt and provided no facts showing sale proceeds were unnecessary or unrelated to debt service or operating needs.

The taxpayer therefore did not provide clear and cogent evidence that the gain came from a discrete passive investment unconnected with Virginia. Alternative allocation was denied.

What this means for you

• Lack of a unitary relationship does not automatically make investment gain nonapportionable.
• Licensing, technical support, strategic influence, and use of proceeds can establish an operational function.
• Alternative apportionment requires detailed evidence, not only proof of separate management.
• Document why an investment was acquired, supported, held, and sold, and how proceeds were used.

Common questions

Did Virginia find the two corporations unitary?

No. It denied relief because the investment still served an operational function.

Why did the stock compensation matter?

The exclusive technology license produced no cash fee or royalty; restricted stock was the compensation, tying the investment's value to the supported business activity.

Citations and references

• Va. Code §§ 58.1-402, 58.1-403, 58.1-407, and 58.1-421.
• Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768 (1992).
• Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425 (1980).
• F.W. Woolworth Co. v. Taxation and Revenue Department of New Mexico, 458 U.S. 352 (1982).

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 11-52

Original ruling text

April 5, 2011

Re: § 58.1-1821 Application: Corporate Income Tax

Dear *:

This will reply to your letter in which you seek a refund of corporate income tax paid by * (the "Taxpayer") for the taxable years ended December 31, 1999 through 2001 and November 30, 2002. I apologize for the delay in the Department's response.

FACTS

The Taxpayer acquired stock in * (Corporation A) through four separate transactions made in 1996 through 1998. In connection with one of the transactions, the Taxpayer granted Corporation A an exclusive license to use technology to produce a product developed by the Taxpayer. Corporation A used the monetary proceeds from the other transactions to build a plant to manufacture the product. During the taxable years at issue, the Taxpayer sold its stock in Corporation A, recognizing a capital gain. The Taxpayer subtracted this gain on its Virginia corporate income tax returns as nonbusiness income.

Pursuant to an audit, the Department disallowed the subtraction of the capital gain and assessed additional tax and interest. The Taxpayer contends it did not have a unitary relationship with Corporation A, and its ownership in Corporation A stock was not operational in nature. The Taxpayer requests a refund of Virginia income tax paid for the taxable years ended December 31, 1999 through 2001, and November 30, 2002.

DETERMINATION

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 protest has been treated as a request for an alternative method of allocation and apportionment in accordance with Va. Code § 58.1-421.

In any proceeding with the Department, the Taxpayer bears the burden of showing that the imposition of Virginia's statute is in violation of the standards enunciated by the United States Supreme Court in Allied-Signal, Inc. v. Director, Division of Taxation , 504 U.S. 768 (1992). In this matter, the Taxpayer must demonstrate that its investments are not operational assets involved in a unitary business. In considering the existence of a unitary relationship, the 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. 352 (1982); and Allied-Signal .)

The decision of the United States Supreme Court in Allied-Signal also 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 test is fact sensitive.

The Taxpayer and Corporation A had no common or centralized sales, marketing, or advertising functions and did not conduct common research programs or maintain common research facilities. The two entities shared no common office or plant facilities. The Taxpayer and Corporation A maintained their own finance, accounting, tax and legal functions.

The Taxpayer and Corporation A did not have common or centralized management. None of the officers or directors of Corporation A was an officer, director or employee of the Taxpayer or subsidiaries. During 1999 and 2000, the Taxpayer had one individual who was an officer of one of its subsidiaries serving on Corporation A's board of directors.

There were no common employees or transfers of employees between the Taxpayer and Corporation A. They did not maintain common pension or employee benefit plans. The Taxpayer and Corporation A did not have any common insurance or self-insurance plans or worker's compensation plans. At no time did the Taxpayer ever own more than 27% of Corporation A.

Based on the information provided, it is clear that no unitary relationship existed between the Taxpayer and Corporation A. As such, the issue to be addressed in this case centers upon whether the Taxpayer's investment in Corporation A fulfilled an operational function rather than a passive investment function.

The Taxpayer avers that its sale of stock in Corporation A did not fulfill an operational function because the Taxpayer's facts differ from those in the examples presented by the Court in Allied-Signal . The application of the decision in Allied-Signal , however, is not limited to the fact patterns of that case.

The Taxpayer also asserts it did not control or manage Corporation A, and Corporation A was not functionally connected to the Taxpayer's other businesses. Further, the Taxpayer contends that it did not use the proceeds from the stock sales for operating purposes, and the technology license with Corporation A was not performed for operating purposes.

While not functionally integrated, the Taxpayer did agree to provide Corporation A with technical assistance, training and instruction in order to enable Corporation A to design, construct, start-up, test and operate a manufacturing facility for the Taxpayer's product. As a result of the Taxpayer's investments, Corporation A was able to build a plant to manufacture and sell the product, and its gross revenues increased by more than 1,600 percent from the 1996 through 1999. The technology license agreement required the Taxpayer to provide technical assistance at Corporation A's manufacturing facility. The agreement also allowed Corporation A employees to observe procedures in the Taxpayers' fabrication line and afforded Corporation A support for the its fabrication process, device modeling, quality control and reliability testing. Based on the agreement and information provided, it appears the Taxpayer was able to significantly influence Corporation A's operations.

In addition, the only compensation received by the Taxpayer for the exclusive technology license was shares of Corporation A restricted common stock. According to the license agreement, Corporation A paid no license fee or royalty to the Taxpayer for the use of the technology. Thus, it would appear that the potential increase in the value of Corporation A's stock was one of the Taxpayer's primary purposes for entering into the licensing agreement. Further, the Taxpayer's extensive technical assistance provided to Corporation A contributed to the rapid increase in the value of Corporation A's stock. Such an active role in supporting Corporation A's operations would appear to be contrary to a passive investment function.

Further, the Taxpayer has significant amounts of long-term debt, and has presented no factual data indicating that its proceeds from the stock sales were not necessary for, or related to, the operational retirement of scheduled debt service or operating expenses. The presence of long-term debt implies a need to refinance, extend, or renew such financing and is indicative of the need to use the proceeds to reduce long-term debt. As such, it would appear likely that the Taxpayer used the proceeds from the sales of the stock in its operations.

In this case, the Taxpayer must prove by clear and cogent evidence that Virginia's statutory method of allocation and apportionment would result in a tax on income derived from a discrete investment function having no connection with Virginia in violation of the principles set forth in Allied-Signal . The Taxpayer has not demonstrated by clear and cogent evidence that an alternative method of allocation and apportionment is appropriate. Accordingly, permission is not granted to allocate the capital gain on the sale of Corporation A's stock out of Virginia apportionable income for the 1999 through 2001 taxable years. As such, the Taxpayer's request for a refund of tax paid for the taxable years ended December 31, 1999 through 2001 and November 30, 2002 is denied. A bill will be issued for interest that had accrued during the time period between the date of assessment and payment of tax.

The Code of Virginia sections cited, along with other reference documents, 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 about this determination, you may contact * in the Department's Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1-3110136235.B