Did Virginia properly add back interest paid to an affiliate and reorder a corporation's net-operating-loss deductions?

Subject

Add back of interest expense from the intercompany loan/ Net operating loss

Plain-English summary

The corporation won the interest issue but not its challenge to Virginia's NOL carryback and ordering rules. Virginia's cited related-party addback applied to interest connected with intangible-property transactions. Because the lending affiliate held no intangible property, the taxpayer did not have to add back that interest expense.

For net operating losses, Virginia followed the federal two-year carryback and 20-year carryforward rules then in effect. A corporation filing federal consolidated returns but separate Virginia returns could elect to forgo a Virginia carryback, but only by attaching the prescribed election statement to the loss-year Virginia return. Simply carrying the loss forward did not create a de facto election.

The taxpayer made no election on its 2000 return, so Virginia properly carried that loss back first. Losses had to be applied to the earliest available years, which exhausted the 2000 and 2001 losses before 2004. A portion of the 2003 loss could offset 2004 income, and the unused remainder plus Virginia modifications could continue forward for 19 more years or until used.

The audit was returned for adjustments, including removal of the interest addback and the NOL treatment described in the ruling.

What this means for you

• Confirm that a related-party interest addback fits the statute's intangible-property connection.
• Make any Virginia NOL carryback election explicitly on the loss-year return.
• Track loss utilization from the earliest permitted year forward.
• Different federal and Virginia filing groups can create special state-election opportunities, but formalities matter.

Common questions

Was carrying the loss forward enough to elect out of carryback?

No. Virginia required an attached election statement on the loss-year return.

What happened to the remaining 2003 loss?

The unused portion and remaining Virginia modifications could be carried forward for 19 taxable years or until fully utilized.

Citations and references

• Va. Code § 58.1-402 B(9)(a)(2).
• Va. Code § 58.1-301; IRC § 172.
• 23 VAC 10-120-325 B(2).
• P.D. 05-47, P.D. 93-83, and P.D. 88-106.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 11-57

Original ruling text

April 12, 2011

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 years ended February 28, 2004 (2003 taxable year) and February 26, 2005 (2004 taxable year). I apologize for the delay in the Department's response.

FACTS

The Taxpayer, commercially domiciled outside Virginia, files a consolidated corporate income tax return with its subsidiaries for federal income tax purposes. In Virginia, the Taxpayer and a number of affiliated entities file separate returns. The Taxpayer was audited for the 2003 and 2004 taxable years, resulting in numerous return adjustments and an assessment for the 2004 taxable year. The Taxpayer filed an appeal contesting: (1) the add back of interest expense from the intercompany loan with one of its affiliates for the 2004 taxable year, and (2) the auditor's adjustments to net operating loss deductions (NOLDs) carried forward into the audit period.

DETERMINATION

Interest Add back

Virginia Code § 58.1-402 B 9 a 2 requires a taxpayer to add back intercompany interest expenses and costs that are directly or indirectly related or connected to transactions involving intangible property. This generally occurs when intercompany license fees generated by a corporation holding an intangible asset are used to make loans to related corporations. In this case, the affiliate held no intangible property. As such, the Taxpayer was not required to add back interest expense paid to the related entity pursuant to Virginia Code § 58.1-402 B 9 a 2.

Net Operating Loss Carryback

The Taxpayer incurred NOLs for the taxable years ended March 3, 2001 (2000 taxable year), March 2, 2002 (2001 taxable year) and February 28, 2004. On its Virginia returns, the Taxpayer carried the resulting NOLDs forward without carrying them back as required under IRC § 172.

In general, Virginia income tax laws do not address the NOLD. 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 Internal Revenue Code (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 year at issue, IRC § 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 loss is incurred.

Title 23 of the Virginia Administrative Code (VAC) 10-120-325 B 2 provides:

A corporation or an affiliated group of corporations may elect to forgo carryback of a net operating loss or net capital loss for Virginia purposes independent of any such election for federal purposes if, and only if, the affiliated group files its Virginia and federal returns on a different basis, or files a federal consolidated return including corporations which are not subject to Virginia income tax. The election for Virginia purposes shall be made by filing a statement with the Virginia return for the loss year in the same manner as prescribed by federal law and regulations.

The Taxpayer contends that because the Department has never issued any guidance on how to elect to forego the carryback, the Taxpayer's carry forward of an NOLD resulting from a net operating loss (NOL) incurred for the taxable year ended 2000 taxable year constituted a de facto election to forgo the carryback of the NOL.

Contrary to the Taxpayer's contention, the Department has issued guidance as to the proper way to elect to forgo the NOL carryback. See Public Document (P.D.) 05-47 (4/6/2005), P.D. 93-83 (3/26/1993) and P.D. 88-106 (5/12/1988). In these rulings, the Department clearly established its policy that a statement of election to forgo the carryback of a NOL must be attached to Virginia return for the taxable year in which the NOL occurred. The Taxpayer did not indicate anywhere on its 2000 Virginia tax return that it intended to elect to forgo the carryback of the NOL incurred in the taxable year ended March 3, 2001. As such, the Department properly carried back the NOLD to the two preceding taxable years.

Net Operating Loss Carryforward

Because the Taxpayer carried the NOLDs forward, the NOL for the 2003 taxable year was not used as an NOLD for the 2004 taxable year. The Taxpayer contends that the auditor erroneously used the NOLD carry forward from the 2003 taxable year before the 2000 and 2001 taxable year NOLDs had been completely utilized.

Under IRC § 172(b)(2), an NOL for any taxable year must be carried to the earliest taxable year to which such NOL may be carried. Thus, when the auditor properly carried back the 2000 taxable year NOLD to the two preceding taxable years, it reduced the amount of NOLD that was eligible to be carried forward to the taxable year ended March 3, 2003 (2002 taxable year). The auditor, therefore, used the NOLD carried forward from the 2001 taxable year to offset federal taxable income for the 2002 taxable year. As a result, there was no NOLD from the 2000 and 2001 taxable years to carry forward to the 2004 taxable year.

Because the NOLDs for the 2000 and 2001 taxable years were fully utilized in previous taxable years as provided under IRC § 172, a portion of the NOL from the 2003 taxable year was carried forward to offset the federal taxable income in the 2004 taxable year. Because the full amount of the 2003 NOLD was not used in the 2004 taxable year, the Taxpayer may carryforward the remaining NOLD for the 2003 taxable year, along with the remaining net Virginia modifications, for 19 taxable years or until fully utilized.

CONCLUSION

Based on this determination, the audit will be returned to the audit staff to adjust the assessment as noted above. After the auditor makes the appropriate adjustments, the Taxpayer will receive a revised bill. The Taxpayer should remit its payment for the outstanding balance as shown on the revised bill within 30 days from the date of the bill to avoid the accrual of additional interest.

The Code of Virginia section, 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 Department's Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1-2106304753.B