Did a corporation substantiate Virginia's foreign-source-income subtraction for overseas software licensing and related technical services?

Subject

A portion of the foreign source income subtraction claimed by the Taxpayer was disallowed.

Plain-English summary

A corporation claimed Virginia's foreign-source-income subtraction for overseas software licensing and technical services and disputed the expenses allocated against that income.

Virginia explained that ordinary services performed abroad did not qualify merely because they were technical. Technical fees had to be incidental to a contract involving foreign real-property rental or licensing of a patent or similar property. Software implementation services could qualify when sufficiently tied to an intangible-property license.

The Department repeatedly requested the corporation's foreign technology and trademark license contracts, but they were not supplied despite extensions. Without those documents, Virginia could not determine which service fees were incidental to qualifying licenses.

Related expenses were allocated using the federal sourcing principles of IRC §§ 861 through 863, with Form 1118 as an appropriate starting point. Virginia found computational errors that would reduce the subtraction, but declined to increase the assessment because the effect was insignificant. The existing assessment was upheld.

Citations and references

• Va. Code § 58.1-302.
• IRC §§ 861 through 863, as applied by the ruling.
• P.D. 86-209, P.D. 91-57, P.D. 06-19, and P.D. 86-154.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 16-174

Original ruling text

September 2, 2016

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 October 31, 2009. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayer was audited by the Department for the taxable year at issue and several adjustments were made, resulting in the assessment of additional Virginia corporate income tax. One of the adjustments made by the auditor was to disallow the portion of the foreign source income (FSI) subtraction claimed by the Taxpayer from the performance of services because it did not provide substantiating documentation.

The Taxpayer appeals the assessment and requests a refund for additional taxes overpaid. The Taxpayer contends the FSI resulted primarily from licensing software to its overseas customers and any technical services incidental to the licensing. In addition, the Taxpayer asserts that the auditor incorrectly reduced certain items of foreign source income by expenses not related to those items of income.

DETERMINATION

FSI - Technical Fees

Virginia Code § 58.1-302 defines foreign source income, in pertinent part, as:

Rents, royalties, license, and technical fees from property located or services performed without the United States or from any interest in such property, including rents, royalties, or fees for the use of or the privilege of using without the United States any patents, copy rights, secret processes and formulas, good will, trademarks, trade brands, franchises, and other like properties.

Pursuant to the Department's long-standing policy, the words “technical fees from property located or services performed” cannot be taken out of their context to create a subtraction for income earned from the performance of services outside the United States for any service that can be characterized as of a technical nature. See Public Document (P.D.) 86-209 (11/3/1986). In order to qualify for the Virginia FSI subtraction, “technical fees” must be incidental to a contract relating to the rental of real property or the licensing of a patent or other like property outside the United States. See P. D. 91-57 (3/29/1991).

In P.D. 06-19 (2/7/2006), the Department held that the consideration paid by a taxpayer for the necessary services to implement custom or application software were “technical fees” incidental to the licensing of intangible property that are subject to the FSI subtraction. The Taxpayer states that it provides design, implementation and support of information technology services on behalf of its overseas customers. As part of these services, it provides its customers with both canned and customized software. The Taxpayer contends that the development, integration, training, and other services provided to its customers were analogous to those performed in P.D. 06-19 because they were included in the contract licensing the software.

FSI - Related Expenses

It has been the Department's long-standing policy that the computation of the Virginia foreign source income subtraction (considering expenses related to the income) be determined in accordance with Internal Revenue Code (IRC) §§ 861 through 863. See P.D. 86-154 (8/14/1986). Virginia law requires the use of the federal sourcing rules of IRC § 861 et seq. , whether or not the taxpayer believes that certain expenses have any connection to income from foreign sources and regardless of what expenses would be under generally accepted accounting principles.

The provisions of IRC § 861 et seq. , contain detailed rules for assigning income and deductions to particular sources. The provisions differentiate between deductions that are definitely allocable and deductions that are not definitely allocable. First, definitely allocable deductions that are directly related to a class of income are allocated and then apportioned between foreign and domestic source income. If a deduction is not definitely related to any gross income, the deduction must be apportioned ratably between each class of foreign and domestic source income.

The purpose of Form 1118 is to compute the limitation on the amount of foreign taxes that can be claimed as a credit against federal tax liability. When the procedures of IRC § 861 et seq. , are used to complete Form 1118, the information reported on this form is considered useful and presumed correct and accurate. Such information is an appropriate starting point for computing the foreign source income subtraction allowed on the Taxpayer's Virginia return.

According to the Taxpayer, the auditor included all definitely allocable deductions when considering expenses related to FSI. A review of the Forms 1118 shows most of definitely allocable deductions were attributable to the performance of services, which did not qualify for the subtraction.

CONCLUSION

The Department requested copies of contracts pertaining to technology and trademark licenses outside of the United States in order to fully consider the facts in this case. The Taxpayer has requested several extensions to provide the requested documentation. As of the date of this letter, the Taxpayer has not provided the requested documents. As such, sufficient evidence to substantiate the claim in the Taxpayer's appeal has not been provided.

Because the Taxpayer has failed to furnish the information requested, the Department is unable to address the Taxpayer's issues regarding the technical fees included in FSI. While definitely allocable expenses attributable to income from the performance or services were reported on the auditor's spreadsheet for the FSI computation, it does not appear they were used to offset eligible FSI. However, a review of the FSI adjustment did show computational errors. A worksheet is enclosed showing the revised computation, which reduces the subtraction. Because the adjustment to the FSI subtraction would have an insignificant effect on the Taxpayer's liability, no adjustment to increase the assessment will be made at this time. Accordingly, the assessment is upheld and collection action will resume.

The Code of Virginia sections and public documents cited are available on-line at www.tax.virginia.gov in the Laws, Rules and Decisions 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/1-5517727556.B