Could a corporate partner include overseas intellectual-property royalties in its Virginia sales-factor denominator while treating them as foreign-source income?

Subject

Foreign Source Income; Sales Factor

Plain-English summary

Virginia upheld removing overseas intellectual-property royalties from the corporation's sales-factor denominator because the royalties qualified for the foreign-source-income subtraction. The corporation received them through a joint venture taxed as a partnership, but partnership income keeps the same character in the partner's hands. The receipts therefore remained royalties.

Royalty receipts ordinarily enter the sales factor. Here, however, foreign entities used the intellectual property overseas, making the royalties foreign-source income under the Virginia definition. Virginia's regulation excludes the property, payroll, and sales used to produce income qualifying for that subtraction from the apportionment-factor denominators.

To claim the subtraction and seek an adjustment, the corporation had to file an amended return within 60 days. The subtraction had to account for related expenses under the federal sourcing rules in IRC §§ 861-863. Virginia would then adjust the assessment and issue any warranted refund; without the return, the assessment would stand and collection would begin.

What this means for you

• Trace each partnership or joint-venture receipt to its original character.
• Confirm where licensed intellectual property is used before classifying royalties as foreign-source income.
• Coordinate subtraction treatment with the required exclusion from apportionment-factor denominators.
• Compute related expenses using the cited federal sourcing rules and meet any amended-return deadline.

Common questions

Q: Did partnership distribution change the royalties into another type of income?

A: No. They retained their royalty character in the corporate partner's distributive share.

Q: Are royalties always excluded from the sales factor?

A: No. The ruling said royalties are generally included, but these were excluded because they qualified for the foreign-source-income subtraction.

Q: Was a refund automatic?

A: No. The corporation had to file the amended return, and Virginia would issue a refund only as warranted after processing it.

Citations and references

• Va. Code §§ 58.1-302, 58.1-391(B), and 58.1-402(C)(8).
• IRC §§ 702(b) and 861-863.
• 23 VAC 10-120-120(A), (B) and 23 VAC 10-120-150(B)(2)(b).
• P.D. 02-52, P.D. 03-65, and P.D. 86-154.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 16-51

Original ruling text

April 11, 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 June 30, 2012.

FACTS

The Taxpayer, an out-of-state corporation that participated in a joint venture (the "Joint Venture"), filed a Virginia corporate income tax return for the taxable year at issue. A portion of the Taxpayer's distributive share of income from the Joint Venture consisted of royalties paid for the use of intellectual property by certain foreign subsidiaries of another partner in the Joint Venture.

Under audit, the Department removed the royalties from the denominator of the Taxpayer's sales factor and issued an assessment. The Taxpayer appealed, contending that such income was properly included in the sales factor denominator because it was part of the Taxpayer's total sales everywhere during the taxable year at issue.

DETERMINATION

Income from a Joint Venture

The Joint Venture was a partnership for federal income tax purposes. Virginia generally conforms to the federal treatment of partnerships. A partnership, as such, is not subject to income tax. Any income tax arising from the income of the partnership is the liability of the partners. Internal Revenue Code (IRC) § 702(b) states, "The character of any item of income gain, loss, deduction, or credit included in a partner's distributive share . . . shall be determined as if such item were realized directly from the source from which realized by the partnership or incurred in the same manner as incurred by the partnership." Each item of partnership income, gain, loss or deduction has the same character for a partner for Virginia income tax purposes as for federal income tax purposes. See Va. Code § 58.1-391 B. In this case, a portion of the income received by the Taxpayer from the Joint Venture included royalties from foreign subsidiaries of another partner in the Joint Venture. Such income retained its character as royalties for purposes of calculating the Taxpayer's Virginia sales factor.

Sales Factor

In general, the sales factor is a fraction, the numerator of which is total sales in Virginia during the taxable year, and the denominator of which is total sales of the corporation everywhere during the taxable year. See Title 23 of the Virginia Administrative Code (VAC) 10-120-120 A. "Sales" is defined as all gross receipts of the corporation except dividends allocated under Va. Code § 58.1-407. See Va. Code § 58.1-302; Title 23 VAC 10-120-120 B. Generally, royalty income from the licensing of intellectual property is included in the sales factor. See Public Document (P.D.) 02-52 (4/16/2002).

The property, payroll and sales of a corporation that are used to produce income qualifying for the subtraction for foreign dividend gross up, subpart F income and foreign source income is not included in the denominator of the fractions. See Title 23 VAC 10­-120-150 B 2 b.

Foreign Source Income

Virginia Code § 58.1-402 C 8 permits a taxpayer to subtract foreign source income from federal taxable income (FTI) to the extent it is included in and not otherwise subtracted from FTI. Under Va. Code § 58.1-302, "foreign source income" is defined 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, copyrights, secret processes and formulas, good will, trademarks, trade brands, franchises or like properties.

In this case, the royalties were received for the use of intellectual property by foreign business entities operating overseas. As such, the royalties qualified for the foreign source income subtraction. See P.D. 03-65 (8/19/2003). Therefore, pursuant to Title 23 VAC 10-120-150 B 2 b, the royalties were properly excluded from the Virginia sales factor denominator.

CONCLUSION

Because it appears the royalties qualified for the foreign source income subtraction under Virginia Code § 58.1-402 C 8, they were properly excluded from the Taxpayer's sales factor. The computation of the Virginia foreign source income subtraction (considering expenses related to the income) is determined in accordance with 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.

If the Taxpayer chooses to claim the foreign source income subtraction, it must file an amended return within 60 days of the date of this letter. The Taxpayer should send the return to: Virginia Department of Taxation, Office of Tax Policy, Appeals and Rulings, P.O. Box 27203, Richmond, Virginia 23218-7203, Attention: *. The return will be processed, and the assessment will be adjusted and a refund issued, as warranted. If the return is not received within the time allotted, the assessment will be deemed to be correct and collection action will begin.

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

Craig M. Burns
Tax Commissioner

AR/1-6119056891.M