Did arbitration proceeds tied to a domestic subsidiary's stock sale qualify for Virginia's foreign-source-income subtraction?

Subject

Foreign source income: Sales Factor; Gain from Sale of Stock

Plain-English summary

A corporation sold a U.S. subsidiary but retained the right to proceeds from a foreign arbitration involving that subsidiary's telecommunications contract. When the arbitration settled, the corporation reported the proceeds federally as gain connected with the stock sale, then sought a Virginia foreign-source-income subtraction.

Virginia denied the subtraction. Although stock of a foreign corporation can qualify as intangible property outside the United States, the subsidiary here was an American corporation headquartered in another state. The proceeds also were not "technical fees": Virginia followed their federal treatment as stock-sale gain, and qualifying technical fees must be incidental to specified foreign property rental or licensing arrangements.

The apportionment result favored the taxpayer in part. Foreign-source income that is subtracted is excluded from the apportionment factors. Because this gain was not subtracted, the net settlement gain had to be included in the denominator of the sales factor. The case was returned to the auditor for that adjustment.

Citations and references

• Va. Code §§ 58.1-301, 58.1-402 C 8, and 58.1-302.
• 23 VAC 10-120-100 A, 10-120-150 B 2 b, and 10-120-20.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 17-3

Original ruling text

January 19, 2017

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 year ended January 31, 2011. I apologize for the delay in responding to your request.

FACTS

In 2005, the Taxpayer sold its stock ownership of * (Corporation A) to an unrelated third party. Prior to the sale, Corporation A had contracted with (Corporation B), headquartered in ** (Country A), to provide telecommunications services. The Taxpayer had negotiated with the purchaser of the stock to retain the rights to proceeds from an arbitration proceeding pending in a Country A court. When the arbitration was settled, the Taxpayer reported the proceeds from the settlement as a gain on its federal income tax return and on its Virginia corporate income tax return.

Subsequently, the Taxpayer filed an amended 2010 Virginia corporate tax return. Among the adjustments made on the amended return was a subtraction for foreign source income and a corresponding adjustment to the sales factor. Under review, the foreign source income subtraction was disallowed. As a result, the Taxpayer's refund was reduced.

The Taxpayer appealed the adjustments, contending that the income was from the gain on the sale of the stock of a foreign corporation. In the alternative, the Taxpayer asserts that the proceeds of the sale represented technical fees. The Taxpayer also contends that if the disallowance of the foreign source income subtraction is allowed, then the gain from the settlement should be included in the denominator of the sales factor.

DETERMINATION

Virginia 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. As such, Virginia's conformity to federal law is limited to the actual use of a specific term in a Virginia statute. Further, conformity does not extend to terms, concepts, or principles specifically provided for in Title 58.1 of the Code of Virginia . For corporate income tax purposes, Virginia generally “conforms” to federal law in that it starts the computation of Virginia taxable income with federal taxable income (FTI).

Virginia Code § 58.1-402 provides that a corporation's Virginia taxable income for any given taxable year is the FTI and any other income taxable to the corporation under federal law for such year, adjusted and modified by certain specified additions, subtractions, and exemptions. For purposes of this statute, the term “federal taxable income” means all income from whatever source derived and however named on which a federal tax is imposed. See Title 23 of the Virginia Administrative Code (VAC) 10-­120-100 A. Virginia conforms to the treatment of the settlement proceeds as a gain for federal income tax purposes.

Gain from Sale of Stock

Virginia Code § 58.1-402 C 8 permits a taxpayer to subtract foreign source income from FTI to the extent it is included in and not otherwise subtracted from FTI. Under Va. Code § 58.1-302, “foreign source income” includes:

Gains, profits, or other income from the sale of intangible or real property located without the United States;

The proceeds from the sale of stock of a foreign corporation qualify for the foreign source income subtraction as a sale of intangible property. See Public Document (P.D.) 88-141 (6/20/1988) and P.D. 94-58 (3/15/1994). In this case, however, Corporation A was not a foreign corporation. It was an American corporation with its headquarters located in * (State A). As such, the gain from the sale would not qualify for the foreign source income subtraction as a gain from the sale of intangible property located outside the United States.

Technical Fees

Virginia Code § 58.1-402 defines foreign source income to include:

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;

Pursuant to the Department's longstanding 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 P.D. 86-209 (11/03/1986). 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).

As indicated above, Virginia's conformity requires the income to be treated the same as it was for federal income tax purposes regardless of how it was reported on an entity's financial statements or accounted for under Generally Accepted Accounting Principles (GAAP). Because the settlement proceeds were reported as a gain on the sales of stock under the IRC, it cannot be treated as technical fees for purposes of the Virginia subtraction.

Sales Factor

The Taxpayer further argues that if the foreign source income subtraction is disallowed, then the settlement award should be included in the denominator to the sales factor. A corporation claiming a subtraction for foreign source income will adjust its apportionment factors in accordance with Title 23 VAC 10-120-150 B 2 b. This regulation provides in pertinent part:

The property, payroll and sales of a corporation which are used to produce income qualifying for the subtraction for ... foreign source income shall not be included in the denominator of the fractions

Title 23 VAC 10-120-20 further provides:

All income and expenses included in foreign source income and property or other activity associated with such income and expenses shall be

excluded from the factors in the Virginia formula for allocating and apportioning Virginia taxable income to sources within and without Virginia

Pursuant to these regulations, foreign source income that qualifies for the Virginia subtraction will be excluded from the denominator of the sales factor. Because the Department finds that the Taxpayer was not eligible for foreign source income subtraction, the net gain from the sale of the stock should be included in the denominator of the Taxpayer's sales factor.

CONCLUSION

The Taxpayer's request to allow the subtraction of the proceeds from the arbitration settlement as foreign source income for the taxable year ended January 31, 2011 is denied because the gain was not derived from the sale of intangible property without the United States and the proceeds were not technical fees. However, because the foreign source income subtraction is not allowed, the gain from the settlement should be included in the denominator of the Taxpayer's sales factor. As such, the case will be returned to the auditor to adjust the Taxpayer's apportionment factor in accordance with this determination.

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 Department's Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/663.B