Could a corporation subtract fees for technical services performed abroad and challenge Virginia's use of later refunds to pay old assessments?

Plain-English summary

Virginia denied the corporation's foreign-source-income subtraction for compensation earned from technical services performed outside the United States. The Department read "technical fees" in context with rents, royalties, licenses, and property rights. To qualify, the technical fees had to be incidental to a contract involving foreign real-property rental or licensing of patents or similar property—not ordinary compensation, professional fees, or other earned income for services.

Virginia also upheld its use of later corporate-income-tax and sales-tax refunds to satisfy the older assessments. State statutes authorized refund offsets for past-due taxes, penalties, and interest. The Department's records showed that the assessments and offset letters preceded the taxpayer's appeal, so the appeal rule stopping collection action had not yet taken effect.

The Department found no due-process violation and denied the requested refunds for both years.

Common questions

Did performing technical work outside the United States create the subtraction? No. Stand-alone service compensation was not a qualifying technical fee.

When could technical fees qualify? Under the ruling, they had to relate to foreign property rental or licensing of a patent or similar property.

Could Virginia apply a later refund to an older assessment? Yes. The cited statutes allowed the offsets.

Why did the appeal not stop these offsets? The offsets and notices occurred before the taxpayer filed the appeal.

Citations and references

• Va. Code §§ 58.1-302 and 58.1-402 C 8
• 23 VAC 10-110-30 F 2 c
• Va. Code §§ 58.1-499 E, 58.1-1823, and 58.1-1821
• Va. Code § 2.2-4800 et seq.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 18-182

Original ruling text

October 29, 2018

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, 2013 and 2014.

FACTS

The Taxpayer was audited by the Department for the taxable years 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 for the performance of technical services outside of the United States. A portion of the Taxpayer’s corporate income tax refund from the 2016 taxable year and a sales tax refund for July 2017 were offset to satisfy the assessments.

The Taxpayer appeals the assessments, contending that the Department’s policy of disallowing the FSI subtraction for the performance of technical services outside the United States is contrary to statute. In addition, the Taxpayer asserts that the utilization of the Taxpayer’s corporate income tax and sales tax refunds to satisfy prior year corporate income tax assessments violates the Due Process Clause of the United States Constitution.

DETERMINATION

Foreign Source Income

Virginia Code § 58.1-402 C 8 provides for the subtraction of foreign source income. Pursuant to Virginia Code § 58.1-302, foreign source income is defined, 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, copyrights, secret processes and formulas, good will, trademarks, trade brands, franchises, and other 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 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).

The Taxpayer contends that the Department’s policy disallowing income earned from technical services performed outside the United States is contrary to the plain meaning of Virginia Code § 58.1-302. It asserts that its interpretation would also mean that rents, royalties and license fees would not be considered foreign source income unless they were from property services performed outside the United States. It argues that the Department’s interpretation disregards the provisions in Internal Revenue Code (IRC) §§ 861 through 863, specifically that rents, royalties and services are broken out. In addition, the Taxpayer also states that such an interpretation is inconsistent with Virginia Code § 58.1-400 that only allows foreign corporations to be taxed on its Virginia source income.

The rationale for the Department’s interpretation of the foreign source income subtraction is articulated in detail in P.D. 86-128 (7/11/1986). In Commonwealth of Virginia v. Champion International Corp., 220 Va. 981 (1981), the Virginia Supreme Court held that certain types of income were required to be allocated to the state from which the corporation is directed or managed instead of apportioned pursuant to Virginia policy. In response to Champion , Senate Bill 641 (1981 Acts of Assembly , Chapter 402) was enacted to remove all classes of income except dividends from allocable income and allowed a subtraction for foreign source income.

The intent of the Virginia foreign source income subtraction was to allow a subtraction for the classes of income that were allocated under prior corporate law. As a general rule, income arising from real estate and intangible property was allocated to foreign countries and not subject to tax by Virginia. Because Senate Bill 641 removed all types of income (except dividends) from the definition of allocable income, an apportioned amount of this income would have become taxable in Virginia without a subtraction for income from foreign sources.

The Taxpayer contends that § 862 of the IRC separately breaks out the provisions of rent, royalties, and services. As such, the Taxpayer asserts that foreign source income should include services performed without the United States. The words “technical fees from ... services performed” are, however, incorporated in a subsection dealing with passive income from the rental of real estate and with income from patents, copyrights and other intangible property. See P.D. 86-209 (11/3/1986). “[W]hen general words and specific words are grouped together, the general words are limited and qualified by the specific words and will be construed to embrace only objects similar in nature to those objects identified by the specific words.” Commonwealth v. United Airlines, 219 Va. 374 at 389, 248 S.E.2d 124 (1978) . As such, in order for technical fees to be included in the foreign source income subtraction, they must be related to the rental of real property or the licensing of a patent or other like property outside the United States.

In addition, Title 23 of the Virginia Administrative Code (VAC) 10-110-30 F 2 c provides that:

“Rents, royalties, license and technical fees” mean those derived from property located outside of the United States or derived from services performed outside of the U.S. The term “technical fees” shall not include wages, salaries, compensation or other “earned income” as defined in IRC § 911(b). Fees for the use outside the U.S. of patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises and other like properties constitute “license and technical fees.”

As such, wages, salaries, compensation, professional fees and other amounts received as compensation for personal services are not “technical fees” and accordingly these same items are not allowed as a subtraction as foreign source income.

Collection Action

The Taxpayer asserts that the Department violated its due process rights by using its income and sales tax refunds to satisfy corporate income tax assessments. Virginia collection procedures are specifically set forth in the Virginia statutes. Under Virginia Code § 58.1-499 E, whenever any taxpayer is entitled to a refund and past income tax is due, the amount of the refund may be credited on the past due income tax. In addition, pursuant to Virginia Code § 58.1-1823, the Department may reduce a refund by the amount of past-due taxes, penalties and interest which have been assessed within the appropriate period of limitations.

Offsets of Virginia tax refunds are allowed to satisfy outstanding Virginia tax liability pursuant to Virginia Code § 2.2-4800 et seq. of the Virginia Debt Collect Act. The Department’s systems check against claims eligible for the offset before refunds are issued. A letter is sent with details of the liability and how much of the refund was applied or withheld and a phone number to call with questions. Pursuant to Virginia Code § 58.1-1821, collections action must cease once an appeal is filed with the Department. According to the Department’s records, corporate tax assessments were issued and offset letters sent prior to the Taxpayer’s appeal being filed. As such, proper collection procedures were followed in accordance with Virginia statutes and the Taxpayer’s rights were not violated.

CONCLUSION

The Department properly disallowed the portion of the foreign source income subtraction related to income earned for technical services performed outside of the United States. In addition, the offset of the Taxpayer’s corporate income tax liability by corporate and sales tax refunds is allowed by statute and did not violate the Taxpayer’s due process rights. Accordingly, the Taxpayer’s request for a refund of Virginia corporate income tax of the taxable years ended December 31, 2013 and 2014 cannot be granted.

The Code of Virginia sections, regulation, 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/1531.B