VA: Use of Income-Producing Activity Test did Not Result in Unconstitutional Apportionment

The Virginia Supreme Court recently rejected a taxpayer’s argument that the application of the Commonwealth’s income-producing activity test to source its service receipts was unconstitutional. The taxpayer at issue was a Virginia-headquartered service provider. Under Virginia’s three-factor double weighted apportionment formula, which uses the income-producing activity test to source service receipts, nearly all of the taxpayer’s service revenues were sourced to Virginia where its employees, property and computer servers were located. Ninety-five percent of the taxpayer’s sales were to customers outside Virginia. Because many other states have moved to market-based sourcing for service receipts, certain of the taxpayer’s receipts were included in both the Virginia sales factor numerator and the sales or receipts factor numerator of the states where the taxpayer’s customers were located. The taxpayer, unhappy with this outcome, filed a request for a Virginia corporate tax refund on the basis that it should be entitled to use an alternative apportionment formula.

The Commonwealth’s highest court did not agree, although it recognized that the popularity of the income-producing activity test was “waning” and that many states had moved to market-based sourcing. It was agreed that Virginia’s apportionment formula was internally consistent. In applying the external consistency test,) the court determined that the inclusion of a taxpayer’s receipts in the numerator of more than one state’s sales factor did not, by itself, violate the constitution. The court noted that there was no U.S. Supreme Court precedent requiring one of two taxing states to “recede simply because both have lawful tax regimes reaching the same income.”  The court next rejected the taxpayer’s argument that it should be entitled to use an alternative sourcing methodology based on customer billing address. Under Virginia’s alternative apportionment regulation, the statutory method is “inequitable” if it results in double taxation and the double taxation is “attributable” to Virginia. Further, a taxpayer is entitled to apportionment relief only if it can establish that the double taxation does not result from the other state having employed a “unique” apportionment method. It was agreed that there was double taxation, but the court determined the inequity was not attributable to Virginia. In the court’s view, the double taxation was attributable to the apportionment changes adopted by other states and that Virginia had adopted a method originally designed to provide uniformity. Furthermore, the court determined the taxpayer had failed to establish that the other state apportionment methods were not “unique”.  A review of the marketing-based sourcing laws and rules employed by other states, the court noted, suggests that they differ considerably in their details, leading the court to determine the taxpayer had failed to prove they were not unique.  Please contact Diana Smith at 703-286-8214 with questions on Corporate Executive Board Company v. Virginia Department of Taxation.