INSIGHT: Double Taxation Not Enough to Invalidate Virginia’s Apportionment Method

The Corporate Executive Board Co. (CEB), a corporation headquartered in Arlington, Va., found itself subject to double taxation under a Virginia statute based on a model act—the Uniform Division of Income for Tax Purposes Act (UDITPA)—that was meant to provide an equitable method for allocating the income of a multistate corporation.

CEB paid income tax in multiple states based on its sales in those states. Nevertheless, the Virginia Department of Taxation allocated nearly 100 percent of CEB’s gross receipts to Virginia. Despite a provision in the state tax law intended to provide relief to a corporation in CEB’s position, the Virginia Supreme Court declined to so in The Corp. Exec. Bd. Co. v. Virginia Dep’t of Taxation, 822 S.E.2d 918 (Va. 2/7/19).

Most of CEB’s revenue comes from an annual fixed fee subscription service of its core product. This subscription service provides “online access to best practices research, executive education and networking events, and tools used by executives to analyze business functions and processes.” CEB also sells professional services or “solutions.”

The vast majority of CEB’s sales occur outside of Virginia. The majority of CEB’s employees who developed and improved the content integrated into CEB’s products, and the costs of performance associated with developing and improving that content, were located in Virginia. The entirety of the content was housed on CEB’s servers located in Virginia.

Virginia’s Uniform Division of Income for Tax Purposes Act (UDITPA)-based statute employs a three-factor formula to determine the taxable income of a corporation. In Virginia, the numerator of the fraction consists of three factors: a payroll factor, a property factor, and a double-weighted sales factor. The denominator of the fraction is four.

The sales factor was based on the ratio of CEB’s sales in the state to its total sales everywhere. Virginia includes sales of intangible property as part of income if: (1) the income-producing activity is performed in the state; or (2) the income-producing activity is performed both inside and outside the state and a greater portion of the income-producing activity is performed in Virginia than in any other state, based on costs of performance. The department allocated nearly 100 percent of CEB’s gross receipts to Virginia. This allocation occurred because the service CEB provided was developed in Virginia by CEB’s Virginia employees, and its product was stored on servers located in Virginia.

‘Inapplicable or Inequitable’

Virginia’s “costs of performance” sales factor has faced mounting criticism. Nationally, the cost-of-performance method is waning, and market-sourcing is inexorably taking its place. The Virginia tax law contains a relief provision under Section 58.1-421 that allows a taxpayer to seek redress from the Virginia Department of Taxation when “the method of allocation or apportionment prescribed ... has operated or will so operate as to subject a corporation to taxation on a greater portion of its Virginia taxable income than is reasonably attributable to business or sources within the Commonwealth.”

A corporation seeking the benefits of the relief provision must propose an alternative method of taxation. If the department “concludes that the method of allocation or apportionment theretofore employed is inapplicable or inequitable, then it shall redetermine the taxable income by such other method of allocation or apportionment as seems best calculated to assign to the Commonwealth the portion of the income reasonably attributable to business and sources within the Commonwealth.”

The regulations provide that a method will be found inapplicable only if it “produces an unconstitutional result.” A method is inequitable only if “it results in double taxation of the income...and the inequity is attributable to Virginia, rather than to the fact that some other state has a ‘unique method’ of allocation and apportionment.” CEB requested a redetermination of its income tax by using the customer’s location, i.e., market-based sourcing. However, the trial court found in favor of the department, and CEB appealed.

The crux of the disagreement between the parties was whether the tax was “fairly apportioned.” See Complete Auto Transit v. Brady. To be fairly apportioned, a tax must be both internally and externally consistent. The parties agreed that Virginia’s method of assessing CEB’s corporate income was internally consistent. The question, therefore, was whether the tax was externally consistent.

The U.S. Supreme Court has recognized that that existence of duplicative taxation does not, in and of itself, violate the U.S. Constitution. The Virginia court concluded that CEB did not suffer from an unconstitutional apportionment of its income. Each time, the court noted, a customer used CEB’s core product, the customer reached into Virginia to consult materials developed in Virginia and stored in Virginia.

Thus, the department’s apportionment of income did not “reach beyond that portion of value that is fairly attributable to economic activity within the taxing State,” the court said. Virginia’s apportionment method satisfied the constitutional standard. Virginia’s taxing scheme, the court concluded, “reasonably reflects the in-state component of the activity being taxed.” Thus, the method of allocation or apportionment was not “inapplicable.”

Distinct Isn’t Unique

A taxpayer is entitled to relief, however, if the method of apportionment is “inequitable.” There is no question that the statutory method, when applied alongside the apportionment methods employed by a number of other states, has resulted in the double taxation of a portion of CEB’s income. This was a start, but the taxpayer, to gain relief, must show that the inequitable apportionment was “attributable to Virginia,” and that it was not attributable “to the fact that some other state has a unique method of allocation and apportionment.”

Here, any double taxation that arose was not attributable to Virginia. CEB’s double taxation was attributable to changes adopted more recently by other states in their apportionment formulas, and in particular to the increased trend of using single-factor sales apportionment. The Commonwealth, the court noted, has adhered to its particular formula for nearly 60 years. Thus, CEB’s double taxation did not “occur in consequence of, or on account of,” Virginia law.

Under the plain language of the regulation, CEB was not entitled to relief unless it could show that the double taxation was not attributable to another state’s unique method of allocation and apportionment. The record failed to establish whether the sourcing methods adopted by other states were “unique.” CEB paid corporate taxes on a portion of its sales to no fewer than 23 states besides Virginia. CEB contended that “the destination-based sourcing method used by these 23 other states ... can in no sense be considered unique.” Cursory investigation revealed, however, that each state had adopted “its own distinctive method, even if those methods share some conceptual similarities.” The fact that states have adopted, in conceptual terms, a market sourcing method did not resolve whether the actual method employed was “unique.”

Our review, the court observed, “of some of the methods employed by states that have taxed CEB’s sales of services ... suggests that the market sourcing methods employed by states for the sale of a service differ in their details, often considerably. In short, the record establishes that a number of States that subject CEB to corporate income tax use conceptually similar sourcing methods, but the record fails to establish whether those methods are unique.” Consequently, the court said, “we are unable to conclude that the circuit court and the Tax Department erred in declining to grant relief.” The judgment of the trial court was affirmed.

It is unclear exactly how a taxpayer would go about, in a manner that would satisfy the court, demonstrating that another state’s taxing apparatus was not unique. Accordingly, despite the massive amount of duplicative taxation that CEB experiences, it, and other similarly situated taxpayers, are almost certainly not going to gain relief from this burden from the tax authorities in Virginia.

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.