ELIMINATE A CORPORATE INCOME TAX LOOPHOLE THAT ALLOWS CERTAIN OUT-OF-STATE CORPORATIONS TO ESCAPE PAYING VIRGINIA CORPORATE INCOME TAX ON EARNINGS FROM THE SALES OF SERVICES IN VIRGINIA
USE THE $150 – $200 MILLION GENERATED TO REPAIR VIRGINIA’S TRANSPORTATION INFRASTRUCTURE
SPRINGFIELD, VA (January 5, 2010)
The problem: Virginia has been failing to charge corporate income tax on out-of-state corporations that sell services into Virginia.
Over forty years ago, Virginia enacted the current laws for how it calculates the amount of corporate income tax a corporation owes for earnings in Virginia on the sales of goods and the sales of services.
Back in 1960, when Virginia Corporation X wanted a good, it could buy it from any number of out-of-state corporations who would ship the good to Virginia. Services were another matter. There were very few out-of-state corporations that could do services in Virginia. In order to deliver a service, a company had to have “feet on the street” to go to the customer and perform the service. Thus, other than companies located in border areas, most all services performed in Virginia were performed by Virginia companies.
When the corporate tax laws were written forty years ago, since goods could come from anywhere and services usually only came from within a state, the states decided to treat the sale of goods and the sale of services differently. This was the approach recommended by the 1957 national Uniform Definition of Income for Tax Purposes Act, which was adopted in whole or in part by almost all of the states.
Using this uniform law as a guide, the Virginia General Assembly counted an out-of-state corporation’s income from the sale of goods to Virginia if that good’s final destination was here in Virginia. But when it came to calculating corporate income tax on the sales of services, Virginia did not use the same “final destination” rule. Since all services were performed locally, the law looked only at where the service was rendered. If it was rendered in Virginia, then the Corporate Income Tax applied. If it was rendered in another state, the tax did not apply.
Since the passage of the Uniform Definition of Income for Tax Purposes Act in 1957, many states have begun moving away from the system of calculating the sales of goods and services differently. These states passed new laws not looking at where the service was performed, but rather toward where the benefit of the service was received –making the location of the sale of a good where it ultimately arrives and the location for the sale of a service where the ultimate benefit is received.
The question for Virginia today is: Should it move with these other states away from the 1957 uniform rule? Does it still make sense to have a “where delivery of the goods occurs” rule for corporate income tax for goods and a separate “where the service was rendered” rule for services?
The answer is “Yes, Virginia should move away from the uniform rule. No, in the modern economy, it does not make sense to have separate rules for goods and services.”
Fast forward from 1957 to 2011, and the reasoning for two different standards does not make sense. In 1957 there were very few multi-state service companies. Today there tens of thousands of multi-state service companies. For example, 20 – 40 years ago, if an out-of-state corporation had a contract to program a Virginia business’ computers, in order to perform this service in Virginia, the corporation had to have employees in Virginia actually perform the programming on the main frame computer. Now, because of the Internet, physical presence is no longer required to perform a service. The service can be done remotely, “in the cloud” via the Internet.
The method for calculating corporate income tax on out-of-state corporations needs to be updated so that this out-of-state corporate income tax “loophole” will be closed. Virginia needs to do what most other states in the U.S. are doing, and collect corporate income tax on all out-of-state corporations that sell services in Virginia, whether or not they have offices or employees in Virginia.
Allowing this out-of-state corporate income tax “loophole” causes numerous problems.
1. One problem is the loss of $150 – $200 million in Virginia corporate tax revenues. According to JLARC, Virginia loses up to $250 million per year in corporate income tax revenue, but the Virginia Dept. of Taxation says that it is difficult to estimate. (When predicting how much this change in the law will generate, Delegate Albo uses the figure $150 – $200 million as an average.)
2. Another issue is the ludicrous situation where, for example, Maryland (which does not have this loophole) is charging Virginia corporations that sell services in Maryland but have no employees or offices in Maryland a corporate income tax, but Virginia is not charging Maryland corporations who sell services in Virginia but have no offices or employees in Virginia.
3. There is an actual disincentive for an out-of-state corporation to move jobs into Virginia because doing so subjects them to corporate income tax. Under current law, they can extract money from Virginia businesses without paying corporate income tax.
4. Last, but not least, some Virginia corporations are being penalized by double taxation. They may be paying taxes on their income from the sales of services to both Virginia and another state!
The solution: Enact the JLARC recommendation to treat the sale of goods and services similarly when calculating the allocation for sales when determining corporate income tax. Then use the $150 – $200 million generated to solve the “Highway Maintenance Budget Shortfall.”
Delegates Albo, Rust and May call for enacting JLARC’s two fold recommendation to update Virginia’s 40 year old corporate income tax calculation method (See: JLARC Report “Review of Virginia’s Corporate Income Tax System” pp. 42-55). Virginia needs to calculate corporate income tax attributable to the sale of services the same as we calculate it for the sale of goods – by looking at where the benefit of the service is received. This method is known as “Market-Based Sourcing.” JLARC recommends moving to the “Market-Based Sourcing” method just as 12 other states have (8 have adopted this since 2004, many of which are competitors of Virginia). Market-Based Sourcing does not look at where the service was performed. Rather, it looks at whether the out-of-state corporation has used Virginia markets and benefited from the sale of the service in Virginia.
In addition to changing to Market-Based Sourcing, JLARC also recommends bringing Virginia in line with the vast majority of states and repeal its policy exempting out-of-state corporations that have no employees or property in Virginia from corporate income tax on profits they generate from the sale of services in Virginia.
Following of this enactment, part of the solution is to use the $150 – $200 million per year generated by these changes in tax policy to fund repairs, paving, and replacements of Virginia’s transportation infrastructure (the Highway Maintenance and Operating Fund “HMOF”). This fund is comprised of numerous revenue sources, including recordation tax on the transfer of property, titling tax on the purchase of motor vehicles, gas tax and other smaller sources. Due to the fact that gas tax is not indexed to inflation and that the Recession is currently killing recordation and titling tax collections, the fund is $500 million short every year. Once the economy recovers and recordation and titling tax revenues increase, Delegate Albo calculated the shortfall to be much less (between $350 – $400 million per year). Designating this new $150 – $200 million in out-of-state corporate income tax revenue as a Non-General Fund source of revenue and dedicating it to the HMOF should solve half of our problem. If Virginia can use some of the surplus created by last years’ reductions in spending to 2006 levels and the savings identified in this years’ Governor’s budget to make up the difference, the “Highway Maintenance Shortfall” is solved!
 States charge out-of-state corporations an income tax based upon how much of its earnings are allocated to such state. Each state uses its own formula. Virginia uses a formula that looks at payroll in Virginia (employees), property in Virginia (offices) and amount of sales in Virginia. This bill deals with this last item – how the Dept. of Taxation allocates sales of goods and services to Virginia.
 Current law on how to calculate corporate income tax liability for the sale of goods § 58.1-415. When sales of tangible personal property deemed in the Commonwealth. Sales of tangible personal property are in the Commonwealth if such property is received in the Commonwealth by the purchaser. In the case of delivery by common carrier or other means of transportation, the place at which such property is ultimately received after all transportation has been completed shall be considered as the place at which such property is received by the purchaser. Direct delivery in the Commonwealth, other than for purposes of transportation, to a person or firm designated by a purchaser, constitutes delivery to the purchaser in the Commonwealth, and direct delivery outside the Commonwealth to a person or firm designated by the purchaser does not constitute delivery to the purchaser in the Commonwealth, regardless of where title passes, or other conditions of sale.
 Current law on how to calculate corporate income tax liability for the sale of services is done through two laws:
(1) § 58.1-416. When certain other sales deemed in the Commonwealth. Sales, other than sales of tangible personal property, are in the Commonwealth if: 1. The income-producing activity is performed in the Commonwealth; or 2. The income-producing activity is performed both in and outside the Commonwealth and a greater proportion of the income-producing activity is performed in the Commonwealth than in any other state, based on costs of performance, and
(2) Voluntary exemption of all corporations with no property (offices) or payroll (employees) from corporate income tax on the sales services in Virginia. (Note: Federal P.L. 86-272 bars states from charging a corporate income tax on corporations without offices or employees in Virginia on the sales of goods. However, Virginia is one of the very few states voluntarily applying this rule to the sale of services also. )
 Dept. of Taxation says, “The revenue impact of adopting Market-Based Sourcing for the sales of services is difficult to estimate because it will reduce the tax liability of Virginia corporations that sell services to customers in other states, while increasing the tax on out-of-state corporations that sell services to Virginia customers. Unfortunately, many of the out of state corporations that would be affected by this proposal have not been required to file Virginia income tax returns in the past, which means that the Dept. of Taxation does not have sufficient data to estimate the revenue impact.” It is presently looking to see in its practical application how much would be collected if Virginia closed this “loophole”, and what effect tax avoidance strategies by out-of-state corporations will have on the actual amount generated by this change in the law.