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Virginia endorses direct labor method for out-of-state BPOL tax assessment

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On Sept. 26, 2018, the Virginia Department of Taxation rejected a city’s assessment of Business, Professional, and Occupational License (BPOL) tax which relied upon the taxpayer’s payroll apportionment to source its gross receipts in computing the out-of-state deduction.1 The case was remanded for the city to recalculate the out-of-state deduction. The taxpayer had originally sourced its gross receipts using the direct labor method, which was accepted by the city during audit and explicitly endorsed by the Department.

Background In Virginia, localities are authorized to impose a BPOL tax generally on the taxpayer’s gross receipts for the privilege of conducting business.2 The tax is imposed and administered by local officials at different rates according to a taxpayer’s classification.3 Generally, taxable gross receipts include only those receipts sourced to a definite place of business within a jurisdiction. For a service provider, this is based on the place where services are performed, or from which they are directed or controlled.4 In computing the BPOL tax liability, a deduction from total gross receipts is permitted for certain qualifying activities, including gross receipts attributable to a business conducted in another state or foreign country in which the taxpayer is liable for an income tax or other tax based on income. 5

The taxpayer, a provider of information technology services, originally filed a refund request with an unnamed Virginia city for the 2011-2013 tax years revising the sourcing of its gross receipts and increasing its out-of-state deduction, which lowered its BPOL tax liability. The city did not originally dispute the taxpayer’s methodology for sourcing gross receipts, but ultimately denied the out-of-state deduction based on a lack of appropriate documentation. The taxpayer appealed to the Department, claiming that the taxpayer only needed to show the Department that gross receipts are included in a measure of income reported on another state’s return to show it reported those receipts on the other state’s return. In computing its out-of-state deduction, the taxpayer had included gross receipts attributable to contracts in which the customer was located in states other than Virginia in which it filed an income tax return. In a published decision, the Department agreed with the taxpayer and remanded the matter back to the city to review the other states’ income tax returns filed by the taxpayer for the years at issue in order to properly compute the deduction. 6

Upon its second review of the refund claim, the city issued a final local determination which used payroll apportionment, rather than the originally employed direct labor method, to calculate the out-of-state deduction. The taxpayer appealed to the Department again, arguing that the city erroneously computed the deduction.

BPOL ruling With another opportunity to consider the matter, the Department first considered the receipts sourcing issue. The city’s final local determination stated that the taxpayer sitused gross receipts using payroll apportionment, under which the entire payroll of the taxpayer’s business was used to determine how to source gross receipts. This was contrary to the taxpayer’s contention that it had used the actual direct labor sourcing method. Under direct labor sourcing, gross receipts are sourced to out-of-state locations by including labor charges made by each employee located in the city as the numerator of a ratio, and the total labor cost charged to these same contracts by all of the taxpayer’s employees across the country as the denominator. The resulting ratio (the direct labor percentage), was multiplied by total receipts from all of the contracts worked on by the employees working at the city’s definite place of business to determine gross receipts attributable to the city, which was the amount eligible for the out-of-state deduction.

In its first ruling covering this matter, the Department had upheld use of the direct labor method in the computation and further indicated that “payroll apportionment provides only a reasonable estimate and has been used only as a method of last resort.” Therefore, the Department confirmed that the use of the direct labor method provided a substantially more accurate measurement than payroll apportionment.

The city and the taxpayer also disagreed about which gross receipts were eligible for the out-of-state deduction. The taxpayer argued that all gross receipts attributable to business conducted in another state or foreign country were eligible.7

The Department, relying on a previous holding, contended that the taxable measure of gross receipts had to be calculated as a first step, before the out-of-state deduction could be determined.8

To be eligible for the deduction, the taxpayer had to complete the second step of identifying the taxable gross receipts actually attributable to business conducted in another state in which it filed an income tax return and paid income tax.

The Department questioned why the city ultimately determined the out-of-state deduction for the taxpayer by multiplying gross receipts sitused outside the city by the direct labor percentage. Finding the calculation at odds with the city’s position that the taxpayer used payroll apportionment to compute the deduction, the Department declined to rule on the accuracy of the new calculation. Instead, it noted the lack of clarity in the computation and remanded the case to the city in order to recalculate the taxpayer’s out-of-state deduction for the tax periods at issue in accordance with the Department’s first decision in this matter. The Department left open the possibility that the city could issue another determination that the taxpayer may disagree with, which could result in the Department’s third evaluation of this matter.

Commentary This ruling clarifies that the Virginia Tax Commissioner endorses the use of the direct labor method to source gross receipts as the first step in determining BPOL tax liability, prior to the calculation of the out-of-state deduction. The ruling also reiterates the Tax Commissioner’s belief that companies may be entitled to take a somewhat liberal approach to apportioning gross receipts outside the state, despite the generally restrictive understanding of how to apportion gross receipts which has been employed by multiple county and city commissioners of revenue. Previously, the Virginia Supreme Court had addressed the out-of-state deduction and concluded that, as the relevant statute does not address the permissible methodology for calculating the deduction, a discretionary method was appropriate.9

With Virginia BPOL filings due on March 1, 2019, taxpayers that are subject to the BPOL tax should consider their current BPOL tax apportionment methodology.

In its decision, the Department explicitly noted that the use of modern technology, coupled with cost accounting methodologies, could allow many businesses to accurately situs gross receipts without adding a significant administrative burden. It will be interesting to see if the Tax Commissioner applies similar reasoning to other areas of Virginia taxation that rely upon considerable amounts of information to compute necessary measures. For example, one conceivably could apply this rationale to the computation of the sales factor for corporate income tax purposes to argue that taxpayers may accurately source gross receipts based on a reasonable method.  



1 Ruling of Commissioner, P.D. 18-168, Virginia Department of Taxation, Sept. 26, 2018.
2 VA. CODE ANN. § 58.1-3703.A.
3 VA. CODE ANN. § 58.1-3706.A.
4 VA. CODE ANN. § 58.1-3703.1.A.3(a).
5 VA. CODE ANN. § 58.1-3732.B.2.
6 Ruling of Commissioner, P.D. 17-93, Virginia Department of Taxation, June 9, 2017.
7 23 VA. ADMIN. CODE § 10-500-80a, Example B1. In this example, a merchant is permitted to deduct all gross receipts from the sale of goods to a North Carolina resident because the merchant filed a North Carolina income tax return.
8 Ruling of Commissioner, P.D. 17-159, Virginia Department of Taxation, Sept. 8, 2017.
9 Nielsen Co. (US), LLC v. County Board of Arlington County, 767 S.E.2d 1 (Va. 2015).




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