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Virginia rules on aged raw materials property use case

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On Feb. 10, 2022, the Virginia Supreme Court held that raw materials being stored in Virginia for aging and then processed and used in manufacturing in another state should not be included in the Virginia property factor for apportionment purposes because the taxpayer did not actually “use” the raw materials in Virginia.1 Under Virginia law, property must be “used” in Virginia in order to be included in the property factor. Mere storage of raw materials without any processing or treatment does not constitute “use” for purposes of construing the property factor.

Background The taxpayer manufactures cigarettes in North Carolina and sells those cigarettes throughout the U.S. It conducts business activities in Virginia and maintains warehouses and facilities in the state. Third-party suppliers deliver leaf tobacco to the taxpayer’s facilities in Virginia, where the tobacco is stored for an aging period of 13 to 23 months. The aging is a natural process that occurs without human intervention or specialized equipment. After the taxpayer’s production and manufacturing team in North Carolina determines that the leaf tobacco has reached the target drying age, it instructs the Virginia facilities to ship the leaf tobacco to North Carolina for processing and manufacturing into cigarettes.

For the relevant tax years, the taxpayer originally included the value of its entire leaf tobacco inventory which was aging in its Virginia facilities in calculating its Virginia property factor for apportionment purposes. In 2011, for the tax years ending in 2008 and 2009, the taxpayer filed a request with the Virginia Department of Taxation to recalculate its apportionment factors. The taxpayer argued that including the value of stored leaf tobacco in its property factor overstated the amount of the taxpayer’s business in Virginia. After the Department denied the taxpayer’s request, the taxpayer sought reconsideration of the decision, and timely filed amended tax returns removing the value of the stored leaf tobacco from the property factor, resulting in a refund request of over $4.6 million. The Department denied the taxpayer’s motion for reconsideration and rejected the taxpayer’s amended tax returns and refund claims.

The taxpayer subsequently filed an application for correction in a circuit court challenging the denial of its refund claims. While the taxpayer’s application was pending before the circuit court, the taxpayer filed amended tax returns and refund claims for the 2010 through 2012 tax years for nearly $6.4 million. The taxpayer’s refund claims were deemed denied and the taxpayer filed a second application for correction with the circuit court. After the circuit court consolidated the taxpayer’s applications, the circuit court determined that the stored leaf tobacco should not be included in the property factor calculation because the taxpayer had not “used” the tobacco in Virginia. The circuit court required the Department to remove the value of the leaf tobacco from the property factor and pay the taxpayer a refund of over $11 million plus interest. The Department appealed this decision.

Virginia apportionment methodology Virginia generally uses a three-factor apportionment formula with a double-weighted sales factor.2 The property factor consists of a ratio between the average value of the taxpayer’s property “owned and used” in Virginia during the tax year and the average value of all the taxpayer’s property “owned and used” during the tax year and located everywhere.3 To be included in the property factor, the property must be used to produce Virginia taxable income, effectively connected with the conduct of a U.S. trade or business, and income derived from the property is includable in federal taxable income.4

Raw materials stored for aging not used for apportionment purposes In affirming the circuit court, the Virginia Supreme Court held that the storing of the leaf tobacco in Virginia for aging did not constitute “use” in the state for Virginia apportionment purposes. The Department unsuccessfully argued that the taxpayer’s storage of the leaf tobacco in Virginia was “use” because the aging of the tobacco was important to its subsequent use. According to the Department, the leaf tobacco was being processed for the next phase of production by being stored at the Virginia facilities, and the leaf tobacco was similar to the “inventoriable goods in process” that its regulation indicates should be included in the property factor.5

The taxpayer responded that the term “used” requires a positive act or activity by the user. As argued by the taxpayer, the storage of the leaf tobacco in Virginia to prevent theft or damage was merely an exercise of ownership and not the “use” of the tobacco as provided in the Virginia property factor statute. The leaf tobacco was being stored for future use in the manufacture of cigarettes in North Carolina. Finally, the taxpayer argued that the regulation did not apply because its list of examples does not include agricultural products such as leaf tobacco that undergo natural aging.

The Virginia Supreme Court explained that the central question in this case was the meaning of “used” in the property factor statute and regulation and whether the leaf tobacco was actually being used in the state even though the owner introduced no extrinsic act initiating or directing the aging process. Because there was no ambiguity in the property factor statute’s employment of the term “used,” the court was bound by the plain meaning of the word. The dictionary defines “used” as “to put into action or service” or “[t]o employ for the accomplishment of a purpose.”6 While the Department’s interpretation of a tax statute is entitled to great weight, the court is not required to follow the Department’s regulation if there is no ambiguity on the face of the statute.

The supreme court agreed with the circuit court’s finding of fact that the storage of the leaf tobacco in Virginia was not necessary to the aging process because the tobacco would age regardless of where it was kept. Allowing raw materials to sit without affirmatively acting upon those materials does not constitute processing because processing requires that these materials undergo treatment that will result in a product that is more marketable or useful. The fact that the leaf tobacco aged in the ambient conditions of the Virginia facilities was a natural consequence of the passage of time rather than any effort by the taxpayer. The supreme court agreed with the circuit court that the regulation did not apply to the instant case because it does not contemplate aging agricultural raw materials in its categories of property that are “used” in Virginia.

Commentary This case is favorable for profitable taxpayers that store raw materials in Virginia as part of an aging process while leaving the materials alone, where such step is a condition precedent to the value-added activities that occur later in the supply chain process. Although this case is limited to states that continue to use a property factor as part of their apportionment methodology, the case could serve as persuasive authority in these states, to the extent they adopt the statutory language from the Multistate Tax Compact requiring that property be “used” in a state in order to be included in the property factor.7 In states that have a “use” requirement in their property factor, taxpayers should closely examine their property holdings, including their in-state inventory. Before automatically including these items in the property factor calculation, taxpayers should consider whether they are actually activating or employing the property in furtherance of their business.

At the same time, it is wise to consider whether a state tax authority has elaborated on the meaning of “used” through a regulation. Despite the fact that the Virginia Supreme Court found the Department’s regulation not to apply in this instance, the court did not take the additional step of striking the regulation in its entirety. By not invalidating the regulation, the Department’s expansive view of what constitutes “used” still may apply in a variety of contexts. For example, property held as reserves or standby facilities, as well as property held as a reserve source of materials are includible in the property factor, according to the Department’s regulation.8

Finally, as in many matters concerning apportionment, a slight change in facts may have led to a dramatically different outcome. If the taxpayer’s storage of the leaf tobacco at the raw materials stage had been located outside Virginia, an exclusion of such out-of-state property from the Virginia property factor would have increased the taxpayer’s overall Virginia apportionment factor under the rationale of this case, leading to an adverse result.



1 Virginia Department of Taxation v. R.J. Reynolds Tobacco Co., Virginia Supreme Court, No. 201263, Feb. 10, 2022.
2 VA. CODE ANN. § 58.1-408.A.
3 VA. CODE ANN. § 58.1-409.
4 Id.
5 23 VA. ADMIN. CODE § 10-120-160.A.4.b.
6 Webster’s Third New International Dictionary 2523 (1993); Black’s Law Dictionary 1853, 1855 (11th ed. 2019).
7 See Multistate Tax Compact, Art. IV, § 10.
8 23 VA. ADMIN. CODE § 10-120-160.A.4.a.



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