Did other-state taxation let a corporation exclude 100% of related-member factoring fees from Virginia's add-back?

Subject

Factoring-fee exception followed affiliate income taxed elsewhere

Plain-English summary

Virginia rejected a 100% exception for related-member factoring fees merely because the affiliate reported the gross payments in other states. The subject-to-tax exception applied only to the portion corresponding to affiliate income actually apportioned and subjected to a net-income-based tax elsewhere.

The Commissioner relied on the statutory words "portion" and "corresponding item" and the approach stated in P.D. 07-153. The ruling also noted Virginia's continuing power to make an equitable adjustment if affiliated arrangements improperly reflected Virginia business, although it found the remaining distortion here insufficient for that step.

The taxpayer's alternative valid-business-purpose request was denied because it had not followed the statutory report-pay-petition procedure. Virginia withheld collection for 30 days to permit compliance or payment.

What this means for you

• An affiliate's other-state return did not support an exception for the entire gross factoring payment.
• Other-state apportionment percentages measured the qualifying subject-to-tax portion.
• A taxpayer seeking business-purpose relief first had to report and pay the add-back liability.
• The published ruling has internal affiliate-count and royalty references that should not be treated as separate factual findings.

Common questions

Was every dollar reported by the affiliate in another state exempt from add-back?

No. Only the portion corresponding to income apportioned and taxed there qualified.

Did Virginia evaluate the merits of the asserted business purpose?

No. It denied the request because the taxpayer had not followed the required procedure.

Citations and references

• Va. Code §§ 58.1-402(B)(8) and 58.1-446.
• Raven Red Ash Coal Corporation v. Henry Absher, 153 Va. 332, 149 S.E. 541 (1929).
• P.D. 03-56, 05-29, and 07-153.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 09-68

Original ruling text

May 13, 2009

Re: § 58.1-1821 Application: Corporate Income Tax

Dear *:

This will reply to your letter in which you seek correction of the corporate income tax assessments issued to * (the "Taxpayer") for the taxable years ended December 31, 2004 through 2006.

FACTS

For the taxable years at issue, the Taxpayer paid factoring fees to an affiliate for the 2004 through 2006 taxable years. The Taxpayer filed Schedule 500AB with its 2004 through 2006 Virginia corporate income tax returns, listing two states in which the affiliate filed income tax returns. The affiliate reported the factoring fees paid by the Taxpayer, and the amount of tax paid based on or measured by net income on the returns. The Taxpayer claimed an exception for 100% of the factoring fees deducted on its federal income tax returns on the grounds that they were subject to tax in another state.

On audit, the Department limited the amount claimed as an exception to the add back by reducing it to correspond to the amount of the affiliate's factoring income apportioned to each state in which the affiliate paid tax and increased the corresponding net add back of factoring fees.

The Taxpayer contests the assessments on the basis that all the factoring fees qualify for an exception to the add back because they were subject to tax based on or measured by net income imposed by other states. The Taxpayer contends its interpretation of the add back provision is accurate and the Department failed to provide any guidance as to the interpretation of the add back statute. Finally, the Taxpayer contends that even if it cannot claim a 100% exception of its factoring fees on the basis that they were subject to tax in another state, the Taxpayer's intercompany transactions have a valid business purpose other than the avoidance or reduction of tax.

DETERMINATION

Subject to Tax Exception

Virginia Code § 58.1-402 B 8 provides that there shall be added back to the extent excluded from federal taxable income:

the amount of any intangible expenses and costs directly or indirectly paid, accrued, or incurred to, or in connection directly or indirectly with one or more indirect transactions with one or more members to the extent that such expenses and costs were deductible or deducted in computing federal taxable income for Virginia purposes.

The Code provides several exceptions to the general rule that an add back is required. The exception relevant to the Department's assessment of the Taxpayer states:

This addition shall not be required for any portion of the intangible expenses and costs if one of the following applies: (1) The corresponding item of income received by the related member is subject to a tax based on or measured by net income or capital imposed by Virginia, another state, or a foreign government that has entered into a comprehensive tax treaty with the United States government. (Emphasis added.)

According to the Taxpayer, the plain meaning of the statute entitles it to exclude 100% of its factoring payments from the add back. This interpretation, however, cannot be reconciled with the legislature's use of the limiting words "portion" and "corresponding item." When interpreting statutes "[a] fundamental rule of statutory construction requires that every part of a statute be presumed to have some meaning, and not be treated as meaningless unless absolutely necessary." Raven Red Ash Coal Corporation v. Henry Absher , 153 Va. 332, 149 S. E. 541 (1929). (Emphasis added).

In Public Document (P.D.) 07-153 (10/2/2007), the Department determined that parsing the statutory language of Va. Code § 58.1-402 B 8 shows that the exception is not all inclusive. When considering this statute in its totality, the exception does not apply to the gross amount of payments that a taxpayer made to an affiliate merely because the gross amount is shown on another state's tax return. Instead, the exception is limited to the portion of a taxpayer's intangible expense payments to its affiliate that correspond to the portion of the affiliate's income subjected to tax in other states, as evidenced by the apportionment percentages shown on the affiliate's tax returns filed with other states.

In this case, the Taxpayer paid factoring fees to two affiliates. The auditor reduced the add back exception to the portion of the Taxpayer's factoring expenses paid to the three affiliates that correspond to the portion of the affiliate's income subjected to tax in other states.

The Taxpayer contends the assessments are unfair because it filed its 2004 through 2006 returns based on its good faith interpretation of Va. Code § 58.1-402 B 8, and the Department issued no guidance until P.D. 07-153 was issued.

The Virginia Supreme Court has consistently held that the construction of a tax statute by a state official charged with its administration is entitled to great weight. See Webster v. Department of Taxation , 219 Va. 81, 84-85, 245 S. E.2d 252, 255 (1978) and Winchester TV Cable v. State Tax. Com. , 216 Va. 286, 290, 217 S.E.2d 885, 889 (1975). The addition for intangible and interest expenses paid to related entities under Va. Code § 58.1-402 B 8 was enacted as part of the Governor's tax reform legislation in 2004. See Chapter 3, Acts of Assembly, 2004 Special Session I . The Department played a primary role in drafting the language in the Governor's plan. This addition was subject to much debate and a number of revisions during the 2004 General Assembly sessions. There can be little doubt that this statute was constructed by the agency charged with its administration.

P.D. 07-153 was not an announcement of a change in policy or interpretation of the addition by the Department. Instead, it articulated the original intent of Va. Code § 58.1-402 B 8 as constructed by the Department. The fact that a taxpayer interprets a statute differently than the Department does not absolve such taxpayer from the consequences of failing to follow the law.

The statutory provision requiring the addition (and allowing exceptions) specifically states in Va. Code § 58.1-402 B 8 c that "[n]othing in subdivision B 8 shall be construed to limit or negate the Department's authority under § 58.1-446." Because the latter section authorizes an equitable adjustment when the Department finds that arrangements between affiliated corporations improperly reflect business done in Virginia, the quoted language clearly authorizes the Department to invoke Va. Code § 58.1-446 when it finds that allowing an exception would result in the taxpayer's income improperly reflecting the business done in Virginia.

If the Taxpayer qualified for the exception with respect to 100% of the addition for royalty and factoring expenses, then the situation would be similar to that described in P.D. 03-56 (8/8/2003) with respect to factoring, and P.D. 05-29 (3/7/2005) with respect to royalties. In those cases the Tax Commissioner upheld an adjustment under Va. Code § 58.1-446 based upon consolidating the affiliated entities with the Taxpayer or disallowing a deduction for amounts paid to the affiliated entity. Under these circumstances, the Department may invoke Va. Code § 58.1-446 to make a similar adjustment to the extent that an addition is not made under Va. Code § 58.1-402 B 8. In this case, however, because the Taxpayer qualifies for only a portion of the requested exception, the Department has concluded that any distortion of the business done in Virginia is not of sufficient magnitude to require an equitable adjustment under Va. Code § 58.1-446.

Valid Business Purpose

The Taxpayer contends it should be allowed to exclude the factoring fees from the add back requirement because the intercompany transactions had a valid business purpose other than the avoidance or reduction of tax.

Virginia Code § 58.1-402 A 8 b provides an exclusion for the add back when the intangible intercompany expenses were incurred through a valid business purpose other than the avoidance or reduction of tax. The statute establishes the specific procedures to follow to claim this exclusion.

In order to apply to the Commissioner for relief based upon the existence of a valid business purpose, a taxpayer must file its Virginia income tax return reporting the addition in accordance with the statute and remit all taxes, penalties and interest due for the taxable year.

A taxpayer may then petition the Commissioner to consider evidence relating to any transactions between it and related members that resulted in its taxable income being increased. The Commissioner may permit the taxpayer to file an amended return if the application demonstrates by clear and convincing evidence that the transactions resulting in such increase in taxable income pursuant to the additions had a valid business purpose other than the avoidance or reduction of the tax. A questionnaire that provides an example of the type of information a taxpayer must provide to the Department to demonstrate a valid business purpose is enclosed.

If the Commissioner grants the application, the taxpayer may file an amended return that excludes the addition related to the specific transaction or transactions identified in the Commissioner's response. The amended return must be filed within one year of the Commissioner's response.

The Taxpayer's request was not made in accordance with the procedure for claiming the business purpose exclusion from the addition for intangible and interest expenses paid related entities pursuant to Va. Code § 58.1-402 B 8 b. As such, the Taxpayer's request to exclude the add back of the royalties and factor fees on the basis that they were incurred for a valid business purpose is denied.

I will, however, withhold additional collection actions for 30 days from the date of this letter to allow the Taxpayer to comply with the procedures in Va. Code § 58.1-402 B 8 b or remit payment for the assessment. If the Virginia income tax return reporting the addition, along with all taxes, penalties and interest due for the taxable year is not received within the allotted time, a revised bill, with interest accrued to date, will be sent to the Taxpayer and collection action will resume.

The Code of Virginia sections and public documents cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions regarding this determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner

AR/1-2696005344.B