How much of related-party royalties escaped Virginia's add-back when affiliates paid tax elsewhere or licensed third parties?

Plain-English summary

Virginia allowed full royalty add-back exceptions for two affiliates, limited a third affiliate to the portion actually subjected to tax elsewhere, and restored payroll factors for subsidiaries with out-of-state payroll. The taxpayer had paid royalties to three affiliated intangible-holding companies on its 2004-2006 combined returns.

For the ordinary subject-to-tax exception, Virginia rejected a 100% exclusion merely because gross royalty income appeared on another state's return. The exception covered only the portion corresponding to the affiliate's income actually apportioned and subjected to tax in other states. The auditor therefore correctly limited the IHCC exception.

IHCA and IHCB separately qualified for the unrelated-third-party licensing exception. More than one-third of their income came from unrelated parties, and the affiliated and third-party licensing used similar arm's-length rates. Virginia allowed the full exception and declined an equitable adjustment for those transactions.

The taxpayer's valid-business-purpose argument for IHCC could not be considered because it had not followed the statute's special application procedure. The ruling also found that subsidiaries with no Virginia payroll but positive payroll elsewhere were entitled to include a payroll factor with a zero Virginia numerator. The audit was remanded for those adjustments and a revised bill.

What this means for you

• Another state's return does not automatically shelter 100% of related-party royalties from add-back.
• Match the exception to the share of affiliate income actually subjected to tax elsewhere.
• Substantial unrelated-party licensing can support a separate statutory exception when its requirements are met.
• A valid-business-purpose claim must follow the specific application process and deadline.
• A zero Virginia payroll numerator still belongs in the formula when total payroll is positive.

Common questions

Q: Why did IHCC receive only a partial exception?
A: Only the share of its royalty income apportioned and subjected to tax in other states qualified.

Q: Why did IHCA and IHCB receive full exceptions?
A: Their documented unrelated-party licensing satisfied the statutory third-party exception.

Q: Did economic substance alone create an exception?
A: No. The taxpayer had to use the separate valid-business-purpose procedure.

Q: Why were subsidiary payroll factors restored?
A: The subsidiaries had payroll outside Virginia, so the denominator was positive even though the Virginia numerator was zero.

Citations and references

• Va. Code § 58.1-402 B 8, including § 58.1-402 B 8 a 2; Va. Code § 58.1-402 A 8 b.
• Va. Code § 58.1-446.
• Va. Code §§ 58.1-407 through 58.1-421 and § 58.1-412; 23 VAC 10-120-150 A 2.
• Virginia Public Documents 07-153, 09-115, 05-29, and 06-47.

Subject

Affiliated entities claimed exception for all of the royalty and interest deductions on the grounds that they were subject to tax in another state.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 13-165

Original ruling text

August 23, 2013

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. I apologize for the delay in responding to your request.

FACTS

The Taxpayer and several of its affiliates file as part of a combined return for Virginia income tax purposes. For the taxable years at issue, the Taxpayer paid royalties to three affiliated entities, the * (IHCA), (IHCB), and ** (IHCC). On its income tax returns, the Taxpayer listed one state in which the affiliated entities filed income tax returns and claimed an exception for all of the royalty and interest deductions 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 affiliates' royalty income apportioned to the state in which the affiliates paid tax and increased the corresponding net add back of royalties and interest.

The Taxpayer filed an appeal contesting the assessments. The Taxpayer argues (1) the full royalty deduction is permitted by the plain language of the statute; (2) the Department's prior rulings misconstrue the add back clause; (3) the Department's policy contradicts its regulations; (4) it followed the Department's return instructions; and (5) the affiliated entities were not sham or shell companies. Further, the Taxpayer asserts that the Virginia add back statute violates the Commerce and Due Process clauses and that the "subject to tax" exception is not limited to separately filed tax returns. The Taxpayer has also provided evidence that the affiliated entities received royalty income from numerous third parties. Finally, the Taxpayer asserts that auditor erroneously eliminated payroll from the payroll factor of several related entities.

DETERMINATION

Subject to Tax Exception

Virginia Code § 58.1-402 B 8 provides several exceptions to the general rule that an add back for certain intangible deductions 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 royalty 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 royalties to three affiliated entities. The auditor reduced the add back exception to the portion of the Taxpayer's royalties paid to the affiliates that corresponds to the portion of the affiliates' income subjected to tax in other states.

Department's Interpretation of Add Back

The Taxpayer contends that the Department's interpretation of Va. Code § 58.1­402 B 8 is erroneous. 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 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 legislation. The addition of this "add back" provision was subject to debate and revision during the 2004 General Assembly sessions in which the Department was actively involved.

The Department's interpretation of Va. Code § 58.1-402 B 8 in 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 enacted by the General Assembly.

"Subject to Tax" as defined by Regulation

The Taxpayer contends that "subject to tax" is defined in the Department's regulations. Title 23 of the Virginia Administrative Code (VAC) 10-120-120 B states that a corporation is presumed to do business entirely in Virginia unless it is subject to one of the enumerated taxes certain taxes. For purposes of 23 VAC 10-120-120 A, the term "subject to" is defined as:

one of the taxes enumerated in [subsection A] if it carries on sufficient business activity within any other state so that the other state has jurisdiction to impose one of the enumerated taxes, whether or not such other state actual imposes one of the enumerated taxes

The definition of "subject to" included in subsection B of Title 23 VAC 10-120-120 clearly limits its application to subsection A of the same regulation. Title 23 VAC 10-­120-120 regulates the Department's authority to tax the entire income of a corporation or require the corporation to apportion income to Virginia.

The use of a term specifically limited to one subsection of a regulation cannot be considered to be its general meaning throughout Title 58.1 of the Code of Virginia or the Virginia Administrative Code. Thus, the meaning of the term "subject to" is limited to Title 23 VAC 10-120-120. It does not define "subject to tax" for purposes of the intangible expense and interest add back.

Return Instructions

The Taxpayer quotes the Virginia instructions for form 500AB and then states that it filed its return in accordance with the Department's instructions. The Taxpayer focuses on the terms "results in a nontrivial increase in tax liability." It believes that IHCA, IHCB, and IHCC accounted for a nontrivial increase in tax liability when they filed tax returns in other states.

The instructions go on to state that consideration must be given for all the deductions, credits, exemptions and other tax policies and preferences resulting in the tax liability of an intangible holding company. Further, the instructions indicate that the Department will examine the actual returns filed in other states in order to determine the impact of the tax liability on an entity's required addition under Va. Code § 58.1-402 B 8. In this case, the Department's auditor examined the returns filed in other states by IHCA, IHCB, and IHCC and adjusted the Taxpayer's addition in accordance with established policy.

Due Process and Commerce Clause

The Taxpayer contends the add back statute violates the Due Process and Commerce clauses of the United States Constitution. In order to determine if a tax violates the Commerce Clause by placing an undue burden on interstate commerce the U.S. Supreme Court has developed a four prong test. Complete Auto Transit Inc, v. Brady , 403 U.S. 274, 279 (1977). A state tax will overcome a Commerce Clause challenge if it "(1) is applied to an activity with a substantial nexus with the taxing State, (2) is fairly apportioned, (3) does not discriminate against interstate commerce, and (4) is fairly related to the services provided by the State." Id.

The add back statute is fairly apportioned. In fact, the amount added back is apportioned twice. First, the law allows an exception to the add back for the portion of intangible expenses on which the affiliated recipient has been subject to tax. Second, the amount added back is then allocated and apportioned with the rest of the Taxpayer's income to determine the portion subject to Virginia tax.

Requiring an add back does not discriminate against interstate commerce. The Commerce Clause requires that a taxing scheme be internally consistent. A taxing "formula must be such that, if applied by every jurisdiction, it would result in no more than all of the unitary business income being taxed." Oklahoma Tax Comm'n v. Jefferson Lines, Inc. , 514 US 159 (1983). The add back statute only requires the taxpayer to add back royalties deducted to the extent that the affiliate's income from those royalties it is not apportioned to another taxing jurisdiction. The amount is further allocated and apportioned under Virginia law. Thus, if every state adopted the same the add-back statute, and had the same allocation and apportionment statute as Virginia, it would not result in taxing more than all of the unitary business income of the taxpayer.

Based on the above analysis, the auditor correctly assessed the Taxpayer for the portion of the royalty fees paid to the affiliate corporation that was not subject to tax in another taxing jurisdiction.

Extension of Add Back Exception to Consolidated Returns

The Taxpayer contends that the add-back statute does not limit the exception to states where separate returns are filed. Rather, it asserts that the inclusion of royalty income in other states' combined and consolidated return should qualify to the subject to tax exception.

While the filing of an income tax return may be evidence that the corporation is subject to tax, merely including an item of income in that return is not proof that the particular item was subject to tax in that state. A corporation doing business in many states typically reports the same item of income on every state's return, and then allocates and apportions the income to determine the portion of income earned in the taxing state.

Theoretically, only the income arising from the use of a particular patent, trademark or other intangible property in a state is constitutionally subject to tax in that state. But when a corporation conducts a unitary business "a separate accounting method is incompatible with proper, accurate and efficient taxation of a multistate corporation conducting a unitary business." Commonwealth of Virginia v. Lucky Stores, Inc. , 217 Va. 121, 225 S.E.2d 870 (1976). Instead, the corporation reports all of its income from patents and trademarks in all states and then uses a formula to calculate the portion of this income attributable to the taxing state. The tax is then imposed on that portion of the corporation's income. This process ensures that a state does not reach out and tax income earned elsewhere. "The central purpose behind the apportionment requirement is to ensure that each state taxes only its fair share of an interstate transaction." Goldberg v. Sweet , 488 U.S. 252, 260, 109 S.Ct. 582, 588 (1989).

Therefore, the exception does not apply to the gross amount of payments that the Taxpayer made to its affiliates merely because the gross amount is shown on another state's tax return. The exception is limited to the portion of the Taxpayer's royalty payments to its affiliates that corresponds to the portion of the affiliates' income or capital subjected to tax in other states, as evidenced by the apportionment percentages shown in the affiliates' tax returns filed with other states. See P.D. 09-115 (7/31/2009).

Valid Business Purpose

The Taxpayer contends it should be allowed to exclude the royalties and 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. It asserts that the IHCA, IHCB, and IHCC each had economic substance and were operated for a valid business purpose and therefore were not "sham" or "shell" companies.

Virginia Code § 58.1-402 B 8 does not provide an exception to the add-back requirement based on the economic substance of the related entities. However, 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 Tax 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 Tax Commissioner to consider evidence relating to any transactions between it and related members that resulted in its taxable income being increased. The Tax 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 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 Tax 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 Tax Commissioner's response. The amended return must be filed within one year of the Tax 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 cannot be considered.

Third-Party Royalty Income

The Taxpayer has provided documents to show that IHCA and IHCB should qualify for the exception for the licensing of intangible property to unrelated third parties. It states that the rates charged by the related entities to corporate affiliates are similar to the rates charged to the unrelated third parties and that more than one-third of IHCA's and IHCB's income was derived from unrelated third parties.

Virginia Code § 58.1-402 B 8 a 2 provides that the add back will not be required

if:

The related member derives at least one-third of its gross revenues from the licensing of intangible property to parties who are not related members, and the transaction giving rise to the expenses and costs between the corporation and the related member was made at rates and terms comparable to the rates and terms of agreements that the related member has entered into with parties who are not related members for the licensing of intangible property.

Based on the documentation provided, IHCA and IHCB have met the requirements for the exception under Va. Code § 58.1-402 B 8 a 2.

Improper Reflection of Income

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." 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 for IHCC with respect to 100% of the addition for royalty expenses, the situation appears to be similar to that described in P.D. 05-29 (3/7/2005). 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 the Taxpayer's case, however, because the Taxpayer qualifies for only a portion of the requested exception, the Department has concluded that any improper reflection of the business done in Virginia is not of sufficient magnitude to require an equitable adjustment under Va. Code § 58.1-446.

In this case, the Taxpayer did qualify for the 100% exception from the add back for IHCA and IHCB under Va. Code § 58.1-402 B 8 a 2. In considering whether to invoke Va. Code § 58.1-446, the Department will consider whether the intercompany transactions are conducted at arm's length. Intercompany transactions conducted at the same rates as those between a related entity holding intangible property and unrelated third parties are given significant consideration. Both IHCA and IHCB derived a significant portion of its revenues from unrelated third parties at arm's length terms and rates. These rates were the same as those charged to the Taxpayer and its affiliates. As such, the Department has chosen not to pursue an adjustment for improper reflection of income with regard to the transactions between IHCA and IHCB at this time.

Payroll Factor

In 2005, four of the Taxpayer's subsidiaries, * and *** (collectively, the

"Subsidiaries") had property and sales within Virginia but had no Virginia payroll. The Taxpayer reported "one" as the denominator of its payroll and divided the total of the property and sales factors by four. The auditor recomputed the apportionment factors for each of the Subsidiaries by dividing the total of the property and sales factors by three. The Taxpayer contests this adjustment and contends that the payroll should be included when determining the denominator of the apportionment factor because even though the affiliates had no Virginia payroll, they reported payroll expense on their federal returns.

If a corporation is subject to taxation in Virginia and at least one other state then all Virginia taxable income, other than dividends allocable under Va. Code § 58.1-407, is apportioned by the appropriate formula as provided in Va. Code §§ 58.1-407 through 58.1-421. All corporations, with several exceptions for particular industries, are required to use a three-factor formula based on the property, payroll and sales within Virginia, with the sales factor counted twice. The formula is the average of the three factors, except if the denominator of any fraction is zero, then that fraction is not included in the average. See Title 23 VAC 10-120-150 A 2. Conversely, if the numerator is zero, but there is a positive denominator, then the fraction is included the average. Also, see P.D. 06-47 (4/11/2006).

Virginia Code § 58.1-412 provides that the payroll factor is a fraction, the numerator being the total amount of compensation paid or accrued within Virginia during the taxable year by a corporation and the denominator being the total compensation paid or accrued everywhere during the taxable year. In this case, the Subsidiaries had no payroll in Virginia, but had payroll elsewhere. As such, they would be entitled to include a payroll factor in each of their apportionment factors even though the numerator was zero.

CONCLUSION

Based on the forgoing, the Taxpayer was entitled to a full deduction for royalties paid to IHCA and IHCB. The auditor made the appropriate adjustment to add back a portion of royalties charged by IHCC. I also find that the Taxpayer properly included each of the Subsidiaries' payroll factors in their respective apportionment factors for the 2005 taxable year.

Accordingly, the audit will be returned to the auditor in order to adjust the audit report and assessments in accordance with this determination. Once the auditor makes the appropriate adjustments, the Taxpayer will receive a revised bill. The Taxpayer should remit payment for the outstanding balance as shown on the revised bill within 30 days from the date of the revised bill to avoid the accrual of additional interest.

If the Taxpayer wishes to apply to the Tax Commissioner for relief based upon the existence of a valid business purpose with regards to IHCC, the Taxpayer must comply with the statutory time period provided by Va. Code § 58.1-402 A 8 b. The questionnaire and all other required documentation should be sent to the Virginia Department of Taxation, Appeals and Rulings, P.O. Box 27203, Richmond, Virginia 23260-7203, Attn: *.

The Code of Virginia sections, regulations 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 * at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

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