Could a corporation exclude all royalties and interest paid to an affiliate because the affiliate filed income-tax returns elsewhere?

Plain-English summary

Virginia rejected a 100% royalty-and-interest add-back exception but allowed a proportional exception tied to the affiliate's income actually taxed in other states. The taxpayer had paid royalties and interest to an affiliated intangible-holding company and added all amounts back on its Virginia returns.

The statutory exception used limiting terms such as “portion” and “corresponding item.” Virginia therefore matched the taxpayer's payments to the affiliate's income subjected to other-state tax, using the apportionment percentages shown on the affiliate's state returns. Merely reporting the gross payments on another state's return did not exempt the whole amount.

The same proportional method applied to interest because the lender affiliate also held the intangible property connected with the loans.

Virginia did not make an additional equitable adjustment under Section 58.1-446 because the partial exception did not create a sufficiently large distortion. The taxpayer received 60 days to file amended 2006-2008 returns with copies of the affiliate's other-state returns.

What this means for you

• The “subject to tax” exception is proportional, not automatically all-or-nothing.
• Use the related member's actual state apportionment percentages to support the exempt share.
• Attach the affiliate's filed state returns and reconcile them to each royalty and interest payment.
• Protective-claim deadlines can be short once Virginia requests amended returns.

Common questions

Q: Did filing returns in other states exempt all payments?
A: No. Only the share corresponding to income actually subjected to other-state tax qualified.

Q: Did the same rule apply to interest?
A: Yes. The affiliate both held the intangible property and made the loan.

Q: Was the refund entirely denied?
A: The requested 100% refund was denied, but Virginia allowed amended returns claiming the supported proportional exception.

Citations and references

• Va. Code §§ 58.1-1824, 58.1-1821, 58.1-402 B 8, 58.1-402 B 9, and 58.1-446.
• Virginia Public Documents 07-153, 05-29, and 05-28, discussed in the determination.
• Raven Red Ash Coal Corporation v. Henry Absher, 153 Va. 332, 149 S.E. 541 (1929).

Subject

Royalty Expense Add-back; Interest Add back

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 13-193

Original ruling text

October 22, 2013

Re: § 58.1-1824 Application: Corporate Income Tax

Dear *:

This will reply to your letter in which you seek a refund of corporate income tax paid by * (the "Taxpayer") attributable to intangible expense add- backs for the taxable years ended December 31, 2006 through 2008. I apologize for the delay in responding to your letter.

FACTS

For the taxable years at issue, the Taxpayer paid royalties and interest to * (the "IHC"), an affiliated entity, for the use of intangible assets and interest for the IHC's licensing program. On its income tax returns, the Taxpayer added back all of its royalty and interest expenses paid to the affiliated entity. The Taxpayer requests a refund, asserting that all the royalties and interest qualify for an exception to the add-back because they were subject to a tax based on or measured by net income imposed by other states.

DETERMINATION

Pursuant to the authority granted the Tax Commissioner under Va. Code § 58.1­1824, a protective claim for refund can be held pending the outcome of another case before the courts or the claim may be decided based upon its merits pursuant to Va. Code § 58.1-1821. As permitted by statute, the Taxpayer's request has been treated as an appeal under Va. Code § 58.1-1821.

Royalty Expense Add-back

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

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 Taxpayer's refund request 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 IHC. As such, the Taxpayer would only be able to claim an exception for the portion of the Taxpayer's royalties paid to IHC that corresponds to the portion of IHC's income subjected to tax in other states.

Interest Add back

Virginia Code § 58.1-402 B 9 a 2 requires a taxpayer to add back intercompany interest expenses and costs that are directly or indirectly related or connected to transactions involving intangible property. This generally occurs when intercompany license fees generated by a corporation holding an intangible asset are used to make loans to related corporations. In this case, the affiliate making the loan also held the intangible property. As such, the Taxpayer was required to add back interest expense paid to the affiliate pursuant to Va. Code § 58.1-402 B 9 a 2 unless an exception to the general rule that an add back for an interest deduction applies.

The exception to the add back requirement for interest expense paid to a related member under Va. Code § 58.1-402 B 9 a 4 i, is the same exception that applied to the royalty expense. Specifically, if:

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

As such, based on the same rationale applied to the Taxpayer's royalty expense, interest expense that could have been claimed as an exception would have been limited to the portion of the interest the Taxpayer paid to IHC that corresponds to the portion of IHC's income subjected to tax in other states.

CONCLUSION

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 with respect to 100% of the addition for royalty and interest expenses, the situation appears to be similar to that described in P.D. 05-29 (3/7/2005) with respect to royalties and P.D. 05-28 (3/7/2005) with respect to interest. 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 or Va. Code § 58.1-402 B 9. In this 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.

Based on the foregoing, the Department is unable to grant the Taxpayer's refund claim of corporate income taxes paid for the 2006 through 2008 taxable years as requested. However, the Taxpayer may be able to claim an exemption for that portion of its royalty and interest expense payments to IHC that corresponds to the portion of IHC's income subjected to tax in other states.

In accordance with this determination, the Taxpayer may submit amended returns for the 2006 through 2008 taxable years. These returns should include copies of IHC's tax returns filed with other states for the taxable years at issue.

This protective claim will be held open for 60 days from the date of this letter in order to allow the Taxpayer to file the required amended returns. The returns should be sent to: Virginia Department of Taxation, Office of Tax Policy, Appeals and Rulings, P.O. Box 27203, Richmond, Virginia 23261-7203, Attention: *. If the returns are not filed within the time allotted, the Taxpayer's original Virginia returns for the 2006 through 2008 taxable years will be deemed to be correct as filed and the protective claim will be closed.

If you have any questions regarding this determination, you may contact * at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1-4621343570.B