My company deducted royalty payments to an affiliated intangible holding company, and I want the full 'subject-to-tax' exception from Virginia's intangible-expense add-back because all the royalty income was taxed somewhere else -- but does a state's 'throw-out' rule (like New Jersey's) affect how much of that exception I actually get?

Plain-English summary

A multistate corporation and several affiliates filed combined Virginia corporate income tax returns claiming a full exception from Virginia's add-back for intangible expenses -- royalty payments made to two related intangible holding companies -- on the theory that all of that royalty income was "subject to tax" in another state. Under audit, the Department limited the exception to the portion of the royalty income actually apportioned to, and taxed in, the states where the holding companies filed returns, which increased the taxpayer's add-back and led to the assessments at issue.

The Kohl's post-apportionment rule. The taxpayer argued the plain language of Va. Code § 58.1-402 B 8 entitled it to exclude 100% of the royalties because all of it was included in the holding companies' taxable income somewhere else. The Department rejected that, consistent with its long-standing position (P.D. 07-153) and the Virginia Supreme Court's decision in Kohl's Department Stores, Inc. v. Virginia Department of Taxation, 295 Va. 177 (2018). The Court held that the "subject-to-tax exception applies only to the extent that the royalty payments were actually taxed by another state" -- on a post-apportionment basis, not a pre-apportionment one. In other words, if a holding company's royalty income is included in its starting taxable income but a large share of that income isn't actually apportioned to (and taxed by) any state, only the apportioned, actually-taxed share qualifies for the exception. Following a later circuit court ruling in the same Kohl's litigation, the taxpayer bears the burden of showing how much royalty income was actually apportioned to and taxed by another state.

How the exception is computed. For states where the intangible holding company files a separate return, the exception equals the affiliate's royalty income times its own apportionment percentage on that separate return. For states where the taxpayer itself faces an add-back (mirroring Virginia's rule), the exception equals the taxpayer's intangible-expense addition on that state's return times its own apportionment percentage there.

The New Jersey throw-out wrinkle. The taxpayer separately argued the auditor used the wrong New Jersey apportionment percentage by ignoring New Jersey's "throw-out" rule. For tax years 2002-2010, New Jersey required corporations to exclude from their sales-factor denominator any sales allocated to a state where the corporation wasn't subject to income tax -- which increases the New Jersey sales factor (and thus New Jersey tax liability), subject to a $5 million annual cap (N.J. Stat. § 54:10A-6(B)(6), since repealed). For 2007-2010, the related intangible holding company hit that $5 million throw-out cap, meaning it paid tax on more New Jersey-apportioned income than its raw apportionment percentage alone would suggest -- but the auditor had calculated the exception using only the reported New Jersey apportionment percentage, without accounting for that extra taxed income.

The Department agreed the throw-out effect has to be factored in: since the subject-to-tax exception is a post-apportionment concept, and a throw-out (or throw-back) rule is part of how a state statutorily determines post-apportionment taxed income, all income actually apportioned to and taxed by a state -- including any extra amount taxed because of a throw-out or throw-back rule -- counts toward the exception. The case was remanded to the auditor to recalculate the exception using the corrected New Jersey figures (and to address any similar issues for other states).

What this means for you

Multistate corporations paying intercompany royalties to an affiliated IP holding company

You can't claim the subject-to-tax exception for 100% of royalty income just because the recipient affiliate's home state taxes it in some form -- only the portion of that income actually apportioned to, and taxed by, another state qualifies. If your evidence doesn't show the apportioned, actually-taxed amount, expect the Department to calculate the exception based on the affiliate's own apportionment percentage in that state.

Anyone computing a subject-to-tax exception involving a state with a throw-out or throw-back apportionment rule

Check whether the other state's throw-out or throw-back rule increased the amount of income actually subject to tax there beyond what the raw apportionment percentage implies. That increased, post-apportionment taxed amount should be included in the exception calculation -- using only the face apportionment percentage can understate the exception.

Common questions

Q: Can I get a 100% exception from Virginia's intangible-expense add-back just because my affiliate's royalty income is included in its taxable income in another state?
A: No. Following Kohl's, the exception only covers the portion of that income actually apportioned to, and taxed by, another state -- a post-apportionment test, not a pre-apportionment one.

Q: Does a state's "throw-out" or "throw-back" rule matter to this calculation?
A: Yes. If a rule like New Jersey's throw-out provision increases the amount of income actually taxed by that state, that additional taxed income should be included when figuring the exception -- the raw reported apportionment percentage alone may understate it.

Q: Who has the burden of proving how much royalty income was actually taxed elsewhere?
A: The taxpayer does. Exemptions and exceptions are strictly construed against the taxpayer, who must affirmatively show the income was apportioned to and actually taxed in the other state.

Citations and references

Statutes:

• Va. Code § 58.1-402 B 8 -- add-back of intercompany intangible expenses and the subject-to-tax exception
• N.J. Stat. § 54:10A-6(B)(6) -- New Jersey's sales-factor "throw-out" rule (2002-2010, since repealed)

Cases cited: Kohl's Department Stores, Inc. v. Virginia Department of Taxation, 295 Va. 177 (2018); Kohl's Department Stores, Inc. v. Virginia Department of Taxation, Circuit Court of the City of Richmond, CL12-1774, 2021 Va. Cir. LEXIS 116 (5/13/2021); Container Corp. of America v. Franchise Tax Bd., 463 U.S. 159 (1983); LZM, Inc. v. Va. Dep't of Taxation, 269 Va. 105 (2005).

Prior rulings referenced (described here, not linked): P.D. 07-153 (10/2/2007) -- the Department's pre-Kohl's position that the exception is limited to actually-taxed, apportioned income.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 24-26

Original ruling text

March 20, 2024

Re: § 58.1-1821 Application: Corporate Income Tax

Dear *:

This will reply to your letters in which you seek correction of the corporate income tax assessments issued to * (the “Taxpayer”) for the taxable years ended December 29, 2007, through October 30, 2012. I apologize for the delay in responding to your requests.

FACTS

The Taxpayer and several of its affiliates filed combined Virginia corporate income tax returns for the taxable years at issue, claiming a full exception to the add- back for intangible expenses paid to two related intangible holding companies on the basis that the income was subject to tax in another state. Under audit, the Department reduced the amount claimed as an exception to the add-back to correspond to the amount of the affiliates’ royalty income apportioned to the state in which the intangible holding companies paid tax. The amount of the add-back was increased accordingly, and assessments were issued.

The Taxpayer filed applications for correction, contending (1) a full exception was permitted by the plain language of the statute; and (2) even if a full exception was not permitted, the Department miscalculated the amount of the exception.

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:

[T]he 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 direct or indirect transactions with one or more related members to the extent 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 assessments 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.]

In its appeal, the Taxpayer argued the plain meaning of the statute entitles it to exclude 100% of the royalty payments from the add-back because all the royalties were included in the affiliated intangible holding companies’ taxable income in another state. The Department’s position has consistently been that 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. See Public Document (P.D.) 07-153 (10/2/2007).

In Kohl’s Department Stores, Inc. v. Virginia Department of Taxation , 295 Va. 177 (2018), the Virginia Supreme Court (the “Court”) interpreted the “subject-to-tax” exception as applied to royalty payments made by Kohl’s Department Stores, Inc. (Kohl’s) to Kohl’s Illinois, Inc. (Kohl’s Illinois). The Court agreed with the Department’s interpretation, stating that “[t]he circuit court correctly determined that only the portion of the royalties that was actually taxed by another state falls within the subject-to-tax exception.” Id . at 191.

Because the phrase “subject to a tax” is not defined under the Code of Virginia , the Court determined its meaning by considering the legislature’s intent and the requirements of the Due Process and Commerce Clauses of the United States Constitution. Specifically, the Court stated that “the Due Process and Commerce Clauses of the United States Constitution mandate that only the amount of a corporation’s income that is fairly apportionable to a given state is legally subject to that state’s income tax.” Id. at 186 ( citing Container Corp. of America v. Franchise Tax Bd ., 463 U.S. 159, 164 (1983)). The Court held that, while intercompany royalties were included in Kohl’s Illinois’ taxable income (pre apportionment income), a substantial amount of those royalties was not apportioned to, or taxed by, every state in which Kohl’s Illinois filed a corporate income tax return. The Court found that an income tax could only be imposed by a state on the amount of royalties apportioned to such state (post-apportionment income), stating:

We therefore hold that the subject-to-tax exception applies only to the extent that the royalty payments were actually taxed by another state. That is, the exception applies on a post-apportionment, rather than a pre-apportionment, basis.

Id . at 190. In making this determination, the Court concluded that the General Assembly intended for the exception to apply only to post-apportionment income because to hold otherwise would negate the intended operation of the statute. Id . at 189-190.

The Court also opined, however, that the “statute only requires that the ‘item of income received by the related member’ . . . be taxed by another state. It does not require that the related member be the entity that pays the tax on that ‘item of income.’” Id . at 191 (quoting Va. Code § 58.1-402(B)(8)(a)). Therefore, payments fall within the exception to the extent they were taxed under a tax based on or measured by net income or capital by another state, regardless of whether it was a separate or combined reporting state, including a state where the payments were subject to an add-back, and regardless of which entity paid the tax. Id . at 191. The Court remanded the case to the circuit court to decide what portion of the royalty payments were actually taxed by another state and, thus, eligible for the exception from the intangible expense addition.

Based on the Virginia’s Supreme Court’s decision in Kohl’s , the computation of the exception amount for states where the intangible holding company is subject to tax (the Separate Return States) and the states where the entity is subject to additions in other states (the Add-Back States) is as follows:

• For Separate Return States, the amount of the exception will be calculated by multiplying a related entity’s intercompany royalty income by that entity’s apportionment percentage on the separate return.

• For Add-Back States, the exception will be equal to the amount of a corporation’s intercompany intangible expense addition on a state’s income tax return multiplied by the corporation’s apportionment percentage in that state.

The Department is aware that some taxpayers have reached agreements with states that allow for an alternative or special method of apportionment for intangible income or expenses. For purposes of Virginia Code § 58.1-402 B 8 a 1, the amount of intangible income or expenses eligible for the exception will be limited to the apportionment percentage reported on the subject state’s return.

Following the Virginia Supreme Court decision, the Department and Kohl’s agreed on a calculation of the add-back exception based upon Kohl’s Illinois’ income subjected to tax in the Separate Return States and Kohl’s intangible income additions subject to tax in most of the Add-Back States. However, the parties disagreed as to whether and to what extent the royalties were actually taxed by the states in which, by requirement or election, Kohl’s and Kohl’s Illinois were included in a unitary combined or consolidated return (Combined Return States). Because the royalty payments were eliminated as intercompany transactions and, therefore not included in the combined group’s taxable income basis and/or the sales factor of the apportionment formula for those states, the Department argued that neither Kohl’s nor Kohl’s Illinois were subject to tax in the Combined Return States. Kohl’s argued that the intercompany royalty income was technically included at the start of the unitary combined or consolidated income computation. In addition, the parties disagreed about the extent to which royalty payments were actually taxed in two of the Add-Back States.

In Kohl’s Department Stores, Inc. v. Virginia Department of Taxation, Circuit Court of the City of Richmond, CL12-1774, 2021 Va. Cir. LEXIS 116 (5/13/2021), the circuit court stated that “Kohl’s now bears the burden to show that the royalty payments were apportioned to and actually taxed in other states in order to correctly calculate and receive the exception . . . because ‘[e]xemptions . . . from taxation are to be strictly construed against the taxpayer’ and ‘[t]he taxpayer has the burden of establishing that it comes within the terms of an exemption.” Id . (quoting LZM, Inc. v. Va. Dep’t of Taxation , 269 Va. 105, 110 (2005)). The court then ruled that Kohl’s failed to meet its burden to show the intercompany royalty payments were apportioned to and actually taxed in Combined Return States, as well as two of the Add-Back States, in order to be eligible for the exception. Thus, the subject-to-tax exception will be limited to the amount of intercompany intangible income, or intangible expense addition, that the taxpayer can demonstrate was actually taxed.

New Jersey

The Taxpayer also contends that the auditor did not use the correct New Jersey apportionment percentages to determine the add-back exception by disregarding the New Jersey “throw-out” rule.

Under New Jersey’s taxing scheme, for taxable years 2002 through 2010, a corporate taxpayer was required to calculate its sales factor for apportionment purposes by excluding from the denominator sales allocated to any state where the entity was not subject to an income tax. This had the effect of increasing the New Jersey sales factor and, accordingly, its tax liability. The impact of this “throw-out” rule was limited to a maximum amount of $5,000,000 for each tax year. See N.J. Stat. § 54:10A-6(B)(6) as enacted for periods beginning on or after 1/1/2002 and repealed for periods beginning on or after 7/1/2010.

For the 2007 through 2010 taxable years, the Taxpayer’s related intangible holding company was liable for the maximum throw-out rule additional tax. The auditor, however, calculated the amount of royalty expense exempt from the add-back by using the apportionment percentages reported on the New Jersey returns without considering the additional tax liability paid by reason of New Jersey’s throw-out rule.

Because the Virginia Supreme Court found that the subject-to-tax exception applies to post-apportionment income, all intercompany intangible income that is subject to an income tax after it has been statutorily apportioned to another state is eligible to be included in the exception. A throw-out rule has the effect of increasing the amount of an entity’s income that is subject to tax by requiring the entity to exclude sales from the denominator of its sales factor to the extent the sales are attributable to a state where the entity is not subject to an income tax. Similarly, some states impose a “throw-back” rule that raises income subject to tax by increasing the numerator of the sales factor to include sales that are not taxed in other states. Accordingly, when a “throw-out” or a “throw-back” rule is part of a state’s statutory apportionment factor calculation, the amount of income eligible for the subject-to-tax exception must include all intercompany intangible income taxed in the state, including any additional income apportioned to, and taxed by, such state by operation of the throw-out or throw-back rule.

CONCLUSION

Based on the Department’s analysis of the Taxpayer’s facts and circumstances regarding the licensing of its intangible property, the subject-to-tax exception claimed by the Taxpayer must be adjusted in accordance with this determination. Accordingly, the case will be remanded to the auditor to calculate the proper amount of royalty expense that could be deducted for the taxable years at issue. In addition, the auditor is directed to adjust the add-back exception for tax paid to New Jersey to account for the additional tax paid as a result of its throw-out rule.

The audit staff will be advised to contact the Taxpayer to arrange for any documentation review that may still be required. The Taxpayer will have 60 days from the date of contact with the auditor to provide all necessary documentation unless a different deadline is agreed to by the Taxpayer and the audit staff. The audit staff will review the documentation, make adjustments as appropriate, and issue updated audit reports and assessments for the taxable years at issue.

The applications for correction concerning these assessments are being closed. At the conclusion of the audit staff’s review, should any issues remain with which the Taxpayer disagrees, the Taxpayer may submit an application for correction within 90 days of the updated audit assessments in accordance with Virginia Code § 58.1-1821.

The Code of Virginia sections and public documents cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions section of the Department's web site. If you have any questions regarding the review of documentation, you may contact the auditor. If you have any questions about the appeals process, please contact * in the Department’s Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/520.X

Related Documents

07-153

16-9

21-170