When must a Virginia company add back royalties paid to a related intangible holding company, and when do the subject-to-tax, unrelated-member, conduit, consolidation, or valid-business-purpose exceptions apply?

Plain-English summary

This is a classic intangible holding company dispute. A franchisor's operating company ("Corp A") paid royalties to a related intangible holding company ("IHC") — the affiliate that owns the group's trademarks. On its 2009–2016 Virginia combined returns, the group tried to fully exclude those royalties from Virginia's related-party intangible-expense add-back. Virginia generally makes a company add back intangible expenses it paid to related members and deducted federally (Va. Code § 58.1-402 B 8), precisely to stop this kind of income-shifting. On audit, the Department allowed the exclusion only for the slice of royalties that IHC actually paid tax on in another state. The group appealed, invoking every exception in the book. The Commissioner rejected almost all of it. Here's each argument and how it came out:

Subject-to-tax exception — only partial (the Kohl's rule)

The group argued that because the royalties were included in IHC's income in another state, 100% should be excluded. Under Kohl's Department Stores, Inc. v. Virginia Department of Taxation, 295 Va. 177 (2018), the exception covers only the portion of the royalty actually subject to tax in another state after apportionment — not the whole amount. The audit allowed the exception for "separate return states" but not "add-back states"; the Commissioner said the taxpayer may still document an additional exception for tax paid in add-back states.

Unrelated-member exception — failed

This exception requires the related member to earn at least one-third of its gross revenue from licensing to unrelated parties and that the intercompany terms be comparable to the unrelated-party terms. Even accepting the Wendy's International circuit-court reading that indirect licensing can count, the exception still failed here: IHC had no agreements with any unrelated third parties to compare against, and the rates weren't comparable anyway — the Corp A–IHC royalty was 2% of gross sales, while Corp A's franchise agreements charged a 4% service fee, a 7% franchise fee, and a 5% royalty.

Conduit exception — failed

The "conduit" (third-party expense) exception applies only where the related member passes the royalty itself through to an unrelated party. IHC's own costs to develop and manage the trademarks (employee pay, consultants, legal fees) don't qualify — IHC wasn't acting as a true conduit for the royalty. The Commissioner tied this to its long-standing refusal to let holding companies net their expenses against royalty income, and to the agency concept used in the local BPOL tax.

Consolidation of accounts (§ 58.1-445 / IRC § 482) — denied

The group asked the Department to consolidate Corp A's and IHC's accounts. Consolidation is a tool to fix inaccurately stated Virginia income, not a way to lower tax on request. The group had elected combined filing, and merely showing that consolidated filing would produce less Virginia tax doesn't make the combined method inaccurate. To change filing methods you must request permission under § 58.1-442 (and it's generally prospective) — no such request was on file.

Valid business purpose exception — not properly claimed

This exception has a strict procedure: you must first file reporting the add-back and paying all the tax, then petition the Commissioner with clear and convincing evidence of a non-tax business purpose. Because the group claimed a full exclusion on its original returns and never remitted the tax, it didn't follow the procedure, so the request couldn't even be considered.

Bottom line: the royalties are added back; the only relief is the Kohl's-limited subject-to-tax exception (with a chance to document more for add-back states). The audit goes back to staff for adjustment.

What this means for you

Companies that pay royalties or interest to a related IP/holding company

Expect Virginia to add those payments back. The exceptions are narrow, strictly construed against the taxpayer, and fact-intensive. The single most useful one — subject-to-tax — is partial: you get relief only for the portion actually taxed elsewhere, computed under the Kohl's framework. Keep state-by-state documentation of where and how much the related member was taxed.

If you want the unrelated-member or conduit exception

Build the facts up front. The unrelated-member exception needs the holding company to have real, comparable third-party licenses — not just intercompany terms. The conduit exception needs the related member to actually pass the specific payment through to an unrelated party; its own operating expenses don't count and can't be netted against royalty income.

On filing method and "valid business purpose"

You cannot get consolidation just because it lowers your tax — request a filing-method change prospectively under § 58.1-442. And if you plan to rely on the valid business purpose exception, pay the tax first and follow the petition procedure; claiming a full exclusion up front forfeits it.

Tax professionals

This determination is a useful one-stop map of Virginia's add-back exceptions and their proof burdens, and it shows the Department pushing back on the circuit court's broader Wendy's reading by enforcing the second ("comparable rates and terms") prong of the unrelated-member exception. Note the strict-construction and anti-surplusage canons the Commissioner leans on.

Common questions

Q: Do I always have to add back royalties I pay to a related trademark holding company?
A: Generally yes under Va. Code § 58.1-402 B 8, unless you fit a specific exception (subject-to-tax, unrelated-member, or conduit) or properly claim the valid business purpose exception.

Q: If the related company paid tax on the royalty in another state, is the whole royalty excluded?
A: No. Under the Kohl's decision, only the portion actually subject to tax in another state (after apportionment) qualifies for the subject-to-tax exception.

Q: Can I use the conduit exception for the holding company's own development and management costs?
A: No. The conduit exception applies only to the portion of the royalty the related member passes directly through to an unrelated party — not to the related member's own expenses, which can't be netted against royalty income.

Q: Can I ask the Department to consolidate the affiliates' accounts to lower my tax?
A: Not simply because it lowers tax. Consolidation addresses inaccurately stated Virginia income. If consolidated filing would suit you better, request a change of filing method under § 58.1-442 (generally effective prospectively).

Q: How do I claim the "valid business purpose" exception?
A: File your return reporting the add-back and pay all tax, penalties, and interest, then petition the Commissioner with clear and convincing evidence of a valid, non-tax purpose. Claiming a full exclusion and not paying forfeits the exception.

Citations and references

Statutes and regulations:

• Va. Code § 58.1-402 B 8 — add-back of intangible expenses and costs paid to related members
• Va. Code § 58.1-402 B 8 a (1)-(3) — subject-to-tax, unrelated-member, and conduit exceptions
• Va. Code § 58.1-402 B 8 b — valid business purpose exception (file with the addition and pay the tax first, then petition)
• Va. Code § 58.1-445, § 58.1-446 — consolidation of related entities' accounts; equitable adjustment where Virginia income is improperly reflected
• Va. Code § 58.1-442 — election of separate, combined, or consolidated filing; changing methods requires permission (generally prospective)
• 23 VAC 10-120-350 — consolidation appropriate where federal income is accurate but Virginia-source income is inaccurately stated
• IRC § 482 — federal transfer-pricing adjustments among related entities

Case law and prior documents (described here rather than linked): Kohl's Department Stores, Inc. v. Virginia Dep't of Taxation, 295 Va. 177 (2018) (subject-to-tax exception limited to income actually taxed by another state); Wendy's International v. Virginia Dep't of Taxation, CL09-3757 (Richmond Cir. Ct. 2012) (indirect licensing can satisfy the one-third test, overruling P.D. 09-14); Howell's Motor Freight (exemptions strictly construed against the taxpayer); Platt v. Union Pacific R. Co., 99 U.S. 48 (1878) and PSINet, Inc. v. Chapman, 362 F.3d 227 (4th Cir. 2004) (avoid interpretations that render statutory language superfluous); and Department determinations P.D. 09-14, 13-211, 14-71, 21-162, and 24-26.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 26-10

Original ruling text

March 4, 2026

Re: § 58.1-1821 Application: Corporate Income Tax

Dear *:

This will respond to your letters in which you seek correction of the corporate income tax assessments issued to * (the “Taxpayer”) for the taxable years ended December 31, 2009, through December 31, 2016.

FACTS

The Taxpayer filed Virginia combined returns for the taxable years at issue, claiming a full exception to the add-back for certain royalties paid by * (Corp A) to *** (“IHC”). Under audit, the Department allowed the exception only for that portion of the royalty upon which IHC paid tax to another state and issued assessments. The Taxpayer applied for correction, contending Corp A was entitled to a full exception to the add-back under each of the subject-to-tax, unrelated member, and conduit expense exceptions. Alternatively, the Taxpayer argues that Corp A was entitled to an exception to the extent that IHC incurred costs related to the development and management of its intangible property. In support of this position, the Taxpayer cites the transfer pricing principles of Internal Revenue Code (IRC) § 482 and the consolidation principles of Virginia Code § 58.1-445. Finally, the Taxpayer asserts that the transactions had a valid business purpose.

DETERMINATION

Addition for Intercompany Intangible Expenses

Virginia Code § 58.1-402 B 8 provides that there shall be added back:

[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.

Subject-to-Tax Exception

The Taxpayer argues that the plain meaning of the statute entitled Corp A to exclude 100% of the royalty payments from the add-back because all the royalties were included in IHC’s taxable income in another state. 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 subject-to-tax exception states:

[T]his 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 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 in Virginia Code § 58.1-402 B 8. The Court agreed with the Department’s interpretation that only the portion of the intangible expense payments that was subject to a tax in another state falls within the exception. In addition, the Court decided the subject-to-tax exception is limited to intercompany intangible income that is subject to an income tax imposed on income after it has been apportioned to another state, regardless of which entity paid the tax. See also Public Document (P.D.) 24-26 (3/20/2024).

Based on the Virginia 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.

In this case, the audit staff allowed an exception for the Separate Return States but not the Add-Back States. Accordingly, the Taxpayer will be permitted to provide documentation to the audit staff to support an additional exception attributable to income tax paid in Add-Back States, if applicable.

Unrelated Member Exception

The Taxpayer also argues that it is eligible for an exception to the add-back pursuant to Virginia Code § 58.1-402 B 8 a 2, which states:

This addition shall not be required for any portion of the intangible expenses and costs if one of the following applies: . . . (2) 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.

In Public Document (P.D.) 09-14 (2/4/2009), the Department determined that the licensing agreements for the use of intangible property must be between an unrelated party and the related entity that owns the intangible property. As such, the exception for licensing at least one third of its gross revenues to an unrelated member was not met in that case because the related member did not receive the intangible property revenue directly from the unrelated franchisees.

The City of Richmond Circuit Court, however, overruled P.D. 09-14 in Wendy’s International v. Virginia Department of Taxation, CL09-3757 (3/29/2012). The court held that the exception merely requires that the related member derive at least one-third of its gross revenues from the licensing of intangible property to parties that are not related members because the statute does not distinguish as to whether the gross revenues were directly or indirectly licensed to an intangible holding company. Therefore, the exception could be claimed when intangible holding companies indirectly license intangible property to independent franchisees through operating companies.

However, Virginia Code § 58.1-402 B 8 a 2 also requires that:

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. [Emphasis added.]

The City of Richmond Circuit Court’s decision in Wendy’s did not analyze whether this second statutory requirement was met. The language of Virginia Code § 58.1-402 B 8 a 2 requires an examination of the terms of the agreements “that the related member has entered into with parties who are not related members.” The statute thus clearly anticipates that there will be contracts directly between the related member and an unrelated member available for the Department to examine.

By reason of their character as legislative grants, statutes relating to exemptions allowable in computing income and credits allowed against a tax liability must be strictly construed against the taxpayer and in favor of the taxing authority. See Howell’s Motor Freight, Inc., et al. v. Virginia Dep’t of Taxation, No. 82-0846 (Roanoke Cir. Ct. Oct. 27, 1983). In addition, it has been a longstanding principle of statutory construction that every part of a statute should be interpreted so as to give it some effect, and that interpretations that render words or phrases in a statute superfluous or repetitious should be avoided. See Platt v. Union P.R. Co., 99 U.S. 48, 58-59 (1878) and PSINet, Inc. v. Chapman, 362 F.3d 227, 232 (4th Cir. 2004). The court’s determination in Wendy’s effectively renders superfluous the language of Virginia Code § 58.1-402 B 8 a 2 that requires an examination of the terms of the agreements “that the related member has entered into with parties who are not related members.”

In this case, IHC’s gross license revenue was derived from royalties paid by unrelated third-party franchisees to Corp A. IHC does not have any agreements with any unrelated third parties. Under such circumstances, the specific language of the statute was not met because IHC, the related member, did not have any contracts with unrelated members, the terms of which the Department could review.

Even if the court’s opinion in Wendy’s is interpreted to mean that licensing agreements between Corp A and franchisees were indirect agreements between IHC and the franchisees, the rates and terms would not be the same. Based on the evidence provided, the rates and terms in the license agreement between Corp A and IHC were substantially different from Corp A’s franchise agreements with the independent franchisees. In particular, the license agreement between Corp A and IHC imposed a royalty fee of 2% of gross sales. In contrast, the franchise agreements between Corp A and various independent franchisees required varying fees, including a service fee equal to 4% of gross sales, a franchise fee of 7% of gross sales, and a royalty fee of 5% of gross sales. Accordingly, Corp A did not meet the unrelated member exception under Virginia Code § 58.1-402 B 8 a 2.

Conduit Exception

The Taxpayer also argued that a portion of the expenses that were added back met the requirements for the exception under Virginia Code § 58.1-402 B 8 a 3. This section provides an exception to the add-back to the extent:

[T]he corporation can establish to the satisfaction of the Tax Commissioner that the intangible expenses and costs meet both of the following: (i) the related member during the same taxable year directly or indirectly paid, accrued or incurred such portion to a person who is not a related member, and (ii) the transaction giving rise to the intangible expenses and costs between the corporation and the related member did not have as a principal purpose the avoidance of any portion of the tax due under this chapter.

The first requirement is that the related member pay the portion of the intangible expense to a person who is not a related member. For example, if a taxpayer pays royalty income to a related member for licenses of both the related member’s own trademarks and trademarks that the related member sublicenses from an unrelated member, the portion of the royalty income that the related member pays to the unrelated member may be eligible for the conduit exception (also known as the third-party expense exception).

In this case, IHC paid expenses to persons who were not related members for the development and management of its intangibles, including employee and officer compensation and benefits, consultant fees, and legal expenses. The Taxpayer believes such expenses were eligible for the conduit exception. The exception’s reference to “such portion,” however, describes the intangible expenses and costs paid to related members; in this case, the royalty fee that was paid by Corp A to IHC. As such, in order to qualify for the conduit exception, IHC had to have passed on the fee itself to the unrelated party. In the Department’s opinion, expenses IHC may have incurred in separate transactions with unrelated parties were not eligible for the conduit exception because there is no indication that IHC was passing on any part of the royalty fee itself to an unrelated party as a true conduit.

This interpretation of the conduit exception is consistent with the Department’s previous determinations that deny attempts to net expenses of intangible holding companies against royalty income to determine the amount of the add-back. See P.D. 13-211 (11/12/2013) and P.D. 14-71 (5/27/2014). This is also consistent with the Department’s application of the concept of agency in the business, professional, and occupational license (BPOL) tax setting. The BPOL tax is imposed on gross receipts without the netting of expenses. Only receipts to which a taxpayer has no claim of ownership because they are received as an agent and must be passed to a third party are eligible for exclusion from gross receipts. See, e.g. , P.D. 21-162 (12/28/21). Similarly, the conduit exception applies only to such portion of the gross royalty fees that the related member is legally obligated to pass directly to a third party.

The second provision of the conduit exception requires that the primary purpose of the transaction is not tax avoidance. The Taxpayer provided evidence as to the purpose of its corporate structure in an attempt to demonstrate that the principal purpose of the transactions at issue was not tax avoidance. Because the Department has determined that the first requirement of the exception was not met, the question of whether the second requirement was met is moot and therefore will not be addressed in this determination.

Consolidation of Accounts

The Taxpayer further asserts that the accounts of Corp A and IHC should be consolidated to accurately account for the costs incurred by IHC related to the development and management of its intangible property. In support of this position, the Taxpayer cites the transfer pricing principles of IRC § 482 and the consolidation provisions of Virginia Code § 58.1-445.

IRC § 482 allows the IRS to adjust the income and deductions of related entities if necessary to prevent tax evasion or to clearly reflect the income of the related entities. Virginia Code § 58.1-445 allows the Department to consolidate the accounts of related entities in certain circumstances. Title 23 of the Virginia Administrative Code (VAC) 10-120-350 provides that consolidation of this nature is appropriate in situations in which federal taxable income is accurately stated, but the income from Virginia sources taxable by Virginia is inaccurately stated. While the statute and the regulation do not specifically define when Virginia taxable income is considered to be inaccurately stated, the Department and the courts have provided guidance on this issue in applying Virginia Code § 58.1-446. Under this statute, the Department may equitably adjust the tax of a corporation when there exists any arrangements that "improperly . . . reflect the business done or the Virginia taxable income earned from business done in this Commonwealth . . . ."

In this case, the Taxpayer filed its Virginia corporate income tax returns on a combined basis, rather than on a consolidated basis. The Taxpayer made an affirmative election to file on a combined basis when it first became subject to Virginia income tax. See Virginia Code § 58.1-442 and Title 23 VAC 10-120-320. While the Taxpayer’s application was pending, it submitted schedules demonstrating that, if the Taxpayer had filed on a consolidated basis, its net Virginia tax liability would be less than under the combined method.

The consolidation of accounts and application of transfer pricing principles are to be applied when necessary to accurately reflect taxpayers’ income attributable to Virginia. The mere fact that the Taxpayer’s Virginia tax liabilities would decrease under account consolidation does not mean that the combined method that it elected to use does not accurately reflect income attributable to Virginia. If the Taxpayer determines that filing on a consolidated basis would be more advantageous, it may file a request for a change in filing method pursuant to Virginia Code § 58.1-442. If granted, permission to change will generally be effective only for returns filed on and after the date the request for permission to change was filed. See Title 23 VAC 10-120-324. To date, the Department has no record of receiving a request to change filing status from the Taxpayer.

Valid Business Purpose

The Taxpayer also asserts that its corporate structure and the licensing transactions between Corp A and IHC met the standards of the valid business purpose exception. Virginia Code § 58.1-402 B 8 b establishes the specific procedures to follow to claim this exception. 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 had a valid business purpose other than the avoidance or reduction of the tax.

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. An amended return reflecting acceptance of a valid business purpose application must be filed within one year of the Commissioner’s response.

As stated above, the Taxpayer claimed a full exception to the add-back on its original returns and thus it did not remit any tax which would have resulted from including the addition in its taxable income in accordance with the statute. Accordingly, the Taxpayer’s request was not made in accordance with the procedure for claiming the valid business purpose exception to the addition for intangible expenses paid to related entities pursuant to Virginia Code § 58.1-402 B 8 b and, as such, the Taxpayer’s request cannot be considered.

CONCLUSION

In accordance with the Kohl’s decision, Corp A was not eligible to claim a subject-to-tax exception for the full amount of the intangible expenses it was required to add back under Virginia Code § 58.1-402 B 8 a. Corp A, however, was eligible for the subject-to-tax exception to the add-back, to the extent that Corp A was subject to tax in another Add-Back State. For the reasons discussed above, Corp A also was not eligible for the unrelated member or conduit exceptions. In addition, the Department does not find it necessary to apply the transfer pricing principles of IRC § 482 or to consolidate the accounts of Corp A and IHC under Virginia Code § 58.1-445. Finally, the Taxpayer has not followed the proper procedure in order to claim a valid business purpose exception.

The audit for the taxable years at issue will be returned to the audit staff for adjustment consistent with this determination. The audit staff will be advised to contact the Taxpayer to arrange for any documentation review that may still be required. The Taxpayer will be responsible for arranging a mutually agreed-upon time with the auditor to provide all necessary documentation. 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 Code of Virginia sections and regulations cited are available online at law.lis.virginia.gov. The public documents cited are available at tax.virginia.gov in the Laws, Rules, & Decisions section of the Department’s website. If you have any questions regarding this determination, you may contact * in the Office of Tax Policy and Legal Affairs, Tax Adjudication and Resolution Division, at or **.

Sincerely,

Kristin L. Collins
Tax Commissioner
Commonwealth of Virginia

AR/585.X

Related Documents

09-14

13-211

14-71

21-162

24-26