When a retailer pays royalties to its own intangible holding company, can the unrelated-member, subject-to-tax, or conduit exceptions excuse Virginia's related-party intangible-expense add-back?

Plain-English summary

This is a textbook intangible holding company dispute. A retailer that both operated and franchised stores set up a wholly owned subsidiary ("IHC") to hold its trademarks and trade names, then paid IHC a royalty of 6% of net sales to use them. The retailer separately charged its own unrelated franchisees a royalty of 6% of gross sales, plus other fees. Virginia generally makes a company add back intangible expenses it pays to related members and deducts federally (Va. Code § 58.1-402 B 8), to stop exactly this kind of income-shifting. The retailer tried three exceptions to avoid the add-back for 2009–2013. The Commissioner rejected all three, upheld the 2011–2013 assessments, and sent the 2009–2010 years back to the auditors for a partial recomputation.

Unrelated-member exception — failed

This exception (§ 58.1-402 B 8 a 2) requires both that the related member earn at least one-third of its gross revenue from licensing to unrelated parties and that the intercompany terms be comparable to the terms of the related member's unrelated-party agreements. Even under the taxpayer-friendly Wendy's International reading (indirect licensing can count toward the one-third test), the exception failed on the comparability prong. IHC had no agreements with any unrelated third party to compare against. And the terms weren't comparable anyway: the franchise agreements loaded the franchisees with duties the company-owned stores didn't have — mandatory training, liability/workers'-comp/business-interruption insurance, prescribed signage and displays, accounting kept to company policy, company-set pricing, and a remodel every five years — while IHC's license to the retailer was far lighter (just review-and-approve rights). The rates differed too: 6% of gross sales plus a 3% advertising fee to the franchisor versus 6% of net sales to IHC. Same headline percentage, different base and add-ons — not comparable.

Subject-to-tax exception (2009–2010) — only partial, under Kohl's

As a fallback for 2009 and 2010, the retailer argued the royalties should be fully excluded because IHC's income was taxed in other states. Because it hadn't filed timely amended returns, the Department treated this as a protective claim under § 58.1-1824. Under Kohl's Department Stores, Inc. v. Virginia Department of Taxation, 295 Va. 177 (2018), the subject-to-tax exception reaches only the portion of the royalty actually subject to tax in another state after apportionment — not the whole amount. So the full refund was denied — but the Commissioner remanded 2009 and 2010 to the audit staff to compute the proper deductible royalty under Kohl's (the taxpayer gets 60 days to supply documentation, and refunds issue as warranted). That's a genuine, if partial, path to relief.

Conduit exception (2011–2013) — failed

The "conduit" (third-party expense) exception (§ 58.1-402 B 8 a 3) applies only where the related member passes the royalty itself through to an unrelated party. The retailer tried to flip the flow — arguing its franchisees were the unrelated members paying IHC indirectly through the retailer. But the statute runs the other way: it's IHC (the related member) that has to pass payments out to unrelated members, and there was no evidence IHC paid any part of the royalty income to an unrelated third party. So the conduit exception didn't apply.

Bottom line: the royalties are added back. The 2011–2013 assessments stand (pay within 30 days), and the 2009–2010 years go back to audit for a Kohl's-limited partial subject-to-tax computation.

What this means for you

Retailers and franchisors that license trademarks from an affiliate

Expect Virginia to add those royalties back. Setting the intercompany rate to mirror your franchise royalty (here, both nominally "6%") is not enough — the Department compares the whole deal, including the base (gross vs. net), extra fees, and the bundle of operational obligations. A bare trademark license between you and your holding company rarely looks "comparable" to a full franchise agreement.

If you're counting on the subject-to-tax exception

Know that it is partial, not all-or-nothing: under Kohl's you get relief only for the slice of the royalty actually taxed by another state after apportionment. Keep state-by-state records of where and how much the related member was taxed — and note that this ruling shows the Department will remand to recompute that partial amount when the record supports it.

If you're counting on the conduit exception

The related member itself must pass the specific royalty through to an unrelated party. You cannot satisfy it by pointing to unrelated customers or franchisees who fund the payment on the way in; the pass-through has to run out of the related member to an unrelated recipient.

Tax professionals

A clean companion to Virginia's other add-back determinations (compare P.D. 26-8 and P.D. 26-10): same statute, same Wendy's/Kohl's framework, but a distinct fact pattern — matching headline royalty percentages defeated by a gross-vs-net base difference and extra fees, plus an express remand for the Kohl's-limited subject-to-tax computation.

Common questions

Q: My intercompany royalty rate is the same as what I charge franchisees. Doesn't that make them comparable?
A: Not by itself. Here both were "6%," but one was 6% of net sales and the other 6% of gross sales plus a 3% advertising fee and a heavy set of operational duties, so the terms weren't comparable and the unrelated-member exception failed.

Q: If the holding company paid tax on the royalty in another state, is the whole royalty excluded?
A: No. Under Kohl's, only the portion actually subject to tax in another state after apportionment qualifies for the subject-to-tax exception. This ruling denied the full exclusion but remanded 2009–2010 so the auditors could compute the partial amount.

Q: Can I use the conduit exception because my franchisees ultimately fund the royalty?
A: No. The conduit exception requires the related member to pass the royalty through to an unrelated party. Payments flowing into the related member from unrelated franchisees don't qualify.

Q: Did the taxpayer win anything?
A: Partly. The 2011–2013 assessments were upheld, but the 2009–2010 years were remanded to the audit staff to calculate a partial subject-to-tax exception under Kohl's.

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 2 — unrelated-member exception (one-third unrelated licensing and comparable rates and terms)
• Va. Code § 58.1-402 B 8 a 3 — conduit / third-party-expense exception (related member must pass the payment through to an unrelated party)
• Va. Code § 58.1-1821 — application to the Tax Commissioner for correction of an assessment
• Va. Code § 58.1-1824 — protective claim for refund (three years from assessment)

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 after apportionment); 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 determination P.D. 09-14.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 26-9

Original ruling text

February 24, 2026

Re: § 58.1-1821 Application: Corporate Income Tax

Dear *:

This will respond to your letters in which you seek a refund of Virginia corporate income tax paid by * (the “Taxpayer”) for the taxable years ended December 31, 2009, and 2010, and correction of the corporate income tax assessments issued to the Taxpayer for the taxable years ended December 31, 2011, through 2013.

FACTS

The Taxpayer operated and franchised retail stores throughout the United States. The Taxpayer’s wholly owned subsidiary (“IHC”) was organized for the purpose of holding the Taxpayer’s intangible property. Pursuant to the Taxpayer’s licensing agreement with IHC, it paid a royalty equal to 6% of its net sales for the use of IHC’s trademarks and trade names. In addition to other charges, such as advertising and financial service fees, the Taxpayer charged its unrelated franchisees a royalty fee of 6% of gross sales.

For the 2009 and 2010 taxable years, the Taxpayer added back the intercompany royalty expenses to federal taxable income for purposes of computing its Virginia taxable income. The Taxpayer did not claim any exception to the add-back on its 2009 Virginia income tax return. In 2010, the Taxpayer claimed an exception for a portion of the royalty expense to the extent the royalty income was taxed in another state (i.e., the “subject-to-tax” exception). The Taxpayer subsequently filed amended returns for refunds, claiming a full exception to the add-back on the basis that IHC received more than one third of its gross revenues from unrelated franchisees (i.e., the “unrelated member” exception). Under review, the Department denied the refunds.

For the 2011 through 2013 taxable years, the Taxpayer claimed a full exception to the add-back on the basis that it qualified for the unrelated member exception. Under audit, the Department determined the Taxpayer did not qualify for that exception but did allow a partial subject-to-tax exception based on tax paid by IHC in other states. The amount of the add-back was increased accordingly and assessments were issued.

The Taxpayer filed applications for correction on the basis that it qualified for the unrelated member exception to the add-back. In the alternative, the Taxpayer claimed it qualified for 1) a full exception to the add-back for the 2009 and 2010 taxable years based on the subject-to-tax exception; and 2) the conduit exception to the add-back for the 2011 through 2013 taxable years.

DETERMINATION

Unrelated Member Exception

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.

The statute provides several exceptions to the general rule that an add-back is required. The exception at issue is 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 the Taxpayer. 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 the Taxpayer and franchisees were indirect agreements between IHC and the franchisees, the rates and terms would not be the same. The terms of the franchise agreement between the Taxpayer and the unrelated franchisees were materially different than the terms applicable to Taxpayer-owned stores. Franchisees had specific duties and responsibilities to perform that were not required by Taxpayer-owned stores. For example, franchisees and their employees had to complete the Taxpayer’s training program. They also had to maintain liability, worker’s compensation, and business interruption insurance. In addition, store signage and displays had to be presented in a particular manner. Further, accounting records had to be kept in accordance with Taxpayer policy. Finally, products had to be priced pursuant to amounts set by the Taxpayer and franchisees were also responsible for remodeling their stores once every five years.

The terms of the licensing agreement for Taxpayer-owned stores were much less stringent. This agreement merely gave IHC the right to review and approve labeling, ads, displays, and other items. The Taxpayer was required to protect the intangible property and execute any documents that the IHC required. There were also no training, insurance, accounting, or remodeling requirements.

In addition, the franchise agreement between the Taxpayer and the unrelated franchisees required a royalty fee equal to 6% of gross sales plus additional fees, including an advertising fee equal to 3% of the gross sales. The licensing agreement between IHC and the Taxpayer imposed a royalty fee of 6% of net sales.

As stated above, Virginia Code § 58.1-402 B 8 a 2 requires that the rates and terms between a taxpayer and related member be comparable to the rates and terms between the related member and unrelated third parties. Not only does the IHC not have agreements with independent franchisees, based on the evidence provided, the rates and terms of the trademark licensing agreements between IHC and the Taxpayer were substantially different from the Taxpayer’s franchise agreements with the independent franchisees. Accordingly, the Taxpayer did not qualify for the unrelated member exception under Virginia Code § 58.1-402 B 8 a 2.

Subject-to-Tax Exception

The Taxpayer alternatively contends that it could claim a full exception to the add-back for the 2009 and 2010 taxable years because the income received by IHC was subject to tax in other states. The Taxpayer did not file amended returns for the 2009 and 2010 taxable years to claim a full subject-to-tax exception and the limitations period for the Taxpayer to file such amended returns has long since passed. The Department, accordingly, will treat the Taxpayer’s claim as a protective claim for refund under Virginia Code § 58.1-1824.

Pursuant to the authority granted the Department under Virginia Code § 58.1-1824, 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 Virginia Code § 58.1-1821.

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.

In accordance with the Court’s decision, the Taxpayer was not entitled to an exception for the full amount of its royalty expense based on the subject-to-tax exception. Accordingly, the Taxpayer’s refund claim cannot be granted.

Conduit Exception

The Taxpayer also argues that the expenses that were added back for the 2011-2013 taxable years 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 this exception. In this case, the Taxpayer argues that the franchisees were the unrelated members that were paying the related member, IHC, indirectly through the Taxpayer. The Taxpayer has not provided any evidence that IHC was paying a portion of the royalty income to an unrelated member. Under the statute, however, it was the related party, i.e. , IHC, that had to pass through payments to unrelated members. As such, the conduit exception was inapplicable.

CONCLUSION

For the reasons discussed above, the Taxpayer was not eligible for the unrelated member exception because the terms of the agreements made with related and unrelated members differ substantially. The Taxpayer was also not entitled to an exception for the full amount of its royalty expense in the 2009 or 2010 taxable years based on the subject-to-tax exception. In addition, the Taxpayer was not eligible for the conduit exception in the 2011 through 2013 taxable years because there is no indication IHC paid any portion of the royalty income to an unrelated third party.

Accordingly, the Taxpayer’s refund claims for the taxable years ended December 31, 2009, and 2010, cannot be granted. With respect to these taxable years, however, the case will be remanded to the audit staff to calculate the proper amount of royalty expense that could be deducted for the 2009 and 2010 taxable years in accordance with the decision in Kohl’s. The audit staff will 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 refunds as warranted.

In addition, the assessments issued for the taxable years ended December 31, 2011, through 2013, are upheld. The Taxpayer will receive updated bills that will include accrued interest to date. The Taxpayer should remit the balance due within 30 days of the bill dates to avoid the accrual of additional interest and possible collection actions.

The Code of Virginia sections 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/573.X

Related Documents

09-14