Did all related-party royalties escape Virginia's add-back merely because affiliates reported the gross royalties in other states?

Subject

Auditor reduced the royalty add-back exception

Plain-English summary

Virginia upheld the auditor's decision to limit the royalty add-back exception to the share of affiliate income actually apportioned and taxed in other states. The taxpayer could not exclude 100% of related-party royalties simply because affiliates reported the gross receipts on their returns.

Virginia generally required an add-back for deductible intangible expenses paid to related members. The relevant exception applied to a “portion” when the “corresponding item” of affiliate income was subjected to a qualifying net-income or capital tax.

The Commissioner read those limiting words to require matching the taxpayer's royalty payment with the affiliate income apportioned to each taxing state. The auditor used the affiliates' apportionment percentages and correctly increased the net add-back for the untaxed portion.

What this means for you

• Gross inclusion on an affiliate's return does not prove the entire royalty was subjected to the other state's tax.
• Keep affiliate returns, apportionment schedules, and tax-base computations supporting the exact exception claimed.
• Match the exception to the corresponding income actually taxed in each jurisdiction.

Common questions

Did the affiliates pay tax in other states? Yes, but only the corresponding apportioned portions qualified for the exception.

Were the Virginia assessments upheld? Yes.

Citations and references

• Va. Code § 58.1-402(B)(8).
• Raven Red Ash Coal Corp. v. Henry Absher, 153 Va. 332, 149 S.E. 541 (1929).
• P.D. 07-153 (October 2, 2007).

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 07-217

Original ruling text

December 20, 2007

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 * (the "Taxpayer") for the taxable year ended January 29, 2005 and January 28, 2006.

FACTS

For the taxable years at issue, the Taxpayer paid royalties to several of its affiliated companies for the use of intangible assets. The Taxpayer filed Schedule 500AB with its 2004 and 2005 Virginia corporate income tax returns listing four states in which the affiliates filed income tax returns. The affiliates reported the royalties paid by the Taxpayer, and the amount of tax paid based on or measured by net income on the returns. The Taxpayer claimed an exception for 100% of the royalties deducted on its federal income tax returns 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 addback by reducing it to correspond to the amount of the affiliates' royalty income apportioned to each state in which the affiliates paid tax and increased the corresponding net add-back of royalties.

The Taxpayer contests the assessments on the basis that all of the royalties qualify for an exception to the add-back because they were subject to tax based on or measured by net income imposed by other states.

DETERMINATION

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.

The Code provides several exceptions to the general rule that an add-back 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 royalty 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 affiliates. The auditor reduced the royalty add-back exception to the portion of the Taxpayer's royalties paid to the three affiliates that correspond to the portion of each affiliate's income subjected to tax in other states.

Accordingly, the auditor's adjustments are correct and the assessments are upheld. A revised bill, with interest accrued to date, will be sent to the Taxpayer. No additional interest will accrue provided the outstanding balance in paid within 30 days from the date of the revised bill. The Taxpayer should remit its payment to: Virginia Department of Taxation, 3600 West Broad Street, Suite 160, Richmond, Virginia 23230, Attention: *. If you have any questions concerning payment of the assessment, you may contact at **.

The Code of Virginia sections and public document 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 ruling, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner

AR/1-1604564661B