Did franchisee royalty payments passed through a restaurant corporation let its related trademark subsidiary qualify for Virginia's unrelated-party add-back exception?

Subject

Restaurant group failed the unrelated-party royalty exception

Plain-English summary

Virginia denied the corporation's refund because its intangible holding subsidiary did not license trademarks directly to unrelated franchisees. The corporation collected a 4% franchise fee, retained 1%, and passed 3% to its wholly owned intangible holding company. Those passed-through amounts made up more than 70% of the subsidiary's revenue.

That payment flow was not enough. The franchise agreements said the corporation, not the subsidiary, held the right to use and license the trademarks. Virginia read the exception to require an actual licensing agreement between the related intangible owner and the unrelated customer. Because the subsidiary received its revenue from the related corporation, it did not derive the required unrelated-party licensing revenue.

The Department therefore required the royalty add-back and denied the 2004-2006 refund. It noted that separate equitable-adjustment authority could apply if an exception otherwise produced an improper reflection of Virginia business, but that issue did not need to be reached here.

What this means for you

• Trace who legally owns the intangible and who is the named licensor in each customer agreement.
• Passing third-party receipts through a related operating company does not necessarily become direct unrelated-party licensing revenue.
• Comparable royalty rates do not cure failure of the direct licensing requirement identified in the ruling.
• Agreements, not promotional descriptions alone, controlled the result.

Common questions

Did the subsidiary receive more than one-third of revenue from franchise royalties?

It received passed-through amounts exceeding that threshold, but Virginia treated the related corporation as the payer because it was the contractual licensor.

Why did the franchise agreements matter?

They granted licensing rights from the corporation, not from the intangible holding company.

Was the refund granted?

No. The unrelated-party exception did not apply.

Citations and references

• Va. Code §§ 58.1-402(B)(8), 58.1-302, and 58.1-446.
• P.D. 96-310.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 09-14

Original ruling text

February 4, 2009

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, 2004 through 2006.

FACTS

The Taxpayer is incorporated and domiciled outside Virginia. It operates and franchises restaurants throughout the United States and various international markets. In 2001, * (IHC), a wholly owned subsidiary of the Taxpayer, was incorporated in *** (State A) for the purpose of holding the Taxpayer's intangible property. The Taxpayer paid royalties to IHC for the use of the trademarks and trade names during the taxable years at issue.

The Taxpayer and franchisees entered into a licensing agreement with IHC for the use of its trademarks and trade names. Each franchisee on a monthly basis pays the greater of 4% of its gross sales or $1,000, as adjusted for inflation, to the Taxpayer. The Taxpayer retains 1% of this amount and then remits the remaining 3% of the royalty to IHC, along with a 3% royalty amount for each company owned restaurant.

The Taxpayer filed Schedule 500AB with its original 2004 through 2006 Virginia corporate income tax returns adding back 100% of the royalties deducted on its federal income tax returns. The Taxpayer requests that it be allowed to report its Virginia taxable income without the add-back of the royalties on the grounds that IHC received more than one-third of its gross revenues from the Taxpayer's independently owned franchisees and that the royalty rate paid by the franchisees and the corporate owned restaurants were comparable.

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 statute 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: . . . (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.

The Taxpayer argues that nothing in the statute prohibits the "indirect" payment of royalties from the franchisees to IHC. Moreover, the Taxpayer contends that it meets the requirements of Va. Code § 58.1-402 B 8 a (2) because IHC receives more than 70% of its gross revenue from license fees paid by independently owned franchisees, and it receives the same royalty rate from both the franchisees and the corporate owned restaurants and that these royalties are comparable to other commonly found within the restaurant industry.

Indirect Payments

The Taxpayer argues that the legislative enactment clause of Va. Code § 58.1-402 B incorporates Va. Code § 58.1-302. Under Va. Code § 58.1-302, the definition of intangible expenses and costs includes:

Expenses, losses and costs for, related to, or in connection directly or indirectly with the direct or indirect acquisition, use, maintenance or management, ownership, sale, exchange, lease, transfer, or any other disposition of intangible property to the extent such amounts are allowed as deductions or costs in determining taxable income.

As such, the Taxpayer contends that the payment of royalties by the franchisees to the Taxpayer and its subsequent remittance to IHC constitutes transactions that satisfy the exception under Va. Code § 58.1-402 B 8 a (2). Pursuant to this exception, a taxpayer may avoid adding back both direct and indirect intangibles expenses and costs if "[t]he related member derives at least one-third of its gross revenues from the licensing of intangible property to parties who are not related members . . . ."

The Taxpayer has provided samples of promotional materials provided to potential franchisees that indicate that the trade names and trademarks are owned by IHC. In addition, 3% of the 4% franchise fee earned by the Taxpayer is passed through to IHC for the use of the trademarks. These passed through revenues constituted more than 70% of IHC's total revenues for each of the taxable years at issue. If the franchisees where licensed through IHC, the Department would agree that the passed through royalty expenses would be licensing to unrelated entities.

The sample franchise agreement, however, is not a contract between a franchisee and IHC. Instead, the sample agreement stipulates in the recitals that the Taxpayer, not IHC, continues to develop, use, and control the use of the trademarks. The agreement further states, in § 7.1.B., that the Taxpayer, not IHC, has the "right to use and license others to use" the trademarks. Under the terms of the franchise contract, the franchisees' are clearly licensing the trademarks from the Taxpayer, not IHC.

Virginia Code § 58.1-402 B 8 a (2) infers that the related entity that owns the intangible property actually engage in licensing with the unrelated third parties. This means that licensing agreements for the use of intangible property must be between the unrelated party and the related entity that owns the intangible property. Based on the sample agreement, IHC did not engage in licensing intangible property to the unrelated franchisees during the taxable years at issue. Because the trademarks were licensed to the franchisees by the Taxpayer, the IHC did not receive the trademark licensing revenue from the unrelated franchisees. Instead, all the revenues generated by IHC were received from the Taxpayer. Accordingly, the Taxpayer does not meet the unrelated party exception.

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." Since 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 then the situation would be similar to that described in P.D. 96-310 (10/31/1996). In that case the Commissioner upheld an adjustment under Va. Code § 58.1-446 based upon consolidating the IHC with the Taxpayer. Under these circumstances the Department may invoke § 58.1-446 to make a similar adjustment to the extent that an addition is not made under § 58.1-402 B 8. In this case, however, since the Taxpayer does not qualify for the requested exception it is not necessary to invoke Va. Code § 58.1-446.

Accordingly, the Taxpayer's request for a refund is denied. The Code of Virginia sections 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 response, you may contact * in the Department's Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner

AR/1-1886185622.B