How did Virginia calculate the related-party royalty add-back exception, including royalties subjected to New Jersey's gross-receipts-based tax?

Subject

Royalty add-back exception used apportioned and gross-receipts ratios

Plain-English summary

Virginia denied the full refund and limited the royalty add-back exception to the share of affiliate income actually subjected to tax in other states. Reporting gross royalty payments on another state's return did not make 100% of the related-party payment eligible.

The taxpayer separately challenged the New Jersey calculation. Because New Jersey did not allow expense deductions comparable to federal taxable income, Virginia treated its tax as effectively based on gross receipts. The appropriate ratio therefore compared royalties reported on the New Jersey return with the holding company's total royalty income everywhere, rather than comparing gross New Jersey receipts with net federal income.

Virginia upheld the auditor's adjustments and denied the 2006-2007 refund.

What this means for you

• Match the exception to the portion of royalty income actually subjected to tax in each jurisdiction.
• Use a ratio consistent with the other state's real tax base; do not compare gross receipts with net income.
• Retain the holding company's state returns, apportionment schedules, and total royalty-income records.
• A partial exception can still leave Virginia's related-party add-back in place.

Citations and references

• Va. Code §§ 58.1-402 B 8 and 58.1-446.
• Raven Red Ash Coal Corp. v. Absher, 153 Va. 332, 149 S.E. 541 (1929).
• Public Documents 05-29 and 07-153, discussed in the ruling.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 13-226

Original ruling text

December 17, 2013

Re: § 58.1-1821 Application: Corporate Income Tax

Dear *:

This will reply to your letter in which you seek a refund corporate income tax paid by * (the "Taxpayer") for the taxable years ended December 31, 2006 and December 31, 2007. I apologize for the delay in responding to your appeal.

FACTS

For the taxable years at issue, three of the Taxpayer's affiliates paid royalties to * (IHC). The IHC filed income tax returns in five different states and claimed an exception for all of the royalty deductions on the grounds that they were subject to tax in another state.

The Taxpayer was audited for the taxable years at issue. The auditor made an adjustment limiting the amount claimed as an exception to the add-back by reducing it to correspond to the amount of the affiliate's royalty income apportioned to each state in which the affiliates paid tax and increased the corresponding net add-back of royalties.

The Taxpayer filed an appeal, contending that all 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. In the alternative, the Taxpayer asserts that the Department erroneously calculated the portion of the add-back attributed to the amount of intangible income subject to tax in New Jersey.

DETERMINATION

Subject to Tax Exception

Virginia Code § 58.1-402 B 8 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 three affiliates paid royalties to IHC. The auditor reduced the royalty add-back exception to the portion of the affiliates' royalties paid to IHC that corresponds to the portion of IHC's income subjected to tax in other states.

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." 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 with respect to 100% of the addition for royalty expenses, the situation appears to be similar to that described in P.D. 05-29 (3/7/2005). In that case, the Tax Commissioner upheld an adjustment under Va. Code § 58.1-446 based upon consolidating the affiliated entities with the taxpayer or disallowing a deduction for amounts paid to the affiliated entity. Under such circumstances the Department may invoke Va. Code § 58.1-446 to make a similar adjustment to the extent that an addition is not made under Va. Code § 58.1-402 B 8. In this case, however, because the Taxpayer qualifies for only a portion of the requested exception, the Department has concluded that any improper reflection of the business done in Virginia is not of sufficient magnitude to require an equitable adjustment under Va. Code § 58.1-446.

New Jersey Add-Back

Under New Jersey statutes, IHC was required to file a return and pay income tax on an allocated portion of its royalty income for the taxable years at issue. The auditor calculated the allowable add-back resulting from tax paid to New Jersey by dividing the royalties allocated to New Jersey by the total royalties reported on the federal income tax return.

The Taxpayer disagrees with the auditor's methodology. According to the Taxpayer, IHC's New Jersey sales were determined by multiplying royalties received from related entities by those entities' respective sales factor. The tax rate was applied directly to these sales in order to determine IHC's New Jersey income tax. Because the New Jersey sales were treated as New Jersey taxable income, the Taxpayer believes the exclusion amount should be determined by multiplying IHC's royalty income by a ratio equal to IHC's New Jersey taxable income divided by IHC's federal taxable income.

Under New Jersey's taxing scheme, IHC is not granted any deductions for expenses similar to those granted for determining federal taxable income. In essence, New Jersey's tax is based on the gross receipts generated in New Jersey. The Department cannot agree with an approach under which gross receipts are compared to net income. Because the New Jersey tax is based on gross receipts, the ratio for determining royalties eligible for the exception must be based on gross receipts.

For purposes of determining the exception from the add back for taxes paid to New Jersey, the New Jersey apportionment percentage will be the intangible holding company's New Jersey taxable income divided by its total royalty income everywhere. Under this method, the exclusion amount would be determined by multiplying the Taxpayer's royalty deduction attributed to IHC by a ratio equal to IHC's royalties reported on the New Jersey return divided by IHC's total royalty income.

CONCLUSION

Based on the foregoing, the auditor's adjustments are correct and the Taxpayer's request for a refund corporate income tax is denied.

The Code of Virginia sections and public documents cited are available on-line at www.tax.virginia.gov in the Laws, Rules and Decisions section of the Department's web site. If you have any questions concerning payment of the assessment, you may contact * at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1-4613914063.B