My company pays royalties to an affiliate that in turn pays a related company for research services -- can I reduce my Virginia royalty add-back for the R&D portion, and how much of a 'subject to tax' exception do I get if the affiliate paid tax on that income elsewhere?

Plain-English summary

A corporation filed Virginia corporate income tax returns for taxable years ending March 2008 and March 2009, reporting intercompany intangible expense add-backs for royalties paid to an affiliate ("Affiliate A"). On audit, the Department increased the add-back to match the full royalty amount reported on the corporation's federal return — a portion of which the corporation claimed was actually for research and development services that Affiliate A had separately obtained from another affiliate, "Affiliate B." The Department also added back interest the corporation paid to several other related entities. The corporation appealed on three separate points.

1. No carve-out for the "research expense" portion of the royalty. Virginia Code § 58.1-402 B 8 requires adding back intangible expenses paid to related members — a category that expressly includes royalty, patent, technical, and copyright fees. The corporation argued some of what it paid Affiliate A was really a pass-through of Affiliate A's own R&D costs (paid to Affiliate B), and shouldn't count as an add-back-eligible royalty. The Department rejected this: the actual contract between the corporation and Affiliate A contained no R&D provision at all — it set royalty payments as a fixed percentage of certain revenue streams, reported as ordinary royalty expense on the federal return. The R&D arrangement was a separate contract between Affiliate A and Affiliate B, one the corporation itself was never a party to. Since the corporation didn't itself incur any R&D expense, its full royalty payment to Affiliate A properly stayed in the add-back, with no reduction — and for the same reason, it couldn't claim a "valid business purpose" exception, since that exception requires the corporation to have had its OWN transaction generating the add-back item, which it didn't have with Affiliate B.

2. A partial win under the "subject to tax" exception. The corporation separately argued that because Affiliate A's (and the underlying intangible holding companies') royalty income was included in taxable income in other states, the ENTIRE royalty add-back should be excused under § 58.1-402 B 8 a 1's "subject to tax" exception. The Department applied the framework the Virginia Supreme Court set out in Kohl's Department Stores, Inc. v. Virginia Department of Taxation (2018): the exception applies only to the portion of royalty income actually taxed by another state on a POST-apportionment basis — not the full pre-apportionment amount — and (per the later circuit-court decision on remand) the taxpayer bears the burden of proving how much was actually taxed, particularly in states where the affiliates filed combined or consolidated returns (where intercompany royalties may be eliminated entirely from taxable income). Applying that framework here, the Department allowed a partial exception, limited to the portion of Affiliate A's income from these royalties that was demonstrably subject to tax in another state — not the full amount the corporation sought — and returned the case to audit staff to calculate the exact figure using the Kohl's apportionment-based formula (multiplying the relevant royalty/expense figure by the applicable state's apportionment percentage).

3. A win on interest unrelated to intangible property. Separately, Virginia's interest add-back (§ 58.1-402 B 9 a 2) only reaches interest connected to transactions involving intangible property — typically where license-fee income funds intercompany loans. Here, the corporation paid interest to certain affiliates for ordinary intercompany cash advances that had nothing to do with intangible property. Because that interest fell outside the statute's scope, it wasn't subject to the add-back at all.

Bottom line: the audit was sent back to Department staff to recompute the assessments consistent with all three holdings — no reduction for the "R&D" royalty argument, a partial subject-to-tax exception calculated under the Kohl's formula, and full relief from add-back for the non-intangible-property-related interest.

What this means for you

Corporations paying royalties to an affiliate that itself pays a THIRD affiliate for services

Only your own contract and your own payments matter for Virginia's add-back analysis. If your agreement with your direct affiliate is purely a royalty arrangement with no service component, you can't recharacterize part of it as a pass-through service cost just because your affiliate used some of that money to pay someone else for services.

Multistate corporations claiming the "subject to tax" exception for intangible expense add-backs

Following Kohl's Department Stores, the exception only covers the portion of your affiliate's royalty income actually taxed by another state AFTER apportionment — not the full pre-apportionment amount — and you bear the burden of documenting exactly how much was taxed, state by state, including showing whether combined/consolidated filing eliminated the income in some states.

Corporations paying interest to affiliates for cash advances unrelated to intangible property

That interest isn't automatically swept into Virginia's intangible-expense add-back regime — the add-back only reaches interest tied to intangible property transactions, so ordinary cash-advance interest should be reviewed separately.

Common questions

Q: Can I reduce my Virginia royalty add-back by arguing part of the payment was really for research services my affiliate obtained from someone else?
A: Not unless your own contract with the paying affiliate actually includes an R&D component. If your agreement is purely royalty-based and the R&D arrangement is between your affiliate and a third affiliate you're not party to, the full royalty stays in the add-back.

Q: How much of my royalty add-back can I exclude if my affiliate's income was taxed in another state?
A: Only the portion actually taxed on a post-apportionment basis in that state — not the full pre-apportionment royalty amount — per the Virginia Supreme Court's Kohl's Department Stores decision, and you bear the burden of proving the exact amount.

Q: Does Virginia's interest add-back apply to all intercompany interest?
A: No — only interest connected to transactions involving intangible property. Interest on ordinary intercompany cash advances unrelated to intangible property isn't covered.

Citations and references

Statutes and regulations:

• Va. Code § 58.1-402 B 8 — intangible expense add-back for payments to related members, subject to exceptions
• Va. Code § 58.1-402 B 8 a 1 — subject-to-tax exception: applies when the related member's corresponding income is taxed by another state
• Va. Code § 58.1-402 B 9 a 2 — interest add-back limited to interest connected to intangible property transactions
• Va. Code § 58.1-302 — definitions of "intangible property" and "intangible expenses and costs," including royalty and license fees

Case law:

• Kohl's Department Stores, Inc. v. Virginia Department of Taxation, 295 Va. 177 (2018) — the subject-to-tax exception applies only to royalty income actually taxed by another state on a post-apportionment basis
• Kohl's Department Stores, Inc. v. Virginia Department of Taxation, Cir. Ct. City of Richmond, CL12-1774, 2021 Va. Cir. LEXIS 116 (2021) — taxpayer bears the burden of proving how much royalty income was actually taxed elsewhere, including in combined/consolidated-return states
• LZM, Inc. v. Va. Dep't of Taxation, 269 Va. 105 (2005) — tax exemptions are strictly construed against the taxpayer, who bears the burden of qualifying

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 24-125

Original ruling text

November 18, 2024

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 “Taxpayer”) for the taxable years ended March 31, 2008, and March 31, 2009.

FACTS

The Taxpayer filed Virginia corporate income returns for the taxable years at issue, reporting intercompany intangible expense additions for royalties paid to * (Affiliate A). Under audit, the Department increased the amount of the add-backs to correspond to the amount of royalty expenses reported on the Taxpayer’s federal income tax return, a portion of which the Taxpayer claims were for research and development expenses paid to *** (Affiliate B). According to the audit report, the Department allowed an exception to the add-back corresponding to the amount of income that was attributable to such payments and on which Affiliate A and Affiliate B paid tax to other states. The Department also included an add-back for interest paid to a number of other related entities.

The Taxpayer filed an application for correction, contending (1) the payments added back by the Department were for research expenses not subject to the add-back; (2) a full exception to the add-back for royalty payments made to Affiliate A was permitted by the plain language of the statute; and (3) a portion of the interest expenses was not subject to add-back because it was not related to intangible property.

DETERMINATION

Virginia Code § 58.1-402 B 8 provides that there shall be added back to the extent excluded from federal taxable income:

[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 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.

Research and Development Expenses

The Taxpayer contends that research expenses were not “intangible expenses and costs” required to be added-back pursuant to Virginia Code § 58.1-402 B 8. Under Virginia Code § 58.1-302, “intangible expenses and costs” are defined as:

1. 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;

2. Losses related to or incurred in connection directly or indirectly with factoring transactions or discounting transactions;

3. Royalty, patent, technical and copyright fees;

4. Licensing fees; and

5. Other similar expenses and costs.

The term “intangible property” is defined in Virginia Code § 58.1-302 to mean “patents, patent applications, trade names, trademarks, service marks, copyrights and similar types of intangible assets.”

The Taxpayer asserts that the royalties paid to Affiliate A included charges for research and development costs. According to the Taxpayer, Affiliate A contracted with Affiliate B to perform the research and development services and these costs were passed through to the Taxpayer.

The contract between the Taxpayer and Affiliate A includes no provision for research and development services. Rather, the Taxpayer paid Affiliate A fees based on a royalty rate computed as a fixed percentage of certain revenue streams. These payments were reported as royalty expenses on the Taxpayer’s federal income tax return, consistent with the contractual terms, and the Department adjusted the amount of the add-back attributable to the royalties to be consistent with the amount reported for federal income tax purposes.

The amounts the Taxpayer wishes to exclude from the add-back relate to a separate contract wherein Affiliate A paid Affiliate B for certain research and development services. As stated above, royalty fees clearly fall within the scope of intangible expenses and costs under Virginia Code § 58.1-302. Because the Taxpayer did not actually incur the research and development expenses incurred by Affiliate A, the adjustments to include all royalties paid to Affiliate A in the add-back were correct.

Valid Business Purpose

In the event the Department concludes that the research expenses paid to Affiliate B were intangible expenses and costs subject to the add-back, the Taxpayer argues that the research expenses were eligible for an exception because they had a valid business purpose. These expenses, however, resulted from fees Affiliate A paid to Affiliate B and were not included in the deductions resulting in the add-backs at issue. As such, the Taxpayer did not have a transaction with Affiliate B that resulted in an addition required under Virginia Code § 58.1-402 8 a, as is required to claim the business purpose exception under Virginia Code § 58.1-402 8 b.

Subject to Tax Exception

In its appeal, the Taxpayer argued the plain meaning of the statute entitles it to exclude 100% of the royalty payments from the add-back because all the royalties were included in the affiliated intangible holding companies’ taxable income in another state. Virginia Code § 58.1-402 B 8 provides that there shall be added back to the extent excluded from federal taxable income:

[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.

Virginia Code § 58.1-402 B 8 provides several exceptions to the general rule for requiring an add-back for certain intangible deductions. The exception relevant to the Taxpayer’s argument 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.]

The Department’s position has consistently been that the exception is limited to the portion of a taxpayer’s intangible expense 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. See Public Document (P.D.) 07-153 (10/2/2007).

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 as applied to royalty payments made by Kohl’s Department Stores, Inc. (Kohl’s) to Kohl’s Illinois, Inc. (Kohl’s Illinois). The Court agreed with the Department’s interpretation, stating that “[t]he circuit court correctly determined that only the portion of the royalties that was actually taxed by another state falls within the subject-to-tax exception.” Id. at 191.

Because the phrase “subject to a tax” is not defined under the Code of Virginia , the Court determined its meaning by considering the legislature’s intent and the requirements of the Due Process and Commerce Clauses of the United States Constitution. Specifically, the Court stated that “the Due Process and Commerce Clauses of the United States Constitution mandate that only the amount of a corporation’s income that is fairly apportionable to a given state is legally subject to that state’s income tax.” Id. at 186 (citing Container Corp. of America v. Franchise Tax Bd ., 463 U.S. 159, 164 (1983)). The Court held that, while intercompany royalties were included in Kohl’s Illinois’ taxable income (pre apportionment income), a substantial amount of those royalties was not apportioned to, or taxed by, every state in which Kohl’s Illinois filed a corporate income tax return. The Court found that an income tax could only be imposed by a state on the amount of royalties apportioned to such state (post-apportionment income), stating:

We therefore hold that the subject-to-tax exception applies only to the extent that the royalty payments were actually taxed by another state. That is, the exception applies on a post-apportionment, rather than a pre-apportionment, basis.

Id . at 190. In making this determination, the Court concluded that the General Assembly intended for the exception to apply only to post-apportionment income because to hold otherwise would negate the intended operation of the statute. Id. at 189-190.

The Court also opined, however, that the “statute only requires that the ‘item of income received by the related member’ ... be taxed by another state. It does not require that the related member be the entity that pays the tax on that ‘item of income.’” Id . at 191 (quoting Virginia Code § 58.1-402 B 8 a). Therefore, payments fall within the exception to the extent they were taxed under a tax based on or measured by net income or capital by another state, regardless of whether it was a separate or combined reporting state, including a state where the payments were subject to an add-back, and regardless of which entity paid the tax. Id . at 191. The Court remanded the case to the circuit court to decide what portion of the royalty payments were actually taxed by another state and, thus, eligible for the exception from the intangible expense addition.

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.

The Department is aware that some taxpayers have reached agreements with states that allow for an alternative or special method of apportionment for intangible income or expenses. For purposes of Virginia Code § 58.1-402 B 8 a 1, the amount of intangible income or expenses eligible for the exception will be limited to the apportionment percentage reported on the subject state’s return.

Following the Virginia Supreme Court decision, the Department and Kohl’s agreed on a calculation of the add-back exception based upon Kohl’s Illinois’ income subjected to tax in the Separate Return States and Kohl’s intangible income additions subject to tax in most of the Add-Back States. However, the parties disagreed as to whether and to what extent the royalties were actually taxed by the states in which, by requirement or election, Kohl’s and Kohl’s Illinois were included in a unitary combined or consolidated return (Combined Return States). Because the royalty payments were eliminated as intercompany transactions and, therefore, not included in the combined group’s taxable income basis and/or the sales factor of the apportionment formula for those states, the Department argued that neither Kohl’s nor Kohl’s Illinois were subject to tax on intercompany intangible expenses in the Combined Return States because income and deductions were either eliminated or set off. Kohl’s argued that the intercompany royalty income was technically included at the start of the unitary combined or consolidated income computation. In addition, the parties disagreed about the extent to which royalty payments were actually taxed in two of the Add-Back States.

In Kohl’s Department Stores, Inc. v. Virginia Department of Taxation, Circuit Court of the City of Richmond, CL12-1774, 2021 Va. Cir. LEXIS 116 (5/13/2021), the circuit court stated that “Kohl’s now bears the burden to show that the royalty payments were apportioned to and actually taxed in other states in order to correctly calculate and receive the exception . . . because ‘[e]xemptions . . . from taxation are to be strictly construed against the taxpayer’ and ‘[t]he taxpayer has the burden of establishing that it comes within the terms of an exemption.” Id. (quoting LZM, Inc. v. Va. Dep’t of Taxation, 269 Va. 105, 110 (2005)). The court then ruled that Kohl’s failed to meet its burden to show the intercompany royalty payments were apportioned to and actually taxed in Combined Return States, as well as two of the Add-Back States, in order to be eligible for the exception. Thus, the subject-to-tax exception will be limited to the amount of intercompany intangible income, or intangible expense addition, that the taxpayer can demonstrate was actually taxed.

The Department permitted a partial subject-to-tax exception based on that portion of Affiliate A’s and Affiliate B’s income attributable to the Taxpayer’s royalty expenses that was subject to tax in another state. As explained above, however, all of the Taxpayer’s royalty expenses that were added back were attributable to royalties paid to Affiliate A. As such, only that portion of Affiliate A’s income that was subject to tax in another state would be eligible for the exception. In addition, the Taxpayer would be eligible for a subject-to-tax exception to the extent it was required to add-back the royalty expenses in any other state and pay tax on them.

Interest Add-Back

Virginia Code § 58.1-402 B 9 a 2 requires a taxpayer to add-back intercompany interest expenses and costs that are directly or indirectly related or connected to transactions involving intangible property. This generally occurs when intercompany license fees generated by a corporation holding an intangible asset are used to make loans to related corporations. In P.D. 11-57 (4/12/2011), the Department found that a corporation was not required to add back interest expense paid to the related entity because the loans were directly or indirectly connected to transactions involving intangible property.

In this case, the Taxpayer paid interest to certain of its affiliates for intercompany cash advances that were not related to intangible property. Any such expenses would not have been subject to the add-back.

CONCLUSION

The Department’s adjustments to the add-back to include all royalties paid to Affiliate A were correct, without further reduction for research and development expenses paid by Affiliate A to Affiliate B. The Taxpayer, however, was eligible for the subject-to-tax exception to the add-back, to the extent the Taxpayer was subject to tax in another add-back state or Affiliate A paid tax to another state on the royalty income received from the Taxpayer. Further, any interest expenses not related to intangible property as defined under Virginia Code § 58.1-302 were not subject to add-back.

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 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, Appeals and Rulings, at or email at **.

Sincerely,

James J. Alex

Tax Commissioner

Commonwealth of Virginia

AR/523.B

Related Documents

07-153

11-57