I paid royalties to an affiliate and added them back to my Virginia taxable income, but claimed a partial exception because some of the affiliate's income was taxed elsewhere -- can I get a refund for the FULL add-back instead of just that partial exception?

Plain-English summary

A corporation paid royalties to an affiliated entity for the use of intellectual property across five taxable years (fiscal years ending in February 2009 through February 2013). Virginia generally requires companies to add back such intercompany royalty and interest expenses to federal taxable income when computing Virginia taxable income. The corporation claimed a partial exception to that add-back for the portion of the expense corresponding to the share of the affiliate's income apportioned to (and taxed in) other states. It then filed a protective claim for refund, this time asserting it was entitled to a FULL exception to the add-back because the underlying royalty income was subject to tax somewhere.

A procedural note on protective claims. Va. Code § 58.1-1824 gives the Department authority to hold a protective refund claim pending the outcome of related litigation, or to decide it on the merits under the normal correction procedure (§ 58.1-1821). Here, the Department decided the claim on its merits rather than holding it.

Kohl's already answered the merits question. In Kohl's Department Stores, Inc. v. Virginia Department of Taxation, 295 Va. 177 (2018), the Virginia Supreme Court interpreted the "subject-to-tax" exception in Va. Code § 58.1-402 B 8 and agreed with the Department's position: only the portion of intercompany intangible expense payments that was subject to an income tax imposed AFTER the income was apportioned to another state falls within the exception -- not the full payment merely because the recipient affiliate paid some tax somewhere. This is the same doctrine this corpus's P.D. 24-80 later applied to an intercompany intangible add-back dispute.

Outcome. Because Kohl's forecloses the FULL exception the corporation sought in its protective claim, the refund request could not be granted -- the corporation's original partial add-back exception (based on the properly apportioned share) remained the correct treatment.

What this means for you

Corporations paying intercompany royalties or interest to an affiliate

The subject-to-tax exception to Virginia's add-back requirement only covers the portion of the payment taxed by another state AFTER that income has been apportioned there -- not the full payment just because the affiliate paid some tax on it somewhere. Compute the exception based on the affiliate's actual apportioned, taxed share.

Anyone considering a protective refund claim based on a broader reading of a settled doctrine

Filing a protective claim doesn't reopen a legal question the Virginia Supreme Court has already resolved -- here, the Department applied Kohl's exactly as it had before, regardless of the claim's protective posture.

Common questions

Q: We add back intercompany royalty expenses to our Virginia taxable income, but claim an exception for the portion subject to tax elsewhere -- can we claim the exception for the FULL royalty payment instead of just the apportioned share?
A: No. Under Kohl's Department Stores, the exception only covers the share of the payment that was subject to an income tax imposed after apportionment to another state, not the full payment.

Q: What's a "protective claim for refund," and does filing one change how the Department analyzes the underlying legal question?
A: It's a mechanism (Va. Code § 58.1-1824) that lets the Department hold a refund claim pending related litigation, or decide it on the merits under the normal correction process -- it doesn't change the substantive legal analysis, which here was already settled by Kohl's.

Citations and references

Statutes:

• Va. Code § 58.1-402 B 8 -- subject-to-tax exception to the intangible expense add-back
• Va. Code § 58.1-1824 -- protective claim for refund, may be held pending related litigation or decided on the merits
• Va. Code § 58.1-1821 -- standard application-for-correction procedure

Case law: Kohl's Department Stores, Inc. v. Virginia Department of Taxation, 295 Va. 177 (2018) -- the subject-to-tax exception applies only to the portion of intercompany intangible expenses subject to tax after apportionment to another state; the same doctrine this corpus's P.D. 24-80 later applied to a different intangible add-back dispute.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 24-35

Original ruling text

March 27, 2024

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”), for the taxable years ended February 1, 2009, January 31, 2010, January 30, 2011, January 29, 2012, and February 3, 2013. I apologize for the delay in responding to your letter.

For the taxable years at issue, the Taxpayer paid royalties to an affiliated entity for the use of certain intellectual property. On its Virginia income tax returns, the Taxpayer added back the royalty and interest expenses to federal taxable income for purposes of computing its Virginia taxable income. The Taxpayer claimed an exception to the add-back for a portion of the expenses based on the amount of the affiliate’s income apportioned to states in which its affiliate paid tax. The Taxpayer subsequently filed a protective claim for refund, asserting that it was entitled to a full exception to the add-back on the basis that the income was subject to a tax in another state.

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 determination in Kohl’s , 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.

The Code of Virginia sections cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions section of the Department’s web site. If you have any questions regarding this determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/584.X

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