My company paid royalties to an affiliate that were taxed in other states -- can I exclude the FULL amount from Virginia's intangible expense add-back, or only the portion that was actually apportioned and taxed there?

Plain-English summary

A corporation filed Virginia income tax returns for six taxable years (fiscal years ending in 2009 through 2014), claiming a FULL exception from Virginia's intercompany intangible expense add-back for royalties it paid to an affiliate, on the theory that all of that royalty income was included in the affiliate's taxable income in another state. Under three separate audits, the Department reduced the exception to match only the portion of the affiliate's royalty income actually apportioned to (and taxed by) the state where the affiliate paid tax -- increasing the add-back and issuing assessments. The taxpayer appealed, arguing (1) the statute's plain language entitled it to the full exception, (2) the arrangement had a valid business purpose, and (3) the adjustment violated the Due Process and Commerce Clauses.

Virginia's add-back rule and its "subject-to-tax" exception. Va. Code § 58.1-402 B 8 generally requires adding back intangible expenses (like royalties) paid to a related affiliate that were deducted for federal tax purposes. But an exception applies if "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 certain foreign governments.

Kohl's settled how much of the exception applies. This exact issue was litigated all the way to the Virginia Supreme Court in Kohl's Department Stores, Inc. v. Virginia Department of Taxation, 295 Va. 177 (2018). The Court agreed with the Department: the subject-to-tax exception applies only on a post-apportionment basis -- that is, only to the extent the royalty payments were actually apportioned to, and taxed by, another state -- not to the full pre-apportionment amount just because it was technically included in the affiliate's taxable income base somewhere. The Court grounded this reading partly in the Due Process and Commerce Clauses, which require that a state can only tax the portion of income "fairly apportionable" to it. The Court also clarified the exception doesn't require the AFFILIATE itself to be the one that paid the tax -- it just requires that the specific item of income was taxed by another state, under any reporting method (separate, combined, or where subject to another state's own add-back).

How the exception is now calculated. Following Kohl's and the follow-on circuit court decision placing the burden on the taxpayer to prove the amount actually taxed elsewhere, the Department applies this formula: for "Separate Return States" (where the affiliate reports separately), the exception equals the affiliate's royalty income times its apportionment percentage on that state's return; for "Add-Back States" (where the payor faces its own add-back in another state), the exception equals the corporation's add-back amount in that state times its apportionment percentage there.

Valid business purpose exception rejected on procedure, not merits. Virginia law offers a SEPARATE way to avoid the add-back: filing the return WITH the add-back, paying the resulting tax, and then separately petitioning the Commissioner with clear and convincing evidence the transaction had a valid business purpose (Va. Code § 58.1-402 B 8 b). This taxpayer never followed that procedure, so the Department couldn't consider the request on its merits at all.

Constitutional challenge declined. Because Virginia statutes are presumed constitutional, and because the Virginia Supreme Court had already examined and upheld this very statute against Due Process and Commerce Clause principles in Kohl's, the Department declined to revisit the constitutional question and will continue applying the statute consistent with that decision.

Result. The case was returned to the auditor to recalculate the proper add-back exception under the post-apportionment method, with 60 days for the taxpayer to provide supporting documentation. If the taxpayer disagrees with the recalculated result, it may file a new appeal within 90 days of the updated assessments.

What this means for you

Corporations paying royalties or other intangible expenses to an affiliate

Don't assume you can exclude the FULL royalty amount from Virginia's add-back just because it was included somewhere in the affiliate's taxable income base in another state. The exception only covers the portion actually apportioned to, and taxed by, that other state -- you'll need your affiliate's actual apportionment percentages on its out-of-state returns to calculate it correctly.

Companies considering the "valid business purpose" exception

This is a separate, procedural pathway -- you must first file your return WITH the add-back and pay the resulting tax, THEN petition the Commissioner with clear and convincing evidence of a valid business purpose. Skipping this sequence (for example, just arguing business purpose in an appeal of an audit assessment) means the Department won't even consider the argument.

Anyone considering a constitutional challenge to this add-back statute

The Virginia Supreme Court has already upheld this add-back statute against Due Process and Commerce Clause challenges in the Kohl's case, and the Department will not revisit that question in individual appeals going forward.

Common questions

Q: If my affiliate's royalty income was included in its taxable income in another state, can I exclude the full amount from Virginia's add-back?
A: No. Following the Virginia Supreme Court's Kohl's decision, the exception applies only to the portion of the royalty income actually apportioned to, and taxed by, that other state -- not the full pre-apportionment amount.

Q: Does it matter whether my affiliate or I am the one that actually paid the tax in the other state?
A: No -- the statute only requires that the item of income was taxed by another state, regardless of which related entity paid that tax or what reporting method was used.

Q: I think my intercompany arrangement had a valid business purpose -- can I raise that in my appeal of an audit assessment?
A: Only if you already followed the required procedure: file your return with the add-back included, pay the tax due, and separately petition the Commissioner with clear and convincing evidence of the business purpose. Raising it for the first time in an appeal isn't enough.

Citations and references

Statutes:

• Va. Code § 58.1-402 B 8 -- add-back of intangible expenses paid to a related member
• Va. Code § 58.1-402 B 8 a (1) -- subject-to-tax exception for income already taxed by Virginia, another state, or a qualifying foreign government
• Va. Code § 58.1-402 B 8 b -- valid business purpose exception, requiring a separate application procedure to the Commissioner

Case law: Kohl's Department Stores, Inc. v. Virginia Department of Taxation, 295 Va. 177 (2018) -- the Virginia Supreme Court holding that the subject-to-tax exception applies only on a post-apportionment basis, grounded partly in Due Process/Commerce Clause fair-apportionment principles; 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) -- on remand, placing the burden on the taxpayer to prove the amount of royalties actually apportioned and taxed elsewhere; LZM, Inc. v. Va. Dep't of Taxation, 269 Va. 105, 110 (2005) -- exemptions are strictly construed against the taxpayer, who bears the burden of proving eligibility; Container Corp. of America v. Franchise Tax Bd., 463 U.S. 159, 164 (1983) -- cited for the fair-apportionment constitutional principle.

Prior rulings the Department relied on (described here, not linked): P.D. 07-153 (10/2/2007), establishing the Department's original position that the exception is limited to the apportioned/taxed portion.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 24-80

Original ruling text

August 21, 2024

Re: § 58.1-1821 Application: Corporate Income Tax

Dear * :

This will reply to your letters in which you seek correction of the corporate income tax assessments issued to * (the “Taxpayer”) for the taxable years ended July 25, 2009, July 31, 2010, July 30, 2011, July 28, 2012, July 27, 2013, and July 26, 2014.

FACTS

The Taxpayer filed Virginia corporate income tax returns for the taxable years at issue, claiming a full exception to the add-back for intangible expenses paid to an affiliate on the basis that the income was subject to tax in another state. Under three separate audits, the Department reduced the amount claimed as an exception to the add-back to correspond to the amount of the affiliate’s royalty income apportioned to the state in which the affiliate paid tax. The amount of the add-back was increased accordingly, and assessments were issued.

The Taxpayer filed applications for correction, contending (1) a full exception was permitted by the plain language of the statute; (2) the transactions had a valid business purpose; and (3) the adjustment to the add-back violated the Due Process and Commerce clauses of the Constitution.

DETERMINATION

Addition for Intercompany Intangible Expenses

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.

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 affiliate’s taxable income in another state. Virginia Code § 58.1-402 B 8 provides several exceptions to the general rule that an add-back for certain intangible deductions is required. The exception relevant to the Taxpayer’s assessments 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). Further, the issue has been litigated in Virginia’s court system. 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.

Following the Court’s 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 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”). 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 in the Combined Return States. 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.

Based on the decisions of Virginia’s courts, the computation of the exception amount for Separate Return States where the intangible holding company is subject to tax and the Add-Back States where the entity is subject to additions in other 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 also 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.

Valid Business Purpose

The Taxpayer also asserts its arrangement with the affiliate met the standards of the valid business purpose exclusion. Virginia Code § 58.1-402 B 8 b establishes the specific procedures to follow to claim this exclusion. In order to apply to the Commissioner for relief based upon the existence of a valid business purpose, a taxpayer must file its Virginia income tax return reporting the addition in accordance with the statute and remit all taxes, penalties, and interest due for the taxable year. A taxpayer may then petition the Commissioner to consider evidence relating to any transactions between it and related members that resulted in its taxable income being increased. The Commissioner may permit the taxpayer to file an amended return if the application demonstrates by clear and convincing evidence that the transactions resulting in such increase in taxable income had a valid business purpose other than the avoidance or reduction of the tax.

If the Commissioner grants the application, the taxpayer may file an amended return that excludes the addition related to the specific transaction or transactions identified in the Commissioner’s response. An amended return reflecting acceptance of a valid business purpose application must be filed within one year of the Commissioner’s response.

The Taxpayer’s request was not made in accordance with the procedure for claiming the business purpose exclusion from the addition for intangible and interest expenses paid related entities pursuant to Virginia Code § 58.1-402 B 8 b. As such, the Taxpayer’s request to exclude the add-back on the basis that the expenses were incurred for a valid business purpose cannot be considered.

Due Process and Commerce Clauses

The Taxpayer contends the add-back statute violates the Due Process and Commerce clauses of the United States Constitution. Consistent with the rules of statutory construction, the Department, the executive agency charged with the administration of Virginia's tax statues, presumes that all statutes enacted by the General Assembly and incorporated into the Code of Virginia are constitutional. Further, the Court in Kohl’s examined the subject-to-tax issue with reference to constitutional principles of fair apportionment and upheld the Department’s interpretation of the statute. Under these circumstances, the Department declines to consider whether any portion of the assessments should be abated on the basis that the add-back statute violates the United States Constitution and will continue to administer the statute consistent with the Court’s decision.

CONCLUSION

In accordance with the Kohl’s decision, the Taxpayer was not eligible to claim a subject-to-tax exception for the full amount of the intangible expenses it was required to add back under Virginia Code § 402 B 8 a. In addition, the Taxpayer has not followed the proper procedure in order to claim a valid business purpose exception. Further, the Taxpayer has not shown that the add-back statute violates the Due Process and Commerce clauses of the United States Constitution.

Accordingly, the case will be remanded to the auditor to calculate the proper amount of royalty expense that could be deducted for the taxable years at issue. The audit staff will contact the Taxpayer to arrange for any documentation review that may still be required. The Taxpayer will have 60 days from the date of contact with the auditor to provide all necessary documentation unless a different deadline is agreed to by the Taxpayer and the audit staff. 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 applications for correction concerning these assessments are being closed. At the conclusion of the audit staff’s review, should the Taxpayer disagree with the auditor’s application of the subject-to-tax exception computation as set forth above, the Taxpayer may submit an application for correction within 90 days of the updated audit assessments in accordance with Virginia Code § 58.1-1821.

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 **.

Sincerely,

James J. Alex

Tax Commissioner

Commonwealth of Virginia

AR/533.B

Related Documents

07-153

24-18

24-31