The Supreme Court of Virginia issued a decision in a case addressing the application of the “subject to tax” exception under Virginia’s related-party addback statute to royalties paid by the taxpayer to an affiliate. The court held that the “subject to tax” exception applies on a post-apportionment basis, provided that the royalties are actually taxed by another state.
The case is: Kohl’s Department Stores, Inc. v. Department of Taxation, No. 160681 (Va. August 31, 2017). Read the Virginia Supreme Court’s decision [PDF 109 KB]
Under Virginia law, certain types of intangibles expenses paid to related parties that are deducted for federal income tax purposes must be added back in determining a corporation’s Virginia taxable income. The addback is not required if the taxpayer qualifies for one of the statutory exceptions to the addback rules.
In this case, the taxpayer claimed that none of its royalties was required to be added back because the affiliate to whom the taxpayer paid the royalties was subject to tax on its royalty income in certain states. In the taxpayer’s view, if the royalties were included in the computation of taxable income in another state, then this qualified for the “subject to tax” exception to the addback requirement.
The Department of Taxation countered that the exception applies only with respect to the amount of the affiliate’s royalty income actually taxed in other states, as evidenced by apportionment percentages shown on the tax returns filed in those states. In other words, it was the Department’s position that the “subject to tax” exception applies on a post-apportionment basis, whereas the taxpayer contended that the exception applies on a pre-apportionment basis. A lower state court found for the Department, and the taxpayer appealed.
The Virginia Supreme Court concluded that the “subject to tax” exception applies on a post-apportionment basis and only to the extent that the royalties are actually taxed by another state.
The court, however, concurred with the taxpayer’s alternative argument that the Department erred in calculating the amount of the subject to tax exception. The taxpayer claimed that the exception would have been greater because it paid tax on some of the royalty income through being included in a combined report with its affiliate or because it was required to add the royalties back in certain separate return states. The court agreed with the taxpayer, and concluded that the exception applies to the extent that the royalties are actually taxed in separate return states (by virtue of the related member being subject to tax), combined return states, or in states with addback rules (by virtue of the taxpayer adding the expense back to federal taxable income).
Tax professionals have observed that what is interesting (and confusing) about the court’s decision is that the court acknowledged, but did not specifically address, retroactive amendments to Virginia law that added limitations to the “subject to tax” exception to more closely align with the Department’s interpretation. Specifically, under the amended law, for tax years beginning on and after January 1, 2004, the “subject to tax” exception “…shall be limited and apply only to the portion of such income received by the related member, which portion is attributed to a state or foreign government in which the related member has sufficient nexus to be subject to such taxes.” Because the decision addresses the exception pre-amendment and because the amendment was retroactive to 2004, the court’s holding must be read in light of the revised law. Although the court considered royalties included in a combined return to be subject to tax, it is not clear how that holding applies, given the revised law.
Three justices dissented, in part because the plain language of the statute did not contain an apportionment mechanism, and the multiple bills proposed to add one indicated that this was not a clarification of existing law.
Read a September 2017 report [PDF 107 KB] prepared by KPMG LLP
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