Document Number
Tax Type
Corporation Income Tax
Taxpayer pays royalties to its Parent for the use of patents and other intangible assets
Corporate Distributions and Adjustments
Taxable Income
Date Issued

October 2, 2007

Re: § 58.1-1821 Application: Corporate Income Tax

Dear *****:

This is in response to your letter of March 8, 2007, in which you protested a notice of assessment on behalf or your client, ***** (the "Taxpayer"), resulting from the add-back to income of the license fee deductions taken on the Taxpayer's 2004 Virginia income tax return.


The Taxpayer is a corporation engaged in business of manufacturing. The Taxpayer pays royalties to its Parent for the use of patents, trademarks and other intangible assets used in the manufacturing and marketing of its products (hereafter these payments will be referred to as "royalties").

The Taxpayer filed Schedule 500AB with its 2004 Virginia Corporate Income Tax return, listing the states of ***** (State A) and ***** (State B) as states in which the related licensor (the Parent) filed 2004 income tax returns, reported the royalties paid by the Taxpayer to the Parent, and the tax paid by the Parent on its income from these royalties based on or measured by net income. The 2004 Virginia Schedule 500 AB claimed an exception for 100% of the royalties deducted on the Taxpayer's federal return on the grounds that they were subject to tax in another state.

On audit, the Virginia Department of Taxation (TAX) limited the amount claimed as an exception to the add-back by reducing it to correspond to the amount of the Parent's royalty income apportioned to each state in which the Parent paid tax. Examination of the returns filed with the other states showed that the Parent's apportionment factors in State A and State B were 1.37% and 1.083% respectively. Therefore, the auditor reduced the Taxpayer's exception amount to 2.453% of the royalties paid to the Parent, and increased the net add-back amount to 97.547% of the royalties.

You protest this assessment on the following basis: 1) all of 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; and 2) the add-back statute violates the due process and commerce clauses of the Constitution of the United States because it taxes the royalty recipient which does not have substantial nexus with Virginia.


Virginia Code § 58.1-402(B)(8)

Virginia Code § 58.1-402(B)(8)(a) provides that there shall be added back to the extent excluded from federal taxable income:
    • the 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 members to the extent that such expenses and costs were deductible or deducted in computing federal taxable income for Virginia purposes.

The Code provides several exceptions to the general rule than an add-back is required. The exception relevant to TAX's assessment of the Taxpayer states that:
    • 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).

You assert that the taxpayer is entitled to exclude 100% of its royalty payments from the add-back because the Parent paid tax in other states on less than 3% of its income corresponding to those royalty payments. Your interpretation of the statute 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 Coal Corp. v. Absher, 153 Va. 332, 149 S.E. 541 (1929) (emphasis added).

Parsing the statutory language above shows that this exception is not an all or nothing type of exclusion. The exception is allowed for any portion of the intangible expenses and costs if one of several conditions is satisfied. The "for . . . if" construction means that the "subject to tax" test must be satisfied for each item of the Parent's income that corresponds to each portion of the Taxpayer's royalty payments for which an exception is claimed. Thus, the exception is not automatically allowed for all of the royalty payments if one of the conditions is satisfied, but is allowed only with respect to the portion of royalty payments for which a condition is satisfied. One portion of the Taxpayer's royalty payments may be excluded from the add-back to the extent it satisfies one of the conditions; while another portion may be excluded to the extent it satisfies another condition. The remainder is added back.

The relevant condition that follows the word "if" in the statute is that an item of income corresponding to a portion of royalty payments must be subject to tax. While the filing of an income tax return may be evidence that the corporation is subject to tax, merely including an item of income in that return is not proof that the particular item was subject to tax in that state. A corporation doing business in many states typically reports the same item of income on every state's return, and then allocates and apportions the income to determine the portion of income earned in the taxing state.

Theoretically, only the income arising from the use of a particular patent, trademark or other intangible property in a state is constitutionally subject to tax in that state. But when a corporation conducts a unitary business "a separate accounting method is incompatible with proper, accurate and efficient taxation of a multistate corporation conducting a unitary business." Commonwealth of Virginia v. Lucky Stores, Inc., 217 Va. 121, 225 S.E.2d 870 (1976). Instead, the corporation reports all of its income from patents and trademarks in all states and then uses a formula to calculate the portion of this income attributable to the taxing state. The tax is then imposed on that portion of the corporation's income. This process ensures that state does not reach out and tax income earned elsewhere. "The central purpose behind the apportionment requirement is to ensure that each State taxes only its fair share of an interstate transaction." Goldberg v. Sweet, 488 U.S. 252, 260 (1989).

Therefore, the exception does not apply to the gross amount of payments that the Taxpayer made to its Parent merely because the gross amount is shown on another state's tax return. The exception is limited to the portion of the Taxpayer's royalty payments to its Parent that correspond to the portion of the Parent's income subjected to tax in other states, as evidenced by the apportionment percentages shown in the Parent's tax returns filed with other states.

Due Process and Commerce Clause

You assert that the add-back statute has the economic effect of taxing the royalty income of the Taxpayer's parent, the licensor. This is not the case; rather, the add-back statute simply disallows a deduction of certain expenses. All deductions are a matter of legislative grace. New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). The Commerce Clause does not require states to allow Taxpayers to deduct items at will, rather the Supreme Court "has consistently upheld deduction denials that represent reasonable efforts to properly allocate a deduction between taxable and tax exempt income, even though the denials mean that the taxpayer owes more than he would without the denial." First Nat. Bank of Atlanta v. Bartow County Bd. of Tax Assesors, 470 U.S. 583, 84 L. Ed. 2d 535, 105 S. Ct. 1516 (1985). Thus, the add-back is not a tax on the income of the Parent but rather a denial of a deduction to the Taxpayer that is within the power of the state.

In order to determine if a tax violates the Commerce Clause by placing an undue burden on interstate commerce the U.S. Supreme Court has developed a four-prong test. Complete Auto Transit Inc, v. Brady, 403 U.S. 274, 279 (1977). A state tax will overcome a Commerce Clause challenge if it "[1] is applied to an activity with a substantial nexus with the taxing State, [2] is fairly apportioned, [3] does not discriminate against interstate commerce, and [4] is fairly related to the services provided by the State." Id.

The add-back statute is fairly apportioned. In fact, the amount added back is apportioned twice. First, the legislature has graciously allowed an exception to the add­back for the portion of intangible expenses on which the affiliated recipient has been subject to tax. Second, the amount added back is then allocated and apportioned with the rest of the Taxpayer's income to determine the portion subject to Virginia tax. The add-back is not a tax (in actuality or in economic effect) on income attributable to the Taxpayer's use of patents and trademarks in other states.

Requiring an add-back does not discriminate against interstate commerce. The Commerce Clause requires that a taxing scheme be internally consistent. A taxing "formula must be such that, if applied by every jurisdiction, it would result in no more than all of the unitary business income being taxed." Oklahoma Tax Comm'n v. Jefferson Lines, Inc., 514 US 159 (1983). The add-back statute only requires the taxpayer to add-back royalties deducted to the extent that the Parent's income from those royalties it is not apportioned to another taxing jurisdiction. Then the amount is further allocated and apportioned under Virginia law. Thus, if every state adopted the same the add-back statute, and had the same allocation and apportionment statute as Virginia, it would not result in taxing more than all of the unitary business income of the taxpayer.

Based on the forgoing, the auditor correctly assessed the Taxpayer for the portion of the royalty fees paid to the parent corporation that were not subject to tax in another taxing jurisdiction.

The Code of Virginia sections cited are available on-line at in the Tax Policy Library section of TAX's web site. If you have any questions regarding this ruling, you may contact ***** in the Office of Policy and Administration, Policy Development, at *****.
                • Sincerely,

                • Janie E. Bowen
                  Tax Commissioner

Last Updated 08/25/2014 16:46