Document Number
13-239
Tax Type
Corporation Income Tax
Description
Royalties paid to IHC for the use of the trademarks and trade names.
Topic
Federal Conformity
Filing Extensions
Out of State Tax Credits
Royalties
Taxable Income
Date Issued
12-19-2013

December 19, 2013



Re: § 58.1-1824 Application: Corporate Income Tax

Dear *****:

This will reply to your letter in which you submit a protective claim for refund of Virginia corporate income tax paid by ***** (the "Taxpayer") attributable to intangible expense add-backs for the taxable years ended December 31, 2008 through 2010.

FACTS


The Taxpayer, incorporated and commercially domiciled outside Virginia, operated and franchised restaurants throughout the United States. ***** (IHC), a wholly owned subsidiary of the Taxpayer, was incorporated in ***** (State A) for the purpose of holding the Taxpayer's intangible property. The Taxpayer paid royalties to IHC for the use of the trademarks and trade names during the taxable years at issue.

The Taxpayer entered into a licensing agreement with IHC for the use of its trademarks and trade names. The Taxpayer, in turn, entered into agreements with the franchisees to sublicense the trademarks and tradenames. Each franchisee paid a percentage of its gross and net receipts to the Taxpayer on a monthly basis. From these payments, the Taxpayer paid IHC a royalty payment equal to 4% of the franchisee owned restaurant's gross sales. The Taxpayer paid a royalty at the same rate for restaurants it owned and operated.

The Taxpayer filed Schedule 500AB with its original 2008 through 2010 Virginia corporate income tax returns adding back 100% of the royalties deducted on its federal income tax returns. The Taxpayer requests that it be allowed to file amended returns and report its Virginia taxable income without the add-back of the royalties on the grounds that it meets the requirements of Wendy's International, Inc. v. Virginia Department of Taxation, CL09-3757 (4/25/2012) in that IHC indirectly received more than one-third of its gross revenues from the Taxpayer's independently owned franchisees, and the royalty rate paid by the franchisees were comparable.

DETERMINATION


Protective Claim

Pursuant to the authority granted the Department under Va. 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 Va. Code § 58.1­1821. As permitted by statute, the Taxpayer's request has been treated as an appeal under Va. Code § 58.1-1821.

Unrelated Member Exception

Virginia Code § 58.1-402 B 8 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 statute provides several exceptions to the general rule that an add-back is required. T he exception relevant to the Department's assessment of the Taxpayer is Va. Code § 58.1-402 B 8 a 2, which states:
    • This addition shall not be required for any portion of the intangible expenses and costs if one of the following applies: . . . (2) The related member derives at least one-third of its gross revenues from the licensing of intangible property to parties who are not related members, and the transaction giving rise to the expenses and costs between the corporation and the related member was made at rates and terms comparable to the rates and terms of agreements that the related member has entered into with parties who are not related members for the licensing of intangible property.

In Public Document (P.D.) 09-14 (2/4/2009), the Department determined that the licensing agreements for the use of intangible property must be between an unrelated party and the related entity that owns the intangible property. As such, the exception for licensing at least one-third of its gross revenues to an unrelated member was not met because the related member did not receive the intangible property revenue directly from the unrelated franchisees.

The City of Richmond Circuit Court, however, overruled P.D. 09-14 in Wendy's International. The court held that the exception merely requires that the related member derive at least one-third of its gross revenues from the licensing of intangible property to parties that are not related members because the statue does not distinguish as to whether the gross revenues were directly or indirectly licensed to an intangible holding company. Therefore, the exception could be claimed when intangible holding companies indirectly license its intangible property to the independent franchisees through the operating company.

The court limited its analysis to whether the taxpayer derived more than one-third of its gross revenues from the licensing of intangible property to parties who are not related members. Accordingly, because approximately 97% of the intangible holding company's gross license revenue was derived from royalties paid by unrelated third-party franchisees to the taxpayer, which in turn paid intangible holding company a royalty payment, the court determined that the relevant exception was met.

However, Va. Code § 58.1-402 B 8 a 2 also requires that:
    • the transaction giving rise to the expenses and costs between the corporation and the related member was made at rates and terms comparable to the rates and terms of agreements that the related member has entered into with parties who are not related members for the licensing of intangible property

In this case, IHC does not have an agreement with any unrelated third parties. Without any agreements between the IHC and unrelated third parties, the Department finds it difficult, if not impossible, to compare the rates and terms of agreements entered into with parties who are not related members with the license agreements made between the Taxpayer and IHC.

Even if the court's opinion is interpreted to mean that licensing agreement between an intangible holding company and a related entity was an indirect agreement between the intangible holding company and the related entity's franchisees, the rates and terms of the Taxpayer's franchise agreements are different from the Taxpayer's agreement with IHC. The Taxpayer's franchise agreements incorporate a license of intangible assets with terms for business operations, product selection, equipment leases, insurance, sanitation standards, trade secrets, training, and advertising. IHC's agreement with the Taxpayer is limited to the licensure of tradenames and trademarks. Further, while the franchise agreements acknowledge IHC as the owner of the trademarks, the franchise agreement does not specify a royalty rate. Instead, the franchise is required to pay a franchise fee based on a percentage of total revenue and a percentage of net income.

In addition, the licensing agreement grants the Taxpayer certain powers over the use and protection of the trademarks not granted to the franchisees. Under the agreement, the Taxpayer is permitted to allow franchisees to use IHC's trademarks. Further, IHC relinquishes its authority to protect the tradenames and trademarks to the Taxpayer. None of the franchisees are granted similar rights or privileges with regard to the trademarks.

Based on the evidence provided, the trademarks were licensed to the franchisees by the Taxpayer and the franchise agreements were substantially different than the license agreement with IHC. In addition, all the franchise fee revenues were received by the Taxpayer and recognized as revenue by the Taxpayer, and license fees accrued under the IHC license agreement were all recorded as deductions by the Taxpayer. Accordingly, the Taxpayer does not meet the unrelated party exception under Va. Code § 58.1-402 B 8 a 2.

The statutory provision requiring the addition (and allowing exceptions) specifically states in Va. Code § 58.1-402 B 8 c that "[n]othing in subdivision B 8 shall be construed to limit or negate the Department's authority under § 58.1-446." The latter section authorizes an equitable adjustment when the Department finds that arrangements between affiliated corporations improperly reflect business done in Virginia. The quoted language clearly authorizes the Department to invoke Va. Code § 58.1-446 when it finds that allowing an exception would result in the taxpayer's income improperly reflecting the business done in Virginia.

Under Va. Code § 58.1-446, the Department has found intragroup transactions conducted in a manner similar to those to between the Taxpayer and IHC to be (1) an arrangement (2) between two commonly-owned corporations (3) in such a manner improperly, inaccurately, or incorrectly to reflect (4) the business done or the Virginia taxable income earned from business done in Virginia. See Commonwealth v. General Electric Company, 236 Va. 54, 372 S.E.2d 599 (1988). The facts of this case are similar to that described in P.D. 96-310 (10/31/1996), P.D. 03-73 (10/15/2003), P.D. 05­139 (8/23/2005), P.D. 06-52 (4/28/2006), and P.D. 06-74 (8/18/2006). The intragroup transactions conducted between the Taxpayer and IHC appear to be the type of arrangement the General Assembly sought to limit when it enacted Va. Code § 58.1­402 B 8. See Chapter 3, Acts of Assembly (2004 Special Session 1). However, because the Taxpayer does not qualify for an exception, the Department does not find it necessary to invoke Va. Code § 58.1-446.

Accordingly, the Taxpayer's request for a refund for the taxable years ended December 31, 2008 through 2010 is denied. The Code of Virginia sections and public document cited are available on-line at www.tax.virginia.gov in the Laws, Rules and Decisions section of the Department's web site. If you have any questions regarding this response, you may contact ***** in the Department's Office of Tax Policy, Appeals and Rulings, at *****.
                • Sincerely,



Craig M. Burns
Tax Commissioner


AR/1-5226342547.B

Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46