Document Number
14-71
Tax Type
Corporation Income Tax
Description
Royalty Expense Add-back
Topic
Allocation and Apportionment
Out of State Tax Credits
Subtractions and Exclusions
Date Issued
05-27-2014

May 27, 2014



Re: § 58.1-1821 Application: Corporate Income Tax

Dear *****:

This will reply to your letter in which you seek correction of the corporate income tax assessments issued to ***** (the "Taxpayer") for the taxable years ended March 28, 2008 and April 3, 2009. I apologize for the delay in responding to your letter.

FACTS


The Taxpayer paid royalties to an affiliated entity, ***** (IHC), during the taxable years ended March 28, 2008 and April 3, 2009. The Taxpayer claimed an exception to the add-back requirement under Va. Code § 58.1-402 B 8 for all of the royalty deductions on the grounds that they were subject to tax in two states in which IHC filed income tax returns.

On audit, the Department limited the amount claimed as an exception to the add-back by reducing it to correspond to the amount of the affiliate's royalty income apportioned to the state in which the affiliates paid tax and increased the corresponding net add-back of royalties. As a result, the Department issued to the Taxpayer assessments for additional tax and interest.

The Taxpayer appeal the assessments, contending that all the royalties qualify for an exception to the add-back because: (1) they were subject to a tax based on or measured by net income imposed by other states, and (2) IHC had a valid business purpose. In the alternative, the Taxpayer asserts that fees received should be netted against royalty expense.

DETERMINATION


Royalty Expense Add-back

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

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 appeal request 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.)

According to the Taxpayer, the plain meaning of the statute entitles it to exclude 100% of its royalty payments from the add-back. This interpretation, however, 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 Red Ash Coal Corporation v. Henry Absher, 153, Va. 332, 149 S.E. 541 (1929). (Emphasis added).

In Public Document (P.D.) 07-153 (10/2/2007), the Department determined that parsing the statutory language of Va. Code § 58.1-402 B 8 shows that the exception is not all inclusive. When considering this statute in its totality, the exception does not apply to the gross amount of payments that a taxpayer made to an affiliate merely because the gross amount is shown on another state's tax return. Instead, 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.

In this case, the Taxpayer paid royalties to IHC. As such, the Taxpayer would only be able to claim an exception for the portion of the Taxpayer's royalties paid to IHC that corresponds to the portion of IHC's income subjected to tax in other states.

Valid Business Purpose

The Taxpayer contends it should be allowed to exclude royalties from the add-back requirement because the intercompany transactions with IHC had a valid business purpose other than the avoidance or reduction of tax.

Virginia Code § 58.1-402 B 8 does not provide an exception to the add-back requirement based on the economic substance of the related entities. However, Virginia Code § 58.1-402 A 8 b provides an exclusion for the add-back when the intangible intercompany expenses were incurred through a valid business purpose other than the avoidance or reduction of tax. The statute establishes the specific procedures to follow to claim this exclusion.

In order to apply to the Tax 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 Tax Commissioner to consider evidence relating to any transactions between it and related members that resulted in its taxable income being increased. The Tax 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. A questionnaire that provides an example of the type of information a taxpayer must submit to the Department to demonstrate a valid business purpose is enclosed.

If the Tax 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 Tax Commissioner's response. The amended return must be filed within one year of the Tax 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 Va. Code § 58.1-402 B 8 b. As such, the Taxpayer's request to exclude the add-back of the royalties and factor fees on the basis that they were incurred for a valid business purpose cannot be considered.

Expense Matching

The Taxpayer further asserts that even if no exception to the add-back applies, "the intercompany contract service fees received should be netted against royalty expenses paid to arrive at a royalty expense add-back amount that would accurately reflect the income and expenses of the Taxpayer." The Taxpayer believes that income should be reduced by its corresponding expenses because Virginia allows foreign source income to be reduced by correlating foreign source expenses.

Virginia Code § 58.1-402 C 8 provides a subtraction for foreign source income as defined in Va. Code § 58.1-302, to the extent included in federal taxable income. The computation of the Virginia foreign source income subtraction (considering expenses related to the income) is determined in accordance with Internal Revenue Code (IRC) §§ 861 through 863. See P.D. 86-154 (8/14/1986). Virginia law requires the use of the federal sourcing rules of IRC § 861 et seq., whether or not the taxpayer believes that certain expenses have any connection to income from foreign sources and regardless of what expenses would be under generally accepted accounting principles.

The addition for intangible expenses under Va. Code § 58.1-402 B 8 is based on costs and expenses incurred by the Taxpayer. Unlike foreign source income where both income and expenses are reported in the accounting records of a taxpayer, costs for the development and administration of an intangible asset are accrued on the books and records of the entity holding the asset, not the taxpayer incurring the expense. As such, because none of IHC's costs and expenses is reported on the Taxpayer's returns, no netting of income against expenses can be permitted.

CONCLUSION


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.

If the Taxpayer qualified for the exception with respect to 100% of the addition for royalty expenses, the situation appears to be similar to that described in P.D. 05-29 (3/7/2005). In that case, the Tax Commissioner upheld an adjustment under Va. Code § 58.1-446 based upon consolidating the affiliated entities with the taxpayer or disallowing a deduction for amounts paid to the affiliated entity. Under these circumstances the Department may invoke Va. Code § 58.1-446 to make a similar adjustment to the extent that an addition is not made under Va. Code § 58.1-402 B 8 or Va. Code § 58.1-402 B 9. In this case, however, because the Taxpayer qualifies for only a portion of the requested exception, the Department has concluded that any improper reflection of the business done in Virginia is not of sufficient magnitude to require an equitable adjustment under Va. Code § 58.1-446.

Based on the foregoing, the auditor's adjustments are correct and the assessments are upheld. A revised bill, with interest accrued to date, will be sent to the Taxpayer. No additional interest will accrue provided the outstanding balance is paid within 30 days from the date of the revised bill. The Taxpayer should remit its payment to: Virginia Department of Taxation, 600 East Main Street, 23rd Floor, Richmond, Virginia 23219, Attention: *****. If you have any questions concerning payment of the assessment, you may contact at *****.

If the Taxpayer wishes to apply to the Tax Commissioner for relief based upon the existence of a valid business purpose with regard to IHC, the Taxpayer must comply with the statutory time period provided by Va. Code § 58.1-402 A 8 b. The questionnaire and all other required documentation should be sent to the Virginia Department of Taxation, Appeals and Rulings, P.O. Box 27203, Richmond, Virginia 23260-7203, Attn: *****.

The Code of Virginia sections and public documents 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/1-212987569.B

Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46