Subject-To-Tax Exception Limitation
March 13, 2024
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 January 31, 2009, and 2010. I apologize for the delay in responding to your request.
FACTS
The Taxpayer and several of its affiliates filed combined Virginia corporate income tax returns for the taxable years at issue, claiming a full exception to the add- back for intangible expenses paid to three related intangible holding companies on the basis that the income was subject to tax in another state. Under audit, the Department reduced the amount claimed as an exception to the add-back to correspond to the amount of the affiliates’ royalty income apportioned to the state in which the intangible holding companies paid tax. The amount of the add-back was increased accordingly, and assessments were issued.
The Taxpayer filed an application for correction contending (1) a full exception was permitted by the plain language of the statute; and (2) even if a full exception was not permitted, the Department miscalculated the amount of the exception. In addition, the Taxpayer argues that certain systems licensing and merchandise buyer service fees were erroneously included with the royalty expense deductions and were not subject to the add-back requirement.
DETERMINATION
Subject-to-Tax Exception
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.
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.]
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 affiliated intangible holding companies’ taxable income in another state. 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).
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 Va. 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.
Based on the Virginia’s Supreme Court’s decision in Kohl’s, the computation of the exception amount for 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) 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 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.
Following the Virginia Supreme Court 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 Separate Return States and Kohl’s intangible income additions subject to tax in most of 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.
In light of the outcome of this litigation, the Taxpayer has acquiesced to the position of the Court with regard to the subject-to-tax exception to the add-back and withdrew its application for correction with respect to this issue. To facilitate the revisions to the audit, the Taxpayer has provided a schedule showing the amount of the subject-to-tax exception to which it was entitled under the Kohl's decision.
Merchandise Buyer Service Fees
The Taxpayer and an affiliate paid a fee equal to 3% of their purchases to a related entity, ***** (IHLP), for the use of its buyer services. The Taxpayer reported this fee as royalty intangible expense that was not required to be added back based on the subject-to-tax exception. As discussed above, Virginia’s auditor reduced the amount the Taxpayer claimed as an exception.
The Taxpayer now contends that these fees were not intangible expenses subject to the add-back requirement. According to information provided, IHLP employed approximately 300 buyers throughout the country who recommended purchases based on the Taxpayer’s retail sales model. A sample agreement provided by the Taxpayer indicated that IHLP was to provide merchandise sourcing and procurement services to the related entities. The services included vendor identification, facilitating merchandise manufacturing, product evaluation, and procurement functions.
Pursuant to Virginia Code § 58.1-302, intangible expenses and costs are defined as:
1. Expenses, losses and costs for, related to, or in connection directly or indirectly with the direct or indirect acquisition, use, maintenance or management, ownership, sale, exchange, lease, transfer, or any other disposition of intangible property to the extent such amounts are allowed as deductions or costs in determining taxable income;
2. Losses related to or incurred in connection directly or indirectly with factoring transactions or discounting transactions;
3. Royalty, patent, technical and copyright fees;
4. Licensing fees; and
5. Other similar expenses and costs.
Based on the evidence provided, the fees paid to IHLP were for specific services that are not the type of expenses included as intangible expenses that are subject to add back under Virginia Code § 58.1-402 B. The Taxpayer has provided a schedule showing the amount of procurement service fees charged during the taxable years at issue.
Systems License Fees
Both the Taxpayer and an affiliate also paid IHLP a percentage of their sales as a license fee for the use of certain trade secrets and other intangible property, including unique computer software application systems, (the “Systems”). In particular, the inventory control software system, owned by IHLP, allocated, tracked and allowed the delivery of thousands of items of merchandise to the retail stores. This system assisted with pricing, markdown, and store inventory replenishment decisions in order to help move inventory through stores in a timely and disciplined manner. IHLP employed a development team located throughout the United States in order to continually upgrade and modify the Systems as needed.
The Taxpayer contends that these fees were not intangible expenses subject to the add-back requirement because they were not expenses related to intangible property for purposes of the addition for intangible expenses and costs. 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. [Emphasis Added.]
As indicated above, Virginia Code § 58.1-302 defines “intangible expenses and costs” to include four categories of expenses that are subject to the add-back and a fifth catch-all category for similar items. The amounts described in the first category include “expenses . . . related to . . . the . . . use . . . of intangible property . . . ” Virginia Code § 58.1-302 also defines “intangible property” to include “patents, patent applications, trade names, trademarks, service marks, copyrights and similar types of intangible assets.” The Taxpayer asserts that the Systems are not specifically included in the list of items considered to be “intangible property” as defined in Virginia Code § 58.1-302. Further, without any clear differentiation, it argues the Systems are not “similar types of intangible assets” as those specifically listed.
Even if the Department determined that the Systems did not fall within the definition of intangible property under Virginia Code § 58.1-302, that would only impact the extent to which the fees qualified as intangible expenses under the first category of the definition of “intangible expenses and costs.” As indicated above, Virginia Code § 58.1-302 provides five categories of expenses that qualify as intangible expenses and costs and only the first category ties the expense to the definition of “intangible property.” The fourth category specifically lists licensing fees without regard to whether the fee is paid for intangible property as specifically defined.
Further, the Department finds the Taxpayer’s assertion that each category of intangible expenses and costs should be limited to those associated with the types of intangible property specifically listed in the Virginia Code § 58.1-302 definition lacks foundation. For example, factoring fees, the second category of intangible expenses and costs, could be deemed inoperable because such fees are related to accounts receivable that are not specifically listed as intangible property in the statutory definition.
In addition, it has been a longstanding principle of statutory construction that every part of a statute should be interpreted so as to give it some effect, and that interpretations that render words or phrases in a statute superfluous or repetitious should be avoided. See Platt v. Union P.R. Co., 99 U.S. 48, 58-59 (1878) and PSINet, Inc. v. Chapman, 362 F.3d 227, 232 (4th Cir. 2004). If categories two through five of the definition of “intangible expenses and costs” were limited to only the listed types of intangible property, they would be superfluous as such expenses would already be included in those expenses described in the first category.
Further, it appears that the Taxpayer’s arguments concerning the Systems licensing fees have evolved over the years. In its most recent submission of supplemental information, the Taxpayer now appears to argue that the fees were paid for the service of maintaining and operating the systems. Previously, the Taxpayer had stated that the entity at issue, IHLP, only engaged in the licensing of software.
Contrary to the Taxpayer’s latest assertion that IHLP operated the program, a sample Systems license agreement provided by the Taxpayer states that IHLP’s employees develop and maintain the software. The agreement did not call for IHLP employees to operate, or assist with the operation of, the software on behalf of the licensees. Further, the licensing fee structure is similar to those normally associated with intellectual assets specifically identified under the definition of intangible property under Virginia Code § 58.1-302.
Accordingly, in the Department’s opinion, the Systems license fee expenses are subject to the add-back provisions of Virginia Code § 58.1-402 B 8. These intangible expenses would be eligible for the subject-to-tax exception based on the amount of the Systems license fee income that is subject to a tax in another state as explained above.
CONCLUSION
Based on the Department’s analysis of the Taxpayer’s facts and circumstances regarding the licensing of its intangible property, the subject-to-tax exception claimed by the Taxpayer must be adjusted in accordance with this determination. The buyer service fees will be excluded from the royalty expense claimed because they were not an intangible expense subject to the add-back requirement. However, the licensing fees for the use of the Systems are subject to Virginia’s add-back to the extent they are not otherwise eligible for an exception.
In accordance with this determination, the audit for the taxable years at issue will be returned to the audit staff for adjustment. The Taxpayer has provided schedules of the amounts it asserts are eligible for the add-back exception, along with amounts it purports to be attributable to the buyer’s fees. Audit staff will review the provided calculations and identify specific documentation needed to verify and adjust the amounts as appropriate. For all states for which it believes it is eligible for an exception, the Taxpayer must provide the state income tax returns as filed with such state so that the audit staff can determine eligibility and confirm exception amounts. Upon completion, the auditor will issue a revised audit report and adjust the assessments.
The application for correction concerning these assessments is being closed. At the conclusion of the auditor’s review, should any issues remain with which the Taxpayer disagrees, the Taxpayer may submit an application for correction within 90 days of the updated audit report in accordance with Virginia Code § 58.1-1821.
The Code of Virginia sections and public document 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 (804) *****.
Sincerely,
Craig M. Burns
Tax Commissioner
AR/513.o