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The Virginia Supreme Court has released a revised split opinion affirming that the safe harbor exception from the Virginia corporation income tax related-party addback for certain corporate expenses applied only to the portion of intangible expenses on which tax was actually imposed.1
In its amended analysis, the Court found legislative intent, rather than Department interpretation, to be the most relevant factor. The Court again affirmed that the exception applied regardless of which entity in the related-party group actually paid the tax.
The taxpayer, Kohl’s Department Stores, Inc. (Kohl’s), operates retail stores throughout the United States and licenses certain intellectual property from an affiliate, Kohl’s Illinois. Pursuant to the terms of a licensing agreement between the two parties, Kohl’s paid royalties to Kohl’s Illinois during the taxable years ending January 31, 2009 and January 31, 2010. In computing federal taxable income, Kohl’s deducted the royalty payments as ordinary and necessary expenses and Kohl’s Illinois included these payments as income.
To compute Virginia taxable income, taxpayers subject to the Virginia corporation income tax are required to add back intangible expenses paid to a related member to the extent such expenses were deducted by the taxpayer in calculating federal taxable income.2
Similar to other states with addback rules, Virginia allows taxpayers to claim an exception from the addback in several instances, including situations where the expense added back is subject to tax in another jurisdiction. Specifically, the original “subject to tax” exception exempted intangible expenses from the addback requirement to the extent that “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.”3
During its 2014 session, the Virginia General Assembly amended the “subject to tax” exception to more closely align with statutes enacted by other jurisdictions which more narrowly construed this exception. The amendment was retroactively effective to tax years beginning on or after January 1, 2004.4
The retroactive amendment modified the exception so that it only applies to the portion of intangible income received by a related member that has been “attributed to a state or foreign government in which the related member has sufficient nexus to be subject to such taxes.”5
Prior to the amendment, Kohl’s interpreted the exception as applying on an unapportioned basis. For the taxable years ending January 31, 2009 and January 31, 2010, Kohl’s Illinois paid state income taxes on its apportionable share of taxable income in several states, including both separate and combined filings.6
As a result, Kohl’s viewed the royalties as qualifying for the “subject to tax” exception and did not add them back when computing its Virginia taxable income for the taxable year that ended on January 31, 2009. For the taxable year that ended on January 31, 2010, Kohl’s requested a refund for the royalties it had originally added back to its taxable income.
Following an audit in 2011, the Virginia Department of Taxation issued a notice of assessment which reduced the royalty addback exception to allow only the portion of Kohl’s royalties paid to Kohl’s Illinois that corresponded to the portion of Kohl’s Illinois’s income subjected to tax in other states.7
Kohl’s protested and the Virginia Circuit Court determined that “to fall within the [subject-to-tax] exception, the intangible expenses paid to a related member must not only be subject to tax in another state, but that tax must actually be imposed.”8
Kohl’s appealed the determination, resulting in a decision by the Virginia Supreme Court affirming that the safe harbor exception from the Virginia corporation income tax related-party addback for certain corporate expenses applied only to the portion of intangible expenses on which tax was actually imposed.9
Kohl’s filed for rehearing, based on its contention that the majority opinion exceeded its statutory authority by giving great weight to the Department’s interpretation and that qualifying for a safe harbor exception to an addback provision does not negate the purpose of that provision. Following a several-month wait, the revised opinion was issued in response to the request for rehearing.
Virginia Supreme Court Initial Ruling
Kohl’s primary argument was that the addback exception applied on a pre-apportionment basis. Alternatively, Kohl’s offered that, even if the exception only covered the amount that was actually taxed, the Department’s computation of that amount was incorrect.
In examining the relevant statute, Va. Code. Ann. Sec. 58.1-402.B.8.a.(1) (prior version), the Court found a lack of clarity regarding whether the legislature intended the exception to apply on a pre- or post-apportionment basis, and noted that the phrase “subject to a tax” is undefined. The Court deferred to the Department’s statutory interpretation, citing earlier decisions concluding that great weight be afforded to an analysis by a state official charged with administration of a statute with doubtful meaning.10
Thus, the Court found that the “subject to tax” exception applies only to the extent that the royalty payments were actually taxed by another state (i.e., on a post-apportionment, rather than pre-apportionment, basis).
Rejecting the Department’s argument that the tax must have been paid by the related member to meet the requirements for the exception, the Court also ruled that the royalties fell within the “subject to tax” exception to the extent that the royalties were actually taxed, regardless of which entity paid the tax. Thus, the Court allowed the exception for royalties taxed by states using both separate and combined return methods, as well as states in which an addback was applied to the royalties.
Revised Virginia Supreme Court Ruling
Although Kohl’s arguments and the Court’s conclusion remain unchanged, the analysis applied by the Court differs significantly. In analyzing the applicability of the subject-to-tax exception, the Court found it necessary to weigh the principle of legislative intent against the principle that tax statutes are generally construed against the taxing authority. In determining that “the intention of the legislature is our guiding star,” the Court cited several decisions from other states considering the principle requiring strict construction of statutes imposing taxes.11
Notably, the Court determined that its highest objective, determining legislative intent, does not change simply because a tax statute is the type of statute being interpreted. Citing the fiscal impact statement provided by the Department to the General Assembly estimating that the legislation adopting the statute at issue would raise the Commonwealth’s annual tax revenue in 2005 by $34 million, the Court noted that “accepting Kohl’s argument would effectively negate the intended operation and undermine this expected revenue.” Accordingly, the Court held that the subject-to-tax exception applies on a post-apportionment basis.
The Court also re-examined Kohl’s alternative argument that the Department erred in calculating the amount of the royalties that falls within the exception. The Court did not change its original impression and found no requirement specifying which member of the related group must have paid the tax in order to qualify. Accordingly, the Court stood firm on its reversal of the Circuit Court decision to this point and remanded the case for further determination of the amount of the royalty payments actually taxed by another state and, therefore, excepted from the addback statute.
As in the original decision, three justices joined in writing a dissent to express their disagreement. Notably, they found the statute at issue unambiguous, though to the extent that ambiguity was present, Virginia statutory construction principles would have required any uncertainty to be resolved in the taxpayer’s favor. While acknowledging the Court’s consideration of the strict interpretation standard, the dissenting justices found the decision in violation of its intent to serve as a limitation on the taxing power of the legislature. Further, the justices found that the legislative history relied upon did not support the Court’s interpretation, noting that the Court intuits “a ‘plainly ascertainable intention’ from a fiscal impact statement.”
The Virginia Supreme Court’s applicability of this new rationale to resolve the ambiguity in the “subject to tax” exception is notable for several reasons. Although the final determination upholding judicial validation of the Department’s long-standing interpretation of the application of related-party addback exceptions12
did not change, the significant difference in analysis is telling. Rather than relying upon the Department’s interpretation in its decision, the Court instead focused solely on an examination of legislative intent. It will be interesting to see if a similar analysis is applied in future decisions interpreting different tax statutes. If so, the Department could be forced to perform a similar process when working with taxpayers to resolve statutory interpretation issues either at the audit level, or through the state’s robust public document process. The focus on legislative intent potentially may impact the Department’s prospective development of regulations designed to interpret statutes, and may embolden the Virginia legislature to more clearly delineate the purpose of newly adopted statutes through legislative intent statements. Further, it will be interesting to see whether other states with similarly worded addback provisions are inspired to interpret their own “subject to tax” exceptions in a similar manner.
The Court’s confirmation of the application of the “subject to tax” exception on a post-apportioned basis serves to substantially limit the ability of corporate taxpayers to utilize an important and frequently used exception to the Virginia related-party addback. Taxpayers that have intercompany transactions with affiliates resulting in expenses that are subject to the Virginia addback rules should determine the extent of their potential exposure in light of this decision. Notably, 2014 and 2016 legislation effectively adopted the Department’s interpretation of the addback rule and will serve to limit the prospective impact of this decision.
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