In a recent ruling, the Virginia Department of Taxation determined that payments made by a taxpayer to an affiliated corporation were not "royalty" payments and should not have been added back to the taxpayer’s Virginia taxable income.1 In the ruling, the Department held that only payments based on a percentage of the licensee’s "profits or a specified sum per item sold" constituted "royalties" subject to Virginia’s intangible expense add-back. Based on the rationale underlying the ruling, taxpayers that make payments to their affiliates on a cost-plus or flat-fee basis should not add back any portion of the payments when computing their Virginia taxable income. In addition, the ruling makes it clear that Virginia, unlike some other states, is not seeking to expand the scope of its intangible expense add-back, by seeking to recharacterize amounts paid for goods or services in intercompany transactions as "disguised royalties."
Virginia Law and the Ruling.
In order to determine its Virginia taxable income, a corporation must start with federal taxable income and make several adjustments to its federal taxable income, including adding back "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."2 Intangible expenses and costs are defined to include "royalties."3
The recent ruling involved a taxpayer that owned a subsidiary that designed, developed, and sold private-label merchandise, which the subsidiary sold exclusively to the taxpayer. The subsidiary "held all of the trademarks related to the merchandise." The subsidiary sold the merchandise to the taxpayer at its own cost, plus a profit percentage. The auditor determined that the "profit percentage" component of the payment was a royalty and added that component of the payment back to taxpayer’s taxable income as an intangible expense. The taxpayer protested, arguing that the "profit percentage" was not a royalty.
The Department agreed with the taxpayer. Relying on a 1996 Ninth Circuit decision involving a federal income tax case,4the Department held that a royalty is a payment "based on a percentage of profits or a specified sum per item sold." Based on this holding, the Department determined that the taxpayer was not paying royalties to its subsidiary because the price that the taxpayer paid for the merchandise was based on the subsidiary’s cost plus a mark-up, rather than on the taxpayer’s own profit or sales.
What should taxpayers do now?
Taxpayers should review their intercompany agreements with a special focus on how the pricing for any goods or services is determined. If the pricing is based on anything other than a percentage of taxpayer profits or a specified sum per item sold by the taxpayer, then the payment should not be treated as a royalty for purposes of Virginia’s intangible expense add-back. If the payment in question was added back to Virginia taxable income on prior year returns, then refund claims should be filed for any open years. Please contact one of the authors of this alert, or the Reed Smith attorney with whom you usually work, to discuss this and other refund opportunities related to Virginia’s intangible expense add-back.