In a 4-3 decision, the Virginia Supreme Court found that royalty payments from a related party must be “actually taxed by another state” to qualify for the “subject-to-tax” exception to Virginia’s addback statute. In Kohl’s Dep’t Stores Inc. v. Virginia Dep’t of Taxation, Record No. 160681 (Va. 2017), the court read Virginia’s “subject-to-tax” exception to apply on a post-apportionment, rather than a pre-apportionment, basis.
Kohl’s Department Stores, Inc. (“Kohl’s”) licensed intellectual property from an affiliate that did not have Virginia nexus, Kohl’s Illinois, Inc. (“Kohl’s Illinois”). For the years at issue, Kohl’s did not add back the royalties paid to Kohl’s Illinois, claiming the “subject-to-tax” exception in Va. Code Ann. § 58.1-402(B)(8)(a)(1) applied because the royalties were included in Kohl’s Illinois’ taxable income. On audit, the Virginia Department of Taxation (“Department”) charged that a significant portion of Kohl’s royalty payments were not entitled to the “subject-to-tax” exception because they were not actually taxed in any other jurisdiction.
The court’s decision caps a storied past involving Virginia’s addback statute. Since its inception in 2004, Virginia’s addback statute included a “subject-to-tax” exception, but the scope of the exception has been up for debate. The Department’s actually paid/post-apportionment position was first stated in Ruling of Commissioner, P.D. 07-153, Virginia Department of Taxation, Oct. 2, 2007. From 2010 to 2013, at the request of the Department, the Virginia General Assembly attempted to amend the “subject-to-tax” exception to require a post-apportionment basis, but those efforts failed. In 2014, the Virginia General Assembly passed an amendment to the “subject-to-tax” exception, with purported retroactive effect. Although the parties agreed to remove the 2014 legislation from consideration in this case, it appears to codify the Department’s position that the exception applies only to that portion of intangible expenses attributed to a state or foreign government where the related member has sufficient nexus to be subject to tax.
The court’s holding is problematic and troubling for several reasons. As pointed out in the well-reasoned dissent, the plain language of the original statute can be read without ambiguity, and perhaps more importantly, any ambiguity that exists should be construed in favor of the taxpayer. The court’s effort to read ambiguity into the statute to support the perceived legislative intent of increased tax revenue is particularly troubling. Also, the decision’s “actually taxed” position is constitutionally suspect and implicates issues of state’s rights and sovereign immunity. Pursuant to the court’s decision (and, perhaps, the 2014 legislation), a taxpayer’s Virginia tax liability is not based on its activities conducted within the state, but rather, at least in part, upon tax policy decisions made by other states regarding the taxability of income earned by other entities.
Most states that have an addback statute also have a “subject-to-tax” exception. The Kohl’s decision sets a troubling example of the direction states may take in interpreting these addback exceptions. Accordingly, taxpayers should analyze their addback filing positions in light of the Kohl’s decision, and expect continued audit activity on this issue.