In Surtees v. VFJ Ventures, Inc., No. 2060478 (Ala. Civ. App. February 8, 2008), the Alabama Court of Civil Appeals reversed a Montgomery County Circuit Court decision which held that the taxpayer qualified for the “unreasonableness” exception to Alabama’s add-back statute and was not required to add back certain intercompany royalty payments. Approximately 20 states and localities have adopted “add-back” statutes and several of these states have adopted exceptions to add-back based on language similar to Alabama’s “unreasonableness” exception. VFJ Ventures, Inc. (“VFJ”) represents the first time that an appellate court has ruled on the scope of a state’s “unreasonableness” exception and thus could be relied upon by other states in interpreting exceptions to their add-back statutes. The court also ruled that Alabama’s subject-to-tax exception applies on a post-apportionment basis. While subject-to-tax exceptions vary significantly among the states, the VFJ court’s post-apportionment approach could be relied on to determine the application of add-back statutes in other states.

Background

VFJ Ventures, Inc. (“VFJ”) challenged the application of the Alabama add-back statute to its intercompany royalty expenses on the grounds that it qualified for both the “unreasonableness” exception and the “subject-to-tax” exception and that the add-back statute violated the Commerce Clause. The trial court agreed with VFJ as to its “unreasonableness” challenge and did not address VFJ’s other arguments. Specifically, the trial court held that “add-back is unreasonable because VFJ’s royalty payments were not abusive – they had economic substance and business purpose – and represent real and necessary costs of doing business in Alabama.” The court also found that to disallow the deductions would distort the amount of VFJ’s income fairly attributable to Alabama. See VFJ Ventures, Inc. v. Surtees, No. CV-03-3172 (Ala. Cir. Ct. Montgomery County, Jan. 24, 2007) (for our full discussion of the trial court’s opinion click here). On appeal, the Alabama Court of Civil Appeals addressed each of VFJ’s arguments and reversed the trial court, holding that the Department of Revenue properly applied add-back to VFJ.

Unreasonableness Exception

Alabama’s “unreasonableness exception” to its add-back statute provides that a “corporation shall make the adjustments. . .unless the corporation establishes that the adjustments are unreasonable.” The appellate court ruled the trial court erred in its interpretation of the “unreasonableness” exception by focusing its analysis on the taxpayer’s business purpose and economic substance.

The court held that to apply the “unreasonableness” exception based upon a showing of business purpose and economic substance would render Ala. Code § 40-18-35(b)(3) meaningless. That section provides an exception to add-back if the taxpayer can establish the principal purpose of the transaction was not the avoidance of Alabama tax liability, and the related member receiving the payment “is not primarily engaged in the acquisition, use, licensing, maintenance, management, ownership, sale, exchange, or any other disposition of intangible property, or in the financing of related entities.”

The appeals court ultimately deferred to the Department of Revenue’s interpretation of the “unreasonableness” exception. The Department testified that it only applied the “unreasonableness” exception where the application of the add-back statute results in a tax that would be “out of proportion with what could reasonably be attributed to the State.” In adopting the Department’s position, the court also relied upon an add-back regulation promulgated in 2003 (after the periods at issue in the case) which documented the Department’s interpretation of the add-back statute.

Sutherland Observation: The court failed to address the portion of the lower court’s holding which provided that disallowing the deductions would distort the amount of VFJ’s income fairly attributable to Alabama and whether this was the same as finding that the tax was “out of proportion with what could be reasonably attributed to the State.” Notwithstanding the appellate court’s failure to address this issue, this decision could be relied upon by other states in analyzing the application of similar “unreasonableness” exceptions. Expense disallowance statutes in several states, including Connecticut, Illinois, Massachusetts, Ohio, New Jersey and Rhode Island, include language similar to Alabama’s “unreasonableness” exception. If other states follow the VFJ court’s analysis, taxpayers will likely have to prove distortion to qualify for an “unreasonableness” exception.

Subject-to-Tax Exception

The court also rejected VFJ’s argument that the subject-to-tax exception to add-back should be applied on a pre-apportionment basis. While several states limit the subject-to-tax exception to instances when the holding company earning the income pays tax within 3% of the taxing state’s rate, Alabama does not have a rate limitation. Accordingly, the court was forced to determine if Alabama’s subject-to-tax exception applied on a pre- or post-apportionment basis.

Sutherland Observation: Most states that have adopted expense disallowance statutes allow a subject-to-tax exception. However, variations in how the subject-to-tax exception is calculated are widespread. Some states, like Alabama and Arkansas, only require that the holding company be subject to tax in another state. Other states, like Maryland, require that the holding company be subject to tax at a specific rate in another state or states. Finally, states like Massachusetts and Connecticut require that the holding company be subject to tax at a cumulative effective tax rate within a certain percentage of the taxing state’s rate.

VFJ argued that the subject-to-tax exception should be interpreted to mean that the entire amount of federal taxable income listed on the holding company’s North Carolina tax returns were “subject to tax” even though only a small amount was apportioned to North Carolina. The court disagreed, however, holding that the subject-to-tax exception is applied on a post-apportionment basis. Therefore, only the percentage of VFJ’s expenses attributable to income taxed by North Carolina were excluded from add-back.

On February 6, 2008, an Alabama House Bill (H.B. 350) purporting to further define the exceptions to the add-back statute was submitted for consideration. This bill states that a taxpayer can establish an adjustment as “unreasonable” only where there is a violation of the U.S. Constitution. The Legislature’s motivation to add this language appears to be to align the statute with the Department’s position that the “unreasonableness” exception only applies upon a showing that the add-back statute results in taxation that is out of proportion to the taxpayer’s activities in the state. However, it could be argued that the bill is unnecessary because U.S. Constitutional principles are always relevant when determining the validity of a state statute.

Alabama H.B. 350 also addresses the subject-to-tax exception to the add-back statute. The bill provides that income which has not been attributed to another taxing jurisdiction is not “included in income for purposes of a tax on net income” and, therefore, shall not be considered “subject to a tax” for purposes of the exception. If enacted, this provision would codify the Department’s post-apportionment interpretation of the subject-to-tax exception.

Sutherland Observation: Alabama H.B. 350 may be evidence that the Department’s interpretation of the unreasonableness exception and the subject-to-tax exception are not supported by the current add-back statute because the bill essentially codifies the Department’s positions as described in VFJ. If Department’s positions as described in VFJ are indeed supported by the current statute, there appears to be no reason for the enactment of H.B. 350.

Constitutionality of Add-back Statute

VFJ argued that application of the add-back statute was an attempt by Alabama to tax the intangible management company’s income, although there was not a sufficient nexus to support the state’s imposition of a tax on that entity. The court disagreed and concluded that the disallowance of a deduction to the taxpayer did not constitute a tax on the corporation receiving the payment.

The court also rejected VFJ’s argument that Alabama’s add-back statute results in a tax that is not fairly apportioned to Alabama. The court noted that VFJ did not provide sufficient evidence to demonstrate the statute lacked external consistency and that VFJ was required to establish by “clear and cogent evidence” that the application of the add-back statute led to a tax that was not fairly attributable to VFJ’s activities in Alabama.