Royalty Expense Addback Update − Ways to Challenge Addback Statutes
In an effort to protect the fisc, 20 separate return filing states have recently enacted “addback” statutes, where deductions for royalty and interest payments to affiliated corporations are added back to income subject to apportionment within and without the taxing state. States that apply the unitary business concept have no need for an addback statute, as both payment and receipt of the royalty and interest are included in a single combined report and offset each other.1 Addback statutes vary from state to state, but many have common threads. The Multistate Tax Commission has adopted a model addback statute, the validity of which it vigorously defends.
VFJ Ventures, Inc. v. Surtees, 2008 Alabama Lexis 1971
In October 2008, the Alabama Supreme Court upheld application of the Alabama addback statute to VFJ Ventures, Inc., a manufacturer of clothing that paid royalties to two related Delaware corporations that owned the Lee and Wrangler trademarks. VFJ Ventures, Inc., has filed a petition for certiorari with the Supreme Court of the United States. The trademark holding entities had tax nexus only in Delaware, and Delaware did not tax the royalty payments, although it could have done so. Alabama would not add back the royalties if Delaware taxed the royalty income, so the petition for certiorari presents a relatively straightforward issue: can Alabama deny the deduction because Delaware chose not to tax the royalties? Several amicus briefs have been filed supporting the taxpayers, including by the COST, TEI, U.S. Chamber of Commerce, IPT and, most notably, the State of Delaware.
If the Supreme Court grants certiorari and ultimately reverses the Alabama Supreme Court, the validity of most, if not all, of the other addback statutes will be seriously threatened. But the converse is not true. If the Supreme Court grants certiorari but upholds the Alabama addback statute as applied to VFJ Ventures, Inc., the addback statutes in other states will still be subject to challenge.
The Virginia Addback Statute
The Virginia addback statute, which has many elements in common with other addback statutes, is unquestionably invalid. To illustrate, consider the following hypothetical example, based upon a real-world, bona fide corporate model typical of numerous major companies. Parent corporation, a manufacturer of high-tech products, pays a royalty for technology licensed to it by an R&D Subsidiary. R&D Subsidiary is based in California, a combined report state. Assume Parent has $1,000 in gross receipts, pays $200 in royalties to R&D Subsidiary, has $600 of other expenses and a net income of $200. R&D Subsidiary has gross receipts of the $200 in royalties, deductions for R&D expenses of $100 and a net income of $100. Together the federal consolidated income of the two entities (as well as GAAP income) is $300. R&D Subsidiary conducts R&D activities in California and in many foreign countries (some with U.S. tax treaties, some without) and has taxable nexus in one separate return state to which it apportions 1 percent of its net income of $100. Here is how Virginia applies its addback statute. Virginia adds the $200 royalty paid to R&D Subsidiary to Parent’s income, but excepts from the addback 1 percent of the royalty, or $2, to reflect the separate return state. No exception from the addback is provided for the portion of the royalty apportioned to California. Thus, Parent’s taxable income in Virginia is $398.
Like many States, Virginia excepts from addback any portion of the intangible expenses and costs incurred by the taxpayer if the corresponding income is “subject to tax” in limited circumstances:
[The addback] 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 a 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. Va. Code § 58.1-402(B)(8)(a)(1).
A plain reading of the first exception, where the royalty is reported as income by the recipient in a Virginia income tax return, would be that the payor does not suffer a denial of deduction for a royalty payment where the payee reports the corresponding royalty as income to Virginia. Under such a reading, the Virginia tax effect of the deduction item and income item would depend upon whether both entities are profitable and on their relative Virginia apportionment percentages. For example, if R&D Subsidiary is profitable and has a higher apportionment percentage than Parent, the net effect of a deduction by Parent and inclusion in income by R&D Subsidiary would be that total Virginia tax payments would increase. But this is not the interpretation adopted by the Virginia Department of Revenue. Virginia only excepts from the addback a percentage of the royalty equal to R&D Subsidiary’s Virginia apportionment factor percentage (that is, $2 in our hypothetical example). See Va. Ruling No. 07-153 (Oct. 2, 2007) (relying on a tortured reading of the “for any portion” phrase in Va. Code § 58.1-402(B)(8)(a)). Since Virginia would include all of the royalty in R&D Subsidiary’s measure of income subject to apportionment, it seems selfevident that the reading of the statute by the Department of Revenue is incorrect.
The second exception from addback in § 58.1-402(B)(8)(a)(1) is where the corresponding royalty is subject to tax based on net income by another state. While the statute appears to except the royalty expense from addback if R&D Subsidiary is subject to tax by another state, Virginia’s interpretation of this exception parallels its treatment of royalties paid to an affiliate that is taxable in Virginia. Thus, Virginia only allows an exception to the extent the royalty income is apportioned to the taxing state. In the example, Virginia would only exclude 1 percent of the royalty, or $2, and addback $198 to Parent’s income. Interestingly, the Alabama addback statute in VFJ Ventures, Inc., is comparable to the Virginia addback statute in limiting the exception to the percentage of business conducted in a state. Thus, had Delaware taxed the royalty income apportioned to the state in VFJ Ventures, Inc., the Alabama statute would have excepted that portion of the royalty taxed in Delaware. However, in VFJ Ventures, Inc., 100 percent of the royalty income presumably would have been apportioned to Delaware. Thus, the sliding-scale feature of the Alabama addback statute is not an issue in that case.
The Virginia Addback Statute Is Unconstitutional
In our hypothetical example, Parent’s separate income is $200. R&D Subsidiary’s gross receipts are $200, its R&D expenses are $100, and its net income is $100. The combined economic income of Parent and R&D Subsidiary is $300. Virginia computes Parent’s taxable income subject to apportionment as $398, and apportions that income within and without Virginia by reference solely to the apportionment factors of Parent. The location of R&D Subsidiary’s payroll and property is disregarded. The Virginia statute is unconstitutional as applied for a host of independent reasons.
Fair Apportionment – Internal Consistency Test: Virginia claims in Ruling 07-153 that the addback statute passes the “internal consistency” test described in Container Corp. v. FTB, 463 U.S. 159 (1983): if every other state adopted Virginia’s addback statute and Virginia’s apportionment rules, the states would tax no more than 100 percent of Parent’s income. The claim is not true. The Virginia statute, like many addback statutes, does not provide an exception from addback where R&D Subsidiary is engaged in business in a foreign country that does not have a U.S. tax treaty. The Supreme Court has acknowledged that the internal consistency test does not require actual discrimination; it is the possibility of multiple taxation that invokes the internal consistency test. In our example, there is more than the possibility of multiple taxation. There is actual multiple taxation, for no exception from addback is provided to reflect the business engaged in by R&D Subsidiary in foreign countries that do not have a U.S. tax treaty. Virginia can no more discriminate against foreign commerce than it can discriminate against interstate commerce. Japan Lines, Ltd. v. Los Angeles, 441 U.S. 434 (1979).
Fair Apportionment – External Consistency Test: The external consistency test of the Commerce and Due Process Clauses of the U.S. Constitution is something of a reality check: does the state taxing statute reflect in a reasonable way the business activity conducted by the taxpayer in the state? The Virginia statute flunks this test completely.
In our example, there are two viable corporations, Parent and R&D Subsidiary. Parent nets $200 in income, and R&D Subsidiary nets $100 in income. Their combined income under any rational method of accounting is $300. Yet Virginia calculates Parent’s income before apportionment to be $398. The Virginia statute not only regards R&D Subsidiary’s gross income as the income of Parent, it denies a deduction for the costs incurred by R&D Subsidiary in the conduct of its regular course of business to earn that income.
The Virginia statute then apportions the artificially overstated income of Parent by reference only to the location of Parent’s activities. The location of R&D Subsidiary’s activities is disregarded. Since the income of R&D Subsidiary is effectively taxed as income of Parent, fair apportionment is denied where R&D’s apportionment factors are not taken into account.
Virginia Ruling No. 17-153 seeks to justify its statute by stating that it is not taxing R&D Subsidiary, that it is only denying a deduction by Parent, and deductions are a matter of legislative grace. The Supreme Court of the United States had a colorful response to a similar argument made by California in Hunt-Wesson, Inc. v. FTB, 528 U.S. 458 (2000), where the Franchise Tax Board argued that it was only denying an interest deduction, not taxing out-of-state income. The Supreme Court said that a tax on sleeping measured by a number of shoes in the closet is a tax on shoes. A tax provision is not judged by what it is called, it is judged by what it is as a practical and realistic matter. Here the practical effect of the addback statute is to tax Parent on the sum of R&D Subsidiary’s net income from licensing its technology plus its cost of doing business. California’s interest offset flunked the external consistency test in Hunt-Wesson, and the Virginia addback statute flunks the external consistency test.
States That Do Not Impose a Tax Measured by Net Income or Capital: Virginia allows an exception to addback where R&D Subsidiary is engaged in business in a state that imposes a tax measured by net income or capital. The statute does not allow an exception to addback where R&D Subsidiary is engaged in business in a state that does not impose tax measured by net income or capital. Those states include Washington, Nevada, Wyoming and South Dakota, and may include Ohio, Texas and Michigan prior to 2008. There can be no rational justification for regarding R&D Subsidiary’s income in these states to be instead located in and taxable by states that impose a tax measured by net income. The concept defines a lack of fair apportionment: Virginia treats income earned in those states as being located instead in states that tax net income, one of which is Virginia. Income earned in another state is not income earned in Virginia.
Discrimination Against Interstate Commerce: The Virginia addback statute discriminates against interstate commerce in more than one way. The failure to provide an exception for business activities conducted by R&D Subsidiary in foreign countries that do not have a tax treaty with the United States has already been mentioned.
Perhaps the most invidious discrimination in the example is the failure to provide an exception for the income R&D Subsidiary reports to a state such as California that embraces the unitary tax principle. An exception is provided for income reported to states that require separate returns, but no exception is provided for income reported to states that require the determination of business income earned in the state by using the mechanics of a combined report. R&D Subsidiary is required to file an income tax return in California and pay a tax on its California income. Combined report mechanics are used to determine R&D Subsidiary’s California unitary, or business, income. That redetermined business income could be greater than, or less than, R&D Subsidiary’s separately stated business income. To that business income R&D Subsidiary adds its California nonbusiness income or loss, takes into account its own separate NOL carryover and reduces its California tax by its own individual tax credits. There is simply no rational justification for the Virginia practice of granting a reduction from addback where R&D Subsidiary is taxable in a separate return state, while denying the reduction where R&D Subsidiary is taxable in a combined return state.
What Should Taxpayers Do when Confronted with an Addback Statute?
Taxpayers faced with a state addback statute that contains one or more of the unconstitutional elements that are found in the Virginia addback statute face a classic dilemma: file the return including the addback and accompany the filing with a claim for refund, or file a return without the addback. Conventional wisdom is that it is best to file without the addback on the theory it is easier to defend against a proposed assessment than it is to get a refund. A current trend is for states to attempt to deny a refund for taxes collected on an unconstitutional statute, or to limit the refund to a hypothetical figure that would be constitutional if the statute had not been overreading. For example, see the petition for certiorari filed February 10, 2009, in the Supreme Court in Ventas Finance I LLC v. FTB, 165 Cal.App. 4th 1207 (2008). Other considerations include the interest rate paid on overpayments compared to the interest rate charged on underpayments. Where a state provides an unreasonably low rate of interest on a refund, regarding the addback statute as invalid becomes more attractive. Also, the risk that certain penalties might be imposed must also be considered. Finally, the decision whether to file a return including the addback and filing a claim for refund, or to file the return without the addback may be influenced by FIN 48 considerations.
Taxpayers should consult their tax advisors on how to respond to an invalid addback statute.
This memorandum was prepared principally by Roy E. Crawford and Roburt Waldow, with the assistance of Leah Samit.