On August 31, 2017, the Virginia Supreme Court issued its opinion holding that only the portion of royalties that are actually taxed by another state falls within its “subject to tax” exception to Virginia’s addback statute for corporate income tax purposes. Kohl’s Department Stores, Inc. v. Virginia Department of Taxation, No. 160681 (August 31, 2017). The Virginia Supreme Court remanded the case to the Circuit Court to determine the portion of the royalty payments actually taxed by another state.
Overview of Exceptions to Virginia’s Addback Statute
For tax years beginning on and after January 1, 2004, corporations are required to “addback” intangible expenses that are otherwise deductible if the expenses are directly or indirectly paid, accrued, or incurred to a related member.1
However, Virginia provides exceptions to this addback statute, including the “subject to tax” exception under Va. Code Ann. § 58.1-402(B)(8)(a)(1). Under the subject to tax exception, a taxpayer is not required to add back (i.e., deduct) intangible expenses to the extent the income received by the related party was “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.”2
Background: Kohl’s Virginia Filings and Circuit Court Decision
For the tax years at issue, Kohl’s Department Stores, Inc. (Kohl’s) paid royalties to an affiliated company, Kohl’s Illinois, Inc. (Kohl’s Illinois), for the use of intellectual property owned, managed and licensed by Kohl’s Illinois. Kohl’s Illinois included in its state corporate income tax returns the royalties it received from Kohl’s. However, Kohl’s Illinois paid state tax on only a portion of the royalties because each state taxed a fraction of Kohl’s Illinois’s taxable income.
The Virginia Department of Revenue (Department) audited Kohl’s Virginia Corporation Income Tax Returns and issued assessments based on a recalculation of Kohl’s Virginia taxable income to include a partial addback of the royalties Kohl’s paid to Kohl’s Illinois. The Department allowed only a partial exception to the addback requirement related to the royalties that were actually subject to tax in other states.
Kohl’s appealed to the Circuit Court, arguing that the royalties paid to Kohl’s Illinois were subject to tax in other states by virtue of its inclusion in Kohl’s Illinois’s state income tax returns, regardless of the fact that the income was included in the pre-apportioned tax base.
The Circuit Court disagreed and held that royalties paid to related members that are reported to, but not taxed by, other states do not qualify for the exception to Virginia’s corporate income tax addback statute. Thus, the Circuit Court interpreted the “subject to tax” standard as an “actual” taxation standard.
Virginia Supreme Court Decision
In a 4-3 decision, the Virginia Supreme Court affirmed the Circuit Court’s holding that only the portion of the royalties that are actually taxed by another state falls within the subject to tax exception.
The Court acknowledged that the plain language of the statute is ambiguous and that both Kohl’s and the Department’s respective positions could be supported by the statute. The Court deferred to the Department’s interpretation. Because of such ambiguity, the Court looked to the legislative intent of the subject to tax exception. The Court stated that it would effectively negate the addback statute’s intended operation and “resurrect the loophole” that the statute was designed to close. Thus, to prevent a conflict with the statute’s purpose and intent, the Court held that the exception applies only to the extent the royalty payments are “actually” taxed by another state.
Note: Three justices dissented to this opinion finding that the statute is not ambiguous and favored the taxpayer’s application of the statute.
The Court, however, upheld Kohl’s alternative argument and held that the Department incorrectly calculated the amount of royalties that qualified for the subject to tax exception. The Department disallowed an exception for royalties apportioned to, and taxed in, states where Kohl’s filed combined income tax returns. The Department argued that the addback statute applies only to intangible expenses for a “related member” and reasoned that the Court can look only to Kohl’s Illinois’s, and not Kohl’s, tax returns. The Court disagreed with the Department, stating that the statute contains no such requirement and thus, to the extent the royalties were actually taxed by separate return states or combined return states, they should qualify for the subject to tax exception. The Court reversed the Circuit Court’s decision in that respect, and remanded for the Circuit Court to recalculate the portion of the royalty payments actually taxed by another state.
In a dissenting opinion, three justices resolved any ambiguity in the addback statute in favor of the taxpayer as they determined that the statute constituted an imposition statute. And, the dissenting justices found that a subsequent law change enacted by the Virginia legislature was evidence that the addback statute should be applied in a manner consistent with the taxpayer’s proposed application.
As the dissent notes, in 2014 and 2016 budget bills, the Virginia Legislature expressed its interpretation that the “subject to tax” exception applied only “to the portion of such income received by the related member, which portion is attributed to a state or foreign government in which the related member has sufficient nexus to be subject to such taxes.”3 The Legislature also expressed its intent to apply this interpretation for tax years beginning on or after January 1, 2004.