On August 31, 2017, the Virginia Supreme Court (Court), in a 4-3 ruling in Kohl's Department Stores,¹ held that a multistate retailer must add back royalties paid to an out-of-state related corporation (Illinois entity) because these payments did not qualify for the "subject to tax" safe harbor exception to Virginia's inter-company add-back statute. In so holding, the Court upheld a lower court ruling and concluded the "subject to tax" exception "applies only to the extent that the royalty payments were actually taxed by another state" (i.e., it applies on a post-apportionment basis only). The Court also held, however, that the exception applies to the extent the royalties were actually taxed in another state, regardless of which entity paid the tax. Three justices joined in a vigorous dissent.

Background

Virginia generally requires corporate taxpayers to file on a separate-company basis, although a consolidated election is available. In this case, the taxpayer (a retail store operator) filed on a separate-company basis and deducted certain royalties paid to the Illinois entity. Under Virginia law, a taxpayer must add back to federal taxable income the amount of any intangible expenses and costs directly or indirectly paid, accrued or incurred in connection, directly or indirectly, with one or more transactions with related members, unless an exception applies. At issue in this case is the exception found in Va. Code Ann. Section 58.1-402(B)(a), which states that an add-back of such a related member payment is not required if: "[t]he corresponding item of income received by the related member is 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 … "

The circuit court held that, under the plain language of the statute, in order to meet the exception, the intangible expense paid to a related member must be subject to tax in another state and the tax must actually be imposed. On appeal, the retailer argued that, under the plain meaning of this provision, income is taxable in another state if the income is simply included in the computation of a corporation's taxable income in another state (i.e., the exception applies on a pre-apportioned basis). Alternatively, the retailer argued the Virginia Department of Taxation (Department) erred in calculating the amount of royalties that fall within the "subject to tax" exception.

Conversely, the Department argued the exception applies on a post-apportionment basis and thus does not apply to the retailer. Even though all the royalties were included in the Illinois entity's taxable income and reported on a combined report in Illinois, they were eliminated, as most of the royalties were not attributable to any other state in which the Illinois entity filed a return. As a result, most of the income was not subject to tax in another state.

Ruling in favor of the Department, the Court held the "subject to tax" exception applies on a post-apportionment basis. The Court found the plain language of the statute unclear on whether the General Assembly intended for the exception to apply on a pre- or post- apportionment basis. Looking at the taxpayer's argument, the Court determined that applying the exception on a pre-apportionment basis "would effectively negate the add[-]back statute's intended operation and undermine this expected revenue … [because] corporations could avoid the application of the add[-]back statute;" therefore, such an interpretation is unreasonable. The Court further reasoned that, under settled law, when a statute is unclear, it will consider the statutory construction of the state official charged with the statute's administration. The Court found the Department's interpretation — applying the exception on a post-apportionment basis — is reasonable. Thus, "the subject-to-tax exception applies only to the extent that the royalty payments were actually taxed by another state."

Turning to the taxpayer's alternative argument, the Court agreed that the Department erred in calculating the amount of royalties that fall within the "subject to tax" exception. The Department only allowed a partial exception to the extent the royalty payments were apportioned and taxed in the separate-return states in which the Illinois entity filed returns. The Department asserted "that the ["subject to tax"] exception only applies to '[t]he corresponding item of income received by the related member.'"² The Court rejected this assertion, finding no such statutory requirement. Accordingly, to the extent the royalties were actually taxed by another state (including separate-return states, combined-return states or add-back states) the "subject to tax" exception applies, regardless of which entity paid the tax. The Court remanded the case for determination of the portion of the royalty payments excepted from the add-back requirement.

The Dissent

Three Justices asserted in a vigorous dissent that the majority of the Court "inserted an apportionment calculation" unsupported by the statute. The dissent found the statutory language unambiguous and would not have deferred to the Department's interpretation. Moreover, the dissent found the majority, in adopting the Department's interpretation, inserted apportionment language reflected in proposed legislative amendments that were not enacted. The dissent also pointed to language enacted by the General Assembly in the 2014 and 2016 Budget Bills, which are not at issue in the case.

Implications

This ruling clarifies the scope of the "subject to tax" exception for the related-member add-back provisions under Virginia law. The ruling still leaves open, however, the precise calculation of what is subject to tax, since the case was remanded to the circuit court for a determination of what portion of the royalty payments was actually taxed by another state and, therefore, excepted from the add-back statute. In particular, it is not clear how combined-reporting states should be treated for purposes of the post-apportionment exception. Taxpayers that have claimed this exception should review the ruling to determine whether they still qualify for the exception, and to see if additional royalty payments may fall within the exception.

Separate-return states such as Virginia have enacted their own versions of add-back statutes. While the "subject to tax" provision is common, the legislative language varies widely. The ruling in this Virginia case could be useful in interpreting the ambiguities in the statutes that may exist in other states with similar provisions.

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ENDNOTES

¹ Kohl's Department Stores, Inc. v. Virginia Department of Revenue, No. 160681 (Va. S. Ct. Aug. 31, 2017).

² Va. Code Section 58.1-402(B)(8)(1).