State & Local Tax Alert Breaking state and local tax developments from Grant Thornton LLP Virginia Supreme Court Affirms Related-Party Addback Safe Harbor Exception Applies on Post-Apportioned Basis In a split 4-3 decision, the Virginia Supreme Court affirmed that the safe harbor exception from the Virginia corporation income tax related-party addback for certain corporate expenses applied only to the portion of intangible expenses on which tax was actually imposed. 1 However, the Court allowed the application of the exception regardless of which entity in the related-party group actually paid the tax. Background The taxpayer, Kohl s Department Stores, Inc. (Kohl s), operates retail stores throughout the United States and licenses certain intellectual property from an affiliate, Kohl s Illinois. Pursuant to the terms of a licensing agreement between the two parties, Kohl s paid royalties to Kohl s Illinois during the taxable years ending January 31, 2009 and January 31, 2010. In computing federal taxable income, Kohl s deducted the royalty payments as ordinary and necessary expenses and Kohl s Illinois included these payments as income. To compute Virginia taxable income, taxpayers subject to the Virginia corporation income tax are required to add back intangible expenses paid to a related member to the extent such expenses were deducted by the taxpayer in calculating federal taxable income. 2 Similar to other states with addback rules, Virginia allows taxpayers to claim an exception from the addback in several instances, including situations where the expense added back is subject to tax in another jurisdiction. Specifically, the original subject to tax exception exempted intangible expenses from the addback requirement to the extent that the 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. 3 Release date September 15, 2017 States Virginia Issue/Topic Corporate Income Tax Contact details Eric Cheek T 703.637.4201 E eric.cheek@us.gt.com Gary Rosen T 703.637.4070 E gary.rosen@us.gt.com Guinevere Seaward Shore T 703.637.4133 E guinevere.seaward@us.gt.com Jamie C. Yesnowitz Washington, DC T 202.521.1504 E jamie.yesnowitz@us.gt.com Chuck Jones Chicago T 312.602.8517 E chuck.jones@us.gt.com Lori Stolly Cincinnati T 513.345.4540 E lori.stolly@us.gt.com Priya D. Nair Washington, DC T 202.521.1546 E priya.nair@us.gt.com www.grantthornton.com/salt 1 Kohl s Department Stores Inc. v. Virginia Department of Taxation, Virginia Supreme Court, Record No. 160681, Aug. 31, 2017 (affirming City of Richmond Circuit Court, Case No. CL 12-1774, Feb. 3, 2016). For further details, see GT SALT Alert: Virginia Court Clarifies Scope of Related Party Addback Safe Harbor Exception. 2 VA. CODE ANN. 58.1-402.B.8 (prior version). Applicable for tax years beginning on or after January 1, 2004. 3 VA. CODE ANN. 58.1-402.B.8.a.(1) (prior version)..
Grant Thornton LLP - 2 During its 2014 session, the Virginia General Assembly amended the subject to tax exception to more closely align with statutes enacted by other jurisdictions which more narrowly construed this exception. The amendment was retroactively effective to tax years beginning on or after January 1, 2004. 4 The retroactive amendment modified the exception so that it only applies to the portion of intangible income received by a related member that has been attributed to a state or foreign government in which the related member has sufficient nexus to be subject to such taxes. 5 Prior to the amendment, Kohl s interpreted the exception as applying on an unapportioned basis. For the taxable years ending January 31, 2009 and January 31, 2010, Kohl s Illinois paid state income taxes on its apportionable share of taxable income in several states, including both separate and combined filings. 6 As a result, Kohl s viewed the royalties as qualifying for the subject to tax exception and did not add them back when computing its Virginia taxable income for the taxable year that ended on January 31, 2009. For the taxable year that ended on January 31, 2010, Kohl s requested a refund for the royalties it had originally added back to its taxable income. Following an audit in 2011, the Virginia Department of Taxation issued a notice of assessment which reduced the royalty addback exception to allow only the portion of Kohl s royalties paid to Kohl s Illinois that corresponded to the portion of Kohl s Illinois s income subjected to tax in other states. 7 Kohl s protested and the Virginia Circuit Court determined that to fall within the [subject-to-tax] exception, the intangible expenses paid to a related member must not only be subject to tax in another state, but that tax must actually be imposed. 8 Kohl s appealed the determination, resulting in this appeal. Virginia Supreme Court Ruling Kohl s primary argument was that the addback exception applied on a pre-apportionment basis. Alternatively, Kohl s offered that, even if the exception only covered the amount that was actually taxed, the Department s computation of that amount was incorrect. Pre-Apportionment Versus Post-Apportionment Measure of the Exception 4 H.B. 5001, 2014 Special Session I, 3-5.11 (effective Jan. 1, 2004). Because the provisions in the bill simply funded Virginia through June 30, 2014 (the end of the state s 2013 fiscal year), rather than including the budget for an entire fiscal period, the bill was referred to as the budget bill caboose. 5 VA. CODE ANN. 58.1-402.B.8.a.(1) (current version). 6 For the years at issue, Kohl s Illinois filed separate tax returns in Arkansas, Florida, Iowa, Louisiana, New Jersey, New Mexico, North Carolina, Oklahoma and South Carolina. Kohl s and Kohl s Illinois filed combined returns in Alaska, California, Idaho, Illinois, Kansas, Maine, Massachusetts, Michigan, Minnesota, Montana, Nebraska, New Hampshire, New York, North Dakota, Oregon, Utah, Vermont, West Virginia and Wisconsin. Notably, a substantial portion of Kohl s Illinois s royalties were not taxed at the state level as they were not fairly attributable to Kohl s Illinois s activities in most states. 7 The amount allowed only included the portion of Kohl s Illinois s income subject to tax in separate return states. 8 Kohl s Department Stores Inc. v. Virginia Department of Taxation, City of Richmond Circuit Court, Case No. CL 12-1774, Feb. 3, 2016.
Grant Thornton LLP - 3 Kohl s first contended that all of the royalties paid to Kohl s Illinois were included in its taxable income, and were thus subject to tax using a pre-apportionment measure. The Department disagreed, finding that the exception applied only to the extent that the taxpayer actually paid the tax on a post-apportioned basis. In examining the relevant statute, Va. Code. Ann. Sec. 58.1-402.B.8.a.(1) (prior version), the Court found a lack of clarity regarding whether the legislature intended the exception to apply on a pre- or post-apportionment basis, and noted that the phrase subject to a tax is undefined. Observing that the addback statute was designed primarily to prevent the deduction of royalties and interest paid to related intangible holding companies, the Court found that accepting Kohl s argument would effectively negate the add back statute s intended operation. Instead, the Court deferred to the Department s statutory interpretation, citing earlier decisions concluding that great weight be afforded to analysis by a state official charged with administration of a statute with doubtful meaning. 9 Thus, the Court found that the subject to tax exception applies only to the extent that the royalty payments were actually taxed by another state (i.e., on a post-apportionment, rather than pre-apportionment, basis). Calculation of the Post-Apportioned Amount Alternatively, Kohl s argued that the Department erred in calculating the amount of the royalties that falls within the subject to tax exception. Specifically, the Department allowed a partial exception to the addback to the extent that the royalty payments were apportioned and taxed in separate return states. However, Kohl s Illinois s income was also included in Kohl s taxable income computation in combined return states. Further, pursuant to addback statutes, Kohl s was required to add all or a portion of the royalties back in computing taxable income in several states. 10 Thus, Kohl s argued that to the extent the royalties were apportioned to and taxed by all of those states, they fell within the subject to tax exception. The Court noted that the relevant addback statute only requires that the item of income received by the related member be taxed by another state. The statute does not require that the related member be the entity that pays the tax on that item of income. Rejecting the Department s argument that the tax must have been paid by the related member to meet the requirements for the exception, the Court ruled that the royalties fell within the subject to tax exception to the extent that the royalties were actually taxed, regardless of which entity paid the tax. Thus, the Court allowed the exception for royalties taxed by states using both separate and combined return methods, as well as states in which an addback was applied to the royalties. Accordingly, the Court reversed the Circuit Court decision and remanded the case for further determination of the amount of the royalty payments actually taxed by another state and, therefore, excepted from the addback statute. 9 Including Verizon Online LLC v. Horbal, 796 S.E.2d 409, 412 (Va. 2017). 10 Kohl s added back the total amount of royalties paid in computing taxable income in Connecticut, Maryland and Massachusetts. A portion of the royalties was added back in computing taxable income for Georgia and New Jersey.
Grant Thornton LLP - 4 Dissent Three justices joined in writing a dissent to express their disagreement with the decision. First, they found that the Court had inserted an apportionment calculation into the statutory addback provision that was not supported by the provision s plain language, which they found unambiguous. Also, they cited several post-2007 efforts to codify language adopting the Department s interpretation of the exception as applying on a postapportionment basis, as well as the retroactive amendment to the legislation. Although the Department did not invoke the retroactive language in this case, the justices found its existence indicative of a desire to change the original intent of the statute. Further, efforts to impose an apportionment limitation on the application of the statute, including the 2014 and 2016 budget bills, supported the conclusion that no such limitation existed in the statute as originally enacted. Finally, even if the justices had found the statutory language ambiguous, they noted that any uncertainty in statutes imposing taxes must be construed in favor of the taxpayer. Commentary The Virginia Supreme Court s decision to uphold the application of the subject to tax exception on a post-apportionment basis strengthens judicial validation of the Department s long-standing interpretation of the application of related-party addback exceptions. 11 Interestingly, like its Circuit Court counterpart, this case did not address the issue of whether the retroactive amendment was valid, as both parties stipulated to remove this issue from consideration. The 10-year period of retroactivity poses equitable and potentially constitutional concerns, as this length of time markedly exceeds the one-year period that Justice O Connor deemed acceptable for a retroactive statute in her concurring opinion in United States v. Carlton. 12 It is possible that other taxpayers in a similar position may challenge the legislation in the future by attacking the period of retroactivity. In its decision, the Court relied on a combination of implied legislative intent and the Department s interpretation to resolve the perceived lack of clarity in its addback statute. It will be interesting to see whether other states with similarly worded addback provisions are inspired to interpret their own subject to tax exceptions in a similar manner. The Court s affirmation of the application of the subject to tax exception on a postapportioned basis serves to substantially limit the ability of corporate taxpayers to utilize an important and frequently used exception to the Virginia related-party addback. Taxpayers that have intercompany transactions with affiliates resulting in expenses that are subject to the Virginia addback rules should determine the extent of their potential exposure in light of this decision. Further, they should consider whether the decision to allow Kohl s the exception for royalties taxed in separate, combined and addback states provides it an opportunity to recoup at least a portion of its excepted amount which could be lost through post-apportionment application. Notably, 2014 and 2016 legislation 11 The Department s policy in this area was first stated in Ruling of Commissioner, P.D. 07-153, Virginia Department of Taxation, Oct. 2, 2007. 12 512 U.S. 26, 37-38 (1994) (O Connor, J., concurring) (stating that [t]he government interest in revising the tax laws must at some point give way to the taxpayer s interest in finality and repose... A period of retroactivity longer than the year preceding the legislative session in which the law was enacted would raise... serious constitutional questions. ).
Grant Thornton LLP - 5 effectively adopted the Department s interpretation of the addback rule and will serve to limit the prospective impact of this decision. The information contained herein is general in nature and based on authorities that are subject to change. It is not intended and should not be construed as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to or suitable for specific circumstances or needs and may require consideration of nontax and other tax factors. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Grant Thornton LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. No part of this document may be reproduced, retransmitted or otherwise redistributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, re-keying or using any information storage and retrieval system without written permission from Grant Thornton LLP. This document supports the marketing of professional services by Grant Thornton LLP. It is not written tax advice directed at the particular facts and circumstances of any person. Persons interested in the subject of this document should contact Grant Thornton or their tax advisor to discuss the potential application of this subject matter to their particular facts and circumstances. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed.