Tax Type
Corporation Income Tax
Description
Taxpayer believes that the add back should be allowed on a pre-apportionment basis.
Topic
Allocation and Apportionment
Appropriateness of Audit Methodology
Royalties
Date Issued
07-31-2009
July 31, 2009
Re: § 58.1-1821 Application: Corporate Income Tax
Dear *****:
This will reply to your letter in which you seek correction of the corporate income tax assessments issued to ***** (the "Taxpayer") for the taxable years ended December 31, 2004 and 2005.
FACTS
For the taxable years at issue, the Taxpayer paid royalties and interest to an affiliated entity. On its income tax returns, the Taxpayer listed four states in which the affiliated entity filed income tax returns and claimed an exception for all of the royalty and interest deductions on the grounds that they were subject to tax in another state.
On audit, the Department limited the amount claimed as an exception to the add back by reducing it to correspond to the amount of the affiliate's royalty income apportioned to each state in which the affiliates paid tax and increased the corresponding net add back of royalties and interest.
The Taxpayer filed an appeal contesting the assessments. The Taxpayer argues that the add back clause violates the Due Process and Commerce clauses of the United States Constitution. It also asserts that auditor's assessment limits the exception beyond the clear meaning of the statute. Further, the Taxpayer challenges the fairness of the exception that does not include tax paid to states where a combined or consolidated return is filed. Finally, the Taxpayer believes that the add back should be allowed on a pre-apportionment basis.
DETERMINATION
Subject to Tax Exception
Virginia Code § 58.1-402 B 8 provides several exceptions to the general rule that an add back for certain intangible deductions is required. The exception relevant to the Department's assessment of the Taxpayer states:
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- This addition 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 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. (Emphasis added.)
According to the Taxpayer, the plain meaning of the statute entitles it to exclude 100% of its royalty payments from the add back. This interpretation, however, cannot be reconciled with the legislature's use of the limiting words "portion" and "corresponding item." When interpreting statutes "[a] fundamental rule of statutory construction requires that every part of a statute be presumed to have some meaning, and not be treated as meaningless unless absolutely necessary." Raven Red Ash Coal Corporation v. Henry Absher, 153, Va. 332, 149 S.E. 541 (1929). (Emphasis added).
In Public Document (P.D.) 07-153 (10/2/2007), the Department determined that parsing the statutory language of Va. Code § 58.1-402 B 8 shows that the exception is not all inclusive. When considering this statute in its totality, the exception does not apply to the gross amount of payments that a taxpayer made to an affiliate merely because the gross amount is shown on another state's tax return. Instead, the exception is limited to the portion of a taxpayer's intangible expense payments to its affiliate that correspond to the portion of the affiliate's income subjected to tax in other states, as evidenced by the apportionment percentages shown on the affiliate's tax returns filed with other states.
In this case, the Taxpayer paid royalties and interest to an affiliated entity. The auditor reduced the royalty and interest add back exception to the portion of the Taxpayer's royalties and interest paid to the affiliate that corresponds to the portion of the affiliate's income subjected to tax in other states.
The Taxpayer contends that all that is required in order to meet the exception is for the item of income to be subject to a tax based on income or capital in Virginia or another state. Further, the language of the statute, according to the Taxpayer, does not limit the exception to states where separate returns are filed.
Theoretically, only the income arising from the use of a particular patent, trademark or other intangible property in a state is constitutionally subject to tax in that state. But when a corporation conducts a unitary business "a separate accounting method is incompatible with proper, accurate and efficient taxation of a multistate corporation conducting a unitary business." Commonwealth of Virginia v. Lucky Stores, Inc., 217 Va. 121, 225 S.E.2d 870 (1976). Instead, the corporation reports all of its income from patents and trademarks in all states and then uses a formula to calculate the portion of this income attributable to the taxing state. The tax is then imposed on that portion of the corporation's income. This process ensures that state does not reach out and tax income earned elsewhere. "The central purpose behind the apportionment requirement is to ensure that each State taxes only its fair share of an interstate transaction." Goldberg v. Sweet, 488 U.S. 252, 260 (1989).
Therefore, the exception does not apply to the gross amount of payments that the Taxpayer made to its affiliate merely because the gross amount is shown on another state's tax return. The exception is limited to the portion of the Taxpayer's royalty payments to its affiliate that corresponds to the portion of the affiliate's income or capital subjected to tax in other states, as evidenced by the apportionment percentages shown in the affiliate's tax returns filed with other states.
Commerce Clause
The Taxpayer asserts that the add-back statute has the economic effect of discriminating against interstate commerce. In order to determine if a tax violates the Commerce Clause by placing an undue burden on interstate commerce the U.S. Supreme Court has developed a four-prong test. Complete Auto Transit Inc, v. Brady, 403 U.S. 274, 279 (1977). Brady held that a state tax will overcome a Commerce Clause challenge if it "[1] is applied to an activity with a substantial nexus with the taxing State, [2] is fairly apportioned, [3] does not discriminate against interstate commerce, and [4] is fairly related to the services provided by the State."
Requiring an add-back does not discriminate against interstate commerce. The Commerce Clause requires that a taxing scheme be internally, consistent. A taxing "formula must be such that, if applied by every jurisdiction, it would result in no more than all of the unitary business income being taxed." Oklahoma Tax Comm'n v. Jefferson Lines, Inc., 514 US 159 (1983). The add-back statute only requires the taxpayer to add-back royalties deducted to the extent that the Taxpayer's income from those royalties it is not apportioned to another taxing jurisdiction. Then the amount is further allocated and apportioned under Virginia law. Thus, if every state adopted the same the add-back statute and had the same allocation and apportionment statute as Virginia, it would not result in taxing more than all of the unitary business income of a taxpayer.
Tax Paid to Another State
For the 2004 taxable year, the auditor granted an exception for income apportioned to ***** (State A). The Taxpayer contends that the auditor did not allow an exception for a portion of the income subject to State A income tax for 2005. The Taxpayer indicated that it included a copy of its 2005 State A return with its appeal, but it was not attached. The Department made several requests to the Taxpayer to provide the return, but the Taxpayer has not responded. Accordingly, the Department cannot grant the adjustment requested.
CONCLUSION
The statutory provision requiring the addition (and allowing exceptions) specifically states in Va. Code § 58.1-402 B 8 c that "[n]othing in subdivision B 8 shall be construed to limit or negate the Department's authority under § 58.1-446." The latter section authorizes an equitable adjustment when the Department finds that arrangements between affiliated corporations improperly reflect business done in Virginia. The quoted language clearly authorizes the Department to invoke Va. Code § 58.1-446 when it finds that allowing an exception would result in the taxpayer's income improperly reflecting the business done in Virginia.
If the Taxpayer qualified for the exception with respect to 100% of the addition for royalty and interest expenses, the situation appears to be similar to that described in P.D. 05-29 (3/7/2005) with respect to royalties and P.D. 05-28 (3/7/2005) with respect to interest. In those cases the Tax Commissioner upheld an adjustment under Va. Code § 58.1-446 based upon consolidating the affiliated entities with the taxpayer or disallowing a deduction for amounts paid to the affiliated entity. Under these circumstances the Department may invoke Va. Code § 58.1-4-46 to make a similar adjustment to the extent that an addition is not made under Va. Code § 58.1-402 B 8. In this case, however, because the Taxpayer qualifies for only a portion of the requested exception, the Department has concluded that any improper reflection of the business done in Virginia is not of sufficient magnitude to require an equitable adjustment under Va. Code § 58.1-446.
The Taxpayer has not provided a copy the State A return for 2005; therefore, the audit assessments must be upheld. The Department will, however, review any additional information you can provide that substantiates your claim concerning income apportioned to State A, provided it is received within 30 days of the date of this letter. Please provide the documentation to the Department of Taxation, Appeals and Rulings, P.O. Box 27203, Richmond, Virginia 23261-7203, Attn: *****.
If the documents are provided and the Department determines an adjustment should be made, the documents will be returned to the auditor in order to adjust the audit report and the assessments. Once, the auditor makes the appropriate adjustments, the Taxpayer will receive a revised bill. The Taxpayer should remit payment for the outstanding balance as shown on the revised bill within 30 days from the date of the revised bill to avoid the accrual of additional interest.
The Code of Virginia sections and public document cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions regarding this determination, you may contact ***** in the Office of Tax Policy, Appeals and Rulings, at *****.
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- Sincerely,
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Janie E. Bowen
Tax Commissioner
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AR/1-2994753611B
Rulings of the Tax Commissioner