Document Number
09-14
Tax Type
Corporation Income Tax
Description
Taxpayer does not meet the unrelated party exception.
Topic
Federal Conformity
Royalties
Taxable Transactions
Taxable Income
Date Issued
02-04-2009


February 4, 2009





Re: § 58.1-1824 Application: Corporate Income Tax

Dear *****:

This will reply to your letter in which you seek a refund of corporate income tax paid by ***** (the "Taxpayer") attributable to intangible expense add-backs for the taxable years ended December 31, 2004 through 2006.

FACTS


The Taxpayer is incorporated and domiciled outside Virginia. It operates and franchises restaurants throughout the United States and various international markets. In 2001, ***** (IHC), a wholly owned subsidiary of the Taxpayer, was incorporated in ***** (State A) for the purpose of holding the Taxpayer's intangible property. The Taxpayer paid royalties to IHC for the use of the trademarks and trade names during the taxable years at issue.

The Taxpayer and franchisees entered into a licensing agreement with IHC for the use of its trademarks and trade names. Each franchisee on a monthly basis pays the greater of 4% of its gross sales or $1,000, as adjusted for inflation, to the Taxpayer. The Taxpayer retains 1% of this amount and then remits the remaining 3% of the royalty to IHC, along with a 3% royalty amount for each company owned restaurant.

The Taxpayer filed Schedule 500AB with its original 2004 through 2006 Virginia corporate income tax returns adding back 100% of the royalties deducted on its federal income tax returns. The Taxpayer requests that it be allowed to report its Virginia taxable income without the add-back of the royalties on the grounds that IHC received more than one-third of its gross revenues from the Taxpayer's independently owned franchisees and that the royalty rate paid by the franchisees and the corporate owned restaurants were comparable.

DETERMINATION


Virginia Code § 58.1-402 B 8 provides that there shall be added back to the extent excluded from federal taxable income:
    • the amount of any intangible expenses and costs directly or indirectly paid, accrued, or incurred to, or in connection directly or indirectly with one or more indirect transactions with one or more members to the extent that such expenses and costs were deductible or deducted in computing federal taxable income for Virginia purposes.

The statute provides several exceptions to the general rule that an add-back is required. The exception relevant to the Department's assessment of the Taxpayer states:
    • This addition shall not be required for any portion of the intangible expenses and costs if one of the following applies: . . . (2) The related member derives at least one-third of its gross revenues from the licensing of intangible property to parties who are not related members, and the transaction giving rise to the expenses and costs between the corporation and the related member was made at rates and terms comparable to the rates and terms of agreements that the related member has entered into with parties who are not related members for the licensing of intangible property.

The Taxpayer argues that nothing in the statute prohibits the "indirect" payment of royalties from the franchisees to IHC. Moreover, the Taxpayer contends that it meets the requirements of Va. Code § 58.1-402 B 8 a (2) because IHC receives more than 70% of its gross revenue from license fees paid by independently owned franchisees, and it receives the same royalty rate from both the franchisees and the corporate owned restaurants and that these royalties are comparable to other commonly found within the restaurant industry.

Indirect Payments

The Taxpayer argues that the legislative enactment clause of Va. Code § 58.1-402 B incorporates Va. Code § 58.1-302. Under Va. Code § 58.1-302, the definition of intangible expenses and costs includes:
    • Expenses, losses and costs for, related to, or in connection directly or indirectly with the direct or indirect acquisition, use, maintenance or management, ownership, sale, exchange, lease, transfer, or any other disposition of intangible property to the extent such amounts are allowed as deductions or costs in determining taxable income.

As such, the Taxpayer contends that the payment of royalties by the franchisees to the Taxpayer and its subsequent remittance to IHC constitutes transactions that satisfy the exception under Va. Code § 58.1-402 B 8 a (2). Pursuant to this exception, a taxpayer may avoid adding back both direct and indirect intangibles expenses and costs if "[t]he related member derives at least one-third of its gross revenues from the licensing of intangible property to parties who are not related members . . . ."

The Taxpayer has provided samples of promotional materials provided to potential franchisees that indicate that the trade names and trademarks are owned by IHC. In addition, 3% of the 4% franchise fee earned by the Taxpayer is passed through to IHC for the use of the trademarks. These passed through revenues constituted more than 70% of IHC's total revenues for each of the taxable years at issue. If the franchisees where licensed through IHC, the Department would agree that the passed through royalty expenses would be licensing to unrelated entities.

The sample franchise agreement, however, is not a contract between a franchisee and IHC. Instead, the sample agreement stipulates in the recitals that the Taxpayer, not IHC, continues to develop, use, and control the use of the trademarks. The agreement further states, in § 7.1.B., that the Taxpayer, not IHC, has the "right to use and license others to use" the trademarks. Under the terms of the franchise contract, the franchisees' are clearly licensing the trademarks from the Taxpayer, not IHC.

Virginia Code § 58.1-402 B 8 a (2) infers that the related entity that owns the intangible property actually engage in licensing with the unrelated third parties. This means that licensing agreements for the use of intangible property must be between the unrelated party and the related entity that owns the intangible property. Based on the sample agreement, IHC did not engage in licensing intangible property to the unrelated franchisees during the taxable years at issue. Because the trademarks were licensed to the franchisees by the Taxpayer, the IHC did not receive the trademark licensing revenue from the unrelated franchisees. Instead, all the revenues generated by IHC were received from the Taxpayer. Accordingly, the Taxpayer does not meet the unrelated party exception.

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." Since 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 then the situation would be similar to that described in P.D. 96-310 (10/31/1996). In that case the Commissioner upheld an adjustment under Va. Code § 58.1-446 based upon consolidating the IHC with the Taxpayer. Under these circumstances the Department may invoke § 58.1-446 to make a similar adjustment to the extent that an addition is not made under § 58.1-402 B 8. In this case, however, since the Taxpayer does not qualify for the requested exception it is not necessary to invoke Va. Code § 58.1-446.

Accordingly, the Taxpayer's request for a refund is denied. The Code of Virginia sections 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 response, you may contact ***** in the Department's Office of Tax Policy, Appeals and Rulings, at *****.
                • Sincerely,


                • Janie E. Bowen
                  Tax Commissioner




AR/1-1886185622.B


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46