Tax Type
Corporation Income Tax
Description
Taxpayer claimed an exception for 100% of royalties deducted on its federal tax returns
Topic
Corporate Distributions and Adjustments
Royalties
Tangible Personal Property
Taxable Income
Date Issued
04-27-2009
April 27, 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 to an affiliated company for the use of intangible assets. The Taxpayer filed Schedule 500AB with its 2004 and 2005 Virginia corporate income tax returns listing six states in which the affiliates filed income tax returns. The affiliates reported the royalties paid by the Taxpayer, and the amount of tax paid based on or measured by net income on the returns. The Taxpayer claimed an exception for 100% of the royalties deducted on its federal income tax returns 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.
The Taxpayer has paid the assessments in full and contests the assessments on the basis that all of the royalties qualify for an exception to the add-back because they were subject to tax based on or measured by net income imposed by other states.
DETERMINATION
Subject to Exception
Virginia Code § 58.1-402 B 8 provides that there shall be added back to the extent excluded from federal taxable income:
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- 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 related members to the extent such expenses and costs were deductible or deducted in computing federal taxable income for Virginia purposes.
Virginia Code § 58.1-402 B 8 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:
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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 royalty 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 to six affiliates. The auditor reduced the royalty add-back exception to the portion of the Taxpayer's royalties paid to the six affiliates that correspond to the portion of each affiliate's income subjected to tax in other states.
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 expenses, the situation would be similar to that described in P.D. 05-29 (3/7/2005). In that case 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 § 58.1-446 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 distortion of the business done in Virginia is not of sufficient magnitude to require an equitable adjustment under Va. Code § 58.1-446.
Due Process and Commerce Clause
The Taxpayer contends that the add-back statute violates the Due Process and Commerce clauses of the United States Constitution. 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). 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." Id.
The add-back statute is fairly apportioned. In fact, the amount added back is apportioned twice. First, the legislature has allowed an exception to the add-back for the portion of intangible expenses on which the affiliated recipient has been subject to tax. Second, the amount added back is then allocated and apportioned with the rest of the Taxpayer's income to determine the portion subject to Virginia tax. The add-back is not a tax (in actuality or in economic effect) on income attributable to the Taxpayer's use of patents and trademarks in other states.
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 affiliate's income from those royalties it is not apportioned to another taxing jurisdiction. 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 the taxpayer.
Based on the above analysis, the auditor correctly assessed the Taxpayer for the portion of the royalty fees paid to the affiliate corporation that was not subject to tax in another taxing jurisdiction.
Late Payment Penalty
The Taxpayer was assessed a penalty for the late payment of income tax for both 2004 and 2005 taxable years when the audit assessments were not paid within 30 days of the assessment date. The Taxpayer was not made aware that the penalty would be assessed at the time of the audit. Further, the Taxpayer avers that it timely filed tax returns in good faith and requests that the penalty be waived.
Under Va. Code § 58.1-455, if the tax, or unpaid balance of the tax, is not paid in full when due then a penalty of 6% per month, or fraction thereof, of the unpaid tax will be imposed up to an aggregate of 30%. However, no penalty is imposed when all three of the following conditions are satisfied:
1. The unpaid tax is attributable to an assessment of additional tax by the Department, and
2. The return was filed by the taxpayer in good faith, and
3. The understatement of tax in the return was not due to any fault of the taxpayer.
In this case, the assessments at issue were generated through the Department's audit programs and meet the three conditions set forth above. Accordingly, the penalties assessed for the 2004 and 2005 taxable years will be abated.
CONCLUSION
In accordance with this determination, a refund for the amount of penalties paid, with applicable interest, will be issued shortly. The remaining balances of the assessments for the 2004 and 2005 taxable years are upheld.
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
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AR/1-3014145509.B
Rulings of the Tax Commissioner