February 24, 2026
Re: § 58.1-1821 Application: Corporate Income Tax
Dear *****:
This will respond to your letters in which you seek a refund of Virginia corporate income tax paid by ***** (the “Taxpayer”) for the taxable years ended December 31, 2009, and 2010, and correction of the corporate income tax assessments issued to the Taxpayer for the taxable years ended December 31, 2011, through 2013.
FACTS
The Taxpayer operated and franchised retail stores throughout the United States. The Taxpayer’s wholly owned subsidiary (“IHC”) was organized for the purpose of holding the Taxpayer’s intangible property. Pursuant to the Taxpayer’s licensing agreement with IHC, it paid a royalty equal to 6% of its net sales for the use of IHC’s trademarks and trade names. In addition to other charges, such as advertising and financial service fees, the Taxpayer charged its unrelated franchisees a royalty fee of 6% of gross sales.
For the 2009 and 2010 taxable years, the Taxpayer added back the intercompany royalty expenses to federal taxable income for purposes of computing its Virginia taxable income. The Taxpayer did not claim any exception to the add-back on its 2009 Virginia income tax return. In 2010, the Taxpayer claimed an exception for a portion of the royalty expense to the extent the royalty income was taxed in another state (i.e., the “subject-to-tax” exception). The Taxpayer subsequently filed amended returns for refunds, claiming a full exception to the add-back on the basis that IHC received more than one third of its gross revenues from unrelated franchisees (i.e., the “unrelated member” exception). Under review, the Department denied the refunds.
For the 2011 through 2013 taxable years, the Taxpayer claimed a full exception to the add-back on the basis that it qualified for the unrelated member exception. Under audit, the Department determined the Taxpayer did not qualify for that exception but did allow a partial subject-to-tax exception based on tax paid by IHC in other states. The amount of the add-back was increased accordingly and assessments were issued.
The Taxpayer filed applications for correction on the basis that it qualified for the unrelated member exception to the add-back. In the alternative, the Taxpayer claimed it qualified for 1) a full exception to the add-back for the 2009 and 2010 taxable years based on the subject-to-tax exception; and 2) the conduit exception to the add-back for the 2011 through 2013 taxable years.
DETERMINATION
Unrelated Member Exception
Virginia Code § 58.1-402 B 8 provides that there shall be added back:
[T]he 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 direct or 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.
The statute provides several exceptions to the general rule that an add-back is required. The exception at issue is Virginia Code § 58.1-402 B 8 a 2, which 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.
In Public Document (P.D.) 09-14 (2/4/2009), the Department determined that the licensing agreements for the use of intangible property must be between an unrelated party and the related entity that owns the intangible property. As such, the exception for licensing at least one third of its gross revenues to an unrelated member was not met in that case because the related member did not receive the intangible property revenue directly from the unrelated franchisees.
The City of Richmond Circuit Court, however, overruled P.D. 09-14 in Wendy’s International v. Virginia Department of Taxation, CL09-3757 (3/29/2012). The court held that the exception merely requires that the related member derive at least one third of its gross revenues from the licensing of intangible property to parties that are not related members because the statute does not distinguish as to whether the gross revenues were directly or indirectly licensed to an intangible holding company. Therefore, the exception could be claimed when intangible holding companies indirectly license intangible property to independent franchisees through operating companies.
However, Virginia Code § 58.1-402 B 8 a 2 also requires that:
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. [Emphasis added.]
The City of Richmond Circuit Court’s decision in Wendy’s did not analyze whether this second statutory requirement was met. The language of Virginia Code § 58.1-402 B 8 a 2 requires an examination of the terms of the agreements “that the related member has entered into with parties who are not related members.” The statute thus clearly anticipates that there will be contracts directly between the related member and an unrelated member available for the Department to examine.
By reason of their character as legislative grants, statutes relating to exemptions allowable in computing income and credits allowed against a tax liability must be strictly construed against the taxpayer and in favor of the taxing authority. See Howell’s Motor Freight, Inc., et al. v. Virginia Dep’t of Taxation, No. 82-0846 (Roanoke Cir. Ct. Oct. 27, 1983). In addition, it has been a longstanding principle of statutory construction that every part of a statute should be interpreted so as to give it some effect, and that interpretations that render words or phrases in a statute superfluous or repetitious should be avoided. See Platt v. Union P.R. Co., 99 U.S. 48, 58-59 (1878) and PSINet, Inc. v. Chapman, 362 F.3d 227, 232 (4th Cir. 2004). The court’s determination in Wendy’s effectively renders superfluous the language of Virginia Code § 58.1-402 B 8 a 2 that requires an examination of the terms of the agreements “that the related member has entered into with parties who are not related members.”
In this case, IHC’s gross license revenue was derived from royalties paid by unrelated third-party franchisees to the Taxpayer. IHC does not have any agreements with any unrelated third parties. Under such circumstances, the specific language of the statute was not met because IHC, the related member, did not have any contracts with unrelated members, the terms of which the Department could review.
Even if the court’s opinion in Wendy’s is interpreted to mean that licensing agreements between the Taxpayer and franchisees were indirect agreements between IHC and the franchisees, the rates and terms would not be the same. The terms of the franchise agreement between the Taxpayer and the unrelated franchisees were materially different than the terms applicable to Taxpayer-owned stores. Franchisees had specific duties and responsibilities to perform that were not required by Taxpayer-owned stores. For example, franchisees and their employees had to complete the Taxpayer’s training program. They also had to maintain liability, worker’s compensation, and business interruption insurance. In addition, store signage and displays had to be presented in a particular manner. Further, accounting records had to be kept in accordance with Taxpayer policy. Finally, products had to be priced pursuant to amounts set by the Taxpayer and franchisees were also responsible for remodeling their stores once every five years.
The terms of the licensing agreement for Taxpayer-owned stores were much less stringent. This agreement merely gave IHC the right to review and approve labeling, ads, displays, and other items. The Taxpayer was required to protect the intangible property and execute any documents that the IHC required. There were also no training, insurance, accounting, or remodeling requirements.
In addition, the franchise agreement between the Taxpayer and the unrelated franchisees required a royalty fee equal to 6% of gross sales plus additional fees, including an advertising fee equal to 3% of the gross sales. The licensing agreement between IHC and the Taxpayer imposed a royalty fee of 6% of net sales.
As stated above, Virginia Code § 58.1-402 B 8 a 2 requires that the rates and terms between a taxpayer and related member be comparable to the rates and terms between the related member and unrelated third parties. Not only does the IHC not have agreements with independent franchisees, based on the evidence provided, the rates and terms of the trademark licensing agreements between IHC and the Taxpayer were substantially different from the Taxpayer’s franchise agreements with the independent franchisees. Accordingly, the Taxpayer did not qualify for the unrelated member exception under Virginia Code § 58.1-402 B 8 a 2.
Subject-to-Tax Exception
The Taxpayer alternatively contends that it could claim a full exception to the add-back for the 2009 and 2010 taxable years because the income received by IHC was subject to tax in other states. The Taxpayer did not file amended returns for the 2009 and 2010 taxable years to claim a full subject-to-tax exception and the limitations period for the Taxpayer to file such amended returns has long since passed. The Department, accordingly, will treat the Taxpayer’s claim as a protective claim for refund under Virginia Code § 58.1-1824.
Pursuant to the authority granted the Department under Virginia Code § 58.1-1824, a protective claim for refund can be held pending the outcome of another case before the courts or the claim may be decided based upon its merits pursuant to Virginia Code § 58.1-1821.
In Kohl’s Department Stores, Inc. v. Virginia Department of Taxation, 295 Va. 177 (2018), the Virginia Supreme Court (the “Court”) interpreted the “subject-to-tax” exception in Virginia Code § 58.1-402 B 8. The Court agreed with the Department’s interpretation that only the portion of the intangible expense payments that was subject to a tax in another state falls within the exception. In addition, the Court decided the subject-to-tax exception is limited to intercompany intangible income that is subject to an income tax imposed on income after it has been apportioned to another state.
In accordance with the Court’s decision, the Taxpayer was not entitled to an exception for the full amount of its royalty expense based on the subject-to-tax exception. Accordingly, the Taxpayer’s refund claim cannot be granted.
Conduit Exception
The Taxpayer also argues that the expenses that were added back for the 2011-2013 taxable years met the requirements for the exception under Virginia Code § 58.1-402 B 8 a 3. This section provides an exception to the add-back to the extent:
[T]he corporation can establish to the satisfaction of the Tax Commissioner that the intangible expenses and costs meet both of the following: (i) the related member during the same taxable year directly or indirectly paid, accrued or incurred such portion to a person who is not a related member, and (ii) the transaction giving rise to the intangible expenses and costs between the corporation and the related member did not have as a principal purpose the avoidance of any portion of the tax due under this chapter.
The first requirement is that the related member pay the portion of the intangible expense to a person who is not a related member. For example, if a taxpayer pays royalty income to a related member for licenses of both the related member’s own trademarks and trademarks that the related member sublicenses from an unrelated member, the portion of the royalty income that the related member pays to the unrelated member may be eligible for this exception. In this case, the Taxpayer argues that the franchisees were the unrelated members that were paying the related member, IHC, indirectly through the Taxpayer. The Taxpayer has not provided any evidence that IHC was paying a portion of the royalty income to an unrelated member. Under the statute, however, it was the related party, i.e., IHC, that had to pass through payments to unrelated members. As such, the conduit exception was inapplicable.
CONCLUSION
For the reasons discussed above, the Taxpayer was not eligible for the unrelated member exception because the terms of the agreements made with related and unrelated members differ substantially. The Taxpayer was also not entitled to an exception for the full amount of its royalty expense in the 2009 or 2010 taxable years based on the subject-to-tax exception. In addition, the Taxpayer was not eligible for the conduit exception in the 2011 through 2013 taxable years because there is no indication IHC paid any portion of the royalty income to an unrelated third party.
Accordingly, the Taxpayer’s refund claims for the taxable years ended December 31, 2009, and 2010, cannot be granted. With respect to these taxable years, however, the case will be remanded to the audit staff to calculate the proper amount of royalty expense that could be deducted for the 2009 and 2010 taxable years in accordance with the decision in Kohl’s. The audit staff will contact the Taxpayer to arrange for any documentation review that may still be required. The Taxpayer will have 60 days from the date of contact with the auditor to provide all necessary documentation unless a different deadline is agreed to by the Taxpayer and the audit staff. The audit staff will review the documentation, make adjustments as appropriate, and issue updated audit reports and refunds as warranted.
In addition, the assessments issued for the taxable years ended December 31, 2011, through 2013, are upheld. The Taxpayer will receive updated bills that will include accrued interest to date. The Taxpayer should remit the balance due within 30 days of the bill dates to avoid the accrual of additional interest and possible collection actions.
The Code of Virginia sections cited are available online at law.lis.virginia.gov. The public documents cited are available at tax.virginia.gov in the Laws, Rules, & Decisions section of the Department’s website. If you have any questions regarding this determination, you may contact ***** in the Office of Tax Policy and Legal Affairs, Tax Adjudication and Resolution Division, at ***** or *****.
Sincerely,
Kristin L. Collins
Tax Commissioner
Commonwealth of Virginia
AR/573.X