While Virginia Supreme Court Holds “Subject-To-Tax” Means “Actually Taxed,” Determination of “Actually Taxed” is Relatively Broad for Purposes of Addback Exception
On August 31, 2017, in a 4-3 split decision, the Virginia Supreme Court (Court) affirmed a circuit court’s ruling that in order for income to qualify for the “subject-to-tax” exception to its addback statute, the income must actually be taxed by another state. Kohl’s Dep’t Stores, Inc. v. Va. Dep’t of Taxation, no. 160681 (Va. Aug. 31, 2017). A copy of the Opinion (Op) is available here. The Court, however, did find for the taxpayer on its alternative argument, concluding that the determination of where income was “actually taxed” includes combined return and addback states, in addition to separate return states, and includes income subject to tax in the hands of the payor, not just the recipient. For our prior coverage of the subject-to-tax exception, see here.
The issue here was whether Kohl’s Department Stores, Inc. (Kohl’s), which operates retail stores throughout the United States (including Virginia), was required to “add back” to its income royalties it paid to a related party for the use of intellectual property owned by that party. Kohl’s deducted the royalty payments as ordinary and necessary business expenses in the computation of its federal income, and the recipient related party included the royalty income in its taxable income calculations in the states in which it filed returns, including both separate and combined reporting states. The Court considered whether the royalty payments paid by Kohl’s must be “added backed” to Kohl’s taxable income under Virginia law, or whether the royalties fell within Virginia’s “subject-to-tax” exception.
Virginia law, like the law of other states, requires taxpayers to add to their state taxable income the amount of intangible expenses and costs paid to a related party to the extent the expenses and costs were deducted in computing federal taxable income. Va. Code Ann. § 58.1-402(B)(8)(a). But Virginia’s addback statute (like those of other states) has a “subject-to-tax” exception under which taxpayers are not required to addback intangible expenses if “[t]he corresponding item of income received by the [recipient] 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.” Id. § 58.1-402(B)(8)(a)(1).
In determining whether the royalties paid by Kohl’s to a related party fell within Virginia’s subject-to-tax exception, the City of Richmond Circuit Court, on the parties’ cross motions for summary judgment, granted the Department of Taxation’s (Department) motion and held that the intangible expenses paid must be “actually taxed in another state” to qualify for the subject-to-tax exception. See Kohl’s Dep’t Stores, Inc. v. Va. Dep’t of Taxation, 91 Va. Cir. 499 (Va. Cir. Ct. Feb. 3, 2016). In reaching this result, the circuit court purported to rely on the plain language of the subject-to-tax exception and the legislature’s intent in enacting the state’s addback statute, which the court determined was “to close a corporate tax loophole and ensure that income attributable to Virginia is taxed.” Id. Kohl’s petitioned for certiorari, which was granted.
On appeal, the Supreme Court affirmed the circuit court’s conclusion that in order for a taxpayer to qualify for the “subject-to-tax” exception, the corresponding income received by a related party must be “actually taxed by another state” (Op. at 11) but for different reasons. First, unlike the circuit court, the Supreme Court found the plain language of the exception ambiguous. See Op. at 8 (“Because the royalties were included in Kohl’s Illinois’s taxable income, they were, to a certain extent, ‘subject to’ the income taxes of other states. At the same time, a substantial amount of the royalties was not apportioned to, and thereby not legally ‘subject to’ the income tax of, any state in which Kohl’s Illinois filed a return.”). Yet in analyzing the plain language of “subject to tax,” the Court also relied on US Supreme Court precedent holding that “only the amount of a corporation’s income that is fairly apportionable to a given state is legally subject to that state’s income tax.” Op. at 7 (citation omitted). Second, the Court relied on legislative intent indicating that the State enacted the addback statute to raise tax revenue, and reasoned that to accept Kohl’s interpretation that “subject-to-tax” means inclusion in the taxable income computation “would effectively negate the add back statute’s intended operation and undermine this expected revenue.” Op. at 10. Third, the Court relied on case law for the notion that courts should look to the administering agency’s interpretation when a statute is ambiguous. See Op. at 10-11 (“Moreover, we have repeatedly held that when a statute’s language is of doubtful import, the construction given to it by a state official charged with its administration may be considered. … The construction of this exception which [the Department] advocates, and which we apply, is reasonable.”) (citations omitted).
At the circuit court level, Kohl’s argued that in the alternative, even if the subject-to-tax exception meant that tax must actually be imposed on the corresponding income, the Department’s method for calculating this amount erroneously excluded income that was actually taxed in states other than separate return states or taxed to the payor by required addback statutes of other states. The circuit court did not rule on Kohl’s alternative argument. On appeal, the Supreme Court found for Kohl’s on this issue, holding that: “To the extent that the royalties were actually taxed by the Separate Return States, Combined Return States, or Addback States, they fall within the subject-to-tax exception regardless of which entity paid the tax.” Op. at 12. In reaching this conclusion, the court rejected the Department’s argument that royalty income was “actually taxed” in only states in which the recipient related party filed a separate return. Rather, the court agreed with Kohl’s that in addition to separate return states, a determination of the amount of corresponding income that was “actually taxed” must be made by examining those amounts in combined return states and states where the income was added back to the payor. Relatedly, the court also concluded that the subject-to-tax exception “does not require that  the [recipient] related member be the entity that pays the tax” on the corresponding income. Op. at 12.
A strongly-worded dissent took issue with the majority’s conclusion that “subject to” tax means “actually taxed.” The dissent chided the majority for reading into the (in its view unambiguous) plain language of the subject-to-tax exception, a requirement that the exception apply only to income on a state tax return to which a state’s apportionment formula has been applied, which results in a portion of the income being taxed in that state (post-apportionment basis). Further, the dissent observed that on several occasions, the Virginia General Assembly failed to enact legislation limiting the exception’s application to a post-apportionment basis. Notably, even after the enactment of budget bills that purported to be retroactive and “apply only to the portion of such income received by the related member, which portion is attributed to a state or foreign government in which the related member has sufficient nexus to be subject to such taxes[,]” addback would not be required in states in which the related party has nexus. See Op. at 15 (quoting 2014 & 2016 budget bills).
Practice Note: In light of this ruling, Virginia taxpayers must reexamine tax treatment in the state(s) where the corresponding income is sourced or added-back. Additionally, this ruling exacerbates the inherent problem of addback statutes taxing income earned in other states by narrowing categories of income that can be excluded from the statute.