On April 1, Virginia Governor Terry McAuliffe signed into law H.B. 5001, enacting Virginia's budget bill "caboose," including a provision imposing retroactive limitations on the intangible expense addback exceptions.1
Limiting the Intangible Expense Addback Exceptions
Under the original version of the addback provision enacted in 2004, Virginia taxpayers were required to add back intangible expenses paid to a related member (defined to include certain related parties) to the extent such expenses were deducted by the taxpayer in calculating federal taxable income for Virginia income tax purposes.2 Exceptions to this addback requirement were provided for taxpayers meeting certain conditions. Specifically, two of these exceptions were commonly referred to as the "subject to tax" and "unrelated third-party revenues" exceptions.3
The originally enacted addback exceptions were perceived by some individuals as being too lenient, since the provisions failed to include language similar to that used by other jurisdictions to limit the exceptions. As a result, this legislation sought to impose a retroactive solution to limit the exceptions for adding back intangible expenses. The modifications are effective retroactively to tax years beginning on or after January 1, 2004.4 "
"Subject to Tax" Exception
Under the "subject to tax" exception, a taxpayer under prior law was excluded from adding back intangible expenses to the extent that the income received by the related party was "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."5 Since its inception, taxpayers have interpreted this exception as applying on an unapportioned basis, thus expanding the amount of intangible expenses subject to the exception. The Commissioner, however, consistently took the position that the amount subject to the exception only included the apportioned amount subject to tax in other jurisdictions.6
With enactment of the current legislation, this exception has been modified to apply only to the portion of intangible income received by the related member that has been "attributed to a state or foreign government in which the related member has sufficient nexus to be subject to such taxes."7
"Unrelated Third-Party Revenues" Exception
Under the original form of the "unrelated third-party revenues" exception, a taxpayer was not required to add back intangible expenses to the extent that the related member derived at least one-third of its gross revenues from the licensing of intangible property to unrelated third parties.8 Taxpayers understood that this exception applied regardless of whether the terms and conditions governing the licensing agreements of unrelated and related parties were comparable.9 The Virginia Department of Taxation attempted to limit the use of this exception to royalties earned directly from unrelated parties,10 but was overruled in this pursuit at the circuit court level.11 The circuit court held that the exception as written simply required that the related member derive at least one-third of its gross revenues from the licensing of intangible property to unrelated parties, and did not distinguish as to whether the gross revenues were directly or indirectly licensed to an intangible holding company. Therefore, the court allowed the exception from the addback rule to apply to an intangible holding company indirectly licensing its intangible property to independent franchisees through an operating company.
With enactment of the current legislation, Virginia has modified the exception to apply only to the portion of the intangible income received by the related member from "licensing agreements for which the rates and terms are comparable to the rates and terms of agreements that the related member has actually entered into with unrelated entities."12
Other Provisions
Other material tax provisions included in the caboose legislation are: (i) adjustments to the maximum amount of qualified equity and subordinated debt investment credit for various tax years;13 (ii) changes to the accelerated sales tax payment provisions;14 (iii) a change in the dealer discount provisions;15 and (iv) an exemption from sales and use tax for certain Internet services.16
Commentary
Practitioners anticipate that the Department will attempt to impose these newly enacted limitations on the intangible expense addback exceptions to tax years as early as 2004. Nonetheless, there exist several viable bases on which taxpayers and businesses can challenge these limitations. First and foremost, the Virginia Code imposes a three-year statute of limitations from the date a return is filed.17 Therefore, the Commonwealth cannot attempt to audit and reassess the liability with respect to any returns filed prior to April 2011 unless other conditions have caused such returns to remain open for audit purposes.
Furthermore, practitioners expect the newly enacted provision to be challenged as unconstitutional. It is possible that these provisions could be found unconstitutional due to the considerably lengthy 10-year period of retroactivity, taking the position found in Justice O'Connor's U.S. Supreme Court concurrence in Carlton v. U.S., which allowed a limited retroactive reach: "[t]he government interest in revising the tax laws must at some point give way to the taxpayer's interest in finality and repose. . . . A period of retroactivity longer than the year preceding the legislative session in which the law was enacted would raise . . . serious constitutional questions."18 Given the one-year guideline for retroactive laws prescribed by the U.S. Supreme Court, it is possible that the 10-year period of retroactivity of these Virginia provisions could be found to violate the Constitution. A Virginia court, however, has upheld a three-year retroactive period for tax legislation which formalized Department policy, despite noting that the period "is longer than generally found acceptable."19 The Virginia court specifically examined whether the retrospective tax law at issue was "arbitrary and does not disturb vested rights, impair contractual obligations, or violate due process," as well as considered the practices governing the legislative body's ability to timely respond to the need for tax law amendments and the nature of the tax in making this determination.
Currently, the "subject to tax" exception is the subject of litigation in Kohl's Department Stores, Inc. v. Virginia Department of Taxation,20 and this venue could provide an early forum to debate Virginia's retroactive policy regarding the intangible expense addback exceptions. In this action, the taxpayer has challenged the Department's policy of limiting the amount of the addback exception to the portion of the taxpayer's expense payments to affiliates which correspond to the portion of the affiliate's income subjected to tax in other states, as evidenced by apportionment percentages shown on the affiliate's tax returns filed with other states.21
While it is likely that businesses and taxpayers will challenge the retroactive imposition of these limitations, taxpayers who have relied on the "subject to tax" or "unrelated third party revenues" exceptions to Virginia's intangible expense addback requirement should determine the extent of their potential exposure if the retroactive legislation is ultimately sustained upon challenge.
Footnotes
1.H.B. 5001, 2014 Special Session I, § 3-5.11 (effective Jan. 1, 2004). Because the provisions in the bill simply fund Virginia through June 30, 2014 (the end of the current fiscal year), rather than including the budget for an entire fiscal period, the bill is referred to as the budget bill "caboose."
2 VA. CODE ANN. § 58.1-402(B)(8) (prior version).
3 Id. This version of the law allowed an exception from the addback for taxpayers if: (i) the corresponding item of income received by the related member was subject to a net income or capital-based tax imposed by Virginia, another state, or qualified foreign government; (ii) the related member derived at least one-third of its gross revenues from the licensing of intangible property to nonrelated parties and the transaction was made at comparable rates and terms as those involving the nonrelated parties; or (iii) expenses and costs were paid by the related member during the same taxable year to a nonrelated party and the transaction giving rise to the expenses/costs between the taxpayer and the related member was not undertaken for the principal purpose of avoiding tax.
4 H.B. 5001, § 3-5.11.
5.VA. CODE ANN. § 58.1-402(B)(8)(a)(1).
6 Ruling of Commissioner, P.D. 09-49, Virginia Department of Taxation (Apr. 27, 2009); Ruling of Commissioner, P.D. 09-96, Virginia Department of Taxation (Jun. 11, 2009); Ruling of Commissioner, P.D. 07-217, Virginia Department of Taxation (Dec. 20, 2007); and Ruling of Commissioner, P.D. 07- 153, Virginia Department of Taxation (Oct. 2, 2007).
7 H.B. 5001, § 3-5.11(i).
8 VA. CODE ANN. § 58.1-402(B)(8)(a)(2).
9 See, however, Ruling of Commissioner, P.D. 13-140, Virginia Department of Taxation (Jul. 19, 2013), addressing exceptions to the addback requirement. VA. CODE ANN. § 58.1-446 permits the Department to equitably adjust tax if any intercompany arrangements improperly reflect the business done or Virginia taxable income earned from business in the Commonwealth. The statutory addback exception provided by VA. CODE ANN. § 58.1-402(A)(8)(b) for intangible intercompany expenses incurred for a valid business purpose other than the avoidance or reduction of tax includes specific qualification procedures.
10 Ruling of Commissioner, P.D. 09-14, Virginia Department of Taxation (Feb. 4, 2009).
11 Wendy's International, Inc. v. Virginia Department of Taxation, Circuit Court, 13th Judicial Circuit, No. CL09-3757 (Mar. 29, 2012).
12 H.B. 5001, § 3-5.11(ii).
13 The amount of the qualified equity and subordinated debt investment credit is limited to $3 million for calendar years beginning in 2006. The credit amount limit for tax years beginning in 2009 is as follows: $5 million for tax year 2010, $3 million for tax year 2011, $4 million for tax year 2012, $4.5 million for tax year 2013, and $5 million for tax year 2014.
14 Beginning with the tax payment remitted in June 2014, the accelerated sales tax payment provisions are adjusted to only apply to those dealers or permit holders with taxable sales and purchases of at least $48.5 million for the 12-month period beginning July 1 and ending June 30 of the previous calendar year. Previously, the provisions applied to dealers or permit holders meeting a $26 million threshold. It is the intent of the legislature that the accelerated sales tax payment requirement be phased out beginning with this fiscal year and eliminated by 2021.
15 Beginning with the June 2010 sales tax return, dealer discounts are unavailable to any dealer required to remit payment by electronic funds transfer. Compensation available to other dealers is limited to a percentage of the first 3 percent of sales and use tax levied, based on monthly taxable sales.
16 For purchases made on or after July 1, 2006, any sales and use tax exemption applicable to production, distribution, and other equipment used by Internet service providers to provide Internet access services must be claimed as a refund request. A similar provision was included in previous budget bills.
17 VA. CODE ANN. § 58.1-104.
18 United States v. Carlton, 512 U.S. 26, 37-38 (1994) (O'Connor, J., concurring).
19 Giesecke v. Department of Taxation, 34 Va. Cir. 455 (Fairfax City Circuit Court, Sep. 22, 1994).
20 Case No. 760CL 12-1774 (City of Richmond Circuit Court, 2014).
21 Ruling of Commissioner, P.D. 07-153, Virginia Department of Taxation (Oct. 2, 2007). In this decision, the Department determined that the "subject to tax" addback exception did not apply to the gross amount of payments that a taxpayer made to an affiliate merely because the gross amount was shown on another state's tax return. Instead, the Department limited the exception to apply to only the portion of the taxpayer's intangible expense payments to its affiliates which corresponded 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 in other states.
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