United States

Virginia enacts intangible addback exception limitations

Retroactive provisions expected to be challenged

TAX ALERT  | 

On April 1, 2014, Virginia enacted S.B. 5001, which includes a retroactive legislative fix to the "subject to tax" and "unrelated third-party revenues" exceptions to the state's intangible expense addback provisions. If upheld, the legislation will likely result in increased income tax liabilities for some Virginia taxpayers, as well as the potential for penalties.

The state's existing addback provisions, which have been in effect since 2004, require Virginia taxpayers to add back intangible expenses paid to a related member (defined as certain related parties) to the extent such expenses were deducted by the taxpayer in calculating federal taxable income for Virginia purposes. There are a number of exceptions to the addback requirement, including a subject to tax exception and an unrelated third-party revenues exception. Under the subject to tax exception, a taxpayer is not required to add 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."  Under the unrelated third-party revenues exception, a taxpayer is not required to add back intangible expenses to the extent that the related member derives at least one-third of its gross revenues from the licensing of intangible property to unrelated third parties. The application of these exception provisions has long been a source of contention, with taxpayers arguing that the subject to tax exception applied on an unapportioned basis and the unrelated third-party revenues exception applied regardless of whether the terms and conditions governing the related and unrelated party licensing agreements were comparable.

Pursuant to S.B. 5001, the subject to tax exception has been modified to apply only to the portion of the 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."  Similarly, the unrelated third-party revenues exception has been modified 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."  Both of these modifications are effective retroactively to tax years beginning on or after Jan. 1, 2004.

The Virginia Department of Taxation likely will immediately seek to retroactively apply the legislative modifications to the subject to tax and unrelated third-party revenues exceptions all the way back to 2004 and will be unlikely to waive penalties given the Department's stated policy in P.D. 07-153. However, taxpayers should be aware that the 10-year retroactivity provision is questionable from both a constitutional and statute of limitations standpoint, and the application of the Department's retroactive policy regarding the subject to tax exception is currently the subject of litigation in Kohl's Department Stores, Inc. v. Virginia Department of Taxation, Circuit Court City of Richmond, Case No. 760CL12-1774. Lastly, it is expected that taxpayers will seek to have these modifications repealed through the state's 2016 biennial budget, which is expected to be finalized in the next few weeks. In the interim, businesses utilizing the subject to tax exemption or unrelated third party revenues exemption to the state's intangible expense addback rule should determine the extent of their risk and prepare to defend their intangible expense deductions.

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