Virginia Supreme Court Decides (Mostly) in Favor of Department in Lead Addback Case

by Reed Smith
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On August 31, 2017, the Virginia Supreme Court issued a decision holding that a taxpayer can claim an exception to Virginia’s intangible expense addback on the basis that the related member receiving the intangible payment is “subject to tax” in another state, only to the extent that the intangible payment is included in the apportioned tax base of the related member in another state. In a concession to taxpayers, however, the court held that this “pro rata” exception is allowed for tax paid in any state, including states that require the filing of corporate income tax returns on a combined basis.

The Virginia Supreme Court has issued its decision in Kohl’s Department Stores v. Virginia Department of Taxation, the lead case on the “subject to tax” exception to Virginia’s intangible addback provision.1 The court held that a taxpayer can only claim the “subject to tax” exception to the extent that the intangible payment is included in the apportioned tax base in states other than Virginia.

The taxpayer had argued that because the royalty payments it made to its related member were included in the pre-apportionment income reported on the related member’s returns filed in other states, the payments were subject to tax in those other states and, as a consequence, the full amount of the payments qualified for the “subject to tax” exception. The Department countered that a taxpayer was only entitled to claim the “subject to tax” exception to the extent that the royalty payments made by the taxpayer were subject to tax in another state on a post-apportionment basis. The Department also argued that this “pro rata” exception only applied if the related member reported the royalty payments on a separate company return.

The Virginia Supreme Court found that the statutory language setting forth the “subject to tax” exemption was ambiguous as to whether a taxpayer that pays tax to another state should receive a full exception or a pro rata exception, but ultimately determined that the Department’s interpretation that the exception applied on a pro rata basis was entitled to deference. The court also noted that “an interpretation of the subject-to-tax exception that would result in a taxpayer’s ability to avoid the add back statute would be unreasonable in light of the statute’s purpose and intent.” In a footnote, the court acknowledged that in the years following the original enactment of the intangible expense addback provision, the legislature had considered and rejected bills that would have enacted statutory language that unambiguously applied the exception on a pro rata basis. However, the court noted that the failed bills “provide examples of how the subject-to-tax exception could be unambiguously worded to apply on a post-apportionment basis,” but do “not contradict our conclusion that the version of the statute before us is ambiguous.”2

In a concession to taxpayers, the court rejected the Department’s limitation of the “subject to tax” exception to amounts included in returns filed by the related member in separate filing states. The court held that a royalty payment was subject to tax “[t]o the extent that the royalties were actually taxed by the Separate Return States, Combined Return States, or Addback States.” The court remanded the case to the circuit court to determine the proper amount of the taxpayer’s subject to tax exception determined on a pro rata basis.

Three of the seven justices joined in a dissenting opinion. The dissent argues that the plain language of the statute is unambiguous and supports a full deduction, and that the Department’s rulings cannot make an unambiguous statute ambiguous. The dissent tracks the various proposed and adopted legislative changes to the “subject to tax” exception, and argued that this post-enactment history demonstrated that the legislature did not intend for the “subject to tax” exception, as originally enacted, to be applied on a pro rata basis. The dissent also criticizes the majority for using judicial construction to implement what the majority might believe represents good policy, rather than leaving policy issues to the legislature.

Interestingly, while the Virginia Supreme Court’s decision affirms the Richmond City Circuit Court’s decision, it rests on an entirely different rationale. The Circuit Court had found that the original wording of the “subject to tax” exception unambiguously supported the Department’s interpretation. In contrast, the Supreme Court found that the original wording of the “subject to tax” exception was ambiguous and deferred to the Department’s interpretation.

Taxpayers with active appeals involving the “subject to tax” exception should consider whether they have any alternative arguments that would support an exception to addback. Taxpayers should also quantify the tax paid on royalties in combined reporting and addback states, because the court’s decision allows an exception for these amounts. Taxpayers may also want to wait to see whether the taxpayer in Kohl’s requests rehearing.  Kohl’s has until September 30 to file a petition for rehearing with the Virginia Supreme Court. Grants of petitions for rehearing are relatively rare, but the strong, three-justice dissent in this case could make a grant more likely.

For more information on the “subject to tax” exception to Virginia’s intangible addback, see our November 1, 2016, February 9, 2016 and April 3, 2014 alerts. To discuss the effect of the Supreme Court’s decision, as well as other issues involving Virginia’s intangible expense addback, contact the authors of this alert or any member of the Reed Smith State Tax team.


  1. Record No. 160681 (Aug. 31, 2017).
  2. Id.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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