Separate return state addback statutes, such as the Virginia addback statute, can overreach to produce an unfair and potentially unconstitutional overstatement of income assigned to the state. Recently Virginia amended its addback statute retroactively 10 years to taxable years beginning on or after January 1, 2004. The legislation is intended to codify an administrative interpretation that significantly limited an addback exception to the extent the income received by a related member is subject to taxes based on net income or capital imposed by Virginia, another state, or a foreign government with a comprehensive tax treaty with the United States (H.B. 5001, enacted April 1, 2004). The legislation limits the subject-to-tax exception so that it applies only on a post-apportionment basis, as illustrated in two rulings of the Commissioner, Ruling 07-153 (Oct 2, 2007) and Ruling 13-140 (July 19, 2013).
Taxpayers, in particular taxpayers that have a significant presence in unitary tax states, should not blindly add back legitimate business expenses to income where the result would be an overstatement of income. Consider this common situation as an example: a parent corporation, a manufacturer of high-tech products, pays a royalty for technology licensed to it by an R&D subsidiary. The R&D subsidiary is based in California, a combined report state. The parent corporation has $1,000 in gross receipts, pays $200 in royalties to R&D subsidiary, has $600 of other expenses and a net income of $200. The R&D subsidiary has gross receipts of the $200 in royalties, deductions for R&D expenses of $100 and a net income of $100. Together the federal consolidated income of the two entities (as well as GAAP income) is $300. The R&D subsidiary conducts R&D activities in California and in many foreign countries (some with U.S. tax treaties, some without) and has taxable nexus in one separate return state to which it apportions 1 percent of its net income of $100. Here is how Virginia applies its addback statute: Virginia adds the $200 royalty paid to the R&D subsidiary to the parent corporation’s income, but excepts from the addback 1 percent of the royalty, or $2, to reflect the separate return state. No exception from the addback is provided for the portion of the royalty apportioned to California. Thus, the parent corporation’s taxable income in Virginia is $398, an amount almost equal to the combined net income of the parent and the subsidiary, plus the bona fide amounts paid by the subsidiary in R&D expenses.
Taxpayers should carefully examine returns filed in addback statute states to see if they fail a sanity test, like the result in the hypothetical example. If the State Department of Revenue doesn’t agree to rational exceptions to the expense disallowance, there are multiple grounds for challenge in the courts.
Plain Meaning of the Statute
A typical addback statute provides an exception when the related member is subject to tax on net income in that state, another state, or a foreign government with a comprehensive tax treaty with the United States. Where the R&D subsidiary pays tax on net income in another state—such as the commercial domicile of the R&D subsidiary—the statute would appear on its face to provide an exception, an issue of statutory construction subject to judicial review. The post-apportionment theory is a product of a tortured reading of the statute.
There are potentially multiple constitutional infirmities with an addback statute, a comprehensive analysis of which is not appropriate for this post, but which can be viewed in a companion White Paper. Among them are:
- Internal Consistency and Foreign Commerce. The Virginia addback statute does not provide an exception for taxes paid in a foreign county that does not have a comprehensive U.S. tax treaty. Virginia can no more discriminate against foreign commerce than it can against interstate commerce. Japan Lines, Ltd. v. Los Angeles, 441 U.S. 434 (1979).
- Fair Apportionment—External Consistency Test. In the above example, the combined income of the parent and the R&D subsidiary is $300, but Virginia computes the parent’s separate taxable income to be $398. This result would flunk any fair apportionment test.
- Fair Apportionment—Income From States That Do Not Impose A Tax Measured By Net Income Or Capital. The Virginia addback statute treats activities and income in states without a tax measured by net income or capital as activities and income located in states with such taxes. Activities and income in states such as Washington, Nevada, Wyoming, South Dakota and possibly Ohio and Texas are not activities and income in Virginia.
- Discrimination Against Interstate Commerce. Perhaps the most invidious discrimination in the example is the failure to provide an exception for the income that the R&D subsidiary reports to a state such as California that embraces the unitary tax principle. An exception is provided for income reported to states that require separate returns, but no exception is provided for income reported to states that require the determination of business income earned in the state by using the mechanics of a combined report. The R&D subsidiary is required to file an income tax return in California and pay a tax on its California income. Combined report mechanics are used to determine the R&D subsidiary’s California unitary, or business, income. That redetermined business income could be greater than or less than the R&D subsidiary’s separately stated business income. To that business income the R&D subsidiary adds its California nonbusiness income or loss, takes into account its own separate net operating loss (NOL) carryover and reduces its California tax by its own individual tax credits. There is simply no rational justification for the Virginia practice of granting a reduction from addback where a R&D subsidiary is taxable in a separate return state, while denying the reduction where a R&D subsidiary is taxable in a combined return state.