Virginia and Georgia are two of the latest states to pass laws responding to the federal tax reform passed in December 2017, known as the Tax Cuts and Jobs Act (TCJA). Both states updated their codes to conform to the current Internal Revenue Code (IRC) with some notable exceptions.

Virginia

On February 22, 2018, and February 23, 2018, the Virginia General Assembly enacted Chapter 14 (SB 230) and Chapter 15 (HB 154) of the 2018 Session Virginia Acts of Assembly, respectively. Before this legislation was enacted, the Virginia Code conformed to the IRC in effect as of December 31, 2016. While the new legislation conforms the Virginia Code to the IRC effective as of February 9, 2018, there are some very notable exceptions. The legislation explicitly provides that the Virginia Code does not conform to most provisions of the TCJA with an exception for “any… provision of the [TCJA] that affects the computation of federal adjusted gross income of individuals or federal taxable income of corporations for taxable years beginning after December 31, 2016 and before January 1, 2018…” Thus, despite Virginia’s update of its IRC conformity date, Virginia largely decouples from the TCJA. Continue Reading Southeast States Respond to Federal Tax Reform and NJ Senate Leader Talks Tax Surcharge to Limit Corporate “Windfall”

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. Continue Reading While Virginia Supreme Court Holds “Subject-To-Tax” Means “Actually Taxed,” Determination of “Actually Taxed” is Relatively Broad for Purposes of Addback Exception

McDermott Will & Emery has released the December 2015 issue of Focus on Tax Controversy, which provides insight into the complex issues surrounding U.S. federal, international, and state and local tax controversies, including Internal Revenue Service audits and appeals, competent authority matters and trial and appellate litigation.

Mark Yopp authored an article entitled “Waiting for Relief from Retroactivity,” which discusses how courts are expanding the ability of state legislatures to retroactively change taxpayer liability going back many years.

View the full issue (PDF).

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.

Constitutional Information

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:

  1. 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).
  2. 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.
  3. 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.
  4. 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.

When state legislatures are in need of additional funds – as they often are – it is tempting to enact retroactive legislation to bring more dollars into state coffers. Two recent developments have Due Process Clause questions of retroactivity back in the news in the SALT world. In Caprio v. N.Y. State Dep’t of Taxation & Fin., No. 651176/11, 2014 NY Slip Op. 02399 (N.Y. App. Div. Apr. 8, 2014), a New York court rejected a retroactive amendment reaching back three years into the past. Virginia, however, recently amended its add-back statute (H.B. 5001, § 3-5.11) with an even longer retroactive period of 10 years.

New York’s Three and a Half Year Retroactive Tax Struck Down As-Applied

In Caprio, Florida residents sold their stock in a New Jersey S corporation in exchange for an installment note. The S corporation was a janitorial services company that also did business in New York. The parties to the transaction made an IRC § 338(h)(10) election for treatment as a deemed asset sale, with the installment note thereby deemed to be distributed in liquidation to the shareholders. When the shareholders subsequently received payments on the installment note, they did not report any New York source income because they treated the payments as gain from the sale of stock, not sourced to New York any more than would be a sale of stock in a Fortune 500 company.

Treatment of gain from a nonresident’s sale of S corporation stock as not sourced to New York was upheld by the New York State Division of Tax Appeals in In re Mintz, DTA nos. 821807, 821806 (Jun. 4, 2009) (for a detailed discussion in Mintz, see Inside New York Taxes), but retroactive legislation in 2010 reversed the result. 2010 N.Y. Laws, c. 57, Part C (amending N.Y. Tax Law § 632(a)(2)).  Caprio voids the retroactive application of the 2010 amendment to the taxpayers as violating the Due Process Clause.

Applying New York’s three-factor test set forth in James Square Assoc. LP v. Mullen, 993 N.E.2d 374, 377 (N.Y. 2013), aff ’g, 91 A.D.3d 164 (N.Y. App. Div. 4th 2011) (which we discussed recently in State Tax Notes), the Appellate Division considered the factors of (1) taxpayer’s forewarning and the reasonableness of the retroactive change, (2) the length of the retroactive period, and (3) the public purpose of the retroactivity. The majority concluded that the 2010 amendment was unconstitutionally retroactive:

  • The taxpayers had no actual forewarning of the 2010 amendment at the time they entered into the transaction, and they reasonably relied on the law as it existed to structure the sale;
  • A three and a half year retroactive period was excessive; and
  • Raising $30 million for the state budget was not a sufficiently compelling public purpose.

The Questionable Validity of Virginia’s 10 Year Retroactive Add-Back Amendments

Just before Caprio came down, Virginia amended its add-back statute, retroactive to 2004, to narrow the subject-to-tax and conduit exceptions. See H.B. 5001, § 3-5.11. Retroactive enforcement of these amendments would essentially codify the Virginia Department of Taxation’s application of Virginia’s add-back statute and would strengthen the Department’s hand in a number of pending cases.

The validity of Virginia’s retroactive amendments under the Due Process Clause is questionable.  10 years is an outrageously long period of retrospective effect. The Department may argue that the amendments are really a technical clarification of existing law rather than a truly retroactive change in the law, but taxpayers facing alleged liabilities as a result of the amendments will certainly experience a real change.