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Inc. v. Virginia Department of Taxation

Supreme Court of Virginia

March 22, 2018

KOHL'S DEPARTMENT STORES, INC.
v.
VIRGINIA DEPARTMENT OF TAXATION

          FROM THE CIRCUIT COURT OF THE CITY OF RICHMOND Walter W. Stout, III, Judge

          Lemons, C.J., Mims, McClanahan, Powell, Kelsey, and McCullough, JJ., and Russell, S.J.

          OPINION

          WILLIAM C. MIMS, JUSTICE

         In this appeal, we consider the extent to which a corporate taxpayer must include in its Virginia taxable income royalties paid to an intangible holding company.[1]

         I. Background and Procedural History

         Kohl's Department Stores, Inc. ("Kohl's") is a corporation organized under the laws of Delaware. It operates retail stores throughout the United States, including Virginia. Kohl's Illinois, Inc. ("Kohl's Illinois"), a corporation organized under the laws of Nevada, is an affiliate of Kohl's. Kohl's Illinois operates retail stores in select states, none of which are in Virginia.

         Kohl's Illinois also owns, manages, and licenses certain intellectual property. Kohl's entered into a license agreement with Kohl's Illinois for the use of this intellectual property. Pursuant to this agreement, Kohl's paid $441, 942, 347 in royalties to Kohl's Illinois during the taxable year that ended on January 31, 2009 and $481, 788, 205 during the taxable year that ended on January 30, 2010. When calculating its federal taxable income for these years, Kohl's deducted these royalty payments from its income as an ordinary and necessary business expense under 26 U.S.C. § 162(a). Conversely, Kohl's Illinois included the royalties as income in its taxable income calculations.

         However, Kohl's Illinois did not ultimately pay state income taxes on a substantial portion of the royalties. Each state in which Kohl's Illinois filed a return only taxed an apportionable share of its taxable income.[2] This left a substantial portion of the royalties untaxed, as they were not fairly attributable to Kohl's Illinois's activities in most states. In this capacity, Kohl's Illinois functions as an intangible holding company ("IHC"). James A. Amdur, State Income Tax Treatment of Intangible Holding Companies, 11 A.L.R. 6th 543 (2006).

Under this type of arrangement, a corporation typically transfers intangible assets (such as patents, trademarks, and trade names) to a subsidiary incorporated for that purpose (an "intangible holding company") that is domiciled in a state which does not tax income from intangibles, generally Delaware. The intangible holding company then licenses the intangibles to the parent corporation . . . in exchange for the payment of royalties, which the licensees deduct on their state income tax returns in the states where they conduct business. However, the intangible holding company does not file income tax returns in those states because it is not physically present there, and thus its royalty income is not subject to state income tax.

Id. at 552-53. This mechanism only operates to avoid state taxation in "separate reporting states" - that is, "states in which each corporation [even within a corporate family] files a separate income tax return." Id. at 553. IHC's "do not reduce state income taxes in 'combined reporting' states, " wherein "an affiliated group of corporations engaged in a common enterprise . . . file a combined income tax return." Id. In these states, "the intercompany transactions are eliminated." Id.[3]

         Generally speaking, Virginia is a separate reporting state. Code § 58.1-400. In 2004, the General Assembly sought to close the IHC loophole by enacting an "add back" statute, Code § 58.1-402(B)(8)(a). Department of Taxation, 2004 Special Session I, Fiscal Impact Statement for HB 5018 (estimating that the add back statute would increase the Commonwealth's tax revenue by $34 million in 2005). Under Code § 58.1-402(A), corporate taxpayers calculate their Virginia taxable income by starting with their federal taxable income and then making certain adjustments. The add back statute requires corporations to add to their federal taxable income "the amount of any intangible expenses and costs" paid to their "related members to the extent such expenses and costs were . . . deducted in computing federal taxable income." Code § 58.1-402(B)(8)(a).

         The parties do not contest that Kohl's royalty payments were "intangible expenses and costs" paid to a "related member." However, Kohl's claims that they fall within the "subject-to- tax" exception to the add back statute. This exception provides that the "addition shall not be required for any portion of the intangible expenses and costs if . . . [t]he corresponding item of income received by the related member is subject to a tax based on or measured by net income or capital imposed by . . . another state." Code § 58.1-402(B)(8)(a)(1). Kohl's Illinois included the royalties as income in each of its state tax returns. This income was then apportioned and taxed by each of these states. The royalties, in Kohl's view, therefore qualify for the subject-to-tax exception, and Kohl's did not add them back when calculating its Virginia taxable income for the taxable year that ended on January 31, 2009. Kohl's further requested a refund for the royalties it mistakenly added back to its taxable income for the taxable year that ended on January 30, 2010.

         In February 2011, the Virginia Department of Taxation audited Kohl's returns for both of the taxable years at issue. The auditor recognized that Kohl's Illinois paid income tax on a portion of the royalties, through the apportionment process, in many of the Separate Return States. The auditor allowed a "partial exception" to the add back statute corresponding to the amount of the royalties that was actually taxed in these states.[4] However, Kohl's Illinois did not pay taxes on most of the royalties, and the auditor required that this untaxed portion be added back to Kohl's taxable income. The Department then issued a Notice of Assessment to Kohl's for the taxable year that ended on January 31, 2009 in the amount of $1, 165, 318.16 in tax plus $120, 682.26 in interest. For the taxable year that ended on January 30, 2012, the Department issued a Notice of Assessment in the amount of $681, 582.84 in tax plus $29, 466.79 in interest.

         Kohl's appealed to the State Tax Commissioner, requesting corrections to both Notices of Assessment. The Commissioner found that the auditor correctly "reduced the royalty add back exception to the portion of [Kohl's] royalties paid to [Kohl's Illinois] that corresponds to the portion of [Kohl's Illinois's] income subjected to tax in other states." Accordingly, the Commissioner upheld the assessments.

         Kohl's then filed an "Application for Correction of Erroneous Assessment and Refund of Corporation Income Taxes" in the circuit court. Kohl's primarily contended that the royalty payments only needed to be included in Kohl's Illinois's taxable income, regardless of whether they were actually taxed, to fall within the subject-to-tax exception. The Department responded that only the portion of the royalty payments that was actually taxed by other states qualifies for the exception. Kohl's alternatively argued that even if the exception only covers the amount that was actually taxed, the Department's calculation of that amount was incorrect.

         The parties submitted a joint stipulation of facts, wherein they agreed that

it shall not be necessary for Kohl's to put on evidence of the amounts of the [subject-to-tax] exception or the resulting additional [corporate income tax] and interest that follows from [the circuit court's] ruling on the application of [the add back statute]. After [the circuit court's] ruling, the parties will confer and attempt to agree on any additional [corporate income tax] and interest amounts.

         Both parties moved for summary judgment, agreeing "that the sole issue for the [circuit court] to decide is the extent to which Kohl's is entitled to the [subject-to-tax] exception to the add back statute." Kohl's Dep't Stores, Inc. v. Va. Dep't of Taxation, 91 Va. Cir. 499, 504-05 (2016). The circuit court issued an opinion denying Kohl's motion for summary judgment and granting the Department's. Id. at 506. It held that "to fall within the [subject-to-tax] exception, the intangible expenses paid to a related member must not only be subject to a tax in another state, but that tax must actually be imposed." Id. at 505. The circuit court's opinion did not address Kohl's alternative argument. Id. at 504-06. We granted Kohl's this appeal.

          II. Analysis

         A. Applicability of the Subject-To-Tax Exception

         As in the circuit court, the primary contention between the parties on appeal is the extent to which Kohl's is entitled to the subject-to-tax exception of Code § 58.1-402(B)(8)(a)(1). The statute provides, in relevant part:

B. There shall be added to the extent excluded from federal taxable income:
8. a. . . . [T]he amount of any intangible expenses and costs directly or indirectly paid, accrued, or incurred to, or in connection directly or indirectly with one or more direct or indirect transactions with one or more related members to the extent such expenses and costs were deductible or deducted in computing federal taxable income for Virginia purposes. This addition shall not be required for any portion of the intangible expenses and costs if one of the following applies:
(1) The corresponding item of income received by the related member is subject to a tax based on or measured by net income or capital imposed by Virginia [or] another state . . . .

Code § 58.1-402(B).

         Kohl's argues that all of the royalties fall within the subject-to-tax exception because they were included in the taxable income of Kohl's Illinois. In its view, if income is included in the computation of a corporation's taxable income in another state, then it is "subject to a tax based on or measured by net income." Code § 58.1-402(B)(8)(a)(1). The Department responds that while all of the royalties were included in the taxable income of Kohl's Illinois, a substantial portion of these royalties was not attributable to any state in which Kohl's Illinois filed its returns and, as a result, not subject to a tax imposed by another state. In other words, Kohl's argues that the subject-to-tax exception applies on a "pre-apportionment" basis, while the Department argues that the subject-to-tax exception applies on a "post-apportionment" basis.

         In resolving this dispute, we note that "[w]hen a [tax] statute, as written, is clear on its face, this Court will look no further than the plain meaning of the statute's words." Department of Taxation v. Delta Air Lines, Inc., 257 Va. 419, 426, 513 S.E.2d 130, 133 (1999). The Court's primary objective is to give effect to the legislative intent, which "is initially found in the words of the statute itself, and if those words are clear and unambiguous, we do not rely on rules of statutory construction." Crown Cent. Petroleum Corp. v. Hill, 254 Va. 88, 91, 488 S.E.2d 345, 346 (1997).

         As stated above, the subject-to-tax exception applies when "[t]he corresponding item of income received by the related member is subject to a tax based on or measured by net income or capital imposed by . . . another state." Code § 58.1-402(B)(8)(a)(1). It is not clear from this language whether the General Assembly intended the exception to apply on a pre or post apportionment basis. Notably, the phrase "subject to a tax" is not defined by the Code. Seeking to provide a definition, Kohl's points out that the term "taxable" is defined as "subject to taxation." Black's Law Dictionary 1688 (10th ed. 2014). From this definition, Kohl's reasons that the royalty payments need only be "taxable" - regardless of whether they are actually taxed - to fall within the subject-to-tax exception. But this does not settle the issue, for the Due Process and Commerce Clauses of the United States Constitution mandate that only the amount of a corporation's income that is fairly apportionable to a given state is legally subject to that state's income tax. Container Corp., 463 U.S. at 164.[5]

          In fact, both of the parties' positions find support in the statute's language. Because the royalties were included in Kohl's Illinois's taxable income, they were, to a certain extent, "subject to" the income taxes of other states. At the same time, a substantial amount of the royalties was not apportioned to, and thereby not legally "subject to" the income tax of, any state in which Kohl's Illinois filed a return. Phrased differently, an income tax could only by "imposed by" another state on the post-apportioned amounts of the royalties. Code § 58.1-402(B)(8)(a)(1). This principle is demonstrated in Kohl's 2009 Virginia Income Tax Return, which indicates that less than 4% of Kohl's "taxable income" was "apportioned to Virginia, " and that only this post-apportioned amount was "subject to Virginia Tax." (S.J.A. 002) (emphases added). Thus, the General Assembly's decision to limit the applicability of the subject-to-tax exception to when the income is "subject to" an income tax "imposed by" another state suggests that it intended the exception to apply on a post-apportionment basis. Code § 58.1-402(B)(8)(a)(1).[6]

          Therefore, looking only at the plain language of the statute, it is doubtful and uncertain whether the General Assembly intended the subject-to-tax exception to apply on a pre or post apportionment basis.[7]Newberry Station Homeowners Ass'n v. Board of Supervisors.285 Va. 604, 614, 740 S.E.2d 548, 553 (2013) (A "statute is ambiguous when its language is capable of more senses than one, difficult to comprehend or distinguish, of doubtful import, of doubtful or uncertain nature, of doubtful purport, open to various interpretations, or wanting clearness or ...


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