Corporate Close-Up: Virginia Add-Back Ruling May Look to Alabama

“Tell me who you walk with, and I’ll tell you who you are,” says the old Mexican proverb. The saying might be particularly troublesome to taxpayers awaiting the outcome of Kohl’s Department Stores, Inc. v. Virginia Dept. of Taxation, a case over the safe harbor provisions in Virginia’s intangible add-back statute. Virginia’s highest court is set to rule on it in 2017, after a lower court sided with the state based on its reliance on an Alabama ruling on the issue. 

“Add-back” statutes require taxpayers to add royalty and interest payments made to related parties back to the taxpayer’s tax base, instead of allowing the deduction taken at the federal level. Those expenses, often amounting to millions of dollars, are typically made to holding companies that maintain intellectual property like patents and trademarks for the taxpayer. Currently, 19 states have add-back statutes, and two have related statutes.

The Kohl’s opinion cited Surtees v. VFJ Ventures, a 2008 Alabama case litigating the safe harbor provisions of the Alabama add-back statute. In both cases, the courts held that the taxpayers did not qualify for exceptions to the add-back statutes. In both Kohl’s and VFJ Ventures, taxpayers argued that their income did not apply to the add-back statute because they were subject to tax in another state. The states argued that the statute did apply because the taxpayers did not actually pay the tax in those states.

“Alabama has taken steps to increase its tax reach, including enacting an ‘add-back’ statute that seeks to prevent the use of intangible holding companies to reduce Alabama taxes. The Alabama courts ultimately upheld a fairly broad interpretation of this add-back statute in VFJ Ventures,” said Gregory Rhodes, Shareholder at Sirote & Permutt’s Birmingham office and principal author of the Alabama Chapter of the Bloomberg BNA Corporate Income Tax Navigator (subscription required).  

Alabama requires taxpayers to add otherwise deductible interest expenses and costs in transactions with related members to taxable income, unless exceptions apply. Alabama follows the federal definition of “related members,” entities of which at least 50% are owned by the taxpayer. Taxpayers fighting the add-back statute insist that their Alabama tax liability should not be affected by whether other states decide to tax these expenses and payments.

VFJ Ventures is consistent with Alabama’s increased focus on eliminating what it perceives as income tax loopholes,” Rhodes told Bloomberg BNA, “The court noted that only a small portion of the company’s income was subject to tax in another state and applying the ‘subject-to-tax’ exception in such a situation would thwart the intent of the statute.”

To complicate the matter further, Virginia amended its add-back statute in 2014 to make it retroactive for ten previous tax years. It remains to be seen as to whether the Supreme Court of Virginia will take the same view as Alabama and other states or allow taxpayers to continue to apply the exception to its add-back statute as they have in the past.

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: Do you think that the add-back statute in your state is overbroad?

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