United States: Virginia Circuit Court Holds Addback Exception Applies If Licensing Royalties Are Indirectly Paid To Related Member

A Virginia circuit court has held that a taxpayer was entitled to an exception to the general rule requiring the addback of federal intangible expense deductions and costs to taxable income.¹ Virginia law provides an exception for certain taxpayers that license intangible property to unrelated parties. The taxpayer was a franchisor that sublicensed the intangible property to franchises that were not related to the original licensor. The court determined that the original licensor met the "licensing to unrelated parties" requirement based on the sublicense agreements and as a result, the franchisor taxpayer was entitled to a refund based on the exception to the addback rule.

Background

The taxpayer, Wendy's, a national franchise restaurant chain, formed Scioto Insurance Company to insure various Wendy's liability and property damage risks. Scioto established Oldemark, LLC, the owner of Wendy's trademarks and trade names. Oldemark was a disregarded entity for federal income tax purposes, so its income and deductions flowed through to Scioto.

Oldemark licensed its intellectual property to Wendy's, and Wendy's subsequently entered into sublicense agreements with individual Wendy's restaurants or franchises. These Wendy's restaurants were owned by both companies that were related and unrelated to Wendy's. The restaurants paid 4 percent of their gross sales to Wendy's for use of the intellectual property. Wendy's, in turn, paid 3 percent of the restaurants' gross sales to Oldemark for use of the intellectual property.

Pursuant to Virginia's addback statute, Wendy's added back the royalties paid and deducted on its federal income tax returns for the 2004 to 2007 tax years. In October 2007, Wendy's sought a refund of income paid for these years² based on an exception to the addback statute for certain related companies that lease intangible property to unrelated companies. Following the Virginia Department of Taxation's denial of the refund request, Wendy's brought the refund claim before the circuit court. Both Wendy's and the Department filed motions for summary judgment.

Addback Statute and Exception

While federal law permits corporate taxpayers to deduct certain intangible expenses and costs, Virginia law does not. Rather, Virginia law specifically requires the addback to taxable income of "the amount of any intangible expenses and costs directly 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."³ The addback statute provides three exceptions or "safe harbors" to the addback requirement. This case concerned the exception that applies if a related member "derives at least one-third of its gross revenues from the licensing of intangible property to parties who are not related members ...."⁴ The rates and terms of the agreements with respect to related members must also be comparable to the rates and terms of agreements with respect to non-related members.⁵

Taxpayer Qualified for Exception to Addback Statute

The issue before the circuit court was whether the exception to the addback statute required the taxpayer to directly license the intangible property to non-related members. Oldemark acquired at least one-third of its gross revenues from non-related members, as required by the statutory exception, only by taking into account the payments made by unrelated franchises to Wendy's under the sublicensing agreement. Oldemark did not directly license the intangible property to the unrelated franchises.

In reaching its decision, the circuit court maintained that the language of the statute was unambiguous and as such, the court considered the plain meaning of the language in order to determine the legislature's intent.

Pursuant to the statute, the exception to the general addback requirement applies to a related member that "derives" at least one-third of its revenues from non-related members. The court determined that the word "derives," based on its common meaning, did not infer that the one-third requirement must be met by direct licensing, rather than sublicensing agreements. Therefore, the Court found that no direct connection between the related member licensor and unrelated licensee was required to take advantage of the exception.

The court summarily held that Oldemark was not required to directly license the intellectual property to the restaurants, and as a result, Wendy's was entitled to the exception by virtue of the pass-through of its licensing revenues (the same rates and terms applied to both related and unrelated restaurants) from the restaurants to Oldemark.

Commentary

Multiple states have enacted statutes that require the addback of intangible expenses, but there have been few court decisions that have considered the application of exceptions to these addback requirements. Thus, this case is significant, at least for purposes of the Virginia corporation income tax because it potentially opens the doors for refund opportunities for certain taxpayers that historically have added back intangible expenses when they may qualify for the "unrelated party" exception based on sublicensing agreements. That is, a company that licenses intangible property to an unrelated party through a franchising entity, such as Wendy's, can meet the "derives at least one-third" of its gross revenues from licensing to unrelated parties requirement. The franchising entity can thus qualify for the exception based on its sublicensing agreements with entities that are unrelated to the original licensor. Of course, it is possible that the Department could appeal the decision, and if so, protective refund claims may be in order pending a final outcome.

It should be noted that Virginia is the only state with an addback requirement that has this particular exception to the requirement, so the analysis in this case is unlikely to be directly applicable to other states' exceptions to addbacks. While the court determined that the meaning of the term "derived" was unambiguous and was evidence of the legislative intent to allow direct and indirect relationships to count towards the one-third requirement, the court did not take the extra step to focus on what actually happened when the bill was initially drafted and debated in the Virginia legislature.

Footnotes

1 Wendy's International, Inc. v. Virginia Department of Taxation, Circuit Court of the City of Richmond, Virginia, Case No. CL09-3757, March 29, 2012.

2 The court's opinion was silent on how Wendy's could have applied for a refund for a tax year in which it had not yet filed. Perhaps the refund claim covered the 2004-2006 tax years, and the 2007 tax year was later added to the refund claim, or the 2007 tax year was a short-period return for which a filing was made prior to the end of 2007.

3 VA. CODE ANN. Ã,§ 58.1-402(B)(8)(a).

4 VA. CODE ANN. Ã,§ 58.1-402(B)(8)(a)(2).

5 Id. The other exceptions are available if (i) the corresponding income received by the related member is subject to a tax based on or measured by net income or capital imposed by Virginia, another state, or a foreign government that has entered into a tax treaty with the U.S. government; or (ii) the corporation can show that the intangible expenses and costs meet both of the following: (a) the related member during the same taxable year paid, accrued or incurred such portion to a person who is not a related member, and (b) the transaction giving rise to the intangible expenses and costs did not have the avoidance of Virginia corporate income tax as its principal purpose. VA. CODE ANN. Ã,§ 58.1-402(B)(8)(a)(1), (3).

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