Retroactive Tax Legislation in Virginia

February 12, 2010

Currently pending in the 2010 session of the Virginia General Assembly is retroactive tax legislation to amend a safe harbor for the intangible expense additions enacted in 2004 for the corporate income tax. In 2004, Virginia joined a number of other states by adopting legislation severely limiting the ability of corporations conducting business in Virginia to enjoy the benefits provided by the use of intellectual property or passive investment holding companies.

The 2004 Virginia General Assembly significantly curtailed the benefits by requiring additions to be made to federal taxable income for certain deductions claimed for intangible property and interest expenses related to intangible holding companies.

Corporations are required to add back to federal taxable income any interest and intangible expense directly or indirectly paid to one or more related members. However, the add-back is not required if the corresponding item of income is subject to a tax in another state. Specifically, Virginia Code section 58.1-402(B)(8)(a) states:

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, another state, or a foreign government that has entered into a comprehensive tax treaty with the United States government; . . .

Since the adoption of this statute, the Virginia Tax Commissioner has issued six separate determinations that discuss the application of the “subject to tax” exception. In each of the six rulings, the taxpayer appealed an assessment of additional corporate income taxes by arguing it was entitled to exclude 100 percent of its royalty payments from the add-back, because the related member paid tax to other states on a portion of its income corresponding to those royalty payments.

The Virginia Tax Commissioner determined in each instance that only the portion of the royalty payment that was subject to tax in another state may be excluded from the add-back, not 100 percent of the royalty payment. To date, these six determinations are the only interpretations of the “subject to tax” exception as the Virginia Department of Taxation has not promulgated any regulations to implement the 2004 add-back legislation.

Former Gov. Kaine’s Amendment to the Add-back Statute

In his proposed budget for the 2011 and 2012 fiscal years, 2010 House Bill 30 and 2010 Senate Bill 30, former Gov. Tim Kaine seeks to amend the language of Virginia Code section 58.1-402(B)(8)(a) as follows:

This addition shall not be required for any portion of the intangible expenses and costs if to the extent that 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, another state, or a foreign government that has entered into a comprehensive tax treaty with the United States government; . . .

This amendment would change the language of the “subject to tax” add-back so that it is consistent with the Virginia Tax Commissioner’s six rulings. Alone, the changes to the statute contained in the amendment are not unconstitutional. However former Gov. Kaine’s budget applies the amendment retroactively to the 2004 taxable year. This retroactivity element is unconstitutional.

Constitutionality of Retroactive Tax Legislation

Using the U.S. Supreme Court decision in United States v. Carlton, 512 U.S. 26 (1994), and the Virginia Supreme Court decision in Colonial Pipeline Company v. Virginia, 206 Va. 517 (1965) as guidance, the Fairfax County Circuit Court in Giesecke v. Department of Taxation, 34 Va. Cir 455 (Fairfax County, 1994) succinctly cited the two tests enunciated in Colonial Pipeline Company v. Virginia to determine whether due process considerations are satisfied by retroactive tax legislation.

The tests as stated by the Fairfax County Circuit Court are “(1) Should the taxpayer reasonably have known that the statute at issue would be amended with retroactive application as to them? and (2) Whether the period of retroactive application of a tax statute is reasonable?” Using this two-part test is the best method to determine if former Gov. Kaine’s proposed changes to the add-back are constitutional.

First, should Virginia corporate taxpayers reasonably know that the add-back statute would be retroactively amended? Based on conversations with the parties directly involved in adopting the 2004 add-back statute, the answer is clearly no. With respect to the 2004 add-back statute, there has been no judicial or other interpretation by a government official that taxpayers may exclude 100 percent of royalty payments from the add-back because a related member paid tax to other states on a portion of its income corresponding to those royalty payments.

In fact, the only official interpretation available are the six rulings from the Virginia Tax Commissioner that state that only the portion of the royalty payment that was subject to tax in another state may be excluded from the add-back, not 100 percent of the royalty payment. If the Tax Commissioner believes she is interpreting the statute correctly, there is no need to amend the statute and no reason for Virginia taxpayers to know that the statute would be amended retroactively. This legislation fails the first prong of the two-part due process test.

The legislation also fails the second prong of the due process test. The question here is whether the period of retroactive application of the legislation is reasonable. The legislation applies retroactively to six taxable years, which is unreasonable.

In United States v. Carlton, the retroactive period was slightly more than one year, which the Court characterized as modest. The retroactive period in Colonial Pipeline was reasonable as the retroactive operation of the statute was within the current year, and within three months of the date on which the statute became effective.

In Giesecke, the retroactive period was three years, which the circuit court admitted was longer than generally acceptable. However the legislation in controversy in Giesecke was a reaction to a Virginia Supreme Court decision that invalidated a long-standing 30-year-old policy of the Virginia Department of Taxation. The retroactive period of the current legislative proposal will be six years for some taxpayers.

If the legislative proposal is enacted, it will be approximately six years from the date the add-back statute was originally enacted. Not only was there no prompt action to amend the add-back statute after enactment, there has been no legislative action of any kind. Simply put, there is nothing reasonable about the retroactive period covered by this legislation. The legislative proposal fails the second prong of the due process test.

Conclusion

The retroactive application of the amendment to the add-back statute fails every due process test. It is unquestionably unconstitutional. The obvious impetus for making these changes retroactive is to protect against any potential revenue loss should a Virginia court decide that the Virginia Tax Commissioner’s interpretation of the “subject to tax” exception is incorrect.

If the Tax Commissioner’s interpretation is ever overturned in court, and retroactive legislation is introduced at that time, the same due process standards should be applied. However no such judicial decision exists, and without an intervening judicial opinion concerning the application of the “subject to tax” exception, the possibility of that decision should not be considered. If a future negative (from the state’s perspective) judicial decision could be considered, the Virginia General Assembly might be allowed to retroactively amend any tax statute it sees fit.

Obviously if the Virginia General Assembly began retroactively amending tax statutes at will, such actions would be unconstitutional. As such, the retroactive amendment to the add-back statute proposed by former Gov. Kaine is unconstitutional, and this provision of his budget should be removed immediately so the substantive tax policy implications of the legislative proposal may be properly considered.

McGuireWoods has attorneys with significant experience in Virginia taxation, and who actively follow all tax legislation introduced in the 2010 Virginia General Assembly. The intangible expense addition has been a source of controversy in Virginia in recent years. McGuireWoods attorneys are very familiar with the controversy surrounding the addition, and they will actively follow any changes made as a result of this legislation.

In addition, McGuireWoods offers a full range of state and local tax planning and litigation services to taxpayers of all types and sizes, both public and privately held. Our state and local tax attorneys are highly versed in all aspects of state and local tax planning, as well as all aspects of tax compliance, including civil audit and general and procedural matters before local and state tax authorities.

We regularly represent clients in the preparation of private letter ruling requests, administrative tax protests, and offers in compromise for outstanding tax assessments. We also offer the complete range of trial and appellate state and local tax litigation services frequently demanded by cutting-edge taxpayers. We would be pleased to discuss any interest you may have in the intangible expense addition or any other Virginia tax issue. Please do not hesitate to contact us at your convenience.

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