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...