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Alabama Supreme Court Grants Certiorari to Review the Issue of Royalty Payments to Intangible Holding Companies in Surtees v. VFJ Ventures

Tax Development May 09, 2008

On April 8, 2008, the Alabama Supreme Court granted certiorari in the case of Surtees v. VFJ Ventures to review the February 8, 2008 Court of Civil Appeals decision that reversed the trial court holding. The trial court’s holding negated an assessment resulting from the adding back of a taxpayer’s royalty payments made to related intangible holding companies for use of trademarks and other intangible property.

A jeans manufacturer made payments to two Delaware-based subsidiaries for use of their trademarks, deducting the payments as ordinary business expenses. An audit by the Alabama Department of Revenue required the taxpayer to add these expenses back under Ala. Code § 40-18-35(b)(1), the state’s add-back statute, and imposed penalties and interest. The taxpayer sought to vacate the assessment under Ala. Code § 40-18-35(b)(2), the unreasonableness exception to the state’s add-back statute, claiming the payments were made to legitimate entities and had a valid business purpose. At trial, the taxpayer maintained that the subsidiaries were established for more than just state tax planning and also existed to segregate the ownership and management of its trademarks, resulting in increased efficiency by concentrating management in one group of employees instead of being spread throughout the various operating subsidiaries, specifically allowing them to develop the expertise necessary to maintain the necessary registrations as well as monitor and combat trademark infringement worldwide. Duplicative efforts, costs, and reliance on outside counsel were also reduced, increasing efficiency, saving at least $60,000 per month in fees paid to outside counsel when it began its centralized trademark management. Third-party licensing agreements were coordinated and managed; expenses and revenues associated with tangible assets were more easily monitored, and the arrangement also was part of the taxpayer’s effort to share all common services throughout the company. The trial court agreed that the structure was legitimate after having seen how the company’s Wilmington, Delaware office operated and also in light of the fact that the taxpayer paid a standard 5%, arms-length royalty to the subsidiaries. Because the trial court believed the add-back statute effectively denied the taxpayer a deduction for a necessary cost of doing business in Alabama and resulted in a calculation of taxable income that included income fairly attributable to other states, summary judgment was granted to the taxpayer, and the assessment was vacated. The Department of Revenue appealed the judgment.

On appeal, the higher court gave deference to the Department’s interpretation of the unreasonableness exception that it applied only when the resulting tax would be “out of proportion” with the taxpayer’s presence in Alabama, regardless of whether transactions involving intangibles had any economic substance. The Court also agreed that the unreasonableness exception was not based entirely on whether transactions between related companies involving the use of intangibles had any economic substance, as this would imply the add-back statute existed only to disallow sham transactions. The Court also deemed the Department’s interpretation of the unreasonableness exception concerning whether a taxpayer would be taxed out of proportion to their activities in Alabama as consistent with the commonly accepted meaning of “unreasonable” as irrational or exceeding the bounds of reason or moderation.

The taxpayers further argued the intangible holding companies that received the royalty payments were subject to tax in North Carolina, and the add-back did not apply. However, the Court noted that the “subject to tax” exception required that the intangible income both be reported and included in income for other state income tax purposes, and since the Legislature had used both words, “included” meant something different than “reported.” The Court then held that “reported” meant actually taxed by another state and further held that because the companies paid North Carolina tax only on the apportioned part of the income, the pre-apportionment monies paid to the related company for the royalty payments could not escape taxation. The Court also noted that the Department consistently interpreted this other exception to the add-back statute in this manner and deferred to their interpretation again recognizing that an interpretation by the agency charged with administering the law should be given great weight.

Finally, the taxpayers argued that the add-back statute violated the Due Process and Commerce Clauses by attempting to tax income of their related companies that do not have any nexus with the State of Alabama. Additionally, the taxpayers maintained that the state’s add-back statute resulted in a tax that was not fairly apportioned to the state and was externally inconsistent. The Court again disagreed, stating that the statute simply disallows a deduction on a taxpayer having nexus in the state, and the Department only intended to apportion the amounts of royalty payments not already subject to tax in North Carolina. The Court concluded that the Department’s interpretation of the add-back statute was consistent with requirements of nexus between Alabama and interstate activities.

Surtees, et al. v. VFJ Ventures, Inc. f/k/a VF Jeanswear, Inc., Ala. Ct. Civ. App., Dkt. No. 2060478, February 8, 2008, rev’g Ala. Cir. Ct., Dkt. No. CV-03-3172, January 24, 2007.