The Virginia Department of Revenue (i) applied its narrow interpretation of the State’s related member add-back provision to disallow a taxpayer’s factoring company discount losses, and (ii) prohibited the taxpayer and its affiliated factoring company from filing a combined return because the factoring company did not have nexus with the State. Va. Public Document No. 11-162 (Sept. 26, 2011).

The taxpayer sold, or “factored,” its account receivables to a bankruptcy remote affiliate at a discounted price and claimed deductions for its losses on the discounted sales. The taxpayer did not add back its factoring discount losses paid to a related party because the add-back statute provides a “subject to tax” exception from the add-back requirement if the related party was subject to tax in any other state. In this case, the factoring company was subject to tax in one state. Notwithstanding the literal language of the exception, the Department interprets the subject to tax exception narrowly to allow an exception only for the amount actually apportioned to and taxed by other states and, on audit, reduced the taxpayer’s losses accordingly. The Commissioner upheld the auditor’s narrow interpretation of the subject to tax exception, limiting it to post-apportionment amounts, consistent with prior rulings (See Va. Pub. Doc. Nos. 09-49, 09-115).

The taxpayer also argued that the statutory add-back exception for transactions with a valid business purpose should apply. The Commissioner declined to address the argument based on procedural grounds, ruling that the business purpose exception is only available if the taxpayer reports the add-back on its return, pays the resulting tax, and then petitions the Commissioner to allow the business purpose exception. The Commissioner may grant the request if the taxpayer demonstrates by clear and convincing evidence that the transactions had a valid business purpose other than the avoidance of tax. If granted, the taxpayer must then file amended returns and claim a refund.

In the alternative, the taxpayer argued that the factoring company should be included in the taxpayer’s elective combined return. Under Virginia law, however, only companies with nexus in Virginia may be included in a combined return, and the Commissioner ruled that the factoring company did not have nexus and cannot be included in a combined report.