VFJ Ventures, Inc. v. Surtees permissibility of Alabama's add-back statute: on April 29, 2008, Tax Executives Institute filed a brief amicus curae in with the Supreme Court of Alabama in VFJ Ventures, Inc. v. Surtees, relating to the permissibility of Alabama's add-back statute.

In Alabama and several other states, the computation of "taxable income" begins with federal taxable income but then requires various additions and subtractions peculiar to each state's taxing regime. After these adjustments are made, the state applies its unique apportionment and allocation formulae to determine its respective share of taxable income. States vary considerably in the type and extent of adjustments made to federal taxable income.

Alabama, like many other states, requires corporate taxpayers to "add back" otherwise deductible interest and intangible expenses paid to or incurred with respect to related members. It was under this statute that Alabama denied VFJ a deduction for the arm's-length royalties paid to Lee and Wrangler.

The Court of Civil Appeals rejected the findings of the circuit court and denied the royalty deductions claimed by VFJ. In doing so:

(1) the Court of Civil Appeals misapprehended the "unreasonableness" exception to the Alabama add-back statute; the Court thereby contravened legislative intent, ignored business reality and common business practice, and by constricting that provision to the point of mootness, exposed routine business arrangements to add-back exposure;

(2) the Court of Civil Appeals failed to recognize that under the analytical framework of the U.S. Supreme Court's decision in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the "subject-to-a-tax" provision of the Alabama add-back statute unconstitutionally discriminates against interstate commerce; and

(3) the Court of Civil Appeals incorrectly interpreted the "reported and included" language of the subject-to-a-tax exception of the add-back statute.

For the foregoing reasons, the Supreme Court should reverse the decision of the Court of Civil Appeals and reinstate the determination and rationale of the circuit court.

Background--Factual Summary

VFJ Ventures, Inc. (VFJ) is a domestic manufacturer and seller of jeans sold under the brand names of Lee[R] and Wrangler[R]. (R. 90.) VFJ has two distribution facilities and a "cutting" facility in Alabama with approximately 600 employees. (R. 90-91.) VFJ licensed the use of several trademarks from the H.D. Lee Company, Inc. (Lee) and Wrangler Clothing Corp. (Wrangler) in its national manufacturing and marketing operations. (See R. 233, 239, 323-25.) Lee and Wrangler are subsidiaries of VF Corporation, headquartered in Greensboro, North Carolina, and related to VFJ. (PX 13; R. 89-90.) They serve as intangible management companies that, among other things, maintain, protect, and regulate the Lee and Wrangler trademarks. (R. 91-92.)

For the tax year at issue, Lee and Wrangler charged VFJ an arm's-length royalty to use their trademarks. (PX 11.) (Lee and Wrangler also licensed these trademarks to third parties at similar rates.) (R. 180-81.) On its 2001 federal income tax return, VFJ deducted, as an ordinary and necessary business expense, the amount paid in royalty fees to Lee and Wrangler for use of their trademarks. (R. 98-99.) Since federal taxable income is the starting point for computing taxable income in Alabama, VFJ's 2001 Alabama corporate tax return reflected this deduction. See Ala. Code 1975, [section] 40-18-33.

On audit, the Department of Revenue invoked the Alabama add-back statute, Ala. Code 1975, [section] 40-18-35(b), to effectively deny VFJ a deduction for the Lee and Wrangler royalty payments in calculating the company's Alabama income. (See C. 35-49.) Further, the Department determined that the statutory exceptions to the add-back requirement were inapplicable, and it assessed VFJ additional income attributable to the denied royalty deductions. (See id.)

VFJ petitioned the Montgomery County Circuit Court for review contending that the royalty deductions were properly claimed, not subject to add-back (owing to the application of a statutory exception) and, alternatively, that the add-back statute was unconstitutional under the Commerce Clause of the U.S. Constitution. U.S. Const. art. I, [section] 8, cl. 3; (See C. 8-49). The trial court upheld VFJ's challenge, finding that the royalties were deductible pursuant to the "unreasonableness" exception to the Alabama Add-Back statute. Ala. Code 1975, [section] 40-18-35(b)(2); (C. 638). Explaining that the purpose of the add-back statute is to "prevent abusive deductions and to ensure that income fairly attributable to Alabama is taxed in Alabama," the court held that VFJ's royalty payments were not abusive:

[T]hey have economic substance and business purpose and represent real and necessary costs of doing business in Alabama, and to disallow these deductions would distort the amount of VFJ's income fairly attributable to this state. VFJ Ventures, Inc. v. Surtees, CV-03-3172, Alabama Circuit Court, Jan. 24, 2007; (C. 639).

On appeal, the Alabama Court of Civil Appeals reversed, holding that the "unreasonableness" exception to add-back does not focus on a showing of business purpose or economic substance, that the statute's exception for royalties "subject-to-a-tax" elsewhere requires that "the income at issue is actually taxed as part of a tax on net income," and that the "Department's interpretation of the add-back statute is consistent with the requirements of a nexus between Alabama and the interstate activities, i.e., the royalty payments." Surtees v.

VFJ Ventures, No. 2060478, 2008 LEXIS 50, at *35-*36, *63, *79--So. 2d--, (Ala. Civ. App. Feb. 8, 2008).

VFJ has petitioned this Court to reverse the decision of the Court of Civil Appeals.

Misapprehension by the Alabama Court of Civil Appeals of the "Unreasonableness" Exception to the Alabama Add-Back Statute Unduly Constricts that...