Appendix — VFJ Ventures, Inc. v. Surtees (No. 08-916)

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APPENDIX A

SUPREME COURT OF ALABAMA

1070718

Ex parte VFJ VENTURES, INC., f/k/a VF JEAN°WEAR,

INC.;

(In re: G. THOMAS SURTEES, in his official capacity as

commissioner of the Alabama Department of

Revenue, and the Alabama Department of Revenue

We

VFJ VENTURES, INC., f/k/a VF JEANSWEAR, INC.)

PETITION FOR WRIT OF CERTIORARI

TO THE COURT OF CIVIL APPEALS

September 19, 2008, Released

As Corrected September 25, 2008.

OPINION

JUDGES: LYONS, Justice. Cobb, C.J., and See,

Woodall, Stuart, Smith, Bolin, Parker, and Murdock,

JJ., concur.

OPINION BY: LYONS

LYONS, Justice.

VFJ Ventures, Inc., f/k/a VF Jeanswear, Inc.

(“VFJ”), sued in the Montgomery Circuit Court the

commissioner of the Alabama Department of

2a

Revenue, in his official capacity, and the Alabama

Department of Revenue. At the time the complaint

was filed, Dwight Carlisle was the commissioner of

the Alabama Department of Revenue. During the

pendency of the case, G. Thomas Surtees was

substituted pursuant to Rule 25(d), Ala. R. Civ. P., as

a defendant, in his official capacity, when he became

the commissioner of the Alabama Department of

Revenue. Tim Russell is now the commissioner of the

Alabama Department of Revenue; he is now a

defendant, in his official capacity, pursuant to Rule

43(b), Ala. R. App. P. (Russell and the Alabama

Department of Revenue will hereinafter be referred

to collectively as “the Department.”) The trial court

entered a judgment in favor of VFJ. The Department

appealed to the Court of Civil Appeals; that court re-

versed the judgment of the trial court and remanded

the case for the entry of a judgment in favor of the

Department. Surtees v. VFJ Ventures, Inc., |Ms.

2060478, February 8, 2008] So. __ 2d __, (Ala. Civ.

App. 2008). VFJ then filed a petition for certiorari

with this Court; we granted certiorari review.

After considering the record in this case, the briefs

of the parties and the amici curiae, the oral

arguments of the parties, and the opinion of the

Court of Civil Appeals, we agree with the views

expressed by Presiding Judge Thompson in his

thorough and well reasoned opinion. In light of that

thoughtful opinion, we see no need to explicate

further. We affirm the judgment of the Court of Civil

Appeals, and we adopt Presiding Judge Thompson’s

opinion in its entirety, as the opinion of this Court.

AFFIRMED

3a

Cobb, C.J., and See,’ Woodall, Stuart, Smith, Bolin,

Parker, and Murdock, JJ., concur.

1 ‘ . . °

Although Justice See did not sit for oral argument of this

case, he has viewed the video recording of that oral argument

4a

APPENDIX B

COURT OF CIVIL APPEALS OF ALABAMA

2060478

G. THOMAS SURTEES, in his official capacity as

commissioner of the Alabama Department of

Revenue, and the Alabama Department of Revenue

¥.

VFJ VENTURES, INC., f/k/a VF JEANSWEAR, INC.

February 8, 2008, Released

As Corrected October 22, 2008.

OPINION

JUDGES: THOMPSON, Presiding Judge. Thomas

and Moore, JJ., concur. Pittman and Bryan, JJ., con-

cur in the result, without writings.

OPINION BY: THOMPSON

THOMPSON, Presiding Judge.

VFJ Ventures, Inc. (““VFJ”), f/k/a VF Jeanswear,

Inc., filed an appeal in the Montgomery Circuit Court

(“the trial court”) pursuant to § 40-2A-7(b)(5)(b), Ala.

Code 1975, challenging a decision of the Alabama

Department of Revenue assessing against VFJ an

amount representing additional corporate income tax

purportedly owed the State; it also named the com-

missioner of the Department as a defendant.’ We re-

VFJ named “Dwight Carlisle, in his official capacity as the

commissioner of the Department of Revenue” as a defendant, it

5a

fer to the two named defendants collectively as “the

Department.”

The Department responded, arguing that the as-

sessment should be upheld. The Department later

filed a motion for a partial summary judgment, which

the trial court denied. The trial court conducted a

lengthy trial at which evidence was presented ore

tenus and numerous exhibits submitted. The trial

court also accepted posttrial briefs from the parties.

On January 24, 2007, the trial court entered a

judgment in favor of VFJ. The Department timely

appealed to this court pursuant to § 12-3-10, Ala.

Code 1975.

VFJ manufactures and sells jeanswear sold under

the Lee@ and Wrangler® brand names in the United

States. VFJ has two distribution facilities and a

“cutting” facility in Alabama. Those facilities employ

approximately 600 people. In 2001, the tax year at

issue in this case, VFJ’s gross sales were approxi-

mately $2.1 billion; only a portion of VFJ’s gross sales

were attributable to its activities in Alabama. “Under

both the Due Process and the Commerce Clauses of

the [United States] Constitution, a state may not,

when imposing an income-based tax, ‘tax value earned

outside its borders.” Container Corp. of America v.

Franchise Tax Bd., 463 U.S. 159, 164, 103 S. Ct.

2933, 77 L. Ed. 2d 545 (1983) (quoting ASARCO, Inc.

v. Idaho State Tax Comm’n, 458 U.S. 307, 315. 102 S.

Ct. 3103, 73 L. Ed. 2d 787 (1982)). Thus, oniy that

part of VFJ’s income that was fairly attributable to

later substituted G. Thomas Surtees as a defendant in place of

Carlisle when Surtees came to hold the office of commissioner of

the Department of Revenue. See Rule 25(d), Ala. R. Civ. P.

6a

its presence in Alabama is subject to taxation in this

state.

When a corporation such as VFJ has manufactur-

ing facilities or operating facilities or performs activi-

ties in more than one state, a formula known as an

“apportionment factor” is used to determine how

much income is attributable to each state. The appor-

tionment factor is used to determine the portion of

the corporation’s income that is subject tc income tax

in each of the states in which the corporation has ac-

tivity. See Allied-Signal, Inc. v. Director, Div. of

Taxation, 504 U.S. 768, 778, 112 S. Ct. 2251, 119 L.

Ed. 2d 533 (1992) (“Because of the complications and

uncertainties in allocating the income of multistate

businesses to the several States, we permit States to

tax a corporation on an apportionable share of the

multistate business carried on in part in the taxing

State.”). In this case, the Department and VFJ seem

to have agreed on the application of a common three-

part apportionment factor that has been approved

by the United States Supreme Court. See Container

Corp. of America v. Franchise Tax Bd., 463 U.S. at

170 (“[NJot only has the three-factor formula met our

approval, but it has become .. . something of a

benchmark against which other apportionment for-

mulas are judged.”).

Alabama, like a number of other states, has adopted

the apportionment factor referenced in Container

Corp. of America v. Franchise Tax Bd., supra, for

determining the portion of a multistate corporation’s

income that may be taxed in this state. The appor-

tionment factor is set forth in § 40-27-1, Art. IV, 7 9,

Ala. Code 1975, as a part of Alabama’s adoption of

the Multistate Tax Compact. The Multistate Tax

Compact creates a uniform system for taxing entities

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such as VFJ, who have operations or are active in

more than one state. State Dep’t of Revenue v. MGH

Megmt., Inc., 627 So. 2d 408, 408-09 (Ala. Civ. App.

1993) (“The [Multistate] Tax Compact provides for

the allocation and apportionment of income of tax-

payers doing business in more than one state in such

a manner as to avoid duplicative taxation.”).

In opening statements during the trial of this mat-

ter, one of the attorneys accurately summarized Ala-

bama’s apportionment factor for the trial court as

follows:

“You take the ratio of the property in the state to

the property out of state, a ratio of the sales in

the state to the sales out of the state, a ratio of

the payroll in the state to the sales [sic] out of

the state, add them together and divide by three,

and that average is your apportionment factor.”

For the 2001 tax year, VF.J’s apportionment factor

for Alabama was 13.9299%. Using that factor, VFJ

reported approximately $13,702,000 in income to

be apportioned to Alabama on its state corporate

income-tax return for the 2001 tax year.

VFJ is a subsidiary of VF Cozporation (“VF”), a

parent holding company comprising hundreds of sub-

sidiaries worldwide. VF’s corporate headquarters is

located in Greensboro, North Carolina. Among VF’s

subsidiaries are numerous intangible management

companies (“IMCOs”) that owa and manage trade-

marks, most of which are used by other VF subsidi-

aries. All the IMCOs are Delaware corporations.

A treatise on state taxation has explained the func-

tion of IMCOs like those in the VF corporate family

as follows:

8a

“One of the standard tax-planning devices corpo-

rations employ to reduce taxable income in states

where they conduct their operations is to trans-

fer their trademarks or trade names to an intan-

gibles holding company ({IMCO]) and license

back the trademarks or trade names for a roy-

alty. The royalty, which is deductible to the op-

erating company, reduces its income in the states

where it carries on its business. The [IMCO], on

the other hand, ordinarily pays no tax on its roy-

alty income because it is taxable—or at least

taxpayers so contend—only in a state that does

not tax such income (e.g., Delaware).”

J. Hellerstein & W. Hellerstein, State Taxation

q 9.20[3] j] (2007 Cum. Supp.).

Two of the IMCQOs in the VF corporate family are

the H.D. Lee Company, Inc. (“Lee”), and the Wran-

gler Clothing Corporation (“Wrangler”), which own

and manage trademarks for Lee® and Wrangler®

brands, respectively. Lee and Wrangler license their

respective trademarks to VFJ and other VF subsidi-

aries, as well as to third parties. It is undisputed that

VFJ and the other subsidiaries of VF, including Lee

and Wrangler, are “related members” as that term is

defined for the purpose of determining Alabama’s

corporate income tax. Testimony at trial indicated

* Section 40-18-1(18), Ala. Code 1975. defines the term “re-

lated member” as:

“A person that, with respect to the taxpayer any time

during the taxable year, is a related entity as defined in

this section, a component member as defined in 26 U.S.C.

§ 1563(b) of a controlled group of which the taxpayer is also

a component, or is a perso. to or from whom there is attri-

bution of stock ownership in «cordance with 26 U.S.C.

§ 1563/e).”

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that Lee and Wrangler generally charge a 5% royalty

rate to both related-member and third-party licen-

sees. In 2001, the tax year at issue, approximately

78% of Lee’s income came from licensing agreements

with related members. For that same year, approxi-

mately 97% of Wrangler’s licensing income was de-

rived from lic-nsing agreements with related mem-

bers.

In Delaware, [MCOs such as Lee and Wrangler are

subject to taxation only under limited circumstances.

See Del. Code Ann. tit. 30, § 1902. Because the roy-

alty payments are generally deductible expenses as

to the licensee operating companies, the royalty pay-

ments made by related-member licensees that com-

prise the corporate income of the IMCOs escape taxa-

tion on the state level. Accordingly, the creation of

the Delaware IMCOs created significant state-tax

savings for VF.J and other subsidiaries of VF by effec-

tively shifting income out of states that do impose

corporate income tax to a state that does not impose

such a tax.

To illustrate this process, the record indicates that

in 2001 VFJ paid Lee $36,220,000 in licensing royalty

fees for its use of the Lee» trademarks on its prod-

ucts, and it paid Wrangler $66,420,000 for the use of

its Wrangler® trademarks. On its 2001 federal in-

come-tax return, VFJ deducted those royalty pay-

ments as ordinary and necessary business expenses,

see 26 U.S.C. § 162, thereby reducing the amount of

its federal taxable income. Because federal taxable

income is the starting point for the calculation of tax-

able income in Alabama, see § 40-18-33, Ala. Code

1975, the deduction of those royalty payments as

business expenses also served to reduce VF.J’s tax-

able income in Alabama. Thus, the royalty payments

10a

VFJ made to Lee and Wrangler for the use of their

trademarks in its operating facilities in Alabama and

other states worked to transfer funds out of this

state, which has a corporate income tax, to the Dela-

ware IMCOs, thereby ensuring that those royalty

payments could not be subjected to taxation on the

state level. In the 2000 tax year, the use of the prac-

tice of making royalty payments to the related-

member IMCQOs resulted in a total state-tax savings

for VFJ (for its total operations, not just those in

Alabama) of approximately $ 5.5 million. VFJ’s 2001

state-tax savings as a result of royalty payments to

the related-member IMCOs was approximately $ 6

million.

The payment of royalty fees to a related member

located in a jurisdiction that does not impose a state

corporate income tax works to avoid state taxation

only in states known as “separate-entity” or “sepa-

rate-reporting” states. In those states, including Ala-

bama, each entity in a corporate group that has

activity in the state must file a separate corporate

income-tax return in the state. The basis of taxation

is the amount of income earned within the state by

the individual corporate entity. In a_ separate-

reporting state, “each part of an affiliated group of

corporations is treated as a separate entity” for the

purpose of determining the amount of taxable income

to be apportioned to that state. E.g., Bridges v. Auto-

Zone Props., Inc., 900 So. 2d 784, 792 (La. 2005).

Other states allow a practice known as “combined

reporting,” pursuant to which a taxing state treats a

group of commonly owned companies, such as VF and

its subsidiaries, as a single taxpayer. In a combined-

reporting state, the incomes of the various members

of the group are combined and a formula is applied to

determine what portion of the entire group’s income

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is attributable to, and therefore taxable in, that state.

See Citizens Utils. Co. of Illinois v. Department of

Revenue, 111 Ill. 2d 32, 40, 488 N.E.2d 984, 987, 94

Ill. Dec. 737, 740 (1986) (containing a thorough dis-

cussion of the difference in the methods of taxatiori

of combined-reporting states and separate-entity

states). In combined-reporting states, transactions

between related members do not work to shift income

because all income from the various members of the

corporate group (including IMCQs) is included in the

determination of taxable income for that state.

The difference between combined-reporting states

and separate-entity states has been aptly illustrated

as follows:

“Intercompany arrangements of this type [IM-

COs] do not reduce state income taxes in ‘com-

bined reporting’ states, that is, states which re-

quire an affiliated group of corporations engaged

in a common enterprise (a ‘unitary business’),

part of which is conducted in the state, to file a

combined income tax return. In those states, the

[IMCO] ordinarily must be included in the com-

bined return, and the intercompany transactions

are eliminated. ...

“In ‘separate reporting’ states, that is, states in

which each corporation leven within a corporate

family} files a separate income tax return, a

number of state tax administrators have at-

tempted to tax the income of out-of-state [IM-

COs] that were not physically present in the

state but earned income from licensing intangi-

ble assets to related corporations that conducted

business in the state.”

12a

James A. Amdur, State Income Tax Treatment of In-

tangible Holding Companies, 11 A.L.R. 6th 543, 553

(2006).

As indicated earlier, Alabama is a separate-re-

porting state. Alabama requires certain adjustments

to the federal taxable-income amount in order to de-

termine the amount of state taxable income. § 40-18-

33, Ala. Code 1975. The Alabama Legislature created

one such adjustment when it enacted Act No. 2001-

1088, Ala. Acts 2001, which amended § 40-18-35, Ala.

Code 1975, to add subsection (b). Subsection (b) of

§ 40-18-35 is now referred to as Alabama’s “add-back”

statute.”

Alabama’s add-back statute restricts the deducti-

bility of certain intangible and interest expenses for

the purpose of calculating state taxable income. Al-

though Alabama’s add-back statute was enacted in

December 2001, the Aiabama Legislature specified

that the statute was effective “for all tax years beyin-

ning subsequent to December 31, 2000.” See Act No.

‘In addition to Alabama, the following separate-reporting

states also have add-back statutes: Arkansas, see Ark. Code

Ann. § 26-51-423(g)(1); Connecticut, see Conn. Gen. Stat. § 12-

218(c); District of Columbia, see D.C. Code § 47-18035.02; Geor-

gia, see Ga. Code Ann. § 48-7-28.3; Illinois, see 35 Ill. Comp.

Stat. 5/203(a)(2); Indiana, see Ind. Code § 6-3-2-20; Kentucky,

see Ky. Rev. Stat. Ann. § 141.205; Maryland, see Md. Code Ann.,

Tax-Gen. § 10-306.1; Massachusetts, see Mass. Gen. Laws ch.

63, § 311; Michigan, see Mich. Comp. Laws § 208.1201; Missis-

sippi, see Miss. Code Ann. § 27-7-17; New Jersey, see N.J. Stat.

Ann. § 54:10A-4.4; New York, see N.Y. Tax Law § 208; North

Carolina, see N.C. Gen. Stat. § 105-130.7A; Ohio, see Ohio Rev.

Code Ann. § 5733.042: South Carolina, see S.C. Code Ann. § 12-

6-1130; Tennessee, see Tenn. Code Ann. § 67-4-2006(b); and

Virginia, see Va. Code Ann. § 58.1-402(B).

l3a

2001-1088, § 10. Therefore, the add-back statute ap-

plied to the 2001 tax year.

Alabama’s add-back statute provides, in relevant

part:

“(b) Restrictions on the deductibility of certain

intangible expenses and interest expenses with a

related member.

“(1) For purposes of computing its taxable in-

come, a corporation shall add back otherwise de-

ductible interest expenses and costs and intangi-

ble expenses and costs directly or indirectly paid,

accrued, or incurred to, or in connection directly

or indirectly with one or more direct or indirect

transactions, with one or more related members,

except to the extent the corporation shows, upon

request by the commissioner, that the corre-

sponding item of income was in the same taxable

year: a. Subject to a tax based on or measured by

the related member’s net income in Alabama or

any other state of the United States, or b. subject

to a tax based on or measured by the related

member’s net income by a foreign nation which

has in force an income tax treaty with the United

States, if the recipient was a ‘resident’ (as de-

fined in the income tax treaty) of the foreign na-

tion. For purposes of this section, ‘subject to a tax

based on or measured by the related member's

net income’ means that the receipt of the pay-

ment by the recipient related member is reported

and included in income for purposes of a tax on

net. income. and not offset or eliminated in a

combined or consolidated return which includes

the payor.

l4a

“(2) The corporation shall make the adjust-

ments required in subdivision (1) unless the

corporation establishes that the adjustments are

unreasonable, or the corporation and the Com-

missioner of Revenue agree in writing to the

application or use of alternative adjustments and

computations. Nothing in this section shall be

construed to limit or negate the commissioner’s

authority to otherwise enter into agreements and

compromises otherwise allowed by law.

“(3) The adjustments required in subdivision

(1) shall not apply to that portion of interest ex-

penses and costs and intangible expenses and

costs if the corporation can establish that the

transaction giving rise to the interest expenses

and costs or the intangible expenses and costs

between the corporation and the related member

did not have as a principal purpose the avoidance

of any Alabama tax and the related member is

not primarily engaged in the acquisition, use,

licensing, maintenance, management, ownership,

sale, exchange, or any other disposition of intan-

gible property, or in the financing of related enti-

ties. If the transaction giving rise to the interest

expenses and costs or intangible expenses and

costs, as the case may be, has a substantial busi-

ness purpose and econumic substance and con-

tains terms and conditions comparable to a

similar arm’s length transaction between unre-

lated parties, the transaction will be presumed to

not have as its principal purpose tax avoidance,

subject to rebuttal by the Commissioner of the

Department of Revenue.”

§ 40-18-35(b).

15a

Thus, Alabama’s add-back statute requires that a

corporation add back into its taxable income expenses

and costs related to intangibles such as trademarks

that are paid to a related member. In this case, the

Department contends that, subject to § 40-18-35(b),

the royalty payments VFJ made to Lee and Wrangler

during the 2001 tax year must be added to VFJ’s fed-

eral taxable income for the purpose of calculating

VFJ’s taxable income in Alabama.

It is undisputed that the royalty payments VFJ

made to Lee and Wrangler in 2001 for the use of the

IMCOs’ trademarks were the type of intangible ex-

penses referenced in Alabama’s add-back statute.

VFJ deducted those royalty payments from its federal

taxable income, and, therefore, those deductions

flowed through to the starting point of corporate net

income subject to taxation in Alabama. Accordingly,

unless one of the three exceptions set forth in § 40-

18-35(b)(1), (2), or (3), applies, Alabama’s add-back

statute requires that those deductions for intangible

expenses paid to the related IMCOs be added back

into the calculation of VFJ’s taxable income for Ala-

bama.

In calculating and paying its Alabama corporate

income tax for the 2001 tax year, VFJ did not add

back into the calculation of its taxable income the in-

tangible expenses required to be added by Alabama’s

add-back statute. The Department conducted an au-

dit of VFJ’s corporate tax return for the 2001 tax

year. Thereafter, the Department issued a notice of

final assessment to VFJ, demanding payment of an

additional $1,019,899 in state taxes. The vast major-

ity of that assessment was attributable to the De-

partment’s inclusion, based on the add-back statute,

in the Department’s determination of VFJ’s taxable

16a

income of the royalty payments VFJ made to Lee and

Wrangler for the use of the trademarks of those IM-

COs. VFJ has challenged only the portion of the as-

sessment attributable to the add-back statute.

In the trial court, VFJ challenged that part of the

Department’s assessment that was based on the ap-

plication of the add-back statute. VFJ argued that

the add-back statute should not apply, based on cer-

tain exceptions contained in the statute. Specifically,

VFJ maintained that the royalty payments had been

subject to taxation in another jurisdiction, see § 40-

18-35(b)(1), and that the application of the add-back

statute was unreasonable because the royalty pay-

ments to Lee and Wrangler had a legitimate business

purpose ana economic substance, see § 40-18-35(b)(2).

VFJ also challenged the constitutionality of Ala-

bama’s add-back statute. The Department responded

and insisted that the assessment was valid. Later, in

its motion for a partial summary judgment, the De-

partment argued that VFJ’s argument regarding the

business purpose and economic substance of the IM-

COs was not relevant to a determination of unrea-

sonableness under § 40-18-35(b)(2).

The trial court received ore tenus evidence and

heard the arguments of the parties during a four-day

trial. In addition, each party submitted numerous

exhibits. Much of the evidence pertained to VFu’s at-

tempt to demonstrate that the Lee and Wrangler

IMCOs had legitimate business purposes and eco-

nomic substance, and, therefore, according to VFu’s

argument, application of the add-back statute would

be unreasonable. Some of the evidence presented at

the trial was summarized by the trial court in its

judgment as follows:

17a

“At trial, VFJ established several other pur-

poses [other than the avoidance of state taxation]

for segregating the ownership and management

of [VF’s] trademarks into the IMCQOs. Centraliza-

tion of trademarks increased efficiency by con-

centrating management in one group of employ-

ees instead of being spread throughout the

various operating subsidiaries around the world.

Centralization also allowed the employees to de-

velop the expertise necessary to maintain the

necessary registrations and monitor and combat

infringement worldwide. The centralization and

specialization also reduced duplicative efforts,

costs, and reliance on outside counsel, increasing

efficiency. VF was able to save at least $ 60,000

per month in fees paid to outside counsel when it

began its centralized trademark management.

“Centralization of trademark management al-

lowed third party licensing efforts to be coordi-

nated and managed. It also allowed easier moni-

toring of expenses and revenues associated with

the intangible assets. Furthermore, centraliza-

tion of intangible property was also part of a

larger effort by [VF] in the 1990s to begin

sharing common services (such as data process-

ing, information technology, payroll, treasury,

employee benefits and legal services) to capital-

ize on economies of scale.

“The parties vigorously disputed at _ trial

whether segregation of the different families of

trade-marks into different IMCOs facilitated the

ease of sale of VF companies or lines of business.

I find that the evidence established that in VF's

history of both selling and purchasing several

lines of business, such sales were facilitated by

18a

having the intangibles owned by an IMCO,

thereby avoiding the need to transfer and assign

each trademark, which could require thousands

of assignments and filings around the world. VF

in fact sold two IMCQs, Healthtex Apparel Corp.,

and Jantzen Appa:el Corp., to third party

purchasers in recent years and found that the

IMCO structure facilitated the transfer of the

intangibles.

“Segregating the intangible assets into sepa-

rate management companies provided a more

flexible business structure in other ways as well.

For example, this structure would give the

affiliated group more options in the case of a

hostile takeover. It also became easier for the

affiliated group to borrow money when it could

demonstrate that the I[MCOs had valuable assets

as potential collateral and steady streams of in-

come, without potential for unforeseen liabilities.

The use of several different IMCOs ensured clean

title to the different families of trademarks, and

segregated the liabilities of the operating compa-

nies from the very valuable intangible assets. It

also made it easier to track the profitability of

the different families of trademarks.

“There were also several advantages to incor-

porating the IMCOs in Delaware. Delaware has

advanced and favorable corporate law, and the

U.S. District Court of Delaware has developed a

specialty in intellectual property law. Delaware

has an experienced workforce with experienced

service providers in the intellectual property

area.

“[VFJ] did an excellent job during the course

of this trial convincing the Court that Lee and

19a

Wrangler are not merely ‘shell’ corporations, but

carry on substantial activities. The Court had the

benefit of watching a videotape which set out the

entire operation in Delaware. They had 3,200

square feet of office space in Wilmington, Dela-

ware. Lee currently has at least fifteen employ-

ees, including two trademark attorneys, six

trademark paralegals, one licensing paralegal,

three trademark assistants, controller, staff

accountant, and receptionist. These employees

perform work for Wrangler as well. There was no

question that this is a ‘working office,’ not just an

empty space with a post office box.

“The [IMCO] employees monitor and maintain

thousands of trademark registrations throughout

the world. They license trademarks to VF affili-

ates like VFJ and also to numerous third parties.

In 2001, approximately 22% of Lee’s royalty

income and 3.2% of Wrangler’s royalty income

were derived from third parties. Helen Winslow,

assistant general counsel of Lee, reviews license

applications from third parties and has _ the

authority to turn down a license application from

a potential licensee « 10se products might tar-

nish a brand’s image wu: raise liability issues. Ms.

Winslow can and often does require a test period

for a new licensee or grant a license only in a

certain geographic territory. Ms. Winslow en-

gages in negotiations with the licensee, licensee’s

counsel, and usually a representative from a VF

manufacturing company in order to set the ternis

of the license. Ms. Winslow, a past president of

the Delaware State Bar Association, does not

merely rubber stamp any paper brought to Lee

by a related company.

20a

“The IMCOs generally charged the same arm’s-

length rates for intercompany license agreements

as third-party license agreements. The general

rule was a flat 5% license or royalty fee, as

determined by industry standards.

“... The IMCOs then negotiated with poten-

tial licensees in order to ensure the quality stan-

dards were sufficiently high that the licensees’

use of the trademarks would not harm their

value. If the standards were acceptable, the

IMCO adopted those quality standards for the

license; if the potential licensee would not agree

to sufficiently high quality standards, no license

was granted.

“In order to ensure compliance with the stan-

dards, the IMCOs entered into ‘Technical Assis-

tance and Know-How Agreements’ with related

VF manufacturing companies. In these agree-

ments, the manufacturing entity agreed to pro-

vide certain technical assistance to the entities

to which the IMCOs licensed particular trade-

marks. The assistance included provision of

technical know-how and expertise with respect to

the design, manufacture, quality control, promo-

tion, marketing and distribution of the branded

products. In exchange, the IMCOs reimbursed

the manufacturing company for all costs associ-

ated with such consulting plus 5%.

“The IMCOs monitored all licenses, both VF

and third-party, for proper trademark usage.

In addition, the IMCOs hired third parties to

investigate licensees’ factories and ensured that

the affiliated group’s centralized audit group

also investigated factories for quality control.

The inspection program also ensured proper

2la

quality control over the goods manufactured by

[the] licensees.

“Lee and Wrangler also engaged in monitoring

for potential trademark infringements. The IMCO

staff received and reviewed ‘watch service’

reports daily to monitor for trademark applica-

tions claiming rights in trademarks that resem-

bled Lee’s or Wrangler’s trademarks. They also

reviewed weekly the Official Gazette, a publica-

tion of the U.S. Patent and Trademark Office

that lists all approved trademark applications. If

an IMCO discovered a potential infringement, it

took steps to protect its trademarks, including

filing court proceedings against the potential

infringers if necessary.

“VFJ entered into license agreements with Lee

and Wrangler that governed the licensing ar-

rangement; these agreements contained terms

comparable to those in the IMCOs’ agreements

with third parties. There is no dispute that the

5% royalty rate was an arm’s length rate.

Pursuant to these license agreements, VFJ paid

royalties in cash to Lee and Wrangler for the use

of their trademarks based on the amount of

VFJ’s sales. VFJ transferred cash to Lee and

Wrangler when making royalty payments.”

In addition to the foregoing, VFJ presented the tes-

timony of Professor Richard Pomp, an expert witness

in the area of state and local taxation, who testified

that there are no add-back statutes of which he ap-

proves. He characterized Alabama’s add-back statute

as “overbroad [and] overreaching.” Pomp testified

that royalties on intangibles are business expenses

that should be deducted in determining taxable in-

come regardless of whether the royalty payments are

22a

made to a related-member company. In Pomp’s opin-

ion, the appropriate inquiry in determining whether

the application of an add-back statute is unreason-

able is whether the deduction is truly one for a le-

gitimate or ordinary and necessary business expense.

According to Pomp, the determination of whether it

is unreasonable to require a corporation to comply

with the add-back statute should focus on whether

there is a legitimate business purpose or economic

substance to the royalty-payment transactions. On

cross-examination, Pomp acknowledged that states

have other methods of preventing those deductions

that lack a legitimate business purpose or economic

substance, also known as “sham” deductions. There-

fore, Pomp also conceded that add-back statutes are

not limited to the prevention of sham deductions.

The Department presented the testimony of wit-

nesses who spoke in support of the add-back statute.

Dr. Alan Shapiro, a professor of finance at the Uni-

versity of Southern California, testified ¢::at add-back

statutes attempt to “cure some of the distortions”

that arise in separate-reporting states because

of transactions between related corporations. Dr.

Shapiro explained that Alabama operating companies

add value to their products through the use of intan-

gibles for which royalties are paid and that the add-

back statute is an attempt to allocate some of that

value or income to Alabama.

Peter Enrich, a law professor from Northeastern

University who specializes in state and local taxa-

tion, testified that add-back statutes are not designed

to address the issue of sham deductions. Enrich

stated that he believed that unreasonableness excep-

tions to add-back statutes, such as the one in § 40-18-

35(b)(2), are designed to avoid situations in which the

23a

resultant tax on the corporation would be out of pro-

portion to the corporation’s activity in the taxing

state.

Joe Garrett, the Department’s administrator of tax

policy, testified that in August 2003 the Department

adopted a regulation (“the add-back regulation”) that

interprets the provisions of the add-back statute. See

Rule 810-3-35-.02, Ala. Admin. Code (Department of

Revenue). In essence, that regulation, in part, inter-

prets the unreasonableness exception to apply when

there is “no fair relation” to the corporate taxpayer’s

activities in Alabama. It is undisputed, however, that

the add-back regulation does not apply to this case

because it was adopted by the Department after this

dispute arose.

Garrett’s testimony indicated that on numerous oc-

casions during the 14-month interim between the De-

cember 2001 enactment of the add-back statute and

the August 2003 adoption of the add-back regulation,

the Department had granted exceptions pursuant to

§ 40-18-35(b)(2). Garrett explained that the Depart-

ment had granted exceptions both on the basis of the

unreasonableness exception to the add-back statute

and as an alternative adjustment by the commis-

sioner. See § 40-18-35(b)(2). Garrett testified that a

large number of taxpayers had sought to avoid the

add-back statute by asserting that the unreasonable-

ness exception set forth in subsection (b)(2) applied to

the transactions at issue because of business purpose

or economic substance and that the Department has

denied those requests.

According to Garrett, the Department has applied

the unreasonableness exception to those situations in

which a corporation’s tax as a result of the applica-

tion of the add-back statute would be “out of propor-

24a

tion with what could reasonably be said to be attrib-

uted to the State.” Garrett stated that the add-back

regulation was formulated in response to questions

concerning the interpretation of the add-back statute.

Garrett testified that the provisions of the add-back

regulation pertaining to the unreasonableness excep-

tion were consistent with the interpretation the De-

partment had followed from the date the add-back

statute was enacted. Garrett also stated that the

adoption of the add-back regulation had not resulted

in a change in the manner in which the Department

had interpreted or applied the unreasonableness ex-

ceptien to the add-back statute.’

VFJ also presented expert testimony to support its

claim that the subsection (b)(1) exception, known as

the “subject-to-tax exception,” of the add-back statute

exempted it from the statute’s application. That evi-

dence is set forth in the section of this opinion ad-

dressing VFJ’s claim with regard to the subject-to-tax

exception.

* Garrett testified, in part:

“[GARRETT:} Well, we—--we told our people—our people

meaning primarily our audit staff, people who reviewed

returns—from early on, as soon as returns came in with

the add-back issues on them, particularly with regard to

the exceptions we're talking about here today, what our

interpretation was.

“THE COURT: Right.

“[GARRETT:] . . . . And at least with respect to the

unreasonableness exception, that business purpose,

economic substance, arm’s length pricing was not enough.

“THE COURT: Okay.

“{(GARRETT:] And so we didn’t really -we didn’t have to go

backward and do anything differently after the reg came

about.”

25a

Judgment

In its judgment, the trial court concluded that the

unreasonableness exception to the add-back statute

contained at § 40-18-35(b)(2) applied, and, therefore,

it reversed the Department’s assessment. In con-

cluding that the add-back statute did not apply be-

cause the unreasonableness exception disposed of the

case, the trial court found it unnecessary to resolve

VFJ’s claim regarding the subject-to-tax exception

found in § 40-18-35(b)(1) and VFJ’s constitutional

challenges to the add-back statute.’ The Department

timely appealed.

* We conclude that the trial court’s judgment is final. The

trial court disposed of the case based on one of the exceptions to

the add-back statute claimed by VFJ; accordingly, it was unnec

essary for it to address the other claimed exception. The trial

court was not required to address the constitutional challenges

VFJ had asserted, because, once the trial court had ruled in fa-

vor of VFJ on another basis, it was not necessary to reach the

constitutional issues. Our supreme court has explained:

““A court has a duty to avoid constitutional questions

unless essential to the proper disposition of the case.” Lowe

v. Fulford, 442 So. 2d 29, 33 (Ala. 1983) (quoting trial

court’s order citing Doughty v. Tarwater, 261 Ala. 263, 73

So. 2d 540 (1954); Moses v. Tarwater, 257 Ala. 361, 58 So.

2d 757 (1952); and Lee v. Macen County Bd. of Educ., 231

F. Supp. 743 (M.D. Ala. 1964)). “Generally courts are

reluctant to reach constitutional questions, and should not

do so, if the merits of the case can be settled on non-

constitutionai grounds.” Lowe, 442 So. 24 at 33 (quoting

trial court’s order citing White v. U.S. Pipe & Foundry Co.,

646 F.2d 203 (5th Cir. 1981)). “No matter how much the

parties may desire adjudication of important questions of

constitutional law, broad considerations of the appropriate

exercise of judicial power prevent|] such determinations

unless actually compelled by the litigation before the

court.” Lowe, 442 So. 2d at 33 (quoting trial court’s order

26a

As an initial matter, this court must resolve a con-

flict in the manner in which the parties interpret the

trial court’s judgment. In making its arguments to

this court, the Department asserts that the trial

court’s judgment was based on a finding that the ap-

plication of the add-back statute would be unreason-

able because the royalty payments to the IMCOs had

a business purpose and an economic substance. In

contrast, VFJ contends that the trial court based its

judgment on a determination that the application of

the add-back statute would result in a distortion of

VFJ’s income attributable to Alabama.

In reaching its legal conclusions, the trial court

stated, in pertinent part:

“Because add-back in VFJ’s circumstances effec-

tively denies it a deduction for a necessary cost of

doing business in Alabama, thereby resulting in

a calculation of taxable income that includes in-

come fairly attributable to other states, add-back

is unreasonable and thus not required for VFJ.

“States have rightfully been concerned about

taxpayers taking advantage of IMCO structures

by setting up ‘shell’ or ‘sham’ corporations in low-

tax jurisdictions such as Delaware or Nevada or

several other states and shifting substantial por-

tions of their income to low-tax jurisdictions

without any real business activity taking place in

those other states. See, e.g., Syms Corp. v. Com-

missioner of Revenue, 436 Mass. 505, 765 N.E.2d

758 (Mass. 2002). In response to taxpayers gen-

erating large deductions from these sham or

citing Troy State Univ. v. Dickey, 402 F.2d 515 (5th Cir.

1968)).”

Chism v. Jefferson County, 954 So. 2d 1058, 1063 (Ala. 2006).

27a

shell corporations, several states passed statutes

intended to deny taxpayers tax benefits from

these sham corporations. Alabama’s add-back

statute is one of these statutes.

“Lee and Wrangler, however, are not sham or

shell corporations. There were several business

purposes for their creation and continued viabil-

‘ty. They carry on substantial activities that are

vital to the business operations of the VF group.

VFJ had a business purpose for making the roy-

alty payments—it needed the use of these valu-

able trademarks in its operations. The payments

also had economic substance—they were made in

cash and conferred on VFJ the right to use the

trademarks.

“Deductions for the cost of doing business are

an essential part of any tax on net income.

Recognizing this, Alabama has long allowed

deductions for ‘the expenses of carrying on such

business.’ Subdivision 5, § 454, Code of Alabama

‘1886). Alabama encourages such deductions for

ordinary and necessary business expenses, ‘(t]he

theory being, presumably, that the spending of

money to make money should be encouraged to

the end that taxes will be paid on the net accom-

plished.’ Boswell v. Bonham, 53 Ala. App. 54, 297

So. 2d 379 (Ala. Civ. App. 1974).

“An expense is an ‘ordinary’ business expense

when it is normal, common, and accepted under

the circumstances by the business community.

Welch v. Helvering, 290 U.S. 111, 113-115, 54 S.

Ct. 8, 78 L. Ed. 212, 1933-2 C.B. 112 (1933). The

testimony revealed that payment of royalties to

IMCOs (both related and non-related) is normal,

common, and accepted in the business commu-

28a

nity. An expense is a necessary business expense

when it is ‘appropriate and helpful’ in developing

the taxpayer’s business. Welch v. Helvering, 290

U.S. [at] 113... (also noting that courts ‘should

be slow to override [the taxpayer’s] judgment’ as

to whether an expense is ‘necessary’). The royalty

payments made by VFJ in 2001 were thus ordi-

nary and necessary in its business, giving VFJ

the right to manufacture jeanswear with the

valuable Lee and Wrangler trademarks.

“Unreasonable’ is not defined in the statute; it

thus should be interpreted in accordance with

the legislature’s intent in enacting the statute.

State Dep’t of Revenue v. Amerada Hess Corp,

788 So. 2d 179 (Ala. Civ. App. 2000). Since the

purposes of the add-back statute are to prevent

abusive deductions and to ensure that income

fairly attributable to Alabama is taxed in Ala-

bama, it is unreasonable to require add-back

when these purposes would be frustrated by add-

back. Add-back is unreasonable in VFJ’s case be-

cause VFJ’s royalty payments are not abusive—

they have economic substance and business pur-

pose—and represent real and necessary costs of

doing business in Alabama, and to disallow these

deductions would distort the amount of VF J's in-

come fairly attributable to this state.

“Accordingly, considering the language and

purpose of the add-back statute, Alabama public

policy allowing deductions for business expenses

in determining net income, and the particular

facts of this case, I find that it would be ‘unrea-

sonable’ to require add-back to VFJ’s royalty

payments.”

(Emphasis added. )

29a

After reviewing the legal conclusions in the trial

court’s judgment, we agree with the Department’s

characterization of the nature of the trial court’s de-

termination with regard to the unreasonableness ex-

ception to the add-back statute. The trial court’s

judgment sets forth a finding that VFJ’s income

would be distorted by the application of the add-back

statute. However, the language of the judgment indi-

cates that the trial court interpreted the unreason-

ableness exception as being largely dependent on

whether there 1s business purpose or economic sub-

stance to the royalty-payment transactions. Specifi-

cally, the judgment indicates that the trial court con-

cluded that so long as a plausible business purpose

for the royalty payments exists or the royalty deduc-

tions are not abusive, any refusal to allow the deduc-

tion for those royalty payments would result in a dis-

tortion of VFJ’s income attributable to Alabama.

As further support for this conclusion, it should be

noted that other than some very general testimony,

VFJ presented no evidence tending to support a

finding that the application of the add-back statute

would distort its income attributable to Alabama.

VFJ has asserted generally that disallowing the de-

duction for royalty payments to a related member

distorts its income by not allowing it to deduct that

expense as an ordinary and necessary cos. vu. doing

business in Alabama. As discussed later in this opin-

ion, however, states may fashion their own income-

tax formulas and are not required to grant all the de-

ductions allowed by the federal taxing scheme. VFJ

did not challenge the Department’s calculation of the

amount of income to be added back under § 40-18-

35(b), nor did it present any evidence tending to sup-

port a conclusion that the amount of tax resulting

from the application of the add-back statute would

30a

result in its paying an amount of tax disproportionate

to its presence and operations in Alabama. Thus, the

trial court’s finding that the application to VFJ of the

add-back statute would “distort the amount of VFJ’s

income fairly attributable to this state” is based upon

its interpretation of the general effect of the applica-

tion of the add-back statute. We next address the ar-

guments presented by the parties with regard to the

unreasonableness exception of the add-back statute,

which exception is set forth at § 40-18-35(b)(2), Ala.

Code 1975.

The Unreasonableness Exception

The Department raises several arguments on ap-

peal to support its contention that the trial court

erred in interpreting the unreasonableness exception

to Alabama’s add-back statute. It contends that the

trial court’s interpretation of the unreasonableness

exception found in § 40-18-35(b)(2) effectively nulli-

fies another exception to the add-back statute, spe-

cifically the exception contained in subsection (b)(3).

The Department also contends that the trial court’s

interpretation of the unreasonableness exception

renders the add-back statute itself ineffective by

giving it no field of operation, or, phrased another

way, that the trial court’s interpretation allows the

exception to “swallow the add-back rule.”

As mentioned earlier in this opinion, the un-

reasonableness exception to the add-back statute

provides, in pertinent part, that the costs or expenses

related to intangibles owned by related-member cor-

porations are to be added back into the calculation of

taxable income “unless the corporation establishes

that the adjustments are unreasonable ... .” § 40-18-

35(b)(2). The term “unreasonable” is not defined in

the article governing income taxation contained in

3la

the Alabama Code. Our general rule of statutory in-

terpretation is that the commonly accepted definition

of a term should be used when the legislature enacts

legislation that fails to define the term therein. Our

supreme court has explained:

“It is this Court’s responsibility to give effect to

the legislative intent whenever that intent is

manifested. State v. Union Tank Car Co., 281

Ala. 246, 248, 201 So. 2d 402, 403 (1967). When

interpreting a statute, this Court must read the

statute as a whole because statutory language

depends on context; we will presume that the

Legislature knew the meaning of the words it

used when it enacted the statute. Ex parte Jack-

son, 614 So. 2d 405, 406-07 (Ala. 1993). Addi-

tionally, when a term is not defined in a statute,

the commonly accepted definition of the term

should be applied. Republic Steel Corp. v. Horn,

268 Ala. 279, 281, 105 So. 2d 446, 447 (1958).

Furthermore, we must give the words in a stat-

ute their plain, ordinary, and commonly under-

stood meaning, and where plain language is used

we must interpret it to mean exactly what it

says. Ex parte Shelby County Health Care Auth.,

850 So. 2d 332 (Ala. 2002).”

Bean Dredging, L.L.C. v. Alabama Dep’t of Revenue,

855 So. 2d 513, 517 (Ala. 2003).

The term “unreasonable” has been defined as “[n]ot

guided by reason; irrational or capricious,” see Black’s

Law Dictionary 1574 (8th ed. 2004), and as “not gov-

erned by or acting according to reason” or “exceeding

the bounds of reason or moderation,” Merriam-Web-

ster’s Collegiate Dictionary 1371 (11th ed. 2003).

32a

The add-back regulation has established guidelines

for determining whether the “unreasonableness” ex-

ception applies. In essence, that regulation specifies

that the application of the add-back statute will be

deemed “unreasonable” when the tax resulting from

the application of the statute has no “fair relation” to

or is out of proportion to the corporation’s activities in

Alabama.° The add-back regulation does not apply to

this case because it was not in effect at the time this

dispute arose. However, the fact that the add-back

regulation does not apply does not mean that we

should disregard the Department’s interpretation of

the provisions of the add-back statute during the pe-

riod between the enactment of the add-back statute

and the adoption of the add-back regulation.

The Departnient’s interpretation of the add-back

statute is entitled to deference. See Farmer v. Hypo

Holdings, Inc., 675 So. 2d 387, 390 (Ala. 1996) (“[A]n

interpretation placed on a statute by an adminis-

* With regard to the unreasonableness exception to Alabama’s

add-back statute, the add-back regulation specifies:

“(h) The [add-back statute] will be considered unreasonable

if:

“1. The taxpayer establishes that, based on the entirety

of the taxpayer’s particular facts and circumstances, the

adjustments have increased the taxpayer’s Alabama

income tax lability to an amount that bears no fair

relation to the taxpayer’s Alabama presence, or

“2. The taxpayer establishes that the interest or intangi-

ble expense was paid to a related member that passed

through the interest or intangible payment via a

corresponding interest or intangible expense payment to

an unrelated third party... .”

Rule 810-3-35-.02(3)(h), Ala. Admin. Code (Department of

Revenue).

33a

trative agency charged with its enforcement will be

given great weight and deference by a reviewing

court.”). The deference to be afforded the De-

partment’s interpretation of the add-back statute is

based on the Department’s expertise in the area of

taxation. Hamrick v. Alabama Alcoholic Beverage

Control Bd., 628 So. 2d 632, 633 (Ala. Civ. App.

1993). “[W]hen the highest administrative officials

charged with the duty of administering the tax

laws have construed a tax statute, their construction

should be given favorable consideration.” Bean

Dredging, L.L.C. v. Alabama Dep’t of Revenue, 855

So. 2d at 517.

“{I]t is well established that in interpreting a

statute, a court accepts an administrative inter-

pretation of the statute by the agency charged

with its administration, if that interpretation is

reasonable. Ex parte State Dep’t of Revenue, [683

So. 2d 980 (Ala. 1996)] (citing Alabama Metal-

lurgical Corp. v. Alabama Pub. Serv. Comm’n,

441 So. 2d 565 (Ala. 1983)). Absent a compelling

reason not to do so, a court will give great weight

tou an agency’s interpretations of a statute and

will consider them persuasive. Ex parte State

Dep’t of Revenue, supra (citing Moody v. Ingram,

361 So. 2d 513 (Ala. 1978)).”

State v. Pettawa,;. 794 So. 2d 1153, 1157 (Ala. Civ.

App. 2001).

The undisputed evidence presented by the De-

partment indicates that the Department had previ-

ously interpreted the “unreasonableness” exception in

the manner now set forth in the add-back regulation.

Garrett’s testimony indicated that even before the

adoption of the add-back regulation, the Department

had consistently interpreted the unreasonableness

34a

exception as applying when the resulting tax would

be “out of proportion” to the corporation’s presence in

Alabama. He further testified that on many occasions

before the adoption of the add-back regulation, the

Department, in evaluating a taxpayer corporation’s

claim that the add-back statute was unreasonable

under subsection (b)(2), had refused to consider

whether the transactions paid to a related company

had a legitimate business purpose or economic sub-

stance. Thus, the Department has consistently inter-

preted the unreasonableness exception as not being

determined by business purpose or economic sub-

stance. Further, the foregoing demonstrates that the

interpretation of the unreasonableness exception the

Department implemented even before the adoption of

the add-back regulation 1s consistent with the com-

monly accepted definition of the term “unreasonable,”

i.e., exceeding reasonable limits or clearly excessive.

See Bean Dredging, L.L.C. v. Alabama Dep’t of Reve-

nue, supra. The remainder of the Department’s ar-

guments with regard to the unreasonableness excep-

tion strengthen the presumption in favor of its

interpretation of that exception.

The Department argues that to interpret the un-

reasonableness exception as based almost exclusively

on a determination of whether transactions pertain-

ing to intangibles between related companies have a

business purpose or economic substance would pro-

vide the add-back statute with little, if any, field of

operation other than to disallow sham deductions.

The Department insists that the add-back statute

was not enacted in order to address the problem of

deductions based on sham transactions, 1.e., those

transactions that lack a legitimate business purpose

or economic substance. The evidence presented at

trial referenced on several occasions an example of a

35a

classic sham royalty-payment transaction. In that

situation, a parent company creates a corporation to

which royalty payments or licensing fees are paid.

The sham corporation has no employees or business

office; its sole function is to receive licensing fees or

royalty payments from a related member. Because

the sham corporation is located in a state in which

that royalty income would not be subject to corporate

income tax, the payments escape state taxation.

The parties did not dispute that both before and af-

ter the enactment of the add-back statute, Alabama

could, without resorting to the add-back statute, in-

vestigate and refuse to grant deductions such as

those just described on the basis that payments made

to sham corporations did not have a legitimate busi-

ness purpose or economic substance. As indicated

earlier, the starting point for determining a corpora-

tion’s taxable income in Alabama is the amount of

federal taxable income. Under the Internal Revenue

Code, a deduction is allowed for all “ordinary and

necessary expenses paid or incurred during the tax-

able year in carrying on any trade or business.” 26

U.S.C. § 162(a). Alabama can challenge a sham de-

duction as being not “ordinary and necessary” under

26 U.S.C. § 162. See § 40-18-33, Ala. Code 1975 (“In

the case of a corporation... , the term ‘taxable in-

come’ means federal taxable income without the

benefit of federal net operating losses plus the addi-

tions prescribed and less the deductions and adjust-

ments allowed by this chapter and as allocated and

apportioned to Alabama.”); see also Baisch v. De-

partment of Revenue, 316 Ore. 203, 850 P.2d 1109

(1993). The parties do not dispute the Department’s

power to contest sham transactions in this manner,

and at trial, all the witnesses who were asked about

this matter confirmed that Alabama has the power to

36a

challenge sham transactions without reference to the

add-back statute.

Given the foregoing, it seems unlikely that the

legislature intended the add-back statute to address

the problem of sham transactions, a problem that

may be addressed in the absence of an add-back stat-

ute. It e!so seems unlikely that in enacting the add-

back statute the Alabama Legislature was attempt-

ing to create a new method by which it could chal-

lenge sham transactions. Rather, the courts should

assume that in enacting the add-back statute the

legislature had in mind « different purpose and field

of operation.

“This court notes that a statute is presumed to

have been enacted with a meaningful purpose.

Adams v. Mathis, 350 So. 2d 381, 385-86 (Ala.

1977). “The legislature wil! not be presumed to

have done a futile thing in enacting a statute.”

Ex parte Watley, 708 So. 2d 890, 892 (Ala.

1997).””

Board of School Comm’rs of Mobile County v. Biggs,

939 So. 2d 942, 945 (Ala. Civ. App. 2006) (quoting

State v. Pettaway, 794 So. 2d at 1156).

The title to Act No. 2001-1088, which, in part, cre-

ated the add-back statute, indicates that the legisla-

ture intended, among other things, to “disallow de-

ductions for certain payments for intangible property

(patents and copyright) and interest expense to re-

lated entities” and “to waive certain interest and

penalties ... and the add back of certain interest

and intangible expenses.” That statement of legisla-

tive purpose does not mention any intent to address

the issue of sham or fraudulent transactions or de-

ductions.

37a

Rather, in enacting the add-back statute, the leg-

islature evidenced its intent to eliminate, subject to

certain exceptions, one type of deduction for ordinary

and necessary business exceptions. A state, subject to

constitutional limitations, may fashion its own taxing

scheme. In doing so, a state is not required to use the

same deductions the federal-taxation scheme allows.

“{A] statutory tax deduction or exemption is a matter

of legislative grace.” Ex parte State Dep’t of Revenue,

441 So. 2d 598, 601 (Ala. 1983). In enacting the add-

back statute, the Alabama Legislature elected not to

extend its “grace” to deductions for transactions be-

tween related entities involving royalty payments for

intangible assets. Under the general rules of statu-

tory interpretation, which provide that a statute ic

presumed to have a meaningful purpose, we conclude

that Alabama’s add-back statute was intended to

have the purpose set forth by the legislature in Act

No. 2001-1088. Such an interpretation affords the

add-back statute both a meaningful purpose and a

field of operation.

Each of the exceptions to the add-back statute

should also be interpreted as having a meaningful

purpose and effect. ““There is a presumption that

every word, sentence, or provision [of a statute] was

intended for some useful purpose, has some force and

effect, and that some effect is to be given to each, and

also that no superfluous words or provisions were

used.””” Ex parte Uniroyal Tire Co., 779 So. 2d 227,

236 (Ala. 2000) (quoting Sheffield v. State, 708 So. 2d

899, 909 (Ala. Crim. App. 1997)).

Section 40-18-35(b)(3) provides an exception when

the corporation can establish, first, that the pay-

ments to the related-member IMCO did not have as

their primary purpose the avoidance of state taxa-

38a

tion, and, second, that the related member to whom

the payment was made was not engaged primarily in

managing intangible assets. The § 40-18-35(b)(3) ex-

ception specifies that a transaction will be presumed

not to have tax avoidance as its primary purpose if

the transaction has a substantial business purpose or

economic substance. “ee § 40-18-35(b)(3), Ala. Code

1975. However, in order for the existence of a busi-

ness purpose or economic substance to be relevant,

there must also be a showing that the related entity

to which the transaction is paid does not have the

management of intangible assets as its primary busi-

ness purpose. § 40-18-35(b)(3).

In this case, VFJ did not seek an exception from

the add-back statute under subsection (b)(3). Lee and

Wrangler, the related members to whom VFJ made

its royalty payments, are undisputedly engaged pri-

marily in managing intangible assets, as specified in

§ 40-18-35(b)(3), so that subsection could not apply to

the facts of this case. However, the trial court seems

to have focused on the first part of the subsection

(b\(3) exception in determining that the application of

the add-back statute in this case was unreasonable

because the royalty-payment transactions had a sub-

stantial business purpose or economic substance. In-

terpreting the unreasonableness exception of subsec-

tion (b)(2) in that manner, however, nullifies the

effect of the subsection (b)(3) exception by eliminating

the need for that exception. As the Department

points out, the trial court’s interpretation “would en-

sure that the [unreasonableness exception in § 40-18-

35(b)(2) would] apply in every case in which the (b)(3)

exception might apply.” In other words, to construe

the unreasonableness exception in subsection (b)(2)

as requiring only a showiny of a business purpose or

economic substance would effectively render ineffec-

39a

tive the exception set forth in § 40-18-35(b)(3), which

requires a similar showing as well as a showing that

the related company to whom the payment is made

does not manage an intangible asset. We must pre-

sume that the legislature did not, in enacting subsec-

tion (b)(3), create a redundant exception to the add-

back statute. Ex parte Uniroyal Tire Co., supra (it

must be presumed the legislature did not intend to

enact a superfluous provision).

The rules of statutory construction require that

each statute or part thereof be given effect when pos-

sible. Ex parte Uniroyal Tire Co., supra. Accordingly,

in order for the unreasonableness exception to have

its own effect or field of operation that is not duplica-

tive of the subsection (b)(3) exception, the unreason-

ableness exception must be interpreted not to focus

on a showing of business purpose or economic sub-

stance.

The Department has interpreted the unreason-

ableness exception as being concerned with whether

the add-back statute results in taxation that is out of

proportion to the corporation’s activities in Alabama.

That interpretation, which was later formalized in

the add-back regulation, is consistent with the com-

mon-usage definitions of the term “unreasonable” as

“irrational,” “capricious,” or “exceeding the bounds of

reason or moderation.” Black's Law Dictionary 1574;

Merriam-Webster’s Collegiate Dictionary 1371. “Ab-

sent a compelling reason not to do so, a court will

give great weight to an agency’s interpretations of a

statute and will consider them persuasive.” State v.

Pettaway, 794 So. 2d at 1157 (citing Ex parte State

Dep’t of Revenue, 683 So. 2d 980 (Ala. 1996), citing in

turn Moody v. Ingram, 361 So. 2d 513 (Ala. 1978)).

VFJ has presented no “compelling reason” that leads

40a

this court to disagree with the arguments submitted

by the Department or its interpretation of the unrea-

sonableness exceptior to the add-back statute. Ac-

cordingly, we hold that the Department’s interprcta-

tion of the unreasonableness exception is appropriate

and is the correct interpretation that should govern

the disposition of this matter.

The parties have disputed only the interpretation

of the add-back statute. They did not present any

evidence regarding whether the facts of this case jus-

tify the application of the subsection (b)(2) exception

to the add-back statute. There is no specific evidence

showing a possible distortion of VFJ’s income if the

add-back statute is applied, and there is no evidence

indicating that the amount of tax to which VFJ is

subject under the add-back statute is out of propor-

tion to VFJ’s activities in Alabama. In other words,

the record does not demonstrate that the application

of the add-back statute to VFJ for the tax year in

question was unreasonable under the proper inter-

pretation of the exception in subsection (b)(2) of the

statute. Given the arguments and evidence pre-

sented, we must reverse that part of the trial court’s

judgment that concluded that the application of the

add-back statute to VFJ was unreasonable under

§ 40-18-35(b)(2),

It is well settled that an appellate court may affirm

a judgment if the judgment is correct for any reason,

even one not argued. Tucker v. Nichols, 431 So. 2d

1263, 1264-65 (Ala. 1983); see also Bay Lines, Inc. v.

Stoughton Trailers, Inc., 833 So. 2d 1013, 1017 (Ala.

2002); Boykin v. Magnolia Bay, Inc., 570 So. 2d 639,

642 (Ala. 1990); Bennett v. Bennett, 454 So. 2d 535,

538 (Ala. 1984); and Upchurch v. Universal Un-

derwriters Ins. Co., 610 So, 2d 1163, 1167 (Ala. Civ.

4la

App. 1992). Accordingly, we next consider whether

the trial court’s judgment in favor of VFJ may be af-

firmed on the basis of VFJ’s alternate claim that the

exception found in § 40-18-35(b)(1), Ala. Code 1975,

exempts it from the application of the add-back stat-

ute. See Steele v. Walser, 880 So. 2d 1123 (Ala. 2003)

(noting the rule that an appellate court may affirm a

judgment based on an issue that is rejected by the

trial court by considering an alternative argument

asserted by the appellee).

The Subject-to-Tax Exception

VFJ argued at trial that the subject-to-tax excep-

tion found in subsection (b)(1) of the add-back statute

precluded the Department from imposing its assess-

ment. We reiterate the specific language of the sub-

section (b)(1) exception:

“(1) For purposes of computing its taxable in-

come, a curporation shall add back otherwise de-

ductible interest expenses and costs and intangi-

ble expenses and costs directly or indirectly paid,

accrued, or incurred to, or in connection directly

or indirectly with one or more direct or indirect

transactions, with one or more related members,

except to the extent the corporation shows, upon

request by the commissioner, that the corre-

sponding item of income was in the same taxable

year: a. Subject to a tax based on or measured by

the related member’s net income in Alabama or

any other state of the United States, or b. subject

to a tax based on or measured by the related

member’s net income by a foreign nation which

has in force an income ‘ ax treaty with the United

States, if the recipient was a ‘resident’ (as de-

fined in the income tax treaty) of the foreign na-

tion. For purposes of this section, ‘subject to a tax

42a

based on or measured by the related member's

net income’ means that the receipt of the pay-

ment by the recipient related member is reported

and included in income for purposes of a tax on

net income, and not offset or eliminated in a

combined or consolidated return which includes

the payor.”

§ 40-18-35(b)(1).

VFJ filed a corporate income-tax return in North

Carolina, a separate-reporting state, for the tax year

in question. For reasons not fully explained in the re-

cord, Lee and Wrangler also filed corporate income-

tax returns in North Carolina, although each IMCO

filed that return “under protest.” Joseph McGraw,

VF’s manager of state taxes, opined that Lee and

Wrangler did not have a sufficient nexus with North

Carolina to require those IMCOQOs to pay corporate in-

come tax in that state. The testimony at trial showed

that the IMCOs may have filed the returns in North

Carolina in order to benefit VFJ and other VF sub-

sidiaries. Pursuant to North Carolina’s add-back

statute, VFJ and other VF subsidiaries with activity

in North Carolina would not have to add back the

royalty payments they made to the IMCOs if the IM-

COs also filed corporate income-tax returns in North

Carolina. See N.C. Gen. Stat. § 105-130.7A(c).

In calculating taxable income in North Carolina,

each IMCO listed its federal taxable income on its

North Carolina corporate tax return. Lee reported

federal taxable income of $ 73,021,142, and Wrangler

reported $ 69,644,967 in federal taxable income.

Each IMCO applied its apportionment factor to

determine the amount of income attributable or

apportionable to North Carolina. Therefore, neither

IMCO paid North Carolina state income taxes on the

43a

full amount of its federal taxable income. For the

2001 tax year, Lee’s apportionment factor for North

Carolina was 2.8783%, and Lee paid $ 143,480 in

North Carolina corporate income tax. For the 2001]

tax year, Wrangler’s apportionment factor for North

Carolina was 3.9415%, and it paid $ 190,155 in

corporate income tax in that state.

With regard to the specific facts of this case, the

subject-to-tax exception applies if Lee and Wrangler

(the “related members” under the subject-to-tax ex-

ception) “reported and included” the royalty pay-

ments from VF.J (the taxpayer corporation) “for pur-

poses of a tax on net income” in another state (in this

case, North Carolina). See § 40-18-35(b)(1), Ala. Code

1975. The parties dispute the proper interpretation of

the “reported and included” language of the subject-

to-tax exception.

VFJ argues that the subject-to-tax exception

should be interpreted to mean that the entire amount

of federal taxable income the IMCQOs listed on their

respective North Carolina corporate income-tax re-

turns was “subject to tax,” even if only a small part of

that was actually apportioned to North Carolina and

taxed in that state. According to VFJ, the entire

amount of federal taxable income for each of the IM-

COs was both “reported” and “included,” as those

terms are used in § 40-18-35(b)(1), on their respective

North Carolina corporate income-tax returns. Thus,

according to VFJ’s argument, all the IMCOs’ income

was “subject to tax,” and the subsection (b)(1) excep-

tion applies and prohibits this state from adding back

into the calculation of its taxable income any of the

royalty payments it made to the IMCOs.

The Department, on the other hand, argues that

the subject-to-tax exception excludes from the appli-

44a

cation of Alabama’s add-back statute only that in-

come the IMCOs apportioned to North Carolina. In

other words, the Department argues that only

2.8783% of Lee’s income and 3.9415% of Wrangler’s

income, the amounts those IMCOs apportioned to

North Carolina, should be considered “subject to tax”

in that state. According to the Department, the re-

mainder of the IMCQOs’ income, 1.e., that income not

apportioned to North Carolina, is not “reported and

included” as that term is used in the subject-to-tax

exception to Alabama’s add-back statute. Under the

Department’s interpretation, even considering the

subject-to-tax exception, the Department could add

back the royalty payments to VFJ’s federal taxable

income and apply the Alabama apportionment factor

to that part of VFJ’s income that was not apportioned

to North Carolina. In other words, the Department

argues that the subject-to-tax exception should apply

only on what is known as a “post-apportionment” ba-

sis, and VFJ contends that the subject-to-tax excep-

tion should be applied on a “pre-apportionment” ba-

Sis.

Professor Pomp’s testimony concerning the subject-

to-tax exception supported the interpretation ad-

vanced by VFJ. Pomp testified that any income that

is listed on an income-tax return should be subject to

a tax, regardless of whether an apportionment factor

would result in only a minimal taxation of the related

member for a large amount of reported federal tax-

able income.

Professor Enrich testified that a number of states

that have add-back statutes do not have a subject-to-

tax exception because an add-back statute itself re-

quires only that income that can be properly appor-

tioned to that state be included in calculating taxable

45a

income. In Enrich’s opinion, the logical reason for

some states’ inclusion in their add-back statutes of a

subject-to-tax exception is “really nothing more than

an abundance of caution.” Enrich also stated that the

Department’s interpretation achieves a reasonable

result, given that the purpose of an add-back statute

is to ensure that income is taxed in some state.’ Fur-

ther, Enrich pointed out that to interpret the subject-

to-tax exception in the manner advocated by VFJ

would render the add-back statute prectically mean-

ingless because it would be relatively simple for a

corporation to find a way in which to pay a minimal

amount of state tax in one state for the specific pur-

pose of avoiding taxation in states with subiect-to-tax

exceptions in their add-back statutes.

Richard Henninger, the director of individual and

corporate income tax for the Department, testified

that during the interim between the enactment of the

add-back statute and the adoption of the add-back

regulation, the Department haa always applied the

subject-to-tax exception on a post-apportionment ba-

sis. Joe Garrett, the administrator for tax policy for

’ Professor Enrich explained:

“The ambition of the add-back statute is to make sure that

all of the income is subject to tax somewhere, that it’s all

apportioned out and that each state is able to tax or not tax

as it chooses the share that is attributed to it.

“If the statute were read to say, well, if some one state to

which some, perhaps quite small, portion of the income is

attributable, if that state taxes it, then nobody else can—or

we can't attribute our fair share to us would be a non-

sensical reading of the statute, whereas to say, well, to the

extent that one state does tax some, we'll just apportion

the rest, is going to achieve the statutory purpose of

making sure that all the income is attributed to some place

that can choose whether to tax it or not.”

46a

the Department, also testified that the Department

had consistently applied the subject-to-tax exception

on a post-apportionment basis.

The add-back regulation, adopted after this dispute

arose, interprets the definition of “subject to a tax” as

referring to income that is “reported and included in

post-allocation and apportionment income for pur-

poses of a tax applied to the net income apportioned

or allocated to the taxing jurisdiction.” Rule

810-3-35-.02(3)(f), Ala. Admin. Code (Department of

Revenue). The evidence presented at trial indicates

that, similar to the Department’s interpretation of

the unreasonableness exception, the Department has

consistently interpreted the subject-to-tax exception

in the manner eventually adopted in the add-back

regulation and that there was no change in the

Department’s actions with regard to the subject-to-

tax exception when the add-back regulation was

ultimately adopted. Thus, since the enactment of the

add-back statute, the Department’s interpretation of

the subject-to-tax exception has been consistent. As

stated earlier in this opinion, the interpretation of

the add-back statute by the Department, the agency

charged with the enforcement of the statute, is

entitled to deference. Bean Dredging, L.L.C. v.

Alabama Dep't of Revenue, supra; Farmer v. Hypo

Holdings, Inc., supra; and Hamrick v. Alabama

Alcoholic Beverage Control Bd., supra.

The research conducted by the parties and by this

court has failed to uncover any caselaw that has ad-

dressed the application of an exception similar to the

one at issue here. Therefore, we must turn to the spe-

cific language of the subsection (b)(1) exception and

apply the general rules of statutory construction in

interpreting that exception.

47a

“The fundamental rule of statutory construction is

to ascertain and give effect to the intent of the legis-

lature in enacting the statute.” IMED Corp. v. Sys-

tems Eng’g Assocs. Corp., 602 So. 2d 344, 346 (Ala.

1992). Where possible, the legislature’s intent in en-

acting the statute should be discerned from the lan-

guage of the statute. Perry v. City of Birmingham,

906 So. 2d 174, 176 (Ala. 2005). Further, ““lilf the

statute is ambiguous or uncertain, the court may

consider conditions which might arise under the pro-

visions of the statute and examine results that will

flow from giving the language in question one par-

ticular meaning... .”

“In deciding between alternative meanings... ,

we will not only consider the results that flow

from assigning one meaning over another, but

will also presume that the legislature intended a

rational result, one that advances the legislative

purpose in adopting the legislation, that is

“workable and fair,” and that is consistent with

related statutory provisions.”

Ex parte Berryhill, 801 So. 2d 7, 10 (Ala. 2001) (quot-

ing John Deere Co. v. Gamble, 523 So. 2d 95, 100

(Ala. 1988)).

The language of the subsection (b)(1) exception

specifies that the add-back statute does not apply “to

the extent the corporation shows ... that the corre-

sponding item of income was .. . [slubject to a tax

based on or measured by the related member’s net

income in Alabama or any other state of the United

States.” § 40-18-35(b)(1) (emphasis added). The

sub‘ect-to-tax exception goes on to define “subject to a

tax ovased on or measured by the related member's

net income” as meaning “that the receipt of the pay-

ment by the recipient related member ts reported and

48a

included in income for purposes of a tax on net in-

come, and not offset or eliminated in a combined or

consolidated return which includes the payor.” Id.

(emphasis added).

Thus, the legislature specified that for items of in-

come to be “subject to... tax,” they must be both “re-

ported and included in income for purposes of a tax

on net income.” § 40-18-35(b)(1) (emphasis added).

Therefore, this court must assume that the legisla-

ture intended that the terms “reported” and “in-

cluded” have different meanings. The courts must

presume that in enacting the add-back statute, the

legislature intended that each word of the statute

have effect, and we must also presume that the leg:

islature did not. include meaningless language or re-

dundancies in the statute. Ex parte Children’s Hosp.

of Alabama, 721 So. 2d 184, 190-91 (Ala. 1998); see

also Board of School Comm'rs of Mobile County v.

Biggs, supra. Accordingly, under the subsection (b)(1)

exception to the add-back statute, the items of income

are to be reported by the corporation for which those

payments constitute income, ana that income must

be “included in income for the purposes of a tax on

net income.”

We hold that for the purposes of the subject-to-tax

exception, the term “included in income for the pur-

poses of a tax on net income” means that the income

at issue is actually taxed as a part of a tax on net in-

come. Stated another way, we interpret the subject-

to-tax exception set forth in subsection (b)(1) of Ala-

bama’s add-back statute to apply on a post-appor-

tionment, rather than on a pre-apportionment, basis.

We believe that this holding is consistent with the

intention of the legislature in enacting the add-back

statute and that it advances the purpose of the leg

49a

islature in enacting the add-back statute. See Ex

parte Berryhill, supra; John Deere Co. v. Gamble, su-

pra. As Professor Enrich pointed out in his testimony,

interpreting the subject-to-tax exception to apply ona

pre-apportionment basis would effectively negate the

operation of the add-back statute. Under a pre-appor-

tionment interpretation, a corporation could easily

avoid the application of an add-back statute that con-

tains a subject-to-tax exception by paying corporate

income tax in a state in which its apportionment fac-

tor is relatively insignificant. This case is an example

of that possibility. Although each IMCO reported sig-

nificant federal taxable income, Lee had a state-tax

burden in North Carolina of approximvtely .0019% of

its federal taxable income, and Wrangler paid state

tax of approximately .0027% of its federal taxable in-

come.” Based on its argument that that modest level

of taxation met the requirements of the subsection

(b)(1) exception to Alabama’s add-back statute, VFJ

sought to avoid the application of that statute.

An interpretation of the subject-to-tax exception

that, in most cases, would result in a taxpayer’s abil-

ity to avoid the application of the add-back statute

would be “unreasonable, and, consequently, [it can-

not] be considered to be the intent of the legislature.”

John Deere Co. v. Gamble, 523 So. 2d at 100. Such

an interpretation would also serve to place Alabama

back in the position it was in before the enactment of

the add-back statute. “The legislature surely did not

intend such a nonsensical result.” Ex parte State

Dep't of Revenue, 441 So. 2d at 604. We will presume

“Lee reported $ 73,021,142 in 2001 in federal taxable income,

and it paid ¢ 143,480 for state taxes in North Carolina. Wrang-

ler reported $ 69,644,967 in 2001 in federal taxable income, and

it paid $ 190,155 for state taxes in North Carolina.

50a

that the legislature “intended a rational result.” Ex

parte Berryhill, 801 So. 2d at 10 (quoting John Deere

Co. v. Gamble, 523 So. 2d at 100). Because we con-

clude that the trial court erred in its interpretation of

the unreasonableness exception in entering a judg-

ment in favor of VFJ, and because we cannot affirm

the trial court’s judgment on the basis of the subject-

to-tax exception, we reverse the trial court’s judg-

ment. See Steele v. Walser, supra; see also Fidelity

Nat'l Title Ins. Co. of Tennessee v. Jericho Mgmt. Inc.,

722 So. 2d 740, 743-44 (Ala. 1998) (declining to affirm

a trial court’s order based on other arguments as-

serted by the appellee); Mutual Assurance, Inc. v.

Wilson, 716 So. 2d 1160, 1165 (Ala. 1998) (same).

Constitutionality

This court has rejected the other bases VFJ has

advanced in support of the trial court’s judgment in

its favor. Therefore, because the case cannot ““be set-

tled on non-constitutional grounds,”” see Chism uv.

Jefferson County, 954 So. 2d 1058, 1063 (Ala. 2006)

(quoting Lowe v. Fulford, 442 So. 2d 29, 33 (Ala.

1983)), we will consider VFJ’s constitutional chal-

lenges to the add-back statute.

““Tn reviewing [a question regarding] the constitu-

tionality of a statute, we ‘approach the question with

every presumption and intendment in favor of its va-

lidity, and seek to sustain rather than strike down

the enactment of a coordinate branch of the govern-

ment.” Moore v. Mobile Infirmary Ass’n, 592 So. 2d

156, 159 (Ala. 1991) (quoting Alabama State Fed’n of

Labor v. McAdory, 246 Ala. 1, 9, 18 So. 2d 810, 815

(1944)). Moreover, “[w]here the validity of a statute is

assailed and there are two possible interpretations,

by one of which the statute would be unconstitutional

and by the other would be valid, the courts should

5la

adopt the construction [that] would uphold it.” McA-

dory, 246 Ala. at 10, 18 So. 2d at 815. In McAdory,

this Court further stated:

““(I]n passing upon the constitutionality of a

legislative act, the courts uniformly approach the

question with every presumption and intend-

ment in favor of its validity, and seek to sustain

rather than strike down the enactment of a coor-

dinate branch of the government. All these prin-

ciples are embraced in the simple statement that

it is the recognized duty of the court to sustain

the act unless it is clear beyond reasonable doubt

that. it is violative of the fundamental law.”

“246 Ala. at 9, 18 So. 2d at 815 (citation omit-

ted). We must afford the Legislature the highest

degree of deference, and construe its acts as con-

stitutional if their language so permits. [d.””

Kirby v. State, 899 So. 2d 968, 972-73 (Ala. 2004)

(quoting Monroe v. Harco, Inc., 762 So. 2d 828, 831

(Ala. 2000)).

In the trial court, VFJ alleged that the add-back

statute violates both the Due Process Clause and the

Commerce Clause of the United States Constitution.

Although on appeal VFJ purports to challenge the

statute only on the basis that it violates the Com-

merce Clause, we note that at least one part of its ar-

gument on the issue of constitutionality intertwines

with concepts that are related to both the Commerce

Clause and the Due Process Clause. The United

States Supreme Court has stated:

“Article I, § 8, cl. 3 [the Commerce Clause], of the

Constitution expressly authorizes Congress to

‘regulate Commerce with foreign Nations, and

among the several States.’ It says nothing about

52a

the protection of interstate commerce in the ab-

sence of any action by Congress. Nevertheless, as

Justice Johnson suggested in his concurring

opinion in Gibbons v. Ogden, 22 U.S. 1, 9 Wheat

1, 231-232, 239, 6 L. Ed. 23 (1824), the Com-

merce Clause is more than an affirmative grant

of power; it has a negative sweep as well. The

Clause, in Justice Stone’s phrasing, ‘by its own

force’ prohibits certain state actions that inter-

fere with interstate commerce. South Carolina

State Highway Dept. v. Barnwell Brothers, Inc.,

303 U.S. 177, 185, 58 S. Ct. 510, 82 L. Ed. 734

(1938).”

Quill Corp. v. North Dakota, 504 U.S. 298, 309, 112

S. Ct. 1904, 119 L. Ed. 2d 91 (1992). The “negative

sweep” of the Commerce Clause referenced above,

known as “the dormant Commerce Clause,” has been

interpreted by the United States Supreme Court as

prohibiting a state from imposing taxation on income

that is not attributable to that state. Oklahoma Tax

Comm'n v. Jefferson Lines, Inc., 514 U.S. 175, 179-80,

115 S. Ct. 13831, 131 L. Ed. 2d 261 (1995); Quill Corp.

vu. North Dakota, supra.

The United States Supreme Court has established

precedent for determining the constitutionality of a

state-imposed tax on entities or activities that involve

interstate commerce. In Complete Auto Transit, Inc.

v. Brady, 430 U.S. 274, 97 S. Ct. 1076, 51 L. Ed. 2d

326 (1977), the State of Mississippi imposed a tax on

motor vehicles manufactured outside that state. The

Supreme Court upheld the tax. In doing so, the Court

rejected its prior decisions that held that a state

could not tax income from activities that were part of

interstate commerce. See, e.g., Spector Motor Serv. v.

O'Connor, 340 U.S. 602, 71 S. Ct. 508, 95 L. Ed. 573

53a

(1951), and Freeman v. Hewit, 329 U.S. 249, 67 S. Ct.

274, 91 L. Ed. 265 (1946). Instead, the Court relied on

other decisions that held that the Commerce Clause

was not designed to relieve those engaged in inter-

state commerce from the burden of state taxation but

was instead intended to allew a state to impose taxa-

tion only on the state’s fair share of the income de-

rived from interstate activity. See, e.g., General Mo-

tors Corp. v. Washington, 377 U.S. 436, 84 S. Ct.

1564, 12 L. Ed. 2d 430 (1964), and Western Live Stock

v. Bureau of Revenue, 303 U.S. 250, 58 S. Ct. 546, 82

L. Ed. 823 (1938). In reaching its holding, the Su-

preme Court adopted language from cases in which it

“considered not the formal language of the tax

statute but rather its practical effect, and...

sustained a tax against Commerce Clause

challenge when the tax is applied to an activity

with a substantial nexus with the taxing State, is

fairly apportioned, does not discriminate against

interstate commerce, and is fairly related to the

services provided by the State.”

Complete Auto Transit, Inc. v. Brady, 430 U.S. at 279

(citing in a footne . General Motors Corp. v. Washing-

ton, supra; Northwestern Cement Co. v. Minnesota,

358 U.S. 450, 79 S. Ct. 357, 3 L. Ed. 2d 421 (1959);

Memphis Gas Co. v. Stone, 335 U.S. 80, 68 S. Ct.

1475, 92 L. Ed. 1832 (1948); and Wisconsin v. J.C.

Penney Co., 311 U.S. 435, 61S. Ct. 246, 85 L. Ed. 267

(1940)) (emphasis added), The foregoing four factors

have become known as “the Complete Auto test” and

are used to determine the validity of a tax on income

derived from activity involving interstate commerce.

Two of VFJ’s arguments regarding the constitu-

tionality of Alabama’s add-back statute address the

elements of the Complete Auto test. First, VI.J con-

54a

tends that “the add-back statute is effectively an at-

tempt” to tax the income of Lee and Wrangler and

that Alabama lacks a sufficient nexus with those

IMCQOs to justify the imposition of that tax. See Com-

plete Auto, supra; see also Quill Corp. v. North Da-

kota, supra (discussing the requirement that a state

have a “sufficient nexus” with a taxpayer in order for

the taxpayer to be subject to taxation),

The requirement of a sufficient nexus between the

state and the taxpayer has been explained as follows:

“The Due Process and Commerce Clauses of the

Constitution do not allow a State to tax income

arising out of interstate activities—even on a

proportional basis—unless there is a “minimal

connection” or “nexus” between the interstate ac

tivities and the taxing State, and “a rational re-

lationship between the income attributed to the

State and the intrastate values of the enter-

prise.” Exxon Corporation v. Wisconsin Dept. of

Revenue, [447 U.S. 207,] 219-220, 100 S. Ct.

2109, 65 L. Ed. 2d 66 [(1980)], quoting Mobil Oil

Corp. v. Commissioner of Taxes, [445 U.S. 425],

436, 437, 100 8S. Ct. 1223, 63 L. Ed. 2d 510

((1980)].”

Container Corp. of America v. Franchise Tax Bd., 463

U.S. at 165-66.

This court’s research has revealed some examples

in which a state has attempted to tax income received

by an IMCO from a corporation required to pay in-

come tax in that state. In Comptroller of the Treasury

v. SYL, Inc., 375 Md. 78, 106, 825 A.2d 399, 415

(2003), the Maryland Court of Appeals addressed two

companion cases in which tax audits by Maryland's

comptroller of the treasury sought to require a Dela-

55a

ware IMCO to pay taxes on franchise fees paid to it

by a related-member corporation with activities in

Maryland. The tax court had held in each case that

there was not a sufficient nexus between the IMCO

and the State of Maryland to justify the imposition of

the tax on the IMCO. SYL, Inc. v. Comptroller of the

Treasury, No. C-96-0154-01, 1999 Md. Tax LEXIS 3

(Md. Tax Ct. April 26, 1999) (unpublished opinion);

see also Comptroller of the Treasury v. SYL, Inc., su-

pra. In each case, the Circuit Court for Baltimore

City affirmed the tax court’s reversal of the tax as-

sessment, and the comptroller again appealed. The

Maryland Court of Appeals reversed and upheld the

tax assessments, concluding that “an appropriate

portion” of each IMCO’s income was taxable in

Maryland. Comptroller of the Treasury v. SYL, Inc.,

supra. In reaching its holding, however, the Mary-

land Court of Appeals did not focus on the issue of

nexus. Rather, the court based its decision on its de-

termination that neither of the IMCOs at issue had

any real economic substance and that the predomi-

nant reason for the creation of each IMCO was the

avoidance of state taxation. Comptroller of the Treas-

ury v. SYL, Inc., 375 Md. at 106-07, 825 A.2d at 415-

16.

In Geoffrey, Inc. v. South Carolina Tax Commis-

sion, 313 S.C. 15, 437 S.E.2d 13 (1993), the South

Carolina Tax Commission took the position that an

IMCO was required to pay corporate income tax in

that state on income it had received from royalty

payments made—by a related-member corporation

with activities in South Carolina. The South Carolina

Supreme Court held that the IMCO had a sufficient

nexus with that state to justify the taxation at issue

under both the Due Process Clause and the Com-

merce Clause of the United States Constitution. Jd.

56a

In the cases discussed above, each state, pursuant

to its interpretation of its taxation statutes, specifi-

cally sought to impose a tax directly on the out-of-

state IMCOs rather than on the corporations that ac-

tually conducted activity within the state. Alabama’s

add-back statute does not expressly impose a tax on

Lee and Wrangler, nor has the Department sought to

impose a tax directly on those IMCOs. VFJ contends,

however, that the add-back statute does effectively

impose a tax on the IMCOs. We conclude that the

add-back statute does not implicitly (or “effectively”)

impose a tax on the IMCOs. Rather, the add-back

statute disallows a deduction sought by the taxpayer,

VFJ, which does have activities in Alabama sufficient

to justify its paying corporate income tax in this

state. As stated earlier in this opinion, deductions are

a matter of legislative grace. Ex parte State Dep't of

Revenue, 441 So. 2d at 598. We do not agree with VFJ

that disallowing a deduction for an expense it pays

constitutes a tax on the entities to whom it paid that

expense, in this case Lee and Wrangler. Accordingly,

we decline to affirm the trial court’s judgment on this

basis.

We next turn to VFJ’s argument that Alabama’s

add-back statute results in a tax that is not fairly ap-

portioned to Alabama and, therefore, that it fails to

meet the third element of the Complete Auto test. In

discussing this element, the Supreme Court has

stated:

“For over a decade now, we have assessed any

threat of malapportionment by asking whether

the tax is ‘internally consistent’ and, if so,

whether it is ‘externally consistent’ as well. See

Goldberg |v. Sweet, 488 U.S. 252,] 261, 109 S. Ct.

582, 102 L., Ed. 2d 607 [(1989)]; Container Corp.

57a

[of America v. Franchise Tax Board], 463 U.S.

[159], at 169, 103 S. Ct. 2933, 77 L. Ed. 2d 545

((1983)]. Internal consistency is preserved when

the imposition of a tax identical to the one in

question by every other State would add no bur-

den to interstate commerce that intrastate com-

merce would not also bear. This test asks nothing

about the degree of economic reality reflected by

the tax, but simply looks to the structure of the

tax at issue to see whether its identical applica-

tion by every State in the Union would place in-

terstate commerce at a disadvantage as com-

pared with commerce intrastate. A failure of

internal consistency shows as a matter of law

that a State is attempting to take more than its

fair share of taxes from the interstate transac-

tion, since allowing such a tax in one State would

place interstate commerce at the mercy of those

remaining States that might impose an identical

tax. See Gwin, White & Princel, Inc. v. Henne-

ford,| 305 U.S. [434], at 439, 59 S. Ct. 325, 83 L.

Ed. 272 [(1939)]....

“External consistency, on the other hand, looks

not to the logical consequences of cloning, but to

the economic justification for the State’s claim

upon the value taxed, to discover whether a

State’s tax reaches beyond that portion of value

that is fairly attributable to econemic activity

within the taxing State. See Goldberg, supra, at

262; Container Corp., supra, at 169-170. Here,

the threat of real multiple taxation (though not

by literally identical statutes) may indicate a

State’s impermissible overreaching.”

Oklahoma Tax Comm'n v. Jefferson Lines, Inc., 514

U.S. at 185 (emphasis added).

58a

In this case, VFJ has maintained that the add-back

statute lacks external consistency, i.e., that it at-

tempts to tax activity beyond that that is fairly at-

tributable to its activity in Alabama. Oklahoma Tax

Comm'n v. Jefferson Lines, Inc., supra. In support of

its argument, VFJ cites Hans Rees’ Sons, Inc. v.

North Carolina, 283 U.S. 1238, 51S. Ct. 385, 75 L. Ed.

879 (1931). In that case, the evidence indicated that

between 17% and 21% of the taxpayer’s income was

attributable to its activities in North Carolina. How-

ever, the statutory tax provision the taxpayer chal-

lenged had allocated approximately 80% of the tax-

payer’s income to North Carolina for the purpose of

imposing a tax on that income. The Supreme Court

invalidated the tax, concluding that North Carolina

had exceeded its authority in imposing the tax. In so

holding, the Supreme Court determined that the evi-

dence demonstrated that the tax “operated unrea-

sonably and arbitrarily” as applied to the taxpayer

and that it was “out of all appropriate proportion to

the business transacted by the [taxpayer] in [North

Carolina].” Hans Rees’ Sons, Inc. v. North Carolina,

283 U.S. at 135.

Another case to which VFJ refers this court ad-

dresses the issue of fair apportionment. In Hunt-Wes-

son, Inc. v. Franchise Tax Board of California, 528

U.S. 458, 120 S. Ct. 1022, 145 L. Ed. 2d 974 (2000),

the taxpayer challenged as unconstitutional the State

of California’s limitation of a deduction allowed under

its tax code. Under the provision at issue in that case,

California (a unitary or combined-reporting state)

allowed a corporate taxpayer to deduct interest ex-

penses to the extent that the interest expense ex-

ceeded other, unrelated income, e.g., income that did

not arise out of the taxpayer’s activities in California.

528 U.S. at 461-62. The Supreme Court concluded

59a

that, under the facts of that case, the limitation on

the deductibility of interest expenses was not a true

limit on a deduction but was instead more in the na-

ture of an impermissible tax.

The Supreme Court noted that had California

demonstrated that the limitation “reflected the por-

tion of the expense properly related to nonunitary in-

come, the limit would not, in fact, be a tax on nonuni-

tary income” but would instead be a “proper

allocation of the deduction.” 528 U.S. at 465. The

Supreme Court held that the provision at issue was

“not a reasonable allocation of expense deductions to

the income that the expense generate[d],” and, there-

fore, it concluded that the provision violated the Due

Process Clause and the Commerce Clause. Hunt-Wes-

son, Inc. v. Franchise Tax Bd. of California, 528 U.S.

at 468. In reaching its holding, the Supreme Court,

quoting Container Corporation of America v. Fran-

chise Tax Board, 463 U.S. at 165-66, noted that a

state may not impose a tax in the absence of a nexus

between the state and the interstate activities or in

the absence of a “rational relationship” between the

income properly attributable to the state and the “in-

trastate values of the enterprise.” Hunt-Wesson, Inc.

v. Franchise Tax Bd. of California, 528 U.S. at 464.

We find the facts of this case to be distinguishable

from those that would necessitate holdings similar to

the holdings of Hans Rees’ Sons, Inc. v. North Caro-

lina, supra, and Hunt-Wesson, Inc. v. Franchise Tax

Board of California, supra. The Department, pursu-

ant to the add-back statute, seeks to disallow the de-

duction of that part of the royalty payments VFJ

made to Lee and Wrangler that is attributable to

60a

Alabama.” In other words, the Department seeks to

apply VFJ’s Alabama apportionment factor to that

part of the royalty payments that was not subject to

taxation in North Carolina as part of the IMCOs’

taxable income in that state. Accordingly, we con-

clude that the Department’s interpretation of the

add-back statute is consistent with the requirements

of a nexus between Alebama and the interstate ac-

tivities, i.e., the royalty payments. See Hunt-Wesson,

Inc. v. Franchise Tax Bd. of California, supra; Con-

tainer Corp. of America v. Franchise Tax Bd., supra.

Further, the evidence did not demonstrate that the

application of the add-back statute has resulted in

taxation that is out of proportion to VF.J’s activities

in this state. The United States Supreme Court has

established that it is the burden of VFJ, as the

taxpayer, to establish “by “clear and cogent evi-

dence”” that, as a result of the application of Ala-

bama’s add-back statute, “the income attributed to

{Alabama] is in fact “out of all appropriate propor-

tions to the business transacted in [Alabamal],” or has

“led to a grossly distorted result.”” Container Corp. of

America v. Franchise Tax Bd., 463 U.S. at 170

(quoting Moorman Mfg. Co. v. Bair, 437 U.S. 267,

274, 98 S. Ct. 2340, 57 L. Ed. 2d 197 (1978)) (internal

citations omitted). In this case, there has been no

showing that the tax resulting from the application of

Alabama’s add-back statute was out of proportion to

’ With regard to the issue of fair apportionment, VFJ has

challenged only the Department’s interpretation and application

of the add-back statute. It has not argued that the add-back

statute does not contain a provision requiring fair apportion-

ment. We do not attempt to address that issue on its behalf. See,

generally, Jansen v. State ex rel. Downing, 273 Ala. 166, 168,

137 So. 2d 47, 48 (1962) (quoted infra).

6la

VFJ’s activities in Alabama or that the resulting tax

reached “beyond that portion of value that is fairly

attributable to economic activity within the taxing

State [(i.e., Alabama)].” Oklahoma Tax Comm’n uv.

Jefferson Lines, Inc., 514 U.S. at 185; see also Con-

tainer Corp. of America v. Franchise Tax Bd., supra.

Under the facts of this case, we conclude that there

exists a rational relationship between the income the

Department seeks to add back pursuant to § 40-18-

35(b) and the income that is to be included in the de-

termination of VFJ’s taxable income. See Hunt-Wes-

son, Inc. v. Franchise Tax Bd. of California, supra;

Container Corp. of America v. Franchise Tax Bd., su-

pra. Accordingly, we hold that VF.J has not demon-

strated that the add-back statute results in taxation

of income that is not fairly attributable to Alabama.

VFJ also asserts that the add-back statute imper-

missibly discriminates against-interstate commerce.

It is well settled that “[a] state may not tax a trans-

action or incident more heavily when it crosses state

lines than when it occurs entirely within the State.”

Chemical Waste Mgmt., Inc. v. Hunt, 504 U.S. 334,

342, 112 S. Ct. 2009, 119 L. Ed. 2d 121 (1992) (quot-

ing Armco, Inc. v. Hardesty, 467 U.S. 638, 642, 104 S.

Ct. 2620, 81 L. Ed. 2d 540 (1984)). VFJ contends that

under the subject-to-tax exception the income-tax

burden imposed by the add-back statute “depends

upon where the recipient IMCO is located” and,

therefore, that it results in differential treatment

that rises to the level of unconstitutional discrimina-

tion.

In support of its argument, VFJ cites only to au-

thority discussing facially discriminatory statutes.

See South Cent. Tel. Co. v. Alabama, 526 U.S. 160,

119 S. Ct. 1180, 143 L. Ed. 2d 258 (1999); Camps

62a

Newfound /Owatonna, Inc. v. Town of Harrison, 520

U.S. 564, 117 S. Ct. 1590, 137 L. Ed. 2d 852 (1997);

Fulton Corp. v. Faulkner, 516 U.S. 325, 116 S. Ct.

848, 133 L. Ed. 2d 796 (1996); and AT&T Corp. v.

Surtees, 953 So. 2d 1240, 1245 (Ala. Civ. App. 2006).

In order to determine whether a statute is facially

discriminatory, “the text of the statute must treat in-

state economic interests differently from out-of-state

economic interests in such a way as to benefit the in-

state economic interests and burden the out-of-state

economic interests.” AT&T Corp. v. Surtees, 953 So.

2d at 1245 (also setting forth examples of cases in

which the United States Supreme Court found state

statutes to be facially discriminatory).

The subject-to-tax exception of Alabama’s add-back

statute specifies that the exception applies when the

related member’s income is taxed “in Alabama or any

other state of the United States.” § 40-18-35(b)(1)

(emphasis added). Thus, the subject-to-tax exception

challenged by VFJ is implicated regardless of which

state imposes a tax on the related member’s income.

The language of the subject-to-tax exception clearly

indicates that, with regard to that exception, the ap-

plication of Alabama’s add-back statute does not

benefit in-state corporations to the detriment of, or

disproportionately to, out-of-state corporations. Ac-

cordingly, we must conclude that the add-back stat-

ute does not, as VFJ contends, discriminate against

interstate commerce on the ground that the subject-

to-tax exception results in differential tax treatment

between states.

Alternatively, VFJ has asserted in its brief submit-

ted to this court an argument concerning the foreign-

jurisdiction portion of the subject-to-tax exception as

it relates to the Commerce Clause. See § 40-18-

63a

35(b)(1), Ala. Code 1975. However, VFJ presented no

evidence demonstrating that the facts of this case

implicate that part of the subsection (b)(1) exception.

“A party establishes standing to bring a chal-

lenge under the Commerce Clause when it

demonstrates the existence of (1) an actual,

concrete and particularized ‘injury in fact’—‘an

invasion of a legally protected interest’; (2) a

‘causal connection between the injury and the

conduct complained of; and (3) a likelihood that

the injury will be ‘redressed by a favorable

decision.’ Lujan v. Defenders of Wildlife, 504 U.S.

555, 560-61, 112 S. Ct. 2130, 119 L. Ed. 2d 351

(1992). A party must also demonstrate that ‘he is

a proper party to invoke judicial resolution of the

dispute and the exercise of the court’s remedial

powers.” Warth [v. Seldin], 422 U.S. [490] at 518,

95 S. Ct. 2197, 45 L. Ed. 2d 343 [(1975)].”

Alabama Alcoholic Beverage Control Bd. v. Henri-

Duval Winery, L.L.C., 890 So. 2d 70, 74 (Ala. 2003).

VFJ, because it has not shown that the foreign-juris-

diction portion of the subsection (b)(1) exception ap-

plies in this case, has failed to demonstrate sufficient

injury so as to confer standing with regard to this ar-

gument. See Muhammad v. Ford, 986 So. 2d 1158,

1162, 2007 Ala. LEXIS 266, *8 (Ala. 2007) (in the ab-

sence of a legal injury, “there is no case or contro-

versy for a court to consider”).

In addressing the issue of the constitutionality of

Alabama’s add-back statute, this court has addressed

only those arguments VFJ has asserted in an effort to

support the trial court’s judgment in its favor. We de-

cline to address any other arguments that might

have been made regarding the alleged unconstitu-

64a

tionality of Alabama’s add-back statute. As the Ala-

bama Supreme Court has explained:

“In passing on the validity of a statute it must be

remembered that the legislature, except insofar

as specifically limited by the state and federal

constitutions, is all-powerful in dealing with

matters of legislation; that a legislative act is

presumed to be constitutional and valid, and all

doubts are to be resolved in favor of its validity;

that a statute, if reasonably possible, must be so

construed as to sustain its validity and will not

be declared invalid unless the court is clearly

convinced that it cannot stand; that all questions

of propriety, wisdom, necessity, utility and expe-

diency in the enactment of laws are exclusively

for the legislature, and are matters with which

the courts have no concern.”

Jansen v. State ex rel. Downing, 273 Ala. 166, 168,

137 So. 2d 47, 48 (1962).

We reverse the trial court’s judgment in favor of

VFJ, and we remand the case to the trial court for

the entry of a judgment consistent with this opinion.

REVERSED AND REMANDED WITH INSTRUC-

TIONS.

Thomas and Moore, JJ., concur.

Pittman and Bryan, JJ., concur in the result, with-

out writings.

65a

APPENDIX C

IN THE CIRCUIT COURT OF

MONTGOMERY COUNTY, ALABAMA

[Filed Jan 24, 2007]

CV-03-3172

VFJ VENTURES, INC., f/k/a VF JEANSWEAR, INC.,

Plaintiff,

¥.

G. THOMAS SURTEES, in his official capacity as

Commissioner of the Department of Revenuc for

the State of Alabama, and the STATE OF ALABAMA

DEPARTMENT OF REVENUE,

Defendants.

Order

This case concerns the application and constitu-

tionality of section 40-18-35(b), Code of Alabama

(1975) (“the add-back statute”). The Alabama De-

partment of Revenue (the “Department”) issued a Fi-

nal Assessment to VFJ Ventures, Inc. (“VFJ”) for

Alabama corporate income tax in the amount of

$1,019,899 on November 6, 2003. VFJ timely ap-

pealed the Final Assessment to this Court. A trial

was held before this Court from July 26 to July 31,

2006. Although the Final Assessment covers several

issues, the sole issue before this Court is the validity

under the add-back statute of the Department’s re-

quirement that VFJ add the amount of certain roy-

alty payments paid by VFJ to the H.D. Lee Company,

Inc. (“Lee”) and Wrangler Clothing Corp. (“Wran-

66a

gler”) back to VFJ’s Alabama income for the 2001 tax

year. This is a case of first impression in that no

other state has issued a ruling concerning the appli-

cation and constitutionality of add-back statutes.

This Court had the benefit of hearing from the pre-

mier experts in the fields of taxation and patents and

trademarks.

Finding of Fact

VFJ manufactures and markets jeanswear, pri-

marily with the LEE® and WRANGLER® brand

names throughout the United States. During 2001,

VFJ had two distribution facilities and a cutting fa-

cility in Alabama employing approximately 600 em-

ployees. Accordingly, VFJ filed an Alabama corporate

income tax return and paid income tax to the State of

Alabama for that year.

In 2001, VFJ paid $36,220,000 in royalties to Lee

and $66,420,000 in royalties to Wrangler for the use

of dozens of trademarks owned by those corporations

in VFJ’s manufacturing and marketing processes.

VFJ deducted the royalties as business expenses for

federal income tax purposes, and this deduction

flowed through to its Alabama income tax return,

which uses federal taxable income as the starting

point for the calculation of Alabama taxable income.

VIJ, Lee, and Wrangler are among the hundreds of

direct or indirect subsidiaries of V.F. Corporation

(“VF”), which is headquartered in Greensboro, North

Carolina. Lee and Wrangler are Delaware corpora-

tions engaged in the business of owning, managing,

and licemsing extensive trademark portfolios (“intan-

gibles menagement companies” or “IMCOs”). Their

trademark portfolios are quite valuable; one witness

67a

estimated that they were worth approximately $5

billion.

Lee has been engaged in the business of manufac-

turing jeanswear since 1889, In 1983, Lee transferred

its operating and manufacturing assets to The Lee

Apparel Company, Inc., but it retained its trade-

marks. In 1993, VF created several more companies

like Lee that were to hold and manage the many dif-

ferent trademarks it and its subsidiaries used all

over the world. These IMCQOs, including Wrangler,

were located in Delaware. Each IMCO held a differ-

ent family of trademarks.

The establishment of these IMCOs had beneficial

state tax effects for the VF group. If the IMCOs were

located in Delaware, their income would not be sub-

ject to an income tax, but operating subsidiaries, such

as VFJ, could deduct royalties paid to the IMCOs on

the state income tax returns in the states in which

they were doing business.

At trial, VFJ established several other purposes for

segregating the ownership and management of its

trademarks into the IMCOs. Centralization of trade-

marks increased efficiency by concentrating man-

agement in one group of employees instead of being

spread throughout the various operating subsidiaries

around the world. Centralization also allowed the

employees to develop the expertise necessary to

maintain the necessary registrations and monitor

and combat infringement worldwide. The centraliza-

tion and specialization also reduced duplicative ef-

forts, costs, and reliance on outside counsel, increas-

ing efficiency. VF was able to save at least. $60,000

per month in fees paid to outside counsel when it be-

gan its centralized trademark management.

68a

Centralization of trademark management allowed

third party licensing efforts to be coordinated and

managed. It also allowed easier monitoring of ex-

penses and revenues associated with the intangible

assets. Furthermore, centralization of intangible

property was also part of a larger effort by VFJ in the

1990s to begin sharing common services (such as

data processing, information technology, payroll,

treasury, employee benefits and legal services) to

capitalize on economies of scale.

The parties vigorously disputed at trial whether

segregation of the different families of trademarks

into different IMCOs facilitated the ease of sale of VF

companies or lines of business. I find that the evi-

dence established that in VF’s history of both selling

and purchasing several lines of business, such sales

were facilitated by having the intangibles owned by

an IMCO, thereby avoiding the need to transfer and

assign each trademark, which could require thou-

sands of assignments and filings around the world.

VF in fact sold two IMCOs, Healthtex Apparel Corp.

and Jantzen Apparel Corp., to third party purchasers

in recent years and found that the [MCO structure

facilitated the transfer of the intangibles.

Segregating the intangible assets into separate

management companies provided a more flexible

business structure in other ways as well. For exam-

ple, this structure would give the affiliated group

more options in the case of a hostile takeover. It also

became easier for the affiliated group to borrow

money when it could demonstrate that the IMCOs

had valuable assets as potential collateral and steady

streams of income, without potential for unforeseen

liabilities. The use of several different IMCOs en-

sured clean title to the different families of trade-

69a

marks, and segregated the liabilities of the operating

companies from the very valuable intangible assets.

It also made it easier to track the profitability of the

different families of trademarks.

There were also several advantages to incorporat-

ing the IMCOs in Delaware Delaware has advanced

and favorable corporate law, and the U.S. District

Court of Delaware has developed a specialty in intel-

lectual property law. Delaware has an experienced

workforce with experienced service providers in the

intellectual property area.

VF did an excellent job during the course of this

trial convincing the Court that Lee and Wrangler are

not merely “shell” corporations, but carry on substan-

tial activities. The Court had the benefit of watching

a videotape which set out the entire operation in

Delaware. They had 3,200 square feet of office space

in Wilmington, Delaware. Lee currently has at least

fifteen employees, including two trademark attor-

neys, six trademark paralegals, one licensing parale-

gal, three trademark assistants, controller, staff ac-

countant, and receptionist. These employees perform

work for Wrangler as well. There was no question

that this is a “working office,” not just an empty

space with a post office box.

The employees monitor and maintain thousands of

trademark registrations throughout the world. They

license trademarks to VF affiliates like VFJ and also

to numerous third parties. In 2001, approximately

22% of Lee’s royalty income and 3.2% of Wrangler’s

royalty income were derived from third parties.

Helen Winslow, assistant general counsel of Lee, re-

views license applications from third parties and has

the authority to turn down a license application from

a potential licensee whose products might tarnish a

70a

brand’s image or raise liability issues. Ms. Winslow

can and often dues require a test period for a new li-

censee or grant a license only in a certain geographic

territory. Ms. Winslow engages in negotiations with

the licensee, licensee’s counsel, and usually a repre-

sentative from a VF manufacturing company in order

to set the terms of the license. Ms. Winslow, a past

president of the Delaware State Bar Association, does

not merely rubber stamp any paper brought to Lee by

a related company.

The IMCOs generally charged the same arm’s-

length rates for intercompany license agreements as

third party license agreements. The general rule was

a flat 5% license or royalty fee, as determined by in-

dustry standards.

The only criticism of the operation by the Court

was the quality control method used. The IMCOs re-

quired potential licensees, both related and unre-

lated, to submit proposed quality standards, however,

the Court saw definite room for improvement in this

area. The IMCOs then negotiated with potential li-

censees in order to ensure the quality standards were

sufficiently high that the licensees’ use of the trade-

marks would not harm their value. If the standards

were acceptable, the IMCO adopted those quality

standards for the license; if the potential licensee

would not agree to sufficiently high quality stan-

dards, no license was granted.

In order to ensure compliance with the standards,

the IMCOs entered into “Technical Assistance and

Know-How Agreements” with related VF manufac-

turing companies. In these agreements, the manufac-

turing entity agreed to provide certain technical as-

sistance to the entities to which the IMCOs licensed

particular trademarks. The assistance included pro-

T1la

vision of technical know-how ani expertise with re-

spect to the design, manufacture, quality control,

promotion, marketing and distribution of the branded

products. In exchange, the IMCOs reimbursed the

manufacturing company for all costs associated with

such consulting plus 5%.

The IMCOs monitored all lcenses, both VF and

third-party, for proper trademark usage. In addition,

the IMCOs hired third parties to investigate licen-

sees’ factories and ensured that the affiliated group’s

centralized audit group also investigated factories for

quality control. The inspection program also ensured

proper quality control over the goods manufactured

by licensees.

Lee and Wrangler also engaged in monitoring for

potential trademark infringements. The IMCO staff

received and reviewed “watch service” reports daily

to monitor for trademark applications claiming rights

in trademarks that resembled Lee’s or Wrangler’s

trademarks. They also reviewed weekly the Official

Gazette, a publication of the U.S. Patent and Trade-

mark Office that lists all approved trademark appli-

cations. If an IMCO discovered a potential] infringe-

ment, it took steps to protect its trademarks,

including filing court proceedings against the poten-

tial infringers if necessary.

VFJ entered into license agreements with Lee and

Wrangler that governed the licensing arrangement;

these agreements contained terms comparable to

those in the IMCOs’ agreements with third parties.

There is no dispute that the 5% royalty rate was an

arm’s length rate. Pursuant to these license agree-

ments, VFJ paid royalties in cash to Lee and Wran-

gler for the use of their trademarks based on the

72a

amount of VFJ’s sales. VFJ transferred cash to Lee

and Wrangler when making royalty payments.

Lee and Wrangler each file separate corporate in-

come tax returns in North Carolina. Lee apportioned

(and paid tax on) 2.8783% of its income to North

Carolina for tax year 2001. Wrangler apportioned

(and paid tax on) 3.9415% of its income to North

Carolina for tax year 2001. In addition, the IMCOs

are included in VF group consolidated or combined

returns in California, Illinois, Kansas, and Colorado.

VFJ filed Alabama corporate income tax returns in

2000 and 2001. After an audit, the Department is-

sued a Final Assessment to VFJ in the amount of

$1,019,899 on November 6, 2003. VFJ timely ap-

pealed the Final Assessment to this Court. The pri-

mary adjustment in the audit—and the sole issue in

the appeal before this Court—concerns the Depart-

ment’s disallowance of deductions for bona fide roy-

alty payments to Lee and Wrangler under the De-

partment’s interpretation of the add-back statute.

Opinion

The Add-back Statute

In 2001, the Alabama legislature amended section

40-18-35, Code of Alabama (1975), by adding a new

subsection (b), commonly referred to as the “add-back

statute.” This new subsection required corporations,

when computing their taxable income, to “add back

othe: wise deductible ... intangible expenses and costs

directly or indirectly paid, accrued, or incurred to...

one or more related members” unless certain excep-

tions apply. Ala. Code § 40-18-35(b)(1).

In the instant case, there is no dispute that VFJ

and Lee and Wrangler are “related members” or that

73a

the royaltics paid by VFJ to Lee or Wrangler consti-

tute “intangible expenses.” VFJ deducted these roy-

alty payments as ordinary and necessary business

expenses on its federal return, and these deductions

flowed through to its Alabama income tax return.

Therefore, under the add-back statute the amount of

the royalty payments must be added back to VFJ’s

income, unless, as VFJ claims, an exception applies

or the add-back statute is unconstitutional.

I. The Unreasonable Exception

A broad exception to the add-back statute is found

in subsection (b)(2). Add-back is not required if “the

corporation establishes that the [add-back] adjust-

ments are unreasonable.” Ala. Code § 40-18-35(b)(2).

The statute has no definition of “unreasonable.” Joe

Garrett, an attorney with the Alabama Department

of Revenue who helped draft the add-back statute,

testified that the Department has an interpretation

of “unreasonable,” but it is not specifically defined in

the statute. In 2003, the Department issued a regula-

tion, not applicable during the tax year at issue, that

defines the “unreasonable” exception thus: “based on

the entirety of the taxpayer’s particular facts and cir-

cumstances, the adjustments have increased the tax-

payers Alabama income tax liability to an amount

that bears no fair relation to the taxpayer’s Alabama

presence.” Ala. Admin. Code r. 810-3-35-.02(3\h)1.

Because add-back in VFJ’s circumstances effec-

tively denies it a deduction for a necessary cost of

doing business in Alabama, thereby resulting in a

calculation of taxable income that includes income

fairly attributable to other states, add-back is unrea-

sonable and thus not required for VFJ.

T4a

States have rightfully been concerned about tax-

payers taking advantage of IMCO structures by set-

ting up “shell” or “sham” corporations in low-tax ju-

risdictions such as Delaware or Nevada or several

other states and shifting substantial portions of their

income to low-tax jurisdictions without any real

business activity taking place in those other states.

See, e.g., Syms Corp. v. Comm’r of Revenue, 765 N.E.

2d 758 (Mass. 2002). In response to taxpayers gener-

ating large deductions from these sham or shell cor-

porations, several states passed statutes intended to

deny taxpayers tax benefits from these sham corpora-

tions. Alabama’s add-back statute is one of these

statutes.

Lee and Wrangler, however, are not sham or shell

corporations. There were several business purposes

for their creation and continued viability. They carry

on substantial activities that are vital to the business

operations of the VF group. VFJ had a business pur-

pose for making the royalty payments—it needed the

use of these valuable trademarks in its operations.

The payments also had economic substance—they

were made in cash and conferred on VFJ the right to

use the trademarks.

Deductions for the cost of doing business are an es-

sential part of any tax on net income. Recognizing

this, Alabama has long allowed deductions for “the

expenses of carrying on such business.” Subdivision

5, § 454, Code of Alabama (1886). Alabama encour-

ages such deductions for ordinary and necessary

business expenses, “(tlhe theory being, presumably,

that the spending of money to make money should be

encouraged to the end that taxes will be paid on the

net accomplished.” Boswell v. Bonham, 297 So. 2d

379 (Ala. Civ. App. 1974).

75a

An expense is an “ordinary” business expense when

it is normal, common, and accepted under the cir-

cumstances by the business community. Welch uv.

Helvering, 290 U.S. 111, 113-115 (1933). The testi-

mony revealed that payment of royalties to IMCOs

(both related and non-related) is normal, common,

and accepted in the business community. An expense

is a necessary business expense when it is “appropri-

ate and helpful” in developing the taxpayer’s busi-

ness. Welch v. Helvering, 290 U.S. 111, 113 (1933)

(also noting that courts “should be slow to override

[the taxpayer’s] judgment” as to whether an expense

is “necessary”). The royalty payments made by VFJ

in 2001 were thus ordinary and necessary in its busi-

ness, giving VFJ the right to manufacture jeanswear

with the valuable Lee and Wrangler trademarks.

“Unreasonable” is not defined in the statute; it thus

should be interpreted in accordance with the legisla-

ture’s intent in enacting the statute. State Dep’t of

Revenue v. Amerada Hess Corp., 788 So. 2d 179 (Ala.

Civ. App. 2000). Since the purposes of the add-back

statute are to prevent abusive deductions and to en-

sure that income fairly attributable to Alabama is

taxed in Alabama, it is unreasonable to require add-

back when these purposes would be frustrated by

add-back. Add-back is unreasonable in VFJ’s case be-

cause VFJ’s royalty payments are not abusive-—they

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 VFJd’s income fairly attributable

to this state.

Accordingly, considering the language and purpose

of the add-back statute, Alabama public policy al-

lowing deductions for business expenses in deter-

76a

mining net income, and the particular facts of this

case, I find that it would be “unreasonable” to require

add-back to VF\J’s royalty payments.

This conclusion is not altered by the fact that the

transactions may have been motivated by tax consid-

erations. In the words of Judge Learned Hand:

[A] transaction, otherwise within an exception of

the tax law, does not lose its immunity, because

it is actuated by a desire to avoid, or, if one

choose, to evade, taxation. Any one may so ar-

range his affairs that his taxes shall be as low as

possible; he is not bound to choose that pattern

which will best pay the Treasury; there is not

even a patriotic duty to increase one’s taxes.

Helvering v. Gregory, 69 F. 2d 809, 810 (2d Cir. 1934),

affd sub nom. Gregory v. Helvering, 293 U.S. 465

(1935). This principle has long been followed in Ala-

bama law: “A taxpayer may resort to any legal

method available to it in an effort to diminish the

amount of its tax liability.” West Point Pepperell, Inc.

v. State Dep’t of Revenue, 624 So. 2d 579, 582 (Ala.

Civ. App. 1992), writ quashed as improvidently

xranted, 624 So. 2d 582 (Ala. 1993) (citing State v.

Pullman-Standard Car Mfg. Co., 235 Ala. 493, 179

So. 541 (1938)).

Even though this Court’s decision regarding the

“unreasonable exception” disposes of this case, the

Court must point out that the “add-back statute” also

has problems relating to the interpretation of the

“subject-to-tax” exception. The statute does not define

“income.” The Department takes the position that

“included in income” means “included in post-appor-

tioned income.” VF takes the position that “included

in income” means simply “included in (any? income.”

77a

The Department’s own expert, Peter Enrich, who has

never testified as an expert in court, stated the lan-

guage of the “subject-to-tax” exception “is not the

most perspicuous way of stating it.” Professor Rick

Pomp, VF’s expert, testified that the “subject-to-tax”

exception did not set out pre or post-apportionment

language. It was clear to this Court, that if the legis-

lature had wanted the “subject-to-tax” exception to

mean post-apportioned income, then they weuld have

stated it in the statute.

{Because this Court’s decision regarding the unrea-

sonable exception disposes of this case, it is not nec-

essary for me to fully discuss the parties’ arguments

concerning the “subject to tax” exception in subsec-

tion (b)(1) or the constitutionality of the add-back

statute. |

After listening to days of testimony and reading the

parties briefs, the Court must conclude that the “add-

back statute” was a poorly drafted statute. The

Court, however, would again state that it does not

need to dissect and discuss every provision of the

statute as the Court’: decision regarding the unrea-

sonable exception disposes of this case.

It is therefore ordered ORDERED, ADJUDGED),

and DECREED that the Defendant modify the Final

Assessment against the Plaintiff in accordance with

the terms of this order.

DONE AND ORDERED this the 24th day of Jan.,

2007.

/s/ Tracy S. McCooey

TRACY S. MCCOOEY

CIRCUIT JUDGE

78a

APPENDIX D

STATE STATUTES

Ala. Code § 40-18-33. Corporate income tax; taxable

income.

In the case of a corporation subject to the tax

imposed by Section 40-18-31, the term “taxable

income” means federal taxable income, without the

benefit of federal net operating losses plus the addi-

tions prescribed and less the deductions and adjust-

ments allowed by this chapter and as allocated and

apportioned to Alabama.

Ala. Code § 40-18-35(b) (2001). Corporate income

tax; computation of

income.

* ok * *

(b) Restrictions on the deductibility of certain intan-

gible expenses and interest expenses with a related

member.

(1) For purposes of computing its taxable income,

a corporation shall add back otherwise deductible

interest expenses and costs and intangible expenses

and costs directly or indirectly paid, accrued, or

incurred to, or in connection directly or indirectly

with one or more direct or indirect transactions, with

one or more related members, except to the extent

the corporation shows, upon request by the commis-

sioner, that the corresponding item of income was in

the same taxable year: a. Subject to a tax based on or

measured by the related member’s net income in

Alabama or any other state of the United States, or b.

subject to a tax based on or measured by the related

member’s net income by a foreign nation which has in

force an income tax treaty with the United States,

79a

if the recipient was a “resident” (as defined in the

income tax treaty) of the foreign nation. For purposes

of this section, “subject to a tax based on or measured

by the related member’s net income” means that the

receipt of the payment by the recipient related mem-

ber is reported and included in income for purposes of

a tax on net income, and not offset or eliminated in a

combined or consolidated return which includes the

payor.

(2) The corporation shall make the adjustments

required in subdivision (1) unless the corporation

establishes that the adjustments are unreasonable,

or the corporation and the Commissioner of Revenue

agree in writing to the application or use of alterna-

tive adjustments and computations. Nothing in this

section shall be construed to limit or negate the

commissioner’s authority to otherwise enter into agree-

ments and compromises otherwise allowed by law.

(3) The adjustments required in subdivision (1)

shall not apply to that portion of interest expenses

and costs and intangible expenses and costs if the

corporation can establish that the transaction giving

rise to the interest expenses and costs or the intangi-

ble expenses and costs between the corporation and

the related member did not have as a principal

purpose the avoidance of any Alabama tax and the

related member is not primarily engaged in the

acquisition, use, licensing, maintenance, manage-

ment, ownership, sale, exchange, or any other dis-

position of intangible property, or in the financing of

related entities. If the transaction giving rise to the

interest expenses and costs or intangible expenses

and costs, as the case muy be, has a substantial

business purpose and economic substance and con-

tains terms and conditions comparable to a similar

80a

arm’s length transaction between unrelated parties,

the transaction will be presumed to not have as its

principal purpose tax avoidance, subject to rebuttal

by the Commissioner of the Department of Revenue.

(4) Nothing in this section shall require a corpora-

tion to add to its taxable income more than once any

amount of interest expenses and costs or intangible

expenses and costs that the corporation pays, accrues

or incurs to a related member described in subdivi-

sion (1).

(5) Nothing in this section shall be construed to

limit or negate the commissioner’s authority to make

adjustments under this chapter.

(6) This subsection shall not limit the deduction of

the interest portion of rent paid under lease agree-

ments described in subsection (a)(9).

* * * *