Financial institutions have not been shy about challenging Minnesota Department of Revenue tax determinations in court. For example, in the 1980s and early 1990s, the banking industry prevailed against the state’s unconstitutional imposition of the bank excise tax. Then, in 1998, Firstar Corporation (headquartered in Wisconsin) convinced the Minnesota Supreme Court that, for purposes of the corporate franchise tax, the bank’s sale of an office building in Wisconsin was “nonbusiness income” taxable only in Wisconsin, rather than “business income” apportioned among several states, including Minnesota.
Recently, banks have once again started filing court appeals disputing Minnesota’s corporate franchise tax assessments. The uptick in appeals started with HMN Financial, which secured a Minnesota Supreme Court taxpayer-friendly opinion, and continued with Minnesota Tax Court appeals filed by two other banks.
At issue in the HMN appeal was whether, during 2002, 2003, and 2004, HMN was free to structure its subsidiaries and operations in a way that substantially reduced its state income tax liability. In 2002, HMN’s wholly-owned subsidiary bank set up its own wholly-owned subsidiary, Home Federal Holding, Inc. (HF Holding), that owned all of the common stock of a real estate investment trust (REIT). The bank then transferred its interests in real estate loans to the REIT. The REIT, which earned income from the loans, distributed virtually all of its income by paying dividends to HF Holding. HF Holding, in turn, paid dividends to the bank.
In accordance with Minnesota law, on its combined Minnesota corporate franchise tax return, HMN included the bank’s and the REIT’s taxable income, but not HF Holding’s income which was exempt because HF Holding was a “foreign operating corporation.” The REIT, however, had close to zero net taxable income because it had distributed all of its earnings as dividends. Moreover, as permitted by Minnesota law, the bank took an 80 percent deduction for “deemed dividends” equal to the adjusted net income of HF Holding. Thus, HMN essentially paid Minnesota corporate franchise tax on only 20 percent of the income from the real estate loans that it had transferred to the REIT.
The Minnesota Department of Revenue audited HMN and concluded that although HMN’s subsidiary structure and resulting tax consequences were consistent with the plain language of Minnesota law, the structure lacked “economic substance” and should, therefore, be disregarded. The state assessed HMN $2.5 million in tax. HMN appealed, arguing that the state did not have the authority to disregard the structure that HMN had set up and that the plain language of Minnesota law governed. The Minnesota Supreme Court agreed with HMN and reversed the assessment.
Earlier this year, a second bank filed an appeal with the Minnesota Tax Court. At issue in the appeal is the tax treatment of a large dividend a bank’s subsidiary received in 2010 directly from a REIT (this differs from HMN, which related to “deemed dividends” from a foreign operating corporation that was not a REIT). On its originally-filed combined Minnesota corporate franchise tax return, the bank included in its Minnesota taxable income the entire amount of the dividend its subsidiary received from the REIT. However, the bank failed to deduct 80 percent of the dividend because there was no analogous deduction for dividends received from a REIT for federal income tax purposes. Notably, at that time, Minnesota law permitted corporate taxpayers to deduct 80 percent of dividends received from corporations in which the taxpayers owned a greater than 20 percent interest. Minnesota law changed in 2013 to preclude application of the 80 percent dividends received deduction to dividends received from a REIT.
In 2014, the bank filed a timely amended return for tax year 2010, taking advantage of the permissible 80 percent deduction and requesting a refund in the amount of $6.2 million. Minnesota initially paid the refund, but then assessed it back, claiming its payment of the refund was in error. In 2016, the bank filed an appeal with the Minnesota Tax Court to challenge the state’s determination that the previously-paid refund was erroneous. The appeal is pending.
A third bank filed a Minnesota Tax Court appeal in August 2015 regarding how its subsidiary bank should apportion its income to Minnesota. The amount at issue is over $7 million.
Historically, banks have been successful in disputing the Minnesota Department of Revenue’s tax determinations, although the state continues to audit banks and issue assessments that are viewed as contrary to Minnesota law. It is no wonder that banks are continuing to file appeals with increasing frequency. Stay tuned to see who prevails and whether other banks will continue the trend started by HMN.