For the past six years, corporate taxpayers have been battling attempts by the North Carolina Department of Revenue (“Department”) to force combination of separate entity corporate tax returns, which has typically resulted in substantial corporate tax assessments. The Department has relied on an archaic and unclear statute (N.C. Gen. Stat. § 105-130.6), has refused to publish guidelines or regulations indicating when combination was appropriate, has imposed large penalties on taxpayers when the forced combination remedy was used, and has been unwilling to compromise tax assessments based on the forced combination remedy. Williams Mullen has been involved in the defense of many of these assessments and has been involved in efforts to reform the forced combination statute on behalf of the Council on State Taxation.
The General Assembly responded to these problems with the ratification of HB 619, which reforms North Carolina's law on forced combination. The bill was adopted by the General Assembly at the end of the session and was signed by the Governor on June 30, 2011. The new law marks a significant step forward in bringing clarity and standards to an area marked by a lack of clarity and inadequate standards.
The new legislation repeals N.C. Gen. Stat. § 105-130.6, the prior forced combination statute, and portions of N.C. Gen. Stat. § 105-130.16 dealing with distortion of income. A single new statute, N.C. Gen. Stat. § 105-130.5A, is enacted in their place.
The new statute provides that the Secretary may redetermine the net income of a corporation if the Secretary finds that the corporation’s intercompany transactions lack economic substance or are not at fair market value. The Secretary is allowed to require the corporation to file a combined return with its affiliated group only if “adding back, eliminating, or otherwise adjusting intercompany transactions . . . are not adequate under the circumstances to redetermine the corporation’s State net income attributable to its business carried on in the State.”
Under the new statute, the forced combination remedy only allows the Secretary to issue an assessment based on the combined returns of fewer than all members of the corporation’s affiliated group with the consent of the taxpayer.
The new statute includes a definition of economic substance: “A transaction has economic substance if (i) the transaction, or the series of transactions of which the transaction is a part, has one or more reasonable business purposes other than the creation of State income tax benefits and (ii) the transaction, or the series of transactions of which the transaction is a part, has economic effects beyond the creation of State income tax benefits.” In determining whether a combined return may be required, “whether the transaction has economic effects beyond the creation of State income tax benefits may be satisfied by demonstrating material business activity of the entities involved in the transaction.”
The new statute also provides that regulations promulgated under I.R.C. § 482 shall be used to determine whether intercompany transactions are at fair market value, defines the term “affiliated group,” and limits the use of penalties for redeterminations of income.
The new legislation has an effective date of January 1, 2012 and applies to assessments proposed for tax years beginning on and after that date. The new law also extends the time for the Department to make final determinations on requests for review of assessments made under old N.C. Gen. Stat. § 105-130.6 until June 30, 2012.
A last minute amendment to subsection (n) of Section 2 of the bill raised fiscal implications that the main text of the bill did not, resulting in a last minute change in the effective date provision. Due to concern about the wording of the effective date provision, the General Assembly clarified in early September that N.C. Gen. Stat. § 105-130.6 continues to apply to tax years beginning before January 1, 2012. The General Assembly also added a provision allowing for the Department and a taxpayer to agree to an alternative filing methodology without a finding of transactions that lack economic substance or are not at fair market value.
For budgetary and procedural reasons, HB 619 was made applicable for tax years beginning on or after January 1, 2012. The Revenue Laws Study Committee is currently studying whether the legislation should be applicable to open years for pending tax audits.