Update on legislative revision of Secretary of Revenue’s authority to require combined tax returns and make other discretionary adjustments.

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.[1]  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.[2]  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.”[3]

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.[4]

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.”[5]  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.”[6]

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.[7]

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.

Delhaize files petition for discretionary review with the North Carolina Supreme Court.

In January 2011, the North Carolina Business Court decided Delhaize America, Inc. v. Lay.[8]  Delhaize is a forced combination case under the former N.C. Gen. Stat. § 105-130.6 mentioned above. In Delhaize, the Business Court found that the Secretary of Revenue’s assessment of additional corporate income tax, based on the requirement that the taxpayer and certain affiliates file combined corporate income tax returns, was lawful.  The Business Court found that the assessment of penalties, however, was unconstitutional and unauthorized by statute. 

Both parties appealed this decision to the North Carolina Court of Appeals.  Delhaize America, Inc. has also filed a petition for discretionary review by the North Carolina Supreme Court.  The petition requests that the Supreme Court review the Business Court’s decision prior to determination by the Court of Appeals.  The Secretary of Revenue opposes the petition for discretionary review.  The North Carolina Supreme Court has not yet acted on this petition.

Reservation from franchise tax base for amortization of intangible assets allowed.

North Carolina allows certain items to be excluded from the capital base for purposes of calculating the franchise tax.  In addition to the reservation allowed for depreciation of tangible assets, the General Assembly has added, and made retroactively effective for taxable years beginning on or after January 1, 2007, reservations from surplus or undivided profits amounts that represent amortization of intangible assets as permitted for income tax purposes.[9]

The Department of Revenue has issued a notice concerning refund requests relating to prior tax periods. The notice may be found at http://www.dornc.com/taxes/corporate/franchise_tax.pdf.

Update to the Internal Revenue Code reference includes limited decoupling provisions.

The reference to the Internal Revenue Code, which provides the starting point for determining North Carolina taxable income, has been updated to January 1, 2011.[10]  The session law updating the reference to the Internal Revenue Code also included provisions that require adjustments to be made to federal taxable income relating to bonus depreciation deductions allowed under I.R.C. § 168 and expense deductions allowed under I.R.C. § 179.

For tax years 2010 through 2012, taxpayers are required to add to federal taxable income 85% of the amount allowed as a bonus depreciation deduction under I.R.C. §§ 168(k) or 168(n) for property placed in service during the tax year.[11]  For the next five tax years, taxpayers may deduct the amount of bonus depreciation added to federal taxable income in five equal installments.[12]

For tax years 2010 through 2011, taxpayers must add to federal taxable income 85% of the amount by which the taxpayer’s expense deduction under I.R.C. § 179 for property placed in service in tax year 2010 or 2011 exceeds the amount that would have been allowed under I.R.C. § 179 as of May 1, 2010.[13]  For the next five tax years, taxpayers may deduct the amount added to federal taxable income under N.C. Gen. Stat. § 105-130.5(a)(23) or N.C. Gen. Stat. § 105-134.6(c)(15) in five equal installments.[14]

William S. Lee Act installment credit qualifications revised.

In order to encourage business investment, the General Assembly has added a new option to qualify for certain installment credits of tax credits earned under the William S. Lee Act under Article 3A of Chapter 105 (which was repealed for business activities occurring on or after January 1, 2007).  For credits which require that the taxpayer maintain at least 200 employees at the property for a given year, the jobs requirement for that year may also be satisfied if the taxpayer maintains at least 125 employees at the property and, within two years of the date the employment level falls below 200, invests at the property the greater of $5,000,000 or at least twice the value of the remaining installments of the credit.[15]

This new provision is effective for tax years beginning on or after January 1, 2009.