The North Carolina Court of Appeals recently issued a decision against the taxpayer in Delhaize America, Inc. v. Lay, No. COA11-868, (Aug. 21, 2012). It is the latest in the string of taxpayer defeats whereby a taxpayer sought to isolate intangibles, such as intellectual property, and recognize tax savings as a result of deductions for payments to a related company.
Delhaize, formerly known as Food Lion, Inc. (hereinafter Food Lion), a corporation commercially domiciled in North Carolina, owned and operated the Food Lion supermarket chain. In 1996, Food Lion formed a wholly owned subsidiary, FLI Holding Corp. (FLI), which was an acquisition vehicle that operated retail grocery stores primarily in Florida. It also formed FL Food Lion, Inc. (FL), a Florida corporation, as a subsidiary of FLI.
As a result of a restructuring proposed by Coopers and Lybrand (Coopers), Food Lion transferred certain assets to FL, including, but not limited to, the Florida-based Food Lion supermarkets, all Food Lion employees in Florida, certain North Carolina-based Food Lion employees, and certain intellectual property, including its private-label trademarks and the Food Lion name and logo. FL charged Food Lion for the services performed by its employees based upon a transfer price determined by Coopers. Additionally, FL charged Food Lion a royalty for the use of the intellectual property, again based upon a transfer price set by Coopers. The cash flow was circular; that is, the cash paid for the services and the royalties was eventually paid back to Food Lion in the form of a deductible dividend. As a result, Food Lion’s cash flow was unaffected, and a contemporaneous letter from the chief financial officer of Food Lion to the Board of Directors indicated that the purpose of the transactions was the reduction of state tax liabilities.
The Audit and the Trial Court
Both FL and Food Lion filed North Carolina income tax returns, which were audited by the North Carolina Department of Revenue (the Department). As a result of this audit, the Department determined that the income of FL and Food Lion should be combined to reflect the true net earnings in North Carolina. The Department issued an assessment in 2004 for the tax years 1998 through 2000, including penalties and interest. Food Lion paid the tax, penalties and interest and filed for a refund. When the Department denied the refund, Food Lion filed a complaint in Wake County, alleging, among other things, constitutional violations, violations of the North Carolina Administrative Procedures Act, and that the assessment violated N.C. Gen. State. §§ 105-130.6 and 105-130.16. The trial court granted summary judgment to both parties, upholding the Department’s combination of FL and Food Lion, but upholding Food Lion’s motion for a refund of the penalties. Both parties appealed.
The Court of Appeals Decision
The Court of Appeals, consistent with North Carolina law, reviewed the decision of the trial court de novo, per Craig v. New Hanover Cty. Bd. Of Educ., 678 S.E. 2d 351, 354 (N.C. 2009). It noted, initially, that the Court of Appeals had recently upheld the Department’s authority to force combination of entities on a finding that a tax return did not disclose true earnings in North Carolina in Walmart Stores East v. Hinton, 676 S.E. 2d 634, 649 (N.C. 2009).
The crux of Food Lion’s appeal was that the Department violated its procedural due process rights by failing to provide fair notice of changes in its guidelines regarding the combination of corporations pursuant to N.C. Gen. Stat. § 105-130.6, and that it concealed the approach from taxpayers and auditors and applied this approach retroactively. The Court of Appeals cited Peace v. Employment Sec. Comm’n, 507 S.E. 2d 272, 278 for the proposition that the fundamental driver of procedural due process is notice and an opportunity to be heard. This proposition requires a two-step analysis – is there a liberty or property interest which has been interfered with by the state, and if so, are there sufficient procedures leading to this deprivation that were constitutionally sufficient. In re W.B.M., 690 S.E. 2d 41, 49 (N.C. 2010).
Food Lion alleged that the Department did not issue sufficient guidance with respect to N.C. Gen. Stat. § 105.130.6, which reads, in pertinent part:
“The net income of a corporation doing business in this State that is a parent, subsidiary, or affiliate of another corporation shall be determined by eliminating all payments to or charges by the parent, subsidiary, or affiliated corporation in excess of fair compensation in all intercompany transactions of any kind whatsoever. If the Secretary finds as a fact that a report by a corporation does not disclose the true earnings of the corporation on its business carried on in this State, the Secretary may require the corporation to file a consolidated return of the parent corporation and of its subsidiaries and affiliates….” (emphasis added).
Food Lion alleged that, after a long period whereby it only ordered this forced combination in exceptional circumstances when intercompany transactions failed to reflect fair compensation, and only if adjustments could not be made to arrive at true earnings. The Department abandoned this principle, according to Food Lion, in favor of an ad hoc approach without any universal guidelines. Essentially, in abandoning the original methodology in favor of an ad hoc approach without notifying taxpayers or providing guidelines for the change in the way to calculate “true earnings,” Food Lion alleged the Department violated due process. According to Food Lion’s interpretation, using the historical approach, since it had complied with arm’s-length pricing vis-à-vis the use of transfer pricing, forced combination was not appropriate.
The Court of Appeals evaluated these procedural due process standards in light of a recent Supreme Court decision evaluating the Federal Communications Commission (FCC)’s indecency policy in Federal Communications Commission v. Fox Television Stations, 132 S. Ct. 2307 (2012). The Court of Appeals noted that the FCC’s indecency policy evolved over time. For example, in the Fox Television Stations decision, the court noted that the FCC’s definition of indecency had changed over time to be broader than the famous “seven dirty words” from a George Carlin monologue. In 2001, the FCC announced a policy, consistent with orders issued from 1987 to 2001, that the repetition of and persistent focus of indecent material exacerbated the potential offensiveness of a broadcast, whereas fleeting and isolated material may not be considered indecent.
The court considered a Golden Globes Awards ceremony broadcast on NBC whereby a fleeting expletive was uttered in light of two previous broadcasts with the same fleeting expletive as well as another broadcast with seven seconds of fleeting nudity. The FCC reversed its position with respect to the Golden Globes and found the fleeting expletive indecent. The FCC then applied this new standard to the alleged indecency at issue in Fox Television Stations. Fox and ABC alleged that this new standard did not constitute fair notice and therefore violated their procedural due process rights. Crucial to this argument was the incidents at issue preceded the FCC’s order with respect to the Golden Globes broadcast.
The FCC conceded that Fox did not have reasonable notice that the fleeting expletive would be considered indecent since the fleeting expletive occurred before the FCC’s Golden Globes order. However, it contended that ABC should have been on notice, as there was a 1960 decision that nude programming might violate the indecency standards, although there was another ruling that determined that 30 seconds of fleeting nudity was very brief and not actionably indecent. The court concluded, however, that Fox’s and ABC’s procedural due process rights were violated because neither company had proper notice prior to being sanctioned.
The Court of Appeals considered Food Lion’s challenge in light of this recent Supreme Court case. The Court of Appeals noted that subsequent to the 2004 audit that resulted in the forced combination of Food Lion and FL, the court had analyzed the forced combination provisions of N.C. Gen. Stat.§ 105-130.6 in Walmart Stores East. In that case, the court found that the statutory language did not, on its face, limit the Department’s authority to require combined reporting by mandating that the entities in question engage in non-arm’s-length dealings. The Walmart court rejected the taxpayer’s proposition that “true earnings” meant the taxpayer’s income, calculated as if the taxpayer had no affiliates and dealt with all parties at arm’s length. The court noted that in any unitary business, even when affiliates deal at arm’s length, the potential to distort true earnings by the use of intercompany transactions existed.
The Walmart court defined “true earnings” as being limited only by the standards in the United States Constitution. Unsurprisingly, the Department argued that Walmart controlled, and the Court of Appeals agreed. This, of course, still leaves open the question as to whether Food Lion had notice, sufficient to satisfy procedural due process, that the Department considered the definition of “true earnings” was not limited to a determination of whether a group of corporations conducted its intercompany transactions at arm’s length.
The Court of Appeals noted that the concept of forced combination was not new, and that the Department had published guidance dating back to 1964 providing guidance on the subject. The record showed that the Department had required forced combination as far back as 1973. Further, the Court of Appeals agreed with the Department that these historic incidents of forced combination went beyond those in which the definition of true earnings was limited to fair compensation gained through an arm’s-length transaction between related parties.
The Court of Appeals pointed to a 1987 attorney general’s opinion that concluded that the mere diversion of income to a subsidiary would be sufficient to force combination, and that a forced combination need not include all related corporations. Further, in 1997, the Department issued a decision that provided that if the return as filed did “… not disclose the true earnings of the corporation on its business carried on in the state, the Secretary may require the corporation to file a combined return of the taxpayer and those affiliated corporations necessary to determine the true amount of net income earned by the unitary group in the state.” Importantly, there was no reference in this ruling to excess compensation or arm’s-length pricing.
In the 1997 decision, the taxpayer contributed the stock of two subsidiaries to a Delaware holding company and subsequently sold those two subsidiaries. As a result, the gain on these transactions would not be subject to tax in North Carolina absent a forced combination. The decision noted that geographically cherry-picking gains and losses and sourcing them favorably (losses to North Carolina from the result of operations, gain on the sale to the Delaware holding company) impermissibly distorted the taxpayer’s income.
In 2000, the Department issued another decision requiring forced combination of a taxpayer and its affiliated intellectual property holding companies despite the use of arm’s-length transfer pricing because it resulted in an arbitrary shift of income that distorted true income.
Food Lion argued that the Department deliberately concealed its criteria and that it operated on an ad hoc basis with no discernible standards. Based upon the record, the Court of Appeals did not agree. It distinguished the Fox Television Stations decision with respect to the fleeting nudity incident, whereby the only notice the FCC might have given ABC dated to 1960. In this case, according to the Court of Appeals, the 1997 Department decision pre-dated the Coopers analysis presented to Food Lion by three months, and it made no reference to arm’s-length transactions, or the lack thereof, as a predicate to forced combination. In fact, the Coopers report acknowledged that the courts had not resolved whether forced combination required a showing of distortion via the use of something other than arm’s-length transfer pricing. However, the Court of Appeals noted that numerous other taxpayers had requested private letter rulings (Food Lion did not make such a request) and that these rulings were consistent in showing that the definition of true earnings was not limited to a showing that all transactions were at arm’s length.
Further, contrary to the allegation that the Department concealed these standards, in 1997, virtually at the same time as the Coopers report, the Department issued a private letter ruling on the principle at issue here, concluding that arm’s-length pricing did not limit the Department’s ability to force combination. The Coopers report also noted that in July 1997, the Department issued a decision holding the Department “… has the statutory authority to force a combination of entities if it finds that the … corporation’s return does not disclose its true earnings …” to North Carolina. Based upon the existence of these various rulings, the Court of Appeals concluded that Food Lion should have been on notice and that its procedural due process rights were not violated.
The Court of Appeals summarily dismissed Food Lion’s invitation to overturn its Walmart decision as improperly interpreting N.C. Gen. Stat. § 105-130.6. Further, the court found that Walmart had also addressed, and dismissed, Food Lion’s argument that the assessment violated the North Carolina Constitution’s bar on retroactive taxation. It also dismissed an argument that the trial court had improperly interpreted economic substance in its analysis, because, as Food Lion admitted in its appellate brief, the Department did not apply an economic substance analysis.
The Court of Appeals concluded by overturning the trial court’s grant of summary judgment in favor of Food Lion with respect to the penalties imposed by the Department, again relying on a similar analysis upholding such penalties in Walmart.
The Court of Appeals decision is obviously a rousing defeat for the taxpayer. Reading it in a light favorable to the Department, there were ample instances where the Department had required combination without a showing that the taxpayers did not use arm’s-length pricing. The practice of issuing private letter rulings without clear and definable standards of when combination would be required does seem like a star chamber. It raises the spectre that similarly situated taxpayers could be afforded differing treatment without adequate rationale, and may call into question the motivation of the government in treating these taxpayers differently. While there is no evidence that this occurred in North Carolina, it is indisputable that clearly delineated standards are a benefit to everyone, taxpayers and tax administrators alike.