The South Carolina Supreme Court has held that a taxpayer's interest expenses that were related to nonbusiness (and ultimately, nontaxable) dividend income were not deductible.1 The Court determined that the South Carolina allocation statute that sourced these expenses to the taxpayer's principal place of business (outside South Carolina) did not violate the Commerce Clause as applied to the corporation because it did not discriminate against interstate commerce.
Background
The taxpayer, a major publicly-traded corporation engaging in worldwide manufacturing activities, conducted much of its business through many foreign and domestic wholly-owned subsidiaries and received dividends from these subsidiaries. For fiscal years 1999 through 2002, the taxpayer and its subsidiaries timely filed consolidated income tax returns in South Carolina. In its initial returns, the taxpayer did not claim deductions for expenses related to its receipt of dividends from subsidiary corporations. The taxpayer subsequently filed amended returns claiming the deductions and seeking a refund. The South Carolina Department of Revenue disallowed the expense deductions. After the Administrative Law Court (ALC) upheld the Department's decision, the taxpayer directly appealed the case to the South Carolina Supreme Court.
Expense Deductions Allocated to Taxpayer's Principal Place of Business
The Court affirmed the ALC and held that the taxpayer's interest expense deductions must be allocated to Missouri, the taxpayer's principal place of business. As a result, the taxpayer could not use these deductions for South Carolina income tax purposes.
In reaching its decision, the Court initially agreed that the taxpayer properly excluded from its taxable income the dividends received from its wholly-owned subsidiaries. For both federal and South Carolina income tax purposes, dividends received by a parent corporation from a wholly-owned subsidiary generally are not subject to income tax.2 Qualifying dividend income is not taxable because the dividends received deduction (DRD) allows a 100 percent deduction against this income. Therefore, for the tax years in question, the DRD permitted the taxpayer to claim no taxable income for federal or South Carolina purposes as a result of the dividends that it received from its wholly-owned subsidiaries.3
However, the Court disagreed with the taxpayer's treatment of the corresponding expense deductions arising from the dividends paid to the taxpayer's subsidiaries. In reaching its decision, the Court noted the importance of the characterization of the dividend income (ultimately subject to the 100 percent DRD) as nonbusiness income.4 During the relevant period, South Carolina provided that dividends received from corporate stocks owned, less all related expenses, are treated as nonbusiness income and are allocated to the state of the corporation's principal place of business.5
The Court explained that South Carolina follows the "matching principle" for expense deductions. Under this principle, if income is taxable in South Carolina, the expenses incurred in generating that income may be matched against it as a deduction in South Carolina. Conversely, if income is not taxable in South Carolina, the expenses incurred in generating that income may not be matched against it as a deduction in South Carolina.
The Court followed its previous decision in Avco Corp. v. Wasson6 and rejected the taxpayer's argument that allocation of related expenses is triggered only in the presence of taxable income from the receipt of a dividend. According to the Court, Avco correctly construed the allocation statute and supported the Department's determination to allocate the taxpayer's related expenses to its principal place of business.
Commerce Clause Was Not Violated
The Court also rejected the taxpayer's argument that the allocation statute discriminated against nonresident taxpayers in violation of the Commerce Clause of the U.S. Constitution. The taxpayer argued that application of the allocation statute resulted in a denial of interest deductions related to dividends that were not taxable in South Carolina and resulted in disparate treatment of taxpayers based solely on residence. The constitutional challenge was based on the fact that the taxpayer was not allowed the interest expense deductions under Missouri law, the jurisdiction of its principal place of business. The Court rejected the taxpayer's implication that the constitutionality of one state's allocation statute is contingent on the allowance of certain deductions in another state. The Court determined that the allocation statute was internally consistent, particularly in light of the state's matching principle.
Commentary
The decision to deny a taxpayer additional related expense deductions on transactions in which the taxpayer ultimately received a full 100 percent DRD as a means to fairly attribute income to the state is not surprising. The Court summarily dismissed an argument by the taxpayer that it effectively could have been permitted to take the additional deductions for such expenses if the taxpayer were based in South Carolina instead of Missouri.
This case is one of several recently considered in South Carolina dealing with apportionment and allocation issues, instead of tax base or nexus issues (such as Geoffrey7), but resulting in higher tax liabilities for taxpayers with related-member activity. In Carmax Auto Superstores West Coast, Inc. v. Department of Revenue,8 the taxpayer was a subsidiary that received royalty payments. The South Carolina Administrative Law Judge (ALJ) Division determined that the standard apportionment formula used by the taxpayer did not fairly represent the extent of its business in South Carolina. The Department used an alternative apportionment formula that divided the taxpayer's income from royalties and financing from within South Carolina by the taxpayer's royalty and financing receipts from all locations where it conducted business, excluding the taxpayers' operational income receipts. The ALJ found that the Department's apportionment method was reasonable because (i) its method considered only the business conducted in South Carolina and (ii) separate accounting is a method expressly permitted by South Carolina law.
In Media General Communications, Inc. v Department of Revenue,9 the Court upheld a decision of the ALC granting the taxpayers' request to use a nexus consolidation method of computing their corporate income tax liability, overturning the Department's separate entity method. While the decision was limited to the taxpayers' tax period in question, the decision leaves both potential opportunity and risk for taxpayers with significant intercompany transactions. Notably, the decision opens the door for the Department to use combined apportionment or a "forced combination" strategy to "more fairly attribute" income to the state.
Large consolidated groups with significant intercompany transactions should be put on alert by these recent cases, which points to a shifting landscape in South Carolina, as the home of Geoffrey has many new issues to create uncertainty for taxpayers.
Footnotes
1 Emerson Electric Co. v. South Carolina Department of Revenue, South Carolina Supreme Court, No. 27073, Dec. 12, 2011.
2 IRC § 243; S.C. CODE ANN. §§ 12-6-40 (incorporating the IRC by reference), 12-6-1110 (defining South Carolina taxable income by reference to federal taxable income).
3 The taxpayer and the Department of Revenue stipulated to this fact.
4 A corporation's business income is apportioned among the states in which it conducts business, but nonbusiness income is allocated to or deemed to be earned in a particular state depending on its form. S.C. CODE ANN. § 12-6-2210(B); S.C. CODE ANN. § 12-6-2220.
5 S.C. CODE ANN. § 12-6-2220(2). Note that this section was amended in 2005 to provide "[d]ividends received from corporate stocks not connected with the taxpayer's business, less all related expenses, are allocated to the state of the corporation's principal place of business."
6 230 S.E.2d 614 (S.C. 1976).
7 Geoffrey, Inc. v. South Carolina Tax Commission, 437 S.E.2d 13 (S.C. 1993), cert. denied, 510 U.S. 992 (1993).
8 Administrative Law Judge Division, No. 09-ALJ-17-0160-CC, April 22, 2010.
9 694 S.E.2d 525 (S.C. 2010).
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