North Carolina Issues Further Guidance On Department Of Revenue's Income Adjustment And Forced Combination Procedures - Corporate Tax

Earlier this year, North Carolina enacted legislation that clarified the procedures the Secretary of the Department of Revenue must follow in order to adjust a corporation's tax return or require corporations to file on a combined basis.¹ The Department of Revenue has issued a Directive that further explains the Secretary's authority to redetermine a corporation's net income by adjusting the corporation's intercompany transactions or requiring the corporation to file a combined income tax return.²

Background

The legislation enacted earlier this year repealed the Secretary's current statutory authority to adjust a corporation's net income or require a combined return and replaced it with new statutory authority effective for tax years beginning on or after January 1, 2012.³ The legislation also granted to the Secretary the authority to enter into a voluntary redetermination in which the Secretary and taxpayer mutually agree to an alternative filing methodology that accurately reports its North Carolina net income.⁴

The first part of the Directive explains the Secretary's practice under current law to require a corporation to file a combined income tax return with its parent, subsidiaries and affiliates for tax years beginning before January 1, 2012. The second part of the Directive explains the Secretary's authority under the new statute to redetermine a corporation's net income by readjusting the corporation's intercompany transactions or requiring the corporation to file a combined income tax return for tax years beginning on or after January 1, 2012. Also, the second part of the Directive describes when a voluntary redetermination is appropriate.

Tax Years Beginning Before January 1, 2012

The Secretary is authorized under current law to eliminate amounts paid by a corporation to an affiliate in excess of fair compensation.⁵ The Secretary also has the power to require a corporation doing business in North Carolina to file a combined corporate income tax return with some or all of its affiliated corporations if the separate entity income tax return does not disclose its true earnings in the state.⁶ Further, the Secretary may require a corporation to use a different method of accounting in order to clearly reflect its net income.⁷ When a corporation conducts its trade or business in a manner that distorts is true net income and the net income properly attributable to the state, the Secretary may correct the distortion through a variety of methods, including alternative apportionment and allocation.⁸ The application of these last two provisions may result in a combination or the disallowance or reduction of deductions for amounts paid by a corporation to an affiliated corporation.

The Directive outlines the three conditions that must be met for the Secretary to require a combined income tax return: (i) common ownership or control; (ii) unitary business; and (iii) net income properly attributable to North Carolina is not disclosed. The Directive also provides: (i) a comprehensive list of factors that the Secretary may consider in determining whether net income properly attributable to the state is disclosed; (ii) entities that must be included in a combined return; (iii) entities excluded from a combined return; (iv) the methodology that must be used to calculate the combined group's income attributable to the state; and (v) procedures that must be followed. The Directive also details the procedures to be followed by taxpayers when filing income and franchise tax returns, as well as forms required to be eligible for credits.

Tax Years Beginning on or After January 1, 2012

Under the new law, the Secretary may redetermine a corporation's net income if the Secretary finds that the corporation's intercompany transactions either lack economic substance or are not at fair market value.⁹ The Directive discusses: (i) transactions that have economic substance; (ii) determination of economic substance under the two-prong test; (iii) determination of fair market value; (iv) adjustments to net income; (v) combined returns; (vi) other authority and limitations; and (vii) voluntary redeterminations.

Transactions that Have Economic Substance

The new statute requires that a transaction both have one or more reasonable business purposes other than the creation of tax benefits, and economic effects other than the creation of tax benefits.¹⁰ The Secretary will continue to rely on federal and state case law under the common law economic substance doctrine except where case law conflicts with the statute.

Determination of Economic Substance

The Directive includes an overview that discusses several general principles that are incorporated by the economic substance doctrine, namely:

Economic substance is a prerequisite to support any taxpayer deduction.
The taxpayer has the burden of proof to show that the transaction giving rise to the deduction has economic substance and does not have a tax avoidance motive.
The economic substance of a transaction will be viewed objectively rather than subjectively.
The Secretary will examine the transactions rather than the entities to determine economic substance.
Arrangements with subsidiaries or affiliated entities not impacting the economic interest of independent third parties will be closely reviewed.

The Directive lists rules that the Secretary will apply in determining whether a transaction has a business purpose or economic effect other than the creation of tax benefits. The Directive also provides an extensive list of factors that the Secretary may consider in determining whether a transaction has economic substance. Further, the Directive clarifies that reasonable business purposes and economic effects include material benefit (substantial improvement of the economic position of the taxpayer on a pre-tax basis) for a transaction other than the creation of state income tax benefits. In determining whether a transaction has business purpose and economic effect, state income tax benefits are considered if they are consistent with legislative intent. Centralized cash management of an affiliated group is not considered, by itself, evidence of an absence of economic substance. In determining whether to require a combined return, the business activity of the entities involved in the transaction may satisfy the test for economic effects beyond tax benefits.¹¹

Determination of Fair Market Value

The Secretary will apply the standards contained in federal regulations¹² in determining whether transactions between members of the affiliated group are at fair market value.¹³ Also, the Secretary will apply any relevant federal or state case law. It should be noted that a taxpayer's transfer pricing study is not dispositive proof of whether the transactions were consummated at actual fair market value.

Adjustments to Net Income

If the taxpayer cannot meet its burden of satisfying the economic substance test and demonstrate that its transactions are at fair market value, the Secretary may redetermine the taxpayer's North Carolina net income by adding back, eliminating or adjusting intercompany transactions, for example, by:

Disallowing deductions in whole or in part;
Attributing income to related corporations;
Disregarding transactions;
Adjusting the apportionment factor; or
Reclassifying income as apportionable or allocable.

Combined Returns

Alternatively, if the Secretary finds that the above adjustments are not adequate to properly reflect the corporation's North Carolina income, the Secretary may require the corporation to file a combined income tax return. The Secretary may issue a written notice to the corporation to file a combined return, or prepare a combined return for purposes of proposing an assessment. The Directive clarifies the entities that are included in a combined return as well as the entities that must be excluded from a combined return.

It should be noted that the statute for tax years beginning on or after January 1, 2012 requires the Secretary to include the entire unitary business group if it requires a combined income tax return (for tax years beginning prior to January 1, 2012, the Secretary is allowed to choose which entities within the unitary business group should be included in the combined return). Despite this change in policy, pursuant to the Directive, for tax years beginning on or after January 1, 2012, the Secretary can propose, and the corporation may accept, a combination of less than the entire unitary business group if such smaller group is deemed by the Secretary to constitute a reasonable means of redetermining state net income. If no agreement is reached, however, the Secretary is bound to proceed with a full unitary combination.

Other Authority and Limitations

Nothing in the new law limits or negates the Secretary's authority to make tax adjustments otherwise permitted by law.¹⁴ While the Secretary is not allowed to make adjustments that limit a corporation's options for reporting royalty payments, the Secretary is allowed to adjust the amount of the payments if the transactions lack economic substance or are not at fair market value.

Voluntary Redeterminations

If the Secretary believes that any corporation's state net income is not accurately reported on a separate return because of intercompany transactions, the Secretary may allow the taxpayer to use an alternative filing methodology. The Secretary may allow an alternative filing methodology without making a finding that intercompany transactions lack economic substance or are not at fair market value. Both the Secretary and the taxpayer must jointly determine and agree to the alternative filing methodology that accurately reports state net income.

Commentary

The legislation enacted earlier this year attempts to provide clear limits on, and transparency into, the Secretary's authority to force combinations, which has been sought after by the national business community. There has been a long history of disputes between taxpayers and the Department over when and how a combined return could be required. Cases such as WalMart Stores East, Inc. v. Hinton¹⁵ and Delhaize America, Inc. v. Lay¹⁶ have highlighted this dispute and received adverse attention for what many in the business community have seen as the Department's one-sided application of requiring combined returns. The legislation is intended to provide a uniform application of forced combination that is fair to both the Department and taxpayers.

The Directive attempts to clarify how the Secretary will apply the new statutory procedures, and does not provide additional limitations beyond the restrictions that were adopted pursuant to statute. However, taxpayers may argue that the Directive does not provide taxpayers with additional certainty regarding whether the Secretary will adjust a corporation's tax return or require a combined return. Further, some taxpayers may contend that the powers that the Directive provides to the Secretary are too broad and go beyond the statutory authority. For example, some of the possible adjustments to net income listed in the Directive arguably are not supported by the statute. Thus, even after adoption of the statute, and issuance of a comprehensive Directive, there still may be disputes concerning the Secretary's power to adjust income or force a combined return.

Footnotes

1 H.B. 619, Laws 2011; revised by S.B. 580, Laws 2011.

2 Directive No. CD1101, North Carolina Department of Revenue, Nov. 16, 2011. Note that the Directive provides that "[t]he interpretation in this Directive is a protection to the taxpayers affected by the interpretation and taxpayers are entitled to rely on this interpretation."

3 H.B. 619, as revised by S.B. 580, repealed the Secretary's existing statutory authority (N.C. GEN. STAT. §§ 105<130.6, 105<130.15 and 105<130.16) and enacted a statute that provides the Secretary with new authority (N.C. GEN. STAT. § 105<130.5A).

4 This authority was granted in S.B. 580.

5 N.C. GEN. STAT. § 105<130.6.

6 Id.

7 N.C. GEN. STAT. § 105<130.15(a).

8 N.C. GEN. STAT. § 105<130.16(b).

9 N.C. GEN. STAT. § 105<130.5A.

10 N.C. GEN. STAT. § 105<130.5A(f).

11 N.C. GEN. STAT. § 105<130.5A(f)(2).

12 This refers to federal regulations adopted under IRC § 482 (allocation of income and deductions among taxpayers).

13 N.C. GEN. STAT. § 105<130.5A(g).

14 N.C. GEN. STAT. § 105<130.5A(n).

15 676 S.E.2d 634 (N.C. Ct. App. 2009).

16 N.C. Sup. Ct., Wake County, No. 06 CVS 08416, Jan. 12, 2011.

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