United States: Indiana Department Of Revenue Rules On NOL Calculation And Consolidated Group Membership Issues

In an administrative appeal from an assessment published as a Letter of Findings, the Indiana Department of Revenue recently determined that a corporate taxpayer could not factor foreign source dividend deductions into its net operating loss (NOL) deduction calculation. However, the Department permitted the taxpayer to file an amended return for a closed year in order to properly compute the amount of NOL carryforward available, to the extent such changes came as a result of adjustments made to the federal return by the Internal Revenue Service on a Revenue Agent's Report (RAR). The Department also required the exclusion of a taxpayer's out-of-state subsidiary that did not have Indiana source income from the taxpayer's Indiana consolidated income tax return.¹

Background

The administrative appeal from the Department's assessment had three separate components, two based on the taxpayer's NOL calculation, and one based on the composition of the taxpayer's consolidated group. The taxpayer, a parent corporation doing business in Indiana and other states, filed consolidated Indiana adjusted gross income tax returns. The Department examined the taxpayer's 2006 tax year, in which the taxpayer took an NOL deduction from NOLs carried forward from 2001 and 2003. Following the audit, the Department limited the 2001 NOL carryforward due to untimely reporting of RAR adjustments, and also found that the taxpayer's calculation of NOLs from its 1999, 2001 and 2003 years which took foreign source dividend deductions into account was erroneous. Finally, the Department rejected the taxpayer's inclusion of an out-of-state subsidiary in its consolidated Indiana return.

NOL Deduction Based on Foreign Source Dividends

While taxpayers are allowed a deduction from Indiana adjusted gross income for certain foreign source dividends included in Indiana adjusted gross income,² no similar deduction or modification exists in the calculation of the Indiana NOL deduction. The taxpayer claimed that by not allowing an adjustment for foreign source dividends in the Indiana NOL deduction, the Department was unconstitutionally taxing foreign source dividends, and cited the U.S. Supreme Court's decision in Kraft³ for this assertion. In the Letter of Findings, the Department rejected this argument, asserting that a deduction did exist for foreign source dividends in the Indiana statute (unlike the statute in Kraft), and passing on the opportunity to go through a constitutional analysis of the taxpayer's position.

NOL Deduction Based on RAR Adjustments

Indiana law requires that adjustments resulting from an RAR following an audit that changes the taxpayer's Indiana adjusted gross income must be reported on an amended return within 120 days after the federal modification is finalized.⁴ The taxpayer then has six months to submit any potential refund claim. Indiana's statute of limitations for a refund claim on an adjusted tax year is the later of three years from the original return's due date or six months from the IRS issuance of RAR modifications.⁵

In the administrative appeal, the taxpayer admitted the failure to file within the statute of limitations, but asserted that the increased NOLs resulting from the RAR should still be available for use. Because there was no Indiana precedent on the issue, the Department's hearing officer looked to federal guidance and determined that the income from a closed year could be recomputed to properly account for the amount of NOLs available to be carried over to an open year.⁶ In the Letter of Findings, the Department stated that because the NOL from the closed year affects an open year, and since no refund was being requested on the closed year, the taxpayer should be permitted to file an amended return for the 2001 tax year reflecting the RAR changes to be used for informational purposes. The Department would then conduct a supplemental audit to confirm the amount of the NOL that could be used for the 2006 tax year.

Exclusion of Out-of-State Subsidiary from Consolidated Group

Indiana restricts membership in a consolidated group to corporations with Indiana source income.⁷ At audit, the Department removed one of the taxpayer's out-of-state subsidiaries from the consolidated return because the subsidiary reported zero Indiana property, payroll and sales. In the Letter of Findings, the Department concluded that when a taxpayer has business income from sources everywhere, only the business income apportioned to Indiana is deemed to be derived from business sources. Therefore, a taxpayer has Indiana source income only to the extent that it has Indiana property, payroll or sales. The taxpayer argued, to no avail, that the managers of the out-of-state subsidiary, which were the same as the Indiana parent, resulted in the out-of-state subsidiary having an Indiana commercial domicile, creating nexus. The argument was rejected because the taxpayer did not show that the out-of-state subsidiary actually generated Indiana source income.

Commentary

The Letter of Findings addresses substantive and procedural NOL calculation issues that frequently arise in practice. The Department's denial of the taxpayer's inclusion of foreign source dividend deductions in the NOL deduction calculation is not surprising, particularly as the Department was unwilling to draw any constitutional conclusions. If the taxpayer wants relief on this issue, it will need to litigate. On the other hand, the ability to amend closed-year returns to adjust the amount of carryforward NOLs due to an RAR adjustment is a positive development that may provide an opportunity for taxpayers that did not amend Indiana returns following an IRS audit. The carryforward available in open years is limited to the amount that would not have been used during other closed years. In addition to application in Indiana, it would appear that this position would be a tenable one in other states that due to their conformity to the Internal Revenue Code, should follow federal precedents on procedural issues.

Finally, with respect to the out-of-state business not being includible in the Indiana consolidated group, the taxpayer wanted its subsidiary to be included in the group either as a means to lower total Indiana corporate income tax liability by reducing the group's tax base to Indiana and/or by diluting apportionment to Indiana. Given that the taxpayer had elected to file on a nexus consolidated basis and was not forced to file in such a manner, the Department was not likely to broadly interpret the rules to allow the taxpayer to include entities with little tangential connection to the state, as evidenced by the lack of Indiana apportionment factors. The taxpayer had argued that the subsidiary's commercial domicile was located in Indiana because of the location of its managers in the state. If a portion of the salary of the managers or the rent for the Indiana office space in which the managers were located had been paid by the subsidiary instead of the corporate parent, the subsidiary might have been able to report Indiana apportionment factors that would have resulted in its inclusion in the taxpayer's consolidated group.

Footnotes

1 Indiana Letter of Findings 02-20110225, issued Jan. 25, 2012.

2 IND. CODE § 6-3-2-12.

3 Kraft General Foods, Inc. v. Iowa Dep't of Revenue and Finance, 505 U.S. 71 (1992).

4 IND. CODE § 6-3-4-6(c).

5 IND. CODE § 6-8.1-9-1(f).

6 Phoenix Coal Co. v. Comm'r, 231 F.2d 420 (2d Cir. 1956).

7 IND. CODE § 6-3-4-14.

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