The North Carolina Court of Appeals has affirmed a trial court's decision that upheld the Secretary of the North Carolina Department of Revenue's ability to order a combined return under prior law.1 However, the Court of Appeals reversed the trial court's decision that the taxpayer was entitled to a refund of the 25 percent gross understatement penalty that it had paid to the Department.
Background
Delhaize America, Inc. (DZA) was a corporation that had its principal place of business in North Carolina. For the 2000 tax year, DZA filed a separate North Carolina income tax return which included a deduction for expenses arising from a royalty agreement with FL Food Lion, Inc. (FLFL), a Florida corporation and affiliate of DZA. FLFL also filed a 2000 North Carolina corporation income tax return reflecting the income arising from the royalty agreement. The royalty deduction and income arose from a transaction in which DZA transferred assets to FLFL; DZA paid fees and royalties to FLFL for use of the assets, creating a tax deduction in North Carolina for DZA; and FLFL distributed tax-free dividends to DZA.
In 2004, following an audit, the Department concluded that DZA's income should be combined with FLFL's income to reflect DZA's true net earnings in North Carolina. The Department issued a Notice of Corporate Income Assessment of additional tax, interest and negligence penalty against DZA for the 2000 tax year.
In 2006, DZA paid the additional income taxes, interest and negligence penalty to the Department and requested a refund. After the Department denied the refund, DZA filed a complaint against the Secretary of the North Carolina Department of Revenue alleging violations of the statutes allowing the Secretary to require combined returns, the Commerce Clause and the Due Process Clause. In 2011, the trial court granted partial summary judgment for both parties. The trial court found in favor of the Department on the issue of combining the returns and the resulting additional taxes and interest. However, the trial court granted DZA's motion for a refund of the penalties. Both DZA and the Department filed appeals.
Forced Combination Did Not Violate Procedural Due Process
The Court of Appeals denied DZA's argument that the Department's decision to require the combined returns violated procedural due process. Under the law that was in effect prior to 2012, the Department could adjust a corporation's net income by eliminating intercompany payments in excess of fair compensation.2 Also, the Department was authorized to require a combined report if the separate reports did not disclose the taxpayer's true earnings on its business carried on in North Carolina.3
On appeal, DZA argued that the Department violated procedural due process by: (i) failing to provide fair notice of changes in its guidelines regarding forced combinations; (ii) concealing the new approach from taxpayers and auditors; and (iii) applying the new approach retroactively. The main issue in the appeal was the Department's guidelines, or alleged lack of guidelines, regarding the combination of corporations for tax purposes. DZA argued that the Department's policy regarding the calculation of true earnings changed after decades of ordering a combination only in exceptional circumstances. Prior to the policy change, the Department used an arm's-length standard to determine fair compensation. DZA claimed that the Department abandoned its prior policy and adopted an ad hoc approach to requiring combined returns. According to DZA, the forced combination violated procedural due process because the Department failed to notify corporate taxpayers or provide guidelines for the change in the calculation of the true earnings.
In rejecting DZA's argument, the Court of Appeals reviewed its 2009 decision in Wal-Mart Stores East, Inc. v. Hinton.4 In Wal-Mart, the Court held that the Secretary had discretionary authority to force combination of corporations. Also, the Court defined "true earnings" broadly and limited the Secretary's discretion only to the extent the U.S. Supreme Court has limited state taxation of corporations.
The Court of Appeals was required to decide whether the Department violated DZA's procedural due process rights by allegedly failing to give DZA notice that the definition of "true earnings" was not limited to a determination of whether corporations and their affiliates performed transactions at arm's length. The Court examined the Department's previous decisions and guidelines to determine whether DZA received adequate notice of the definition of "true earnings" sufficient to satisfy due process. According to the Court, the record contained documents, including final decisions of the Department, available to DZA at the time it formulated and executed its tax strategy that placed DZA on notice that the definition of "true earnings" was not limited to a showing that all transactions were at arm's length and for fair compensation. Therefore, the Court affirmed the trial court's decision that the Department did not violate DZA's due process rights by forcing a combination of DZA and FLFL.
Taxpayer Subject to Penalty
The Court of Appeals reversed the trial court and held that DZA was subject to the 25 percent gross understatement penalty. The Department assessed this penalty against DZA for understating its tax by more than 87 percent as a result of improper deductions.5 In reversing the trial court on this issue, the Court of Appeals noted that the penalties were upheld in the Wal-Mart6 case under similar circumstances. The Court disagreed with the trial court's attempt to distinguish Wal-Mart and determined that the trial's courts statements were not supported by the record. Also, the Court rejected the trial court's holding that assessment of the penalty was unfair and a violation of the Fourteenth Amendment's procedural due process protections. The Court reiterated that the record contained documents that put DZA on notice that the definition of "true earnings" was not limited to a showing that all transactions were "arm's length" and for "fair consideration." Because DZA received fair notice of the definition of "true earnings," DZA could expect a forced combination.
Commentary
There has been considerable controversy in North Carolina surrounding the Secretary's ability to redetermine income and require combined returns, as a series of high-profile corporate taxpayers have been subjected to audit, and have engaged in litigation with the Department on numerous occasions. On June 30, 2011, in part to reduce future litigation on this issue, North Carolina enacted legislation7 that repealed the Secretary's existing statutory authority8 to adjust a corporation's net income or require a combined return and replaced it with new statutory authority.9 However, the Secretary may require forced combination under the repealed statutory provisions for tax years beginning prior to January 1, 2012. Thus, the Secretary can require forced combination of taxpayers who are under audit for tax years beginning prior to January 1, 2012, and presumably use conclusions reached in this case (barring a successful appeal) to impose gross understatement penalties when deemed appropriate.
Under legislation enacted on June 20, 2012,10 the Secretary is not allowed to adjust income or require combined returns under the new statutory provisions until it adopts an administrative rule that provides guidance on how the Secretary will administer its authority.11 For the foreseeable future, taxpayers will continue to struggle with the proper filing method to use in North Carolina, particularly when such taxpayers undertake restructurings that result in intercompany transactions that are designed to be beneficial from a state tax perspective.
Footnotes
1 Delhaize America, Inc. v. Lay, N.C. Court of Appeals, No. COA11-868, Aug. 21, 2012. Effective for taxable years beginning on or after January 1, 2012, North Carolina repealed the statutes, N.C. GEN. STAT. §§ 105-130.6, 105-130.15 and 105-130.16, which allowed the Secretary to adjust a corporation's net income or require a combined return. These statutes were replaced by a new statute, N.C. GEN. STAT. § 105-130.5A, that authorizes the Secretary to adjust income or combine returns.
2 N.C. GEN. STAT. § 105-130.6, repealed for tax years beginning on or after January 1, 2012.
3 Id.
4 676 S.E.2d 634 (N.C. Ct. App. 2009).
5 N.C. GEN. STAT. § 105-236(a)(5) authorizes the Department to impose a negligence penalty. The statute authorizes a 10 percent penalty if there is a finding of negligence and a 25 percent penalty if a taxpayer understates its tax by 25 percent or more. Note that the statute was amended in 2010 to limit the imposition of a negligence penalty related to a forced combination.
6 676 S.E.2d 634 (N.C. Ct. App. 2009).
7 Ch. 390 (H.B. 619), Laws 2011.
8 The legislation repealed N.C. GEN. STAT. §§ 105-130.6, 105-130.15, 105-130.16.
9 The new statutory authority is provided by N.C. GEN. STAT. § 105-130.5A.
10 Ch. 43 (S.B. 824), Laws 2012.
11 N.C. GEN. STAT. § 105-262.1.
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