On January 3, 2013, the North Carolina Department of Revenue adopted regulations intended to clarify the Secretary's authority to adjust net income or to force combined returns for income tax purposes as mandated by 2012 legislation.1 Prior to these rules, the relevant statutes lacked guidance regarding how the Secretary may adjust income or determine which entities would be included in a combined return. These new regulations clarify the state's economic substance doctrine on which it may rely in evaluating intercompany transactions and modifying the methodology for filing a combined income tax return. While these regulations are effective January 31, 2013, they are applicable to tax years beginning on or after January 1, 2012.

Background

Although taxpayers are required to file income tax returns on a separate company basis in North Carolina, the Department has the authority to adjust net income or to require combined returns if the Secretary determines that the separate filings do not reflect a taxpayer's true earnings. Over the past decade, taxpayers have argued that the Department was abusing its authority when taxpayers did not have adequate insight into the guidelines being used to require forced combinations. These issues were highlighted in two prominent court cases, which were eventually decided in favor of the state.2 In 2011, after years of controversy regarding the Secretary's authority to adjust net income or force affiliated taxpayers to file a combined return, North Carolina enacted legislation that was intended to provide more guidance and procedural limitations with regard to forced combinations.

Later in 2011, and again in 2012, the North Carolina Department of Revenue issued directives intended to provide an interpretation of the newly issued statutes regarding the Secretary's authority to redetermine net income or force combined returns.3

In June 2012, North Carolina Governor Bev Perdue signed legislation that superseded Directive CD-12-02 issued by the Department and prohibited the Secretary from redetermining a taxpayer's net income for tax years beginning on or after January 1, 2012 until the Department issued rules defining the standards for forced combinations.4 As part of this legislation, a statute was added to provide for an expedited procedure for the Department to adopt the required administrative ruling.5

As a result, the Department submitted proposed rules for public commentary in October 2012, and on January 3, 2013, adopted the regulations that provide the additional clarification required by the 2012 legislation.

Economic Substance

In accordance with North Carolina statutes, a transaction will be considered to have economic substance if a two-pronged test is met: (1) the transaction has a reasonable business purpose and (2) the transaction has economic effects beyond the creation of North Carolina income tax benefits.6 The regulations establish that the taxpayer has the burden of proof for the economic substance test.7 In addition, the regulations further clarify the five factors used to determine whether a transaction has economic substance.

The factors outlined in the statutes include the following:

  • Reasonable business purposes and economic effects include, but are not limited to, any material benefit from the transaction other than state income tax benefits not allowable as inconsistent with legislative intent.
  • In determining whether to require a combined return, whether the transaction has economic effects beyond the creation of state income tax benefits may be satisfied by demonstrating material business activity of the entities involved in the transaction.
  • If state income tax benefits resulting from a transaction, or a series of transactions of which the transaction is a part, are consistent with legislative intent, such state income tax benefits shall be considered in determining whether such transaction has business purpose and economic substance.
  • Centralized cash management of an affiliated group does not constitute evidence of an absence of economic substance.
  • Achieving a financial accounting benefit will not be taken into account as a reasonable business purpose for entering into a transaction if the origin of such financial accounting benefit is a reduction of state income tax.8

In determining whether a transaction had a reasonable business purpose, the regulations state that the taxpayer must show that:

  • The business purpose asserted was valid and realistic;
  • The transaction was a reasonable and realistic means to accomplish the asserted business purpose;
  • Evidence exists that shows the taxpayer took steps to achieve the asserted business purpose; and
  • The value of the non-state income tax benefits reasonably anticipated by the taxpayer from the transaction exceeds the additional cost associated with the transaction.9

In addition, the regulations address the requirement that a transaction have economic effects beyond the creation of state income tax benefits. According to the regulation, a taxpayer must prove a material benefit was generated at the time the transaction was initiated, aside from the state income tax benefit.10 Furthermore, the regulation explains that the Secretary must analyze both the economic effect on the taxpayer as well as the aggregate economic effect on the parties to the transaction.11

The regulations also provide the general principles of the common law economic substance doctrine, as established under federal and state case law, on which the Secretary must rely in applying each of the two-prong tests for economic substance.12 In determining whether or not a transaction has economic substance, the regulations require the Secretary to consider all facts and circumstances including the following set of twenty-four factors:

  • The reasons for the transaction;
  • Whether the transaction was a reasonable means to accomplish the asserted purposes;
  • Expectations of benefits obtained from the transactions;
  • The effects the transaction had on the taxpayer's profits;
  • The existence of a reasonable or realistic potential for profit from making the transaction;
  • The objective economic impact of the transaction other than state income tax savings;
  • The transaction's effect on the taxpayer's state income tax liability;
  • The transaction's effect on the taxpayer's tax liability in other states;
  • The transaction's effect on the taxpayer's federal tax liability;
  • Whether the method of determining the amount of payment is an industry practice;
  • The change in the business operations of the parties, if any, after the transaction;
  • Whether assets were transferred between or among related parties;
  • Whether the business operations related to specific assets changed after any transfer of those assets;
  • Whether the entity transferring assets retained control over the assets;
  • The tax consequences of the transfer of assets;
  • The party or parties who created or developed the ideas which led to the transaction;
  • The party or parties who presented the ideas concerning the transaction to the taxpayer;
  • Whether the contemporaneous documentation explaining the transaction to the taxpayer discussed profit potential in addition to tax benefits;
  • The party or parties that drafted the agreements relating to the transaction;
  • The party or parties that negotiated the agreements relating to the transaction;
  • The party or parties that dictated the terms of the agreements relating to the transaction;
  • Cost-benefit analyses or other studies conducted related to the transaction;
  • Non-tax benefits obtained by the taxpayer as a result of the transaction; and
  • Whether the intercompany transaction resulted in a circular cash flow.13

The regulations explain that state income tax benefits resulting from a transaction are allowed to be considered by the Secretary in determining whether a transaction has economic substance and business purpose when the transaction is made in accordance with laws designed to encourage certain activities through tax deductions or tax credits.14

When the transaction involves a centralized cash management system, the regulations direct the Secretary to analyze the transaction for reasonable business purpose and economic effects. The regulations note that if the transaction or series of transactions results in unreasonably excessive interest expense as compared to industry practice, shifting of assets or the reclassification of income as apportionable or nonapportionable, the transaction may be deemed to lack economic substance.15

For purposes of determining whether or not a transaction between members of an affiliated group were made at fair market value in accordance with the regulations adopted under Internal Revenue Code Section 482, the Secretary must evaluate all facts and circumstances relative to the transaction, including any transfer pricing studies provided by the taxpayer, and must apply federal or state case law developed under Section 482 and its regulations.16 However, a transfer pricing study will not by itself be sufficient to establish that a transaction was made at fair market value.17

Adjustments to State Net Income

The regulations also outline specific adjustments the Secretary may make when a transaction is deemed to lack economic substance or not to be at fair market value. The adjustments include:

  • Disallowing deductions in whole or in part;
  • Attributing income to related corporations;
  • Disregarding transactions; and
  • Reclassifying income as apportionable or allocable.18

Beyond these adjustments, the Secretary may also require or allow a combined return if the Secretary determines the adjustments fail to capture the taxpayer's true earnings from the state.

Methodology for Combining Returns

Included in the regulations is the methodology for filing a combined income tax return. A comprehensive step-by-step process is provided for taxpayers which begins with combining the pro forma federal taxable income of each member and then eliminating intercompany transactions among the combined group for both income and apportionment purposes.19 North Carolina modifications provided pursuant to statute are made to determine the combined income subject to apportionment.20 One apportionment factor is calculated by the taxpayer for the combined group.21

The regulation also addresses the utilization of net economic losses (NELs) on a combined return. An NEL may be brought into a combined group and subsequently leave with the same member of the combined group to the extent a loss was not fully utilized by the group. In addition, an NEL sustained by the group in a combined return year is allocated among the members of the combined group that reported losses on their pro forma federal income tax return. To the extent losses generated by the group are not fully utilized, the group's NELs allocated to a corporation may be claimed by the corporation in years the corporation ceases to be a member of the combined group.22

Combined Return Tax Credits

The regulations also provide taxpayers the methodology for utilizing tax credits on a combined income tax return. Similar to the rule for NELs, income tax credits may be brought into and utilized by the group if a member generated and did not fully utilize a credit prior to becoming a member of the combined group. Furthermore, any unused installments or carry forwards of a credit earned by a member of the group remains with the entity if it ceases to be a member of the combined group or is no longer required to file a combined return.23

For credits generated by members who are part of a combined group, the regulation explains that an income tax credit is calculated on a separate company basis and that the appropriate credit schedules are included in the combined return even if the combined tax liability is insufficient for the group to receive any benefit.24

Procedures for Filing Combined Income Tax Return

The regulations state that the principal member should file Form CD-405, C Corporation Tax Return, and all required schedules. The other members of the combined return will not have a separate income tax return filing requirement.25 Included with the combined return should be schedules of the following:

  • Calculation showing North Carolina taxable income of each entity that would be reported if separate returns were to be filed;
  • Schedule of intercompany eliminations;
  • Schedule of all estimated tax payments made by each entity;
  • Schedule of combined apportionment factor as required in the regulation;
  • Schedule of NELs and any use of NELs by member entities and the combined group; and
  • Schedule of eligible tax credits and the use of credits by member entities and the combined group.26

Procedures for Filing Franchise Tax Return

Although North Carolina's rules have not changed in the area of franchise tax, the regulations provide guidance regarding the procedure for filing a franchise tax return when an affiliated group files a combined income tax return. The principal member must file its franchise tax return on the group's combined return by using the principal member's separate company apportionment percentage.27 Each of the other members of the combined return who are doing business in the state will file their own Form CD-405 for franchise tax purposes only and attach a statement to indicate that the member files as part of a combined income tax return.28

Commentary

Although these regulations provide substantial guidance into the thought process for determining when transactions will be deemed to have economic substance, Sections .401 and .501 of the regulations leave a great deal of uncertainty as to how intercompany transactions lacking economic substance will be adjusted (either through a combined return or some other method of adjustment). Furthermore, the state's requirement to apply transfer pricing principles to transactions after 2011 directly conflicts with the "true cost" principles that the Department applied to transactions prior to 2012, as outlined in Directive CD-12-01. While the regulations provide significant information on how taxpayers will be required to be combined, there is substantially less information on when combinations will be undertaken.

With the issuance of these regulations, taxpayers have more formal guidance to rely upon when considering the North Carolina corporate income tax treatment of related party transactions. Ultimately, however, taxpayers will have to wait and see how the courts and the North Carolina Office of Administrative Hearings settle disputes or watch for the North Carolina legislature to settle these issues through legislative action.

Footnotes

1 N.C. ADMIN. CODE tit. 17, r. 05F.0101 et seq., effective January 31, 2013.

2 Wal-Mart Store East, Inc. v. Hinton, 676 S.E.2d 674 (N.C. Ct. App. 2009), appeal dismissed, 689 S.E.2d 375 (N.C. 2009); Delhaize America, Inc. v. Lay, N.C. Sup. Ct., Wake County, No. 06 CVS 08416, Jan. 12, 2011.

3 Directive No. CD-11-01, North Carolina Department of Revenue, Nov. 16, 2011, replaced by Directive Nos. CD-12-01, CD-12-02, North Carolina Department of Revenue, April 17, 2012. CD-12- 01 applies to tax years beginning before January 1, 2012. CD-12-02 applies to tax years beginning on or after January 1, 2012.

4 Ch. 43 (S.B. 824), Laws 2012.

5 N.C. GEN. STAT. § 105-262.1.

6 N.C. GEN. STAT. § 105-130.5A(f).

7 N.C. ADMIN. CODE tit. 17, r. 05F.0201.

8 N.C. GEN. STAT. § 105-130.5A(f).

9 N.C. ADMIN. CODE tit. 17, r. 05F.0202(a).

10 N.C. ADMIN. CODE tit. 17, r. 05F.0203(a).

11 N.C. ADMIN. CODE tit. 17, r. 05F.0203(b).

12 N.C. ADMIN. CODE tit. 17, r. 05F.0204.

13 N.C. ADMIN. CODE tit. 17, r. 05F.0205.

14 N.C. ADMIN. CODE tit. 17, r. 05F.0206.

15 N.C. ADMIN. CODE tit. 17, r. 05F.0207.

16 N.C. ADMIN. CODE tit. 17, r. 05F.0301(a), (b).

17 N.C. ADMIN. CODE tit. 17, r. 05F.0301(c).

18 N.C. ADMIN. CODE tit. 17, r. 05F.0401.

19 N.C. ADMIN. CODE tit. 17, r. 05F.0501(1)-(3), (5).

20 N.C. ADMIN. CODE tit. 17, r. 05F.0501(4).

21 N.C. ADMIN. CODE tit. 17, r. 05F.0501(6).

22 N.C. ADMIN. CODE tit. 17, r. 05F.0501(8).

23 N.C. ADMIN. CODE tit. 17, r. 05F.0501(9).

24 N.C. ADMIN. CODE tit. 17, r. 05F.0503.

25 N.C. ADMIN. CODE tit. 17, r. 05F.0502(a).

26 N.C. ADMIN. CODE tit. 17, r. 05F.0502(b).

27 N.C. ADMIN. CODE tit. 17, r. 05F.0601(b), (d).

28 N.C. ADMIN. CODE tit. 17, r. 05F.0601(c).

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