United States: North Carolina Enacts Significant Income, Franchise And Sales Tax

On September 18, 2015, North Carolina Governor Pat McCrory approved legislation enacting significant changes to the taxation of corporations and individuals. Most of the tax legislation is contingent upon other legislation successfully becoming law. Changes to the North Carolina corporate income tax make it more likely that a tax rate cut from 4 percent to 3 percent will occur in the near future. In addition, changes to the calculation of state net income, new limitations on qualified interest for certain indebtedness, and the gradual implementation of a single sales factor apportionment formula have been adopted. Likewise, the calculation of the franchise tax base has changed. The bill also introduces a reduction in the overall individual income tax rate and the amount of the standard deduction. The sales tax base will expand to include new rules around repair, maintenance and installation services, along with major changes to the definition of retail trade. Finally, the legislation enacts a new article that provides for a tax credit for qualified expenses incurred to rehabilitate historic structures.1

Corporation Income Tax

Corporate Income Tax Rate Reduction

Previous versions of the North Carolina tax law concerning the level of the corporate income tax rate effectively connected the enacted rate to certain revenue targets of the North Carolina General Fund. 2 On July 28, 2015, the Office of the Governor notified the public that General Fund revenues had achieved the level necessary for the corporate income tax rate to be reduced from 5 percent to 4 percent, effective on January 1, 2016. 3 H.B. 97 codifies this change and also makes changes to the rate reduction trigger. When net General Fund tax collected in any fiscal year exceeds $20,975,000,000, the tax rate will decrease to 3 percent effective for the tax year beginning the following January. 4

Consistent with the procedure that resulted in the reduction of the corporation income tax from 5 percent to 4 percent, a rate reduction to 3 percent must be communicated to taxpayers by the Secretary of Revenue. Previously, the rate reduction trigger was only tied to the 2015 or 2016 fiscal years.

Changes to State Modifications

Effective January 1, 2016, changes have been made to the state addition and subtraction modifications used to arrive at state net income before apportionment. An addition modification is required for the amount of net interest expense to a related member. 5 Net interest expense is defined as "the excess of the interest paid or accrued by the taxpayer to a related member during the taxable year over the amount of interest from a related member includible in the gross income of the taxpayer for the taxable year." 6 However, a corresponding subtraction modification has been added for qualified interest expense paid to a related member. 7 The term "qualified interest expense" is defined as the "net interest expense paid or accrued to a related member in a taxable year not to exceed 30 percent of the taxpayer's adjusted taxable income." 8 The 30 percent limitation does not apply if at least one of the following exceptions is available:

  • The related member is subject to tax in North Carolina;
  • The related member pays a net income tax or gross receipts tax to another state on such interest income; or
  • The related member is organized in a foreign country that has a comprehensive income tax treaty with the United States, and that country taxes the income at the same or greater rate than the North Carolina rate; or
  • The related member is a bank. 9

Additionally, the following subtraction modifications have been eliminated:

  • Amortization in excess of depreciation allowed for sewage or waste treatment plants;
  • Depreciation of emergency facilities acquired prior to January 1, 1955;
  • Reasonable expenses in excess of deductions allowed for reforestation and cultivation of commercially grown trees;
  • Eligible income of an international banking facility;
  • Marketing assessments on tobacco grown in North Carolina;
  • Investment earnings of certain trusts;
  • Payments received from the Hurricane Floyd Reserve Fund; and
  • Payments received from the Disaster Relief Fund of the Office of State Budget and Management. 10

Certain provisions related to allowable expenses related to nontaxable dividends have been changed. 11 The new legislation clarifies that the amount that is disallowed for expenses associated with dividends that are not taxed cannot exceed 15 percent of the amount of the dividends while effectively eliminating certain higher allowed amounts for bank and electrical holding companies.

Elimination of Bank Privilege Tax

The bank privilege tax is repealed effective July 1, 2016. 12 This tax is imposed on banks operating in North Carolina at a rate of $30 for each $1,000,000 of total assets. The annual returns are due on July 1.

Phase-In of Single Sales Factor Apportionment

Historically, North Carolina has utilized an apportionment formula consisting of a property factor, a payroll factor, and a double-weighted sales factor. 13 The new legislation makes changes to the weighting of the apportionment formula, which will be phased in over a three-year period. Effective for tax years beginning in 2016, the sales factor will be triple-weighted. 14 For tax years beginning in 2017, the sales factor will be quadrupleweighted. 15 Effective for tax years beginning on or after January 1, 2018, North Carolina will utilize a single sales factor. 16

Market-Based Sourcing Disclosure Requirement

Initial versions of H.B. 97 reflected the proposed enactment of market-based sourcing for sourcing certain service and intangible revenue, in place of the current pro rata cost of performance regime. With the economic impact of such a change uncertain, the enacted version of H.B. 97 includes a provision to perform an economic study on the effects of making such a change. 17 Taxpayers that have more than $10,000,000 of apportionable income and an apportionment factor of less than 100 percent will need to disclose certain information based upon 2014 tax year activity. 18 This information is required to be filed on the date that the 2015 corporation income tax return is originally due, without regard to extensions. 19 Specifically, a taxpayer will be required to report what its sales factor would have been if it had been required to calculate its sales factor using market sourcing based upon model market sourcing principles and regulations drafted by the Multistate Tax Commission. 20 It is important to note that taxpayers that fail to provide this report when due are subject to a civil penalty of $5,000. 21

Franchise Tax Base Changes

Effective for tax years required to be filed on or after January 1, 2017 (the 2016 year report), substantial changes will be made to the calculation of franchise tax due for most taxpayers. Instead of referencing "issued and outstanding capital stock, surplus and undivided profits" to describe the tax base applicable to Schedule C of the corporate tax return, the new law references "net worth." 22 Net worth is defined as total assets less total liabilities, without regard to accumulated depreciation, depletion, or amortization (in accordance with generally accepted accounting principles (GAAP)), as adjusted by several modifications. 23 The following changes to the adjustments allowed to the franchise tax base have also been enacted:

  • A deduction for accumulated depreciation, depletion and amortization in accordance with the method used for federal income tax purposes; 24
  • The adjustment for billings in excess of cost (which were considered deferred liabilities) has been eliminated; 25
  • The addition modification for affiliated indebtedness has been clarified, so that the addback is required if the indebtedness exists between corporate and noncorporate entities;26 and
  • The language allowing a deduction for "definite and accrued legal liabilities" has been removed. 27

The North Carolina franchise tax rate will remain at $1.50 per $1,000 of taxable value. 28 However, the minimum tax that applies to all taxpayers has been increased from $35 to $200. 29 Additionally, the maximum franchise tax applicable to holding companies has been increased from $75,000 to $150,000. 30

Individual Income Tax Reductions

Effective for tax years beginning on or after January 1, 2016, the North Carolina standard deduction amount has been increased from $15,000 to $15,500 for taxpayers with married filing jointly/surviving spouse filing status, from $12,000 to $12,400 for heads of household and from $7,500 to $7,750 for single and married filing separately taxpayers. 31 Also, effective for years beginning on or after January 1, 2015, medical and dental expenses allowed as a deduction for federal income tax purposes are allowed for North Carolina purposes without the overall limitation on itemized deductions as provided under the Internal Revenue Code. 32 Finally, effective for tax years beginning on or after January 1, 2017, the tax rate for individuals will be lowered from 5.75 percent to 5.499 percent. 33

Expanded Sales Tax Base

The new legislation clarifies the definition of a real property contractor to exclude any person engaged in retail trade. 34 The definitions section of the sales tax statutes has also been amended to add the definition of repair, maintenance and installation services, which include keeping tangible personal property or a motor vehicle in proper working order, as well as associated calibration, restoration, troubleshooting and installation activities (except for installation or application of tangible personal property by a real property contractor pursuant to a real property contract). 35

The new legislation also clarifies that the general sales tax rate of 4.75 percent applies to gross receipts derived from repair, maintenance, and installation services. 36 Additionally, it eliminates the exception from tax for gross receipts derived from a service contract for tangible personal property sold at retail that is or will become a part of real property. 37 The definition of a retailer has also been amended to exclude any person that solely operates as a real property contractor or a person whose only business activity is providing repair, maintenance, and installation services where the person's activities do not meet the definition of a retail trade. 38 Further, the newly enacted definition of retail trade means a trade in which the majority of revenue is from retailing tangible personal property, digital property, or services to consumers. The term specifically includes North American Industry Classification System (NAICS) sectors 44 and 45, buying goods for resale, and rendering services incidental to the sale of merchandise. 39

The sales tax provisions become effective March 1, 2016 and apply to sales occurring on or after that date and to gross receipts derived from repair, maintenance and installation services provided on or after that date. 40

Historic Preservation Tax Credit

The legislation creates Article 3L, which provides for a tax credit for expenses incurred for rehabilitating historic structures and applies to expenses incurred on or after January 1, 2016. 41 The new law provides for a credit of 15 percent (10 percent for expenses over $10,000,000 for income-producing structures) of expenses, with different qualifying criteria and application structures depending upon whether such structures produce income. 42 Development tier and target investment bonuses of 5 percent each may also apply if eligibility requirements are met. 43 The credit is allowed against corporate franchise tax, income tax or the gross premiums tax, but the taxpayer must make an election against which tax it chooses to utilize. 44 It is important to note that this credit can be utilized against 100 percent of the taxpayer's chosen liability, after all other tax credits for which the taxpayer is eligible have been applied, with the ability to carry over the unused portion of the credit for up to nine succeeding years. 45 Article 3L will expire for qualified expenditures incurred on or after January 1, 2020. 46

Commentary

These changes begin to bring an end to one of the lengthiest legislative sessions in recent North Carolina history. Two other bills, H.B. 117 and H.B. 943, must also become law before January 1, 2016 for most of the tax law changes contained in the "budget bill" (H.B. 97) to become law. 47 These bills contain various incentive changes and a state bond offering. Both bills are widely expected to be signed as part of an overall budget compromise that permitted the budget bill to become law, which allowed the state to begin operating under the new budget, rather than via continuing resolutions. The Governor has been presented H.B. 117 which significantly expands the ability of the state to offer incentives to large relocation projects. The legislation expands the Job Development Incentive Grant and the North Carolina One Fund for specified "high yield" projects. The state has lost a number of high-profile automotive and high-tech competitive relocation efforts in recent years. In addition, the bill includes sales tax exemptions for airlines and data centers. H.B. 943 also has been presented to the Governor for signature.

The proposed reduction to the corporation income tax rate "when" (not "if") a revenue target is met, and the implementation of personal income tax relief in targeted areas reflects the state's continuing desire to de-emphasize income taxes as a significant source of revenue to the state. The eventual adoption of a single sales factor formula, and the modernization of some aspects of the franchise tax calculation are reflective of trends seen around the country.

The failure to switch to market-based sourcing for sales of items other than tangible personal property is viewed by many as a disappointment, particularly for those taxpayers that would benefit from a lower North Carolina apportionment factor under such a regime. The informational disclosure requirement with respect to a potential change in the sales factor sourcing rules calls to mind the recent efforts by the state of Maryland in gathering information in an attempt to determine whether combined reporting would be beneficial to the state.48 Disclosure efforts in this area have been critiqued as burdensome to corporations, and often do not provide valuable information with respect to effects on revenue. This informational disclosure requirement may be problematic from an accuracy perspective because the information is only being requested for one tax year from a subset of taxpayers. Sales amounts are closely tied to the general economic environment, which change substantially from year to year. Further, due to the North Carolina legislature's history of considering major tax reform primarily in non-election years, it may be 2017 before the issue of market-based sourcing is again addressed.

Footnotes

1 H.B. 97, Laws 2015.

2 N. C. GEN. STAT. § 105-130.3C.

3 SL No. 2013-316. For further discussion of this rate reduction, see GT SALT Alert: North Carolina Lowers Corporate Income Tax Rate, Now the Lowest Top Corporate Rate in the United States.

4 N. C. GEN. STAT. § 105-130.3C(a).

5 N. C. GEN. STAT. § 105-130.5(a)(25).

6 N. C. GEN. STAT. § 105-130.7B(b)(3).

7 N. C. GEN. STAT. § 105-130.5(b)(28).

8 N. C. GEN. STAT. § 105-130.7B(b)(4).

9 N. C. GEN. STAT. § 105-130.7B(b)(4).a-d.

10 N. C. GEN. STAT. § 105-130.5(b)(6), (7), (12), (13), (15), (18), (19), (22) (repealed).

11 N. C. GEN. STAT. §§ 105-130.6A; 105-130.5(c)(5) (repealed); N. C. GEN. STAT. § 105-130.5(b)(3a), (c)(3).

12 N. C. GEN. STAT. § 105-102.3 (repealed).

13 N. C. GEN. STAT. § 105-130.4(i).

14 Id.

15 Id.

16 Id.

17 H.B. 97, § 32.14A.

18 H.B. 97, § 32.14A(a), (b).

19 H.B. 97, § 32.14A(e) (referencing N. C. GEN. STAT. § 105-130.17(b)). Note that the 2015 corporation income tax return itself can be extended. The restriction on extension only applies to the disclosure requirement.

20 H.B. 97, § 32.14A(b), (c).

21 H.B. 97, § 32.14A(e)

22 See generally N. C. GEN. STAT. §§ 105-120.2; 105-122.

23 N. C. GEN. STAT. § 105-122(b). To the extent a corporation does not use GAAP, net worth is computed using the federal income tax calculation used by the taxpayer as long as the method fairly reflects the corporation's net worth for purposes of the franchise tax.

24 N. C. GEN. STAT. § 105-122(b)(1).

25 N. C. GEN. STAT. § 105-122(b)(1a) (repealed).

26 N. C. GEN. STAT. § 105-122(b)(2).

27 N. C. GEN. STAT. § 105-122(b)(1).

28 N. C. GEN. STAT. § 105-122(d).

29 Id.

30 N. C. GEN. STAT. § 105-120.2(b)(1).

31 N. C. GEN. STAT. § 105-153.5(a)(1).

32 N. C. GEN. STAT. § 105-153.5(a)(2).c.

33 N. C. GEN. STAT. § 105-153.7(a).

34 N. C. GEN. STAT. § 105-164.3(33a)

35 N. C. GEN. STAT. § 105-164.3(33d).

36 N. C. GEN. STAT. § 105-164.4(a)(15).

37 N. C. GEN. STAT. § 105-164.4I(c).

38 N. C. GEN. STAT. § 105-164.3(35)(b).

39 N. C. GEN. STAT. § 105-164.3(35b).

40 H.B. 97, § 32.18.(h).

41 N. C. GEN. STAT. §§ 105-129.100 et seq.

42 N. C. GEN. STAT. §§ 105-129.100; 105-129.101.

43 N. C. GEN. STAT. § 105-129.100(a)(2), (3).

44 N. C. GEN. STAT. § 105-129.103(a). It should be noted that a pass-through entity can qualify for the credit as long as certain basis requirements are met. N. C. GEN. STAT. § 105-129.100(b).

45 N. C. GEN. STAT. § 105-129.103(c).

46 N. C. GEN. STAT. § 105-129.105.

47 H.B. 97, § 32.21A.

48 Despite the disclosure study (encompassing the 2006-2010 tax years) showing some level of financial benefit to the state under combined reporting, Maryland has not adopted combined reporting to date.

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