United States: Maryland Comptroller Policy Restricting Carryforwards Of Exempt Federal Obligation Interest Held Unconstitutional

On August 12, 2016, the Maryland Tax Court held that the Maryland Comptroller's policy of restricting carryforwards of exempt federal obligation interest not subtracted discriminates against holders of federal obligations in favor of similarly situated holders of Maryland obligations, and thus violates the Supremacy Clause of the U.S. Constitution.1

Background

Between 1999 and 2008, the taxpayer, Branch Banking and Trust Company, a North Carolina state-chartered commercial bank, conducted business in Maryland and filed Maryland corporate income tax returns. During this period, the taxpayer received a substantial amount of federal and state obligation interest income that was exempt from federal taxable income.2

The treatment of federal and state obligation interest differs for purposes of the Maryland corporation income tax. The calculation of Maryland's corporation income tax begins with federal taxable income as adjusted by statutory addition and subtraction modifications.3 While corporations are not required to add back interest income earned on Maryland obligations to determine Maryland taxable income, corporations are required to add back interest income from federal obligations.4 Following that addback, Maryland allows a statutory subtraction modification for federal obligation interest.5 However, the Maryland Comptroller, pursuant to its policy, only allows this modification to the point that it creates or increases a net operating loss (NOL).6 To the extent federal obligation interest is not able to be subtracted, the Comptroller follows a policy to not allow a carryforward of such amount to future years in which the interest would not create or increase an NOL.7

The taxpayer sought to create a carryover of its exempt federal obligation interest that was not subtracted by filing refund claims for the 2007 and 2008 tax years in which it attempted to subtract federal obligation interest not subtracted from 1999 to 2008. The Comptroller denied the refund requests, and the denial was upheld by the Comptroller's Hearings and Appeals Section. The taxpayer then appealed to the Maryland Tax Court, arguing that the Comptroller violated: (i) the state statute on point by denying the federal interest subtraction carryforward; (ii) the federal statute prohibiting the taxation of federal interest; and (iii) the Supremacy Clause of the U.S. Constitution.8

Comptroller's Policy Violates Supremacy Clause

The Tax Court analyzed whether the Comptroller's policy violated the Supremacy Clause of the U.S. Constitution, which in the Court's view would mean that such policy would inherently violate the federal and state statutes at issue. The Court began by explaining the basic tenets underlying the case. In United States v. County of Fresno,9 the U.S. Supreme Court held that "a state seeking to impose a tax on a party doing business with the United States must establish a tax 'imposed equally on the other similarly situated constituents of the state.'" Subsequently, in Memphis Bank & Trust Co. v. Garner,10 the U.S. Supreme Court held that "a state tax that imposes a greater burden on holders of federal property than on holders of similar state property impermissibly discriminates against federal obligations." The Tax Court then turned to its decision in Kraft General Foods, Inc. v. Comptroller of the Treasury.11 In Kraft, in identical situations in years following a loss year, a taxpayer that received domestic source dividends was treated differently than a taxpayer receiving foreign source dividends. Subtractions of foreign source dividends faced carryover limitations while domestic source dividends did not, leading to discrimination against foreign commerce because of the resulting disparity on Maryland corporation income tax paid by these similarly situated taxpayers.

The Tax Court concluded that, like the disparate treatment in Kraft, the Comptroller's policy similarly discriminates against holders of federal obligations, and favors similarly situated holders of Maryland obligations. The Court explained that a Maryland obligation interest is subtracted in full when computing taxable income and such subtraction is unrestricted if an NOL exists. However, unlike Maryland obligation interest, federal obligation interest is permanently restricted from being subtracted if an NOL exists. Given that the Comptroller's policy resulted in higher Maryland corporate income tax on holders of federal obligations in comparison to holders of state obligations, the Court held that the Comptroller's policy violates the Supremacy Clause and the federal and state statutes governing the tax-exempt status of interest from federal obligations.

Commentary

The decision by the Tax Court marks a clear taxpayer victory and provides potential refund opportunities for other taxpayers that faced similar restrictions on their ability to carryforward tax exempt federal obligation interest that they were not able to subtract. Additionally, on a larger scale, the decision also highlights an opportunity for taxpayers that are able to show disparate tax treatment to file refund claims for open years. The Tax Court's decision in this case is consistent with the earlier Kraft decision that found disparity in the treatment of taxpayers at the state level. Given the taxpayer wins in both cases, taxpayers may want to review their positions to see if similar disparate treatment exists. Finally, the decision shows the Tax Court's willingness to overturn a Comptroller policy that had been in place for a long period of time, which could lead to challenges to other historic policies that may not be consistent with Maryland's statutory language.

Footnotes

1 Branch Banking and Trust Co. v. Comptroller of the Treasury, Maryland Tax Court, No. 13-IN-00-0076, Aug. 12, 2016.

2 Pursuant to 31 U.S.C. § 3124, which provides that "[s]tocks and obligations of the United States Government are exempt from taxation by a state or political subdivision of a state. The exemption applies to each form of taxation that would require the obligation, the interest on the obligation, or both, to be considered in computing a tax."

3 MD. CODE ANN. TAX-GEN. § 10-304.

4 MD. CODE ANN. TAX-GEN. § 10-305(d)(2).

5 Pursuant to MD. CODE ANN. TAX-GEN. § 10-307(a), which states: "In General – To the extent included in federal taxable income, the amounts under this section are subtracted from federal taxable income of a corporation to determine Maryland modified income;" and MD. CODE ANN. TAX-GEN. § 10-307(f), which states: "Interest from United State Obligations – The subtraction under subsection (a) of this section includes interest attributable to an obligation of the United States or an instrumentality of the United States."

6 Id.

7 Id.

8 U.S. CONST. art. VI, § 2.

9 429 U.S. 452 (1977).

10 459 U.S. 392 (1983).

11 No. 98-IN-00-0353 (Md. Tax Ct. 2001).

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