The North Carolina Department of Revenue has issued a notice discussing a change in its interpretation of the statute allowing a deduction to corporations that sustain a net economic loss (NEL) in any or all of the 15 preceding tax years which may impact historic NEL calculations.1 Under the new interpretation, the Department recognizes that any allowable deduction, although not taxable, may not reduce a loss in the year it is created. However, a loss carried forward to a subsequent year must first be offset by any income that is not taxable. The notice includes an example that demonstrates the new interpretation.
General Statutory Provisions
Under North Carolina law, an NEL is generated in any tax year in which allowable deductions, except for deductions for prior year losses, exceed all sources of income.2 Income not subject to the state's corporate income tax is included in the computation of the NELs. The statute specifically provides that income not taxable in North Carolina includes items of income subtracted from federal taxable income in calculating North Carolina taxable income as well as income allocated to other states.3 North Carolina NELs can be carried forward 15 years.4
Historical Treatment of Non-Taxable Income in Computing NELs
Historically, the Department interpreted this statute as requiring an NEL to be reduced in the year it is generated by all income not taxable in North Carolina, as defined above, in thatsame year. This would include items of income deducted from federal taxable income5 aswell as income allocated to other states.6
Department's New Interpretation
The Department has reconsidered the "plain language" of the NEL statute and is now interpreting it to say that items of income that are allowable deductions do not decrease the NEL in the year it is generated.7
Impact of New Interpretation
This new interpretation allows the North Carolina NEL created in the current year to include the deduction for income items. Other income not taxable in North Carolina during the year of creation is still required to be added back in determining the current year NEL. Additionally, in subsequent tax years, the NEL carried forward is reduced by all income not taxable in North Carolina, including items of income deducted from federal taxable income to determine the amount of NEL available to offset North Carolina taxable income. This reinterpretation will likely impact the North Carolina income tax returns for those taxpayers who have generated, carried forward and utilized NELs as well as any entity that has material North Carolina NELs in its financial statements.
Commentary
In many states, a state net operating loss (NOL) does not operate in the same manner as a federal NOL. The state NOL often becomes less useful when deducted than originally expected at the time a taxpayer incurs the loss, due to state-specific distinctions and restrictions. This is particularly true with respect to the calculation and utilization of the North Carolina NEL, which can radically decouple from the federal NOL concept. The guidance issued by the Department clarifies the adjustments required when calculating the NEL generated in a tax year and those required prior to utilizing an NEL carryforward in a subsequent tax year. There are four categories of income not taxed for North Carolina purposes that must be considered when calculating NELs: (i) income not included in federal taxable income (for example, insurance proceeds, municipal interest, etc.); (ii) dividends for which a dividends received deduction is taken; (iii) deductions for income items subtracted from federal taxable income (for example, dividends from non-U.S. sources or income included under Internal Revenue Code (IRC) Section 78); and (iv) non-apportionable income allocated to other states.
The Department's new interpretation does not affect the definition of income not taxed by the state or the items included in the definition. However, the new interpretation changes the year in which certain categories of non-taxable income may affect the calculation of the NEL.
The Department views its new interpretation of the NEL statute as a favourable development for North Carolina taxpayers. However, whether it has a favorable or unfavorable impact depends on the taxpayer's circumstances. If, in prior years, the taxpayer has properly calculated its NEL and the amount of NEL carried forward under the old interpretation, this may be a favorable change. If the taxpayer has not properly followed previous guidance, recalculating the NELs according to this clarification may result in an overall unfavorable change. Also, any entity that has taken North CarolinaNELs into account when calculating its state provision or analyzing potential ASC 740-10 liabilities should ensure that it has calculated the NELs correctly.
Footnotes
1 Important Notice, North Carolina Department of Revenue, Aug. 17, 2012.
2 N.C. GEN. STAT. § 105-130.8(a)(2).
3 N.C. GEN. STAT. § 105-130.8(a)(5).
4 N.C. GEN. STAT. § 105-130.8(a)(6).
5 N.C. GEN. STAT. § 105-130.5.
6 N.C. GEN. STAT. § 105-130.4.
7 N.C. GEN. STAT. § 105-130.8(a)(2).
