Authors: Michael A. Jacobs
Implementing federal tax reform
The omnibus bill includes a number of corporate income tax provisions in response to federal changes in the Tax Cuts and Jobs Act (“TCJA”). S.B. 99 updates the North Carolina reference to the Internal Revenue Code (“IRC”), to define “Code” as the IRC as enacted as of February 9, 2018; thereby incorporating the income tax provisions of the TCJA.
Importantly, however, S.B. 99 decouples North Carolina from several significant provisions of the TCJA. Under S.B. 99, North Carolina has decoupled from the deferral of gain and exclusion of gain for assets invested in an Opportunity Fund under IRC §1400Z-2, the transition tax under IRC §965, the deduction associated with foreign derived intangible income (“FDII”) under IRC §250, and the inclusion and deduction for global intangible low-taxed income (“GILTI”) under IRC §951A and IRC §250.
With respect to the one-time transition/repatriation tax, North Carolina decouples from both the tax on deferred foreign income, as well as the reduced rate applicable to certain liquid and illiquid assets under IRC §965. Under N.C. General Statute section 105-130.5 as revised by S.B. 99, taxpayers are required to add to federal taxable income the amount deducted under IRC §965(c). North Carolina further requires taxpayers to deduct from federal taxable income any amount included in federal taxable income under IRC §965, thereby completely decoupling from the transition/repatriation tax.
Although S.B. 99 does not expressly decouple from the 100% bonus depreciation provision in the TCJA, North Carolina already had enacted legislation that decoupled from all federal bonus depreciation allowed under IRC §168(k). For tax years beginning in 2010, North Carolina requires taxpayers to add back 85% of the amount deducted under IRC §168(k) or IRC §168(n) to federal taxable income, and permits taxpayers to deduct 20% of the add-back in each of the first five taxable years following the year of the add-back. S.B. 99 does not address or update the North Carolina bonus depreciation modifications in effect prior to the TCJA. Accordingly, North Carolina will continue to require the initial add-back of 85% of any bonus depreciation claimed for federal income tax purposes with deductions equal to 20% of the disallowed federal deduction allowed over the first five taxable years after the add-back. Taxpayers that invest in property with a useful life longer than five years will still benefit from the interplay between the full expensing allowed for federal purposes and North Carolina’s decoupling scheme.
North Carolina’s bonus depreciation adjustment is somewhat unique in that North Carolina does not permit readjustment of the depreciated property’s basis. North Carolina therefore requires taxpayers to use the adjusted basis of the property as determined for federal income tax purposes (which would be zero under 100% bonus depreciation), even though the property continues to be depreciated over time for North Carolina income tax purposes. North Carolina’s method of decoupling from federal bonus depreciation could therefore result in the recognition of gain for North Carolina purposes upon disposition of bonus depreciation property in excess of the amount that the economics of the investment in the property would justify.
Notably, North Carolina has not decoupled from the federal interest expense limitations under IRC §163(j). S.B. 99 does not address any of the ambiguities of how the business interest expense deduction under IRC §163(j) is to be computed for North Carolina return purposes; such as whether the deduction must be computed on a separate-company, rather than on a consolidated basis.
Sales factor sourcing
Under current law, North Carolina considers "other sales" to be in North Carolina if any of the following occur: (1) the receipts are from real or tangible personal property located in North Carolina (including receipts from incidental services sold as part of, or in connection with, the sale of tangible personal property in North Carolina); (2) the receipts are from intangible property to the extent the intangible property received within North Carolina; or, (3) the receipts are from services and the income producing activities are in North Carolina.
The technical corrections to the budget under S.B. 335 retain the current law with respect to sourcing receipts from intangibles. The omnibus bill, prior to corrections, would have amended the sourcing of intangibles to be sourced to North Carolina if the intangible property were “used” in North Carolina. This would have been a departure from the prior standard of sourcing receipts from intangible property that are received from sources within North Carolina, and would have represented a market-based method for sourcing intangibles. The correction enacted by S.B. 335 removes this market-based method from the provision for sourcing other receipts.
The sourcing methodology for receipts from real and tangible property was revised by S.B. 99 to specifically provide that receipts from real or tangible personal property include receipts from incidental services sold as part of or in connection with the property. Such incidental service language was not included in the prior version of N.C. General Statute section 105-130.4(l).
The budget retains North Carolina’s method of sourcing receipts from services based on the location of the taxpayer’s income-producing activities. S.B. 99 clarifies the term "income-producing activity" under section 105-130.4 to mean an activity directly performed by the taxpayer or its agents for the ultimate purpose of generating the sales of the service. The additional language further provides that receipts from services, where the income-producing activities are performed within and outside of North Carolina, are attributed to North Carolina in proportion to the ratio of the income-producing activities performed in North Carolina to the total income-producing activities performed everywhere.
During an interview with Reed Smith, Secretary Ronald Penny was hopeful that market-based sourcing would be enacted in North Carolina for sales other than tangible personal property. Although S.B. 99 would have enacted market-based sourcing for intangibles, the technical corrections to the budget retained sourcing for intangibles under current law, such that market-based sourcing ultimately was not achieved through S.B. 99 for any type of receipt.2
S.B. 99 included a decrease of the corporate tax rate from 3.0% to 2.5%, and the personal income tax rate from 5.499% to 5.25% effective for 2019.
S.B. 75, effective June 28, 2018, will submit a ballot question to voters in the November 2018 general election that will determine whether the North Carolina Constitution will be amended to reduce the maximum corporate income tax rate from 10% to 7%. Therefore, even if the rate reduction to 2.5% is not permanent, should voters pass the lowered constitutional cap, the corporate income tax rate would not exceed 7%.
Other business tax updates
- S.B. 99 fulfilled its designation as an omnibus budget, making the following myriad changes to North Carolina business taxes:
- General Statute section 105-228.4A was amended to provide that the tax on captive insurance companies does not apply to foreign captive insurance companies.
- The procedure for filing an amended return upon receipt of a federal determination was updated to require the filing of an income tax return reflecting each change or correction from the federal determination.
- Amended General Statute section 105-263 to add a new subsection, which grants a taxpayer an automatic extension to file North Carolina income and franchise tax returns when the taxpayer has been granted an automatic extension for federal income tax purposes.
- Added General Statute section 105-241A, which provides guidance for filing returns electronically.
Sales tax updates
The bill also makes the following changes to North Carolina sales tax provisions:
- Provides a sourcing principal specifically for renewals of licenses prewritten computer software.
- Defines the term “property management contract”.
- Includes a specific exemption for security or monitoring services for real property.
- Updated the permissible extension of time for filing sales and use returns to allow returns to be filed more than 30 days after the regular due date at the discretion of the Secretary.
Notably absent from the omnibus bill is anything addressing economic nexus in response to the recent Wayfair decision. An economic nexus bill was proposed in North Carolina last year but did not pass. Secretary Penny said at the time that “that bill was one that our General Assembly felt passionate about, or at least some of the members did, because they want to position us to be ready to collect taxes once Quill is overturned.” The Department of Revenue has indicated that it is reviewing the Supreme Court's decision and will be publishing additional information regarding the decision in the near future.
- Notably, S.B. 99 is generally effective June 12, 2018, the date of enactment. However, some provisions have specific effective dates, while there is a “catch-all” date of July 1, 2018 for those provisions not otherwise specified. The tax updates, including the IRC conformity date update to February 9, 2018 as detailed below, for the most part, fall under the catch-all effective date. This raises a couple of issues: (1) the IRC §965 repatriation tax was a tax year 2017 item for most taxpayers; thus, given the effective date, it seems North Carolina’s changes decouple from IRC §965 would not apply to any taxpayers; and (2) for some other corporate income tax changes made by S.B. 99 (e.g., changes to the sales factor sourcing rules, and decoupling from GILTI/FDII treatment), an effective date of July 1, 2018 would result in two different tax treatments for taxpayers with fiscal year ends.
- See Insight: Reed Smith’s Relationships: Ronald Penny, Secretary of Revenue, N.C. Dep’t of Revenue, BNA, (Mar. 14, 2018) available at https://www.bna.com/insight-reed-smiths-n57982089898/.
Client Alert 2018-149