Reed Smith Client Alerts

Last week, the North Carolina Supreme Court issued a decision confirming the importance of properly raising all potential bases for a refund as early as possible in the refund claim process. Merely incorporating an adjustment into an amended return and filing it with the Department of Revenue (“Department”) is not enough to properly raise and preserve an issue. If a taxpayer does not provide the Department with an explanation of a particular refund issue, the taxpayer may be precluded from pursuing that issue on appeal.

Authors: Kenneth R. Levine Megan Q. Miller Gloria Thompson1

On April 3, 2020, the North Carolina Supreme Court issued a one-page order affirming the Superior Court’s 2019 opinion in Railroad Friction Products Corp. v. N.C. Department of Revenue.2 This case involved an apportionment issue and a procedural issue involving the refund claim process. This alert focuses only on the procedural issue because of its broad application to all taxpayers.

In Railroad Friction, the taxpayer filed amended returns3 for its 2011 through 2013 tax years, requesting refunds of corporate income tax and franchise tax based on an apportionment issue. In the amended returns - and in a letter submitted with the amended returns - the taxpayer clearly identified this apportionment issue. Additionally, in one of the amended returns, the taxpayer made another change unrelated to the apportionment issue; it recalculated its affiliated indebtedness for franchise tax purposes. However, the recalculation of affiliated indebtedness was not “explained” in the amended return or the accompanying letter.

The Department denied the refund requests and, in doing so, focused only on the apportionment issue. The Department did not address the affiliated indebtedness issue. The taxpayer appealed to the Office of Administrative Hearings (“OAH”), and the case was heard by an administrative law judge on cross motions for summary judgment. The taxpayer’s summary judgment brief included its argument on the affiliated indebtedness issue. The Department, in its brief, argued that the OAH should not consider the affiliated indebtedness issue because the taxpayer did not properly raise and preserve the issue. The administrative law judge agreed with the Department and ruled that the affiliated indebtedness issue could not be considered because the taxpayer did not give the Department proper notice of the issue.

The taxpayer appealed to the Wake County Superior Court and made various arguments to the court - including equitable and statutory arguments - for why the affiliated indebtedness issue should be addressed. For example, the taxpayer pointed to N.C. Gen. Stat. Section 105-241.7(b), which lays out the process for filing a refund claim and states that “[t]he taxpayer’s statement of the basis of the claim does not limit the taxpayer from changing the basis.” The court addressed each of the arguments made by the taxpayer, and ultimately ruled, in a February 2019 decision, that the administrative law judge properly refused to consider the affiliated indebtedness issue. Specifically, with respect to the statutory argument under N.C. Gen. Stat. Section 105-241.7(b), the court concluded that the right to “change the basis” of a claim applies only during the Department’s review of the claim.