New Initiative to Resolve Intercompany Transaction Issues
The DOR announced a new initiative to work with corporate taxpayers to resolve issues involving intercompany transactions2 for open tax years.3 The initiative began on August 1 and will conclude by December 1. Taxpayers interested in participating must submit an Election to Participate form by September 15. The DOR is also open to resolving other corporate income or franchise tax issues as part of this process.
There is some speculation in the taxpayer community that this initiative is, at least in part, a reaction to the IRS’s victory in the Altera transfer pricing case, in which the Ninth Circuit’s decision arguably strayed from the arm’s length standard.4 The DOR has also been active in challenging intercompany transactions well before Altera—especially since the Wal-Mart Stores East and Delhaize America cases from 2009 and 2012, respectively. In both of those cases, the court upheld the DOR’s forced combination of affiliates engaged in intercompany transactions, and the court also upheld the imposition of the 25% “large tax deficiency” penalty.5
Audits and appeals involving intercompany transaction issues can take a lot of time and resources, so the expedited timing of this initiative could be an important consideration for taxpayers. Taxpayers that elect to participate by September 15 will have until October 16 to submit all requested documentation to the DOR. The DOR will respond within 31 days after receipt of all documentation and will provide a written report proposing adjustments and summarizing its methodology and conclusions. Taxpayers will then have a 15-day period during which they can propose modifications, but an agreement must be reached by the end of the 15-day period. Under this accelerated timeframe, taxpayers could reach a final resolution by year-end and release financial statement reserves into earnings for 2020.
Aside from expedited resolution, there are other factors for taxpayers to consider when deciding whether to participate in this initiative, including the potential for the waiver of all civil penalties associated with issues resolved under the initiative, and the possibility of settling other unrelated corporate income or franchise tax issues.
Taxpayers electing to participate in the new DOR initiative should consider raising other issues in this process in order to offset potential deficiencies related to intercompany transaction issues. For example, there continue to be problems with the franchise tax, such as:
- “Greater of” alternative tax bases is unconstitutional – The franchise tax base is the greater of: (1) the apportioned net worth, (2) 55% of the appraised value of property in North Carolina, or (3) actual investment in property in North Carolina.6 This tax base computation fails the “internal consistency” test under the Commerce Clause of the U.S. Constitution because it favors taxpayers doing business only in North Carolina over taxpayers doing business in multiple states.7
- Affiliated indebtedness addback is unconstitutional – Taxpayers are required to add to net worth the amount of indebtedness owed to an affiliate. If the affiliate-creditor is also subject to North Carolina franchise tax, then that affiliate is entitled to a corresponding deduction from its net worth.8 The limitation of the deduction to indebtedness to affiliates subject to North Carolina franchise tax discriminates against interstate commerce in violation of the Commerce Clause.
- Factor representation required as a matter of fair apportionment – For taxpayers with subsidiaries, the net worth tax base includes components of the net worth of the taxpayer’s subsidiaries, so the taxpayer should be entitled to compute its apportionment by including factors of those subsidiaries. This would avoid a result where the standard statutory apportionment method, as applied to the taxpayer, “subjects a greater proportion of its net worth to tax . . . than is attributable to its business in this State.”9
Aside from those systemic issues with the franchise tax, there are other taxpayer-friendly nuances in the franchise tax calculation that many taxpayers overlook. We recommend taking a fresh look at your franchise tax calculation as part of any analysis of the benefits of the DOR’s new initiative.
Sales-Factor Sourcing Guidance
The DOR issued guidance summarizing the “basic principles for market-based sourcing of receipts”10 in light of last year’s enactment of the market-based sourcing statute, effective for tax years beginning on and after January 1, 2020.11
The DOR had previously adopted market-based sourcing rules in early 2017 - even though the legislature had not yet enacted market-based sourcing.12 The legislation enacting market sourcing directed that those 2017 rules be entered into the North Carolina Administrative Code to apply to taxable years beginning on or after January 1, 2020.13
Like other states’ market-based sourcing rules, North Carolina’s administrative rules are fairly detailed, address several different types of services and intangible property, and provide various cascading rules and safe harbors. In this newly-published guidance, the DOR organizes its rules into tables covering seven key areas: (1) in-person services (other than professional services); (2) professional services; (3) services delivered to the customer, on behalf of the customer, or electronically through the customer; (4) license or lease of intangible property; (5) sale of intangible property; (6) interest income received by a non-bank; and (7) special and industry-specific rules.
North Carolina Conformity to Internal Revenue Code Amendments in COVID-19 Relief Legislation
The DOR published guidance addressing North Carolina’s conformity to the IRC in light of Congress’ enactment of the Further Consolidated Appropriates Act of 2020 (“FCAA”) and the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”).14
On June 30, Governor Roy Cooper signed into law Session Law 2020-58, updating the state’s IRC conformity date from January 1, 2019 to May 1, 2020. As a result, this legislation generally brought North Carolina into conformity with the IRC as amended by the FCAA and the CARES Act. However, the legislation decoupled North Carolina from certain IRC amendments that are relevant for corporate taxpayers.
For example, North Carolina has decoupled from the provision in the CARES Act that increased the federal limitation on deductions for business interest expense under IRC § 163(j) from 30% to 50%. For North Carolina purposes, for 2019 and 2020, the limitation on the business interest expense deduction remains at 30% of adjusted taxable income as calculated on a separate-company basis. Thus, for North Carolina purposes, taxpayers must add back the amount of business interest expenses deducted federally in excess of 30% of adjusted taxable income.
North Carolina also made a change with respect to its treatment of forgiven Payment Protection Program (“PPP”) loan amounts. Similar to the federal treatment, the amount of forgiven PPP loan proceeds is not included in North Carolina taxable income. However, for North Carolina purposes, taxpayers must add-back any deductions claimed for federal purposes for expenses paid using the forgiven PPP loan proceeds.
- Gloria Thompson is a non-attorney consultant at Reed Smith and a former Senior Vice President and State and Local Tax Director at Wells Fargo and Wachovia.
- The DOR has statutory authority under N.C. Gen. Stat § 105-130.5A to adjust income on account of intercompany transactions. Under that provision, if the DOR determines that a taxpayer’s intercompany transactions lack economic substance or are not at arm’s length, the DOR has the authority to recompute the taxpayer’s income attributable to its business conducted in North Carolina by “adding back, eliminating, or otherwise adjusting intercompany transactions . . . or, if such adjustments are not adequate under the circumstances . . . requiring the corporation to file a [unitary combined] return . . . .
- See Important Notice: North Carolina Announces Voluntary Corporate Transfer Pricing Resolution Initiative, N.C. Dep’t of Revenue (July 30, 2020). See also Election to Participate in Transfer Pricing Resolution Initiative, N.C. Dep’t of Revenue.
- Altera Corp. v. Comm’r, Nos. 16-70496, 16-70497 (9th Cir., June 7, 2019); cert. denied, S. Ct. No. 19-1009 (June 22, 2020). For more information on the state tax impact of the Altera decision, please see State Tax Impact of Altera, Kyle O. Sollie and Sebastian C. Watt.
- See Delhaize America, Inc. v. Lay, 731 S.E.2d 486 (N.C. Ct. App. 2012); Walmart Stores East, Inc. v. Hinton, 676 S.E.2d 634 (N.C. Ct. App. 2009).
- N.C. Gen. Stat. § 105-122(d).
- The “internal consistency” test identifies tax regimes that discriminate against interstate commerce by “look[ing] to the structure of the tax at issue to see whether its identical application by every State in the Union would place interstate commerce at a disadvantage as compared with commerce intrastate.” Comptroller of the Treasury of Maryland v. Wynne, 135 S. Ct. 1787, 1803 (2015) quoting Oklahoma Tax Comm’n v. Jefferson Lines, Inc., 514 U.S. 175, 185 (1995). If a hypothetical multi-state taxpayer would pay more tax, in the aggregate, than a wholly in-state taxpayer on the same business, the tax regime fails the test.
- N.C. Gen. Stat. §§ 105-122(b)(2) and (2a).
- N.C. Gen. Stat. § 105-122(c1)(2).
- See Summary for Computing the Sales Factor Based on Market-Based Sourcing, N.C. Dep’t of Revenue (July 16, 2020).
- See S.B. 557, codified at N.C. Gen. Stat. § 105-130.4(l); for additional information see North Carolina Enacts Market-Based Sourcing, Marketplace Sales Tax Collection Obligations, and More, Megan Q. Miller, Jeremy Abrams, Kenneth R. Levine and Gloria Thompson.
- See 17 N.C. Admin. Code § 5G.0101 et seq.
- Session Law 2016-246, S.B. 557, sec. 3(f).
- Important Notice: North Carolina’s Reference to the Internal Revenue Code Updated – Impact on North Carolina Corporate and Individual Income Tax Returns, N.C. Dep’t of Revenue (July 20, 2020).
Client Alert 2020-478
