Reed Smith Client Alerts

During July, the North Carolina Department of Revenue (“DOR”) published several pieces of guidance relevant for corporate taxpayers. The DOR announced a new initiative focused on expediting the resolution of issues involving intercompany transactions and transfer pricing. Taxpayers also have the opportunity to resolve unrelated offset issues as part of this new initiative. Earlier in July, the DOR published guidance on the market-based sales-factor sourcing law enacted in 2019 and the impact of changes to the Internal Revenue Code (“IRC”) resulting from federal COVID-19 relief legislation.

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

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.