The Division’s NOL Limitation
Delaware requires taxpayers to file separate-company corporate income tax returns.The Division has long-recognized that a corporation that is a member of a federal consolidated group must compute its taxable income on its Delaware return on a separate-company basis.2
But, the Division’s audit practice was to adopt the consolidated NOL on the consolidated group’s as-filed federal return as a limitation on the taxpayer’s own separate-company NOL deduction on its Delaware return.3
Taxpayer’s Challenge Successful
Last year, in VeriSign, Inc. v. Director of Revenue, Delaware’s Superior Court found the NOL limitation violated the tax uniformity clause of the Delaware Constitution.4 The court recognized the limitation divided Delaware corporate taxpayers into two groups on the basis of their federal filing status (consolidated versus separate) and applied the limitation to one group (consolidated federal filers) but not the other (separate-company federal filers). The court rejected the Division’s limitation because there was no authority for the agency to create such a classification.
On November 29, 2021, the Delaware Supreme Court affirmed on an alternative basis.5 The Court found that using the consolidated NOL as a limitation was irreconcilable with the Delaware corporate income tax statute, which imposed tax on a separate-company basis.The court did not reach the tax uniformity clause or other constitutional claims raised.
NOL Limitation Codified
On July 30, 2021, after briefing but before argument in the case, Delaware codified the NOL limitation.6 Although the language of the codification is itself internally contradictory, it purports to codify the Division’s NOL limitation at issue in VeriSign.7
Uncertainty exists regarding the tax year to which the now-codified NOL limitation applies because the enacting legislation is effective “on” July 30, 2021, rather than with respect to a specific tax year.
At a minimum, VeriSign should control for pre-2020 calendar years.8 But in our view, VeriSign also controls for calendar year 2020,9 even if the taxpayer filed its return on extension after the legislation’s July 30, 2021 effective date.
Taxpayers that paid tax on an original return as result of the limitation have three years from the date prescribed for filing their original return to file a refund claim (i.e., back to the 2018 calendar tax year). Taxpayers that paid assessments of Delaware corporate income tax resulting from the application of the NOL limitation have two years from the date they paid the assessment to file a refund claim.10
Validity of Codified Limitation
Taxpayers subject to the now-codified limitation should consider its validity. For example, the analysis by both the Superior Court and Supreme Court provides some support for the argument that it violates the tax uniformity clause of the Delaware Constitution.
The first question in such a challenge is the relevant class of disparately treated taxpayers. On that point, the Superior Court recognized the NOL limitation divides corporate taxpayers into two classes—federal consolidated filers and stand-alone filers. The Superior Court then concluded that the NOL limitation treats taxpayers in each of those classes differently—limiting the use of NOLs by taxpayers in one class, but not the other.11 Although the Supreme Court did not analyze the uniformity argument, it helpfully characterized the Superior Court’s uniformity clause analysis as “thoughtful and well-reasoned."12
A future challenger will likely have the additional hurdle of showing the legislature did not have a “rational basis” for enacting the NOL limitation. The Division was not entitled to “rational basis” deference when it “acted alone” to create the limitation.13 However, a court would likely evaluate the now-codified limitation applying that standard. Although a court would likely show some deference to Delaware in applying the rational basis standard, Delaware may have a tough time convincing a court that the standard was satisfied. The Division offered several potential bases for the limitation in the VeriSign litigation; but none, in our view, constituted a “rational” basis for disparate treatment based on federal filing status.
The consolidated NOL limitation may also run afoul of the U.S. Constitution’s foreign commerce clause, which prohibits a state from treating dividends from a foreign subsidiary less favorably than dividends from a domestic subsidiary.14 Corporate taxpayers whose consolidated NOL for federal income tax purposes would be greater if computed without regard to dividends received from foreign subsidiaries should consider challenging the Delaware NOL limitation on foreign commerce clause grounds.
- Dir. of Revenue v. VeriSign, Inc., No. 18, 2021, 2021 Del. LEXIS 375 (Del. 2021).
- 30 Del. C. § 1903(a); see, e.g., Del. Form 1100i (2016).
- Dir. of Revenue v. VeriSign, 2021 Del. LEXIS 375 at *5. Although the Division’s policy had been in place for some time, it was not contained in the Division’s publicly available materials. Id.
- VeriSign, Inc. v. Dir. of Revenue, C.A. No. N19C-08-093 JRJ, 2020 Del. Super. LEXIS 3011 (Del. Super. 2020).
- Dir. of Revenue v. VeriSign, Inc., 2021 Del. LEXIS 375 at *2.
- H.B. No. 171 § 5. The amended statute, 30 Del. C. § 1903(a), provides that a corporation’s “federal taxable income shall be [] adjusted by eliminating: ... i. Any deduction for a net operating loss carryforward calculated in accordance with the provisions of the [IRC], provided however that the deduction may not exceed the amount claimed on the federal return filed for the taxable year in which the taxpayer was included as a party.”
- H.B. No. 171, Bill Synopsis (“Section 5 codifies the long-standing practice of the Division of Revenue to limit Net Operating Loss deductions to those deductions that were claimed on a federal return.”).
- Tax years for which the Delaware tax return is due on extension before H.B. 171’s July 30, 2021 effective date.
- Tax years for which the Delaware tax return is due without regard to extensions before H.B. 171’s effective date.
- 30 Del. C. § 539(a).
- VeriSign, Inc. v. Dir. of Revenue, 2020 Del. Super. LEXIS 3011 at *23.
- Dir. of Revenue v. VeriSign, Inc., 2021 Del. LEXIS 375 at *16.
- VeriSign, Inc. v. Dir. of Revenue, 2020 Del. Super. LEXIS 3011 at *23.
- Kraft Gen. Foods v. Iowa Dep’t of Revenue and Fin., 505 U.S. 71 (1992);see also Kraft Gen. Foods, Inc. v. Comptroller of Treasury, No. 96-IN-OO-0353, 2001 WL 699558 (Md. Tax Jun. 8, 2001) (adopting the federal dividends received deduction that inherently treats foreign subsidiary dividends less favorably than domestic subsidiary dividends violates the U.S. Constitution’s foreign commerce clause), acquiesced to by Maryland Dep’t of Revenue in Md. Tax Admin Release No. 18 (Jul. 2013).
Client Alert 2021-321
