- Complete overhaul of affiliated indebtedness statutory rules for 2020–forward tax returns
For franchise tax reported on 2019 and earlier tax returns, taxpayers were statutorily required to add back to net worth the amount of any payables to affiliates. The only situations when that add back could be reduced were (1) if and to the extent the affiliated creditor was capitalized with debt from a non-affiliate,1 or (2) if the taxpayer was also owed a receivable from that same affiliate. If the taxpayer had a receivable from the same affiliate that was owed the payable, then the taxpayer could net the receivable against the payable for purposes of determining the amount required to be added back.2 Other than those two situations, the statute did not provide for any other exceptions to the addback. However, if the affiliated creditor was also subject to North Carolina franchise tax, then the creditor could claim a deduction from its net worth to the extent the affiliated debtor added back the amounts owed to the affiliated creditor.3
In 2020, the legislature amended the statutory affiliated indebtedness provisions and made substantial changes effective for franchise tax reported on 2020–forward corporation tax returns.4 The legislature explained these changes as “[s]implif[ying] the affiliated indebtedness addback to conform to the calculation already required in computing the interest deduction for income tax purposes.”5 The statute was amended to incorporate two defined terms from North Carolina’s statutory interest addback rules for corporation income tax purposes—“net interest expense” and “qualified interest expense”:
- “Net interest expense” is the excess of interest paid/accrued to an affiliate over the amount of interest income received/accrued from that affiliate during the tax year.6 For income tax purposes, this amount must be added back to federal taxable income, unless an exception applies.
- “Qualified interest expense” is the amount of net interest expense that is allowed to be deducted during the tax year for North Carolina income tax purposes.7 In other words, this is the amount that qualifies for an exception to the interest addback.
The new franchise tax affiliated indebtedness rules enacted in 2020 required that a taxpayer must add back to its net worth any indebtedness that creates “net interest expense” but does not create “qualified interest expense.” Thus, unlike the affiliated indebtedness addback rules that historically contained very limited exceptions, the new rules significantly expanded the available exceptions by incorporating the exceptions from the income tax’s interest addback statute.
The new franchise tax affiliated indebtedness rules enacted in 2020 required that a taxpayer must add back to its net worth any indebtedness that creates “net interest expense” but does not create “qualified interest expense.” Thus, unlike the affiliated indebtedness addback rules that historically contained very limited exceptions, the new rules significantly expanded the available exceptions by incorporating the exceptions from the income tax’s interest addback statute.
Under the new rules enacted in 2020, affiliated indebtedness that creates net interest expense need not be added back to net worth if:
- North Carolina or any other state imposes an income tax or gross receipts tax on the interest income of the affiliated creditor;
- The affiliated creditor is organized in a foreign country that has a comprehensive income tax treaty with the U.S. and taxes the interest income at a rate that is no less than North Carolina’s corporate income tax rate; or
- The affiliated creditor is a bank.
- Narrow statutory change in 2022 relating to interest-free payables
Under the new rules enacted in 2020, the threshold question in determining whether affiliated indebtedness must be added back to net worth was: does the affiliated indebtedness create net interest expense? If the answer to that question was “no,” then that affiliated indebtedness was not added back, regardless of whether an exception applied. This meant that an interest-free payable to an affiliate did not need to be added back to net worth.
Earlier this year, the legislature amended the statute to eliminate the threshold question of whether the affiliated indebtedness creates net interest expense,8 and now the statute’s treatment of interest-free loans is the complete opposite of what it was before this amendment. Under the newly-revised rule, an interest-free payable to an affiliate must always be added back and can never qualify for an exception.
If your company had interest-free payables to affiliates, you should review whether the payables were added back in computing net worth for North Caroline franchise tax purposes for any tax years when that was not required under the statute.
- Ongoing litigation and uncertainty
There is ongoing uncertainty surrounding the pre-2020 affiliated indebtedness provisions because of Commerce Clause discrimination problems.
If your company lent money to an affiliate that did business in North Carolina, the statute allowed your company to deduct that receivable from your net worth for franchise tax purposes. However, if you lent money to an affiliate that did not do business in North Carolina, you were not permitted the deduction.
Last year, an administrative law judge for North Carolina’s Office of Administrative Hearings (OAH) found that this “‘differential treatment’ based on the location of the debtor’s business in-state or out-of-state is clearly discrimination”9 and resulted in a violation of the Commerce Clause based on the facts presented in the petitioner’s case.10 As a result, the administrative law judge held that, when computing the petitioner’s franchise tax, North Carolina is not permitted to apply the portion of the rule that limits the deduction to receivables only from affiliates doing business in North Carolina. The state has appealed this decision to the Wake County Superior Court arguing (1) the OAH did not have jurisdiction to rule on this constitutional issue, and (2) even if the OAH had jurisdiction to rule on the issue, the OAH was incorrect in ruling that the statute produced an unconstitutional result for the petitioner. The court has agreed to address the jurisdictional issue first, the parties’ briefing on that issue is complete, and a hearing on the issue is scheduled for mid-November.
The substantive issue in that pending litigation—which is relevant to taxpayers lending to affiliates—is not the only problem with the pre-2020 affiliated indebtedness provisions. There is also an issue for taxpayers that borrow from affiliates.
Specifically, there is a constitutional discrimination problem for a taxpayer that borrowed money from an affiliate that did not do business in North Carolina. In that scenario, the taxpayer would have been required to add back the affiliated indebtedness in computing its net worth, and the affiliated creditor would not get a deduction in North Carolina because it did not do business in North Carolina and, thus, was not required to file a North Carolina franchise tax return. The result is one level of North Carolina tax on this related-party lending activity. Although that may seem fair on the surface, this result fails the U.S. Supreme Court’s test for “internal consistency” under the Commerce Clause.
This is because this tax regime ensures one level of tax only in situations where the debtor and creditor both do business in North Carolina. But if every state were to adopt the same tax regime as North Carolina—which is what we must assume when testing for internal consistency—then there would be two levels of tax in situations where the debtor and creditor did not do business in the same state (i.e., one level of tax imposed on the debtor required to add back the payable in computing net worth in its state, and one level of tax imposed on the affiliated creditor, which would not be allowed to deduct the receivable in computing its net worth in its state). Because this would cause commerce conducted across state lines to be subject to a greater tax liability in the aggregate than the same exact commerce if concentrated entirely within a single state, this tax regime fails the internal consistency test and is unconstitutional.
If your company had intercompany balances for pre-2020 tax years, you should evaluate the impact of North Carolina’s affiliated indebtedness adjustments on your tax liability and consider filing claims to preserve your right to a refund based on these issues.
- N.C. Gen. Stat. § 105-122(b)(2) (2019).
- 17 N.C. Admin. Code 5B.1110.
- N.C. Gen. Stat. § 105-122(b)(2a) (2019).
- See generally 2020 N.C. Sess. Law 58, section 5.1, 2019 HB 1080.
- N.C. General Assembly, 2019 HB 1080 Bill Summary and Explanatory Memo, Analysis of S.L. 2020-58 (July 16, 2020).
- N.C. Gen. Stat. § 105-130.7B(b)(3).
- N.C. Gen. Stat. § 105-130.7B(b)(4).
- 2022 N.C. Sess. Law 13, section 1.2, 2021 HB 83.
- 20 REV 04215, OAH decision at 12.
- OAH decision at 12-13.
In-depth 2022-350
