North Carolina’s franchise tax treatment of affiliated indebtedness has changed dramatically in recent years and is under attack in court. This alert will get you up to speed on three developments to keep in mind.
When computing North Carolina’s franchise tax, the calculation of the “net worth” tax base includes adjustments related to affiliated indebtedness. This alert highlights the following three developments in this area: (1) the complete overhaul of the affiliated indebtedness statutory rules for 2020–forward tax returns; (2) the narrow statutory change to these rules in 2022 relating to interest-free payables; and (3) the ongoing litigation and uncertainty surrounding these rules.
- 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.