North Carolina long has been a “single entity” state for purposes of state corporate income tax filing. However, since the late 1990s the NCDOR has issued perhaps hundreds of assessments based on “forced combinations” under its vague combination statute, GSNC 105-130.6. After a court victory in a forced combination case in 2009, the NCDOR “settled” over 100 audit contests with corporate taxpayers based on their compelled agreement to file consolidated returns going forward. Many of those settlements were “encouraged” by the prospect of waiver of very large penalties asserted for failing to file combined returns, which the taxpayers could not have done in any event.
In its 2010 legislative session the N.C. General Assembly enacted modest changes to the statutes controlling forced combinations, which somewhat reduce the penalty potential, encourage but do not require the DOR to issue objective guidance on when combination will be required, and appear to encourage taxpayers to seek voluntary combination, although the power and willingness of the DOR to grant voluntary combination where it would lead to lower taxes is questionable.
Forced and Voluntary Combination of Corporations for Income Tax Filing in North Carolina: The 2010 Statutory Changes
The 2010 North Carolina budget bill, S.L. 2010-31 (June 30, 2010), contains a brief but powerful set of amendments to the portions of the Revenue Chapter 105 that address combined filing by corporations. North Carolina is historically a pure separate return state, but the DOR has been very aggressive in recent years in asserting forced combinations under authority purportedly granted by GS 105-130.6. The 2010 amendments do the following:
- Failure to Pay Penalty. If the DOR forces a taxpayer to file a combined return, the taxpayer will not be subject to the 10% failure to pay penalty if it timely files the required combined return without payment, the DOR assesses the tax shown due on the return, and the taxpayer pays then or later after pursuing administrative review of that assessment. GS 105-236(a)(4)c. If the DOR instead proposes a larger assessment based on its own construction of the combined return, there can be no failure to pay penalty unless the taxpayer fails to pay after that assessment become final. The taxpayer’s filing of a forced combined return is not a self-assessment on which collection can be based without a formal notice of assessment. GS 105-241.22(1).
- Negligence Penalty. If the DOR forces a taxpayer to file a combined return the taxpayer will not be subject to the 10% or 25% negligence penalty unless (a) the taxpayer files an amended combined return for the same group of corporations, in which case the penalty can apply only to the incremental tax; (b) the DOR required the combined return because the taxpayer’s facts met criteria the DOR had established in permanent rules describing when it always would require combined filing; or (c) the taxpayer asked if its facts would require filing a combined return, the DOR said yes, and the taxpayer did not file combined. GS 105-236(a)(5)f.
- Rules on Combined Returns. The section that authorizes the DOR to require combined filing, GS 105-130.6, was amended, but not in a way that clarified its meaning. The amendment authorizes, but does not require, the DOR to issue rules describing taxpayer’s facts upon which it will require combined filing. If the DOR adopts such rules, it may still require combined filing on other grounds, with the criteria being the same stated in the existing section: “… the Secretary finds as a fact that a report by a corporation does not disclose the true earnings of the corporation on its business carried on in this State.” The core uncertainty in the section is “true earnings,” which phrase this amendment restates without change or explanation. GS 105-262(b) prescribes a special procedure for the DOR to follow in issuing such defining rules.
- Mandatory and “Voluntary” Combined Filing. A corporation can file a combined return for one of three reasons: (1) it is required to do so by the DOR, under the same ad hoc audit approach as in the past; (2) it voluntarily files combined because it finds itself described in the permanent rules adopted by the DOR stating when it will force combination; or (3) it has obtained a letter ruling from the DOR stating that the DOR will require it to file a combined return. GS 105-130.14.
- Retroactive Law Change. The DOR can no longer change an interpretation of the statute retroactively, meaning that the change can apply only to years beginning after the change. GS 105-264(c). This is not as significant as it looks because it only applies to an interpretation on which the taxpayer had some objective reason to rely, which appears to be limited to (1) specific advice from the DOR to that taxpayer, and (2) rules, bulletins, directives, and other such published authority.
The Core Uncertainty
The core uncertainty of the law in North Carolina concerning forced combination, GS 106-130.6, is when can the DOR require forced combination? There are no administrative rules under this statute; there is no bulletin laying out the grounds of combination; and the North Carolina courts have examined the issue only once in Wal-Mart Stores East, Inc. v. Hinton, 676 S.E. 2d 674 (NC App. 2009), appeal dismissed, 689 S.E. 2d 375 (N.C. 12/10/2009).
The court’s opinion, while unclear, basically interpreted the statute to allow forced combination due to failure of the taxpayer’s separate return to reflect “true earnings in the state,” in the uncontrolled discretion of the DOR. The opinion did not require any finding of lack of arms length payments between the taxpayer and related parties. The taxpayer had argued that GS 105-130.6 gave the DOR two weapons to combat non arms length pricing: (1) correct the pricing, or (2) force combination of the taxpayer and the related party. The Court of Appeals rejected that statutory interpretation and instead adopted the DOR argument that “true earnings in the state” creates some other undefined definition of income that was not satisfied in the Wal-Mart returns.
The North Carolina Supreme Court never got to decide the issue of statutory construction because the parties dismissed the petition for review. Therefore, the question of the proper interpretation of the statute has never been decided by the state’s highest court. However, support for the taxpayer’s statutory argument has come from an unexpected source: The North Carolina Law Review. An article by the Review’s current Editor in Chief, Jeremy M. Wilson, concludes that the Court of Appeals erred in its statutory analysis, and that in fact GS 105-130.6 does provide the DOR only with two methods of solving one problem: improper prices charged to a related party. Wilson, Statutory Interpretation in Wal-Mart Stores East, Inc. v. Hinton and Why North Carolina Courts Should Apply Anti-tax Avoidance Judicial Doctrines in Future Cases, 88 N.C.L. Rev. 1471 (May 2010).
Therefore, absent an assertion by the DOR that a corporate taxpayer has dealt on a non arms length basis with a related party (and perhaps the added assertion that the problem cannot be corrected by revising the prices as reflected in the returns of the filing taxpayer), the DOR would have no basis in GS 105-130.6 to require combined filing. The DOR realized the potential for such an interpretation when it argued that other sections of Ch. 105 independently authorized it to force combination. Therefore, while reversal of the Court of Appeals’ erroneous reasoning may not produce an ultimate victory, it is the necessary first step for corporations facing a forced combination.
Taxpayer groups pressed for relief from the 25% substantial understatement negligence penalty when a taxpayer is required to pay more tax under forced combined returns. The Wal-Mart opinion had upheld such penalties despite a provision of GS 105-130.6 (still in the statute) that appeared to preclude them. The taxpayer also argued that it could not have been negligent because it could not have filed a combined return voluntarily. Of course if the ground of the forced combination was that the taxpayer charged unfair prices to a related party, which was not the case in Wal-Mart, then a taxpayer forced to combine for that reason might be subject to negligence penalty due to the original improper prices charged.
The penalty change was the focus of the 2010 amendments. Now corporations facing a forced combination should not face the combined 35% failure to pay and negligence penalties if they follow the new rules. Of course, the practical benefit of this change will be severely limited because, according to the DOR’s press releases, hundreds of corporations agreed to forced combinations for the indefinite future for the “benefit” of being relieved of some of these penalties, and possibly other reductions of the additional asserted taxes.
The Administrative Rules
The amendment authorizes but does not require that the DOR issue rules defining at least some circumstances in which the DOR will always force combination. It is likely that the General Assembly intends for the DOR to issue such rules and it is equally likely that the DOR will be resistant to issuing such rules. The DOR is happy with the outcome of the Wal-Mart case, which was obtained without any defining rules. Moreover, the “rules” that the DOR had stated informally that it followed were so vague as to be impervious to concise definition. As a practical matter the DOR perceives a taxpayer to be subject to forced combination any time it finds that the taxable income of a corporation that has been doing business in the state declines as a result of its engaging in transactions with a newly created entity that is not a N.C. taxpayer or is a N.C. taxpayer with a substantially lower apportionment fraction.
Presumably none of the discussion of rules in the amendments applies to bulletins that are not administrative rules. However, bulletins do constitute guidance, which if changed, can be changed only prospectively.
The Letter Ruling Route
GS 105-130.14(3) is potentially the most contentious part of the changes. It appears at first reading to authorize taxpayers who want to filed combined to ask the DOR’s permission and then do so if permitted, with no standards set for when such permission will be granted. However, in fact the section does not authorize the DOR to apply some other standard, but rather to apply the same standard appearing in GS 105-130.6 (albeit uncertain); it says “the Secretary will [issue a letter ruling to] require a consolidated or combined return under the facts and circumstances set out in the request … ” The only ground for the Secretary to “require” a combined return is the rule provided in GS 105-130.6.
It is thought that the Secretary, after taking over this task from the defunct Tax Review Board a few years ago, has been “requiring” combined returns of taxpayers who wanted to file combined because they perceived a way to reduce their tax liability. It is likely the Secretary has been nervous about his authority to issue those rulings and so sought this statutory authority. However, the statutory authority does no more than allow the taxpayer to invoke the “true earnings” analysis in the statute, rather than wait for audit and assessment.
Retroactive Law Change
The limitation on retroactive law change likely will reinforce the tendencies already in evidence for the DOR not to issue guidance on matters of high priority to its enforcement efforts. For example, if the DOR issues a rule as permitted by the changes about when combination will be required, and later wants to expand the cases of forced combination in a way that appears to change an exception in the original rule, it may face the argument that such change can only be prospective.
Corporations filing in North Carolina that are not already under a settlement agreement with the DOR to file combined returns (and many are) have two major planning options:
- No dispute pending. If they have not been forced to combine and are not in the process of contesting that issue, they should consider whether combination is desirable, or could be made desirable on the right set of facts. Obviously combining gain and loss companies can produce a desirable result. Combination can reduce the North Carolina apportionment fraction enough to overcome a larger tax base. By “volunteering” into combination, a corporation gets first crack at selecting the group members to be combined. In theory that should be the “unitary group,” but the scope of that group is in the eye of the beholder; and it is not at all clear that the DOR will embrace the unitary group as a requirement. As indicated above, the DOR probably is not authorized to allow combination in a case where it would not require it, but it never hurts to ask (unless the risk of attracting an adverse audit is high).
- Combination dispute pending. If the corporation has been audited and forced to combine and did not settle with the DOR and the dispute is ongoing, it should not be daunted by the erroneous legal conclusion reached by the Court of Appeals in the Wal-Mart case. It also should not be daunted by the costs of litigating with the NCDOR, which can be large. While the proof is in the pudding, the pudding is not done until the North Carolina Supreme Court has spoken. Taxpayers wishing to litigate this issue can attempt to hold down litigation expenses by focusing the court on the legal nature of the challenge, as contrasted with overemphasis on the facts.