A memorandum dated July 19, 2012, from the MTC Counsel to the chair of the MTC Income and Franchise Tax Uniformity Subcommittee proposes adoption of a uniform regulation akin to, or actually adopted under the states’ version of, I.R.C. Section 482. The proposal is posted on the MTC website.
The regulation would authorize a forced combination of two affiliates that have engaged in a nonrecognition asset transfer that the state deems to separate income from related expenses. The proposal will be considered at the MTC meeting on July 29, 2012.
The proposal has these unusual and questionable features:
- The proposal purports to be based on Section 482 principles, but then it rejects the core Section 482 principles as too difficult and time-consuming to apply, by (1) rejecting the relevance of transfer pricing and (2) focusing on the one most contentious and ill-settled aspect of Section 482 law at the federal level: the extent to which a Section 482 adjustment can override a statutorily authorized nonrecognition transaction, such as Section 351 (which usually occurs only for transfers of intellectual property, which now is governed by other specific statutory rules).
- It cites only two case authorities as examples of the type of “distortion” that the regulation would aim at, one of which is wholly inapposite: Wal-Mart Stores East, Inc. v. Hinton, 197 N.C. App. 30, 41 (2009). The holding of that opinion at p. 41 is as follows: “However, where a taxpayer’s business is concededly unitary, and where, as here, the taxpayer attempts to reclassify income as nonbusiness or nonapportionable, the reclassification has the potential to distort true earnings in North Carolina even if all intercompany transactions are accounted for at arm’s length, or fair value, prices [and therefore the Secretary can force combination].” In other words the “distortion” the court relied on was not separating income from expense, but was based on the court’s view that the taxpayer had reclassified what should have been rental income as dividends from a subsidiary, which dividends were not then taxed by North Carolina. That is a very narrow circumstance that depends on an apportionable versus nonapportionable income distinction and a dividends received deduction, none of which is mentioned in the MTC proposal.
- Just as the proposal misconceived the narrow focus of the Wal-Mart decision, it misunderstands its own theory of separations of income from expense. It describes a bank making loans and then transferring the loans to a subsidiary under Section 351. It views this as an improper separation of the loan income from the interest expense the bank pays to its depositors. However, this analysis entirely overlooks the fact that having a subsidiary holding loan does the bank no good unless it can get money out of the subsidiary. Such money normally will come out as dividends. If the bank is taxed on the dividends, there is no separation of income from expense. If a state has chosen to exclude intercompany dividends, presumably the state knew what it was doing, or perhaps it should rethink that decision rather than write a regulation such as this.
- Finally, the proposal would authorize a combination of only the two corporations that were involved in the Section 351 exchanges that the proposal finds problematic. That is, the proposal is not for a full unitary combination when a suspicious asset transfer is discovered. Such a limited combination is both contrary to the Wal-Mart decision and unconstitutional. The Wal-Mart opinion stated: “Functional integration is the key; whether the earnings are derived as divisional profits from a legally integrated enterprise or as dividends from a legally separate entity is of no consequence in determining if a business is unitary for the purposes of computing true earnings.” 197 N.C. App. at 41. The Wal-Mart decision stands for taxing the unitary business. There was no dispute in that case about what comprised the unitary group, because the taxpayer did not contest the limited combination that the DOR asserted. However, where it better serves the taxpayer to argue for full combination, it will be fully supported by constitutional principles in asserting that the DOR can only force a combination of the unitary group under the proposed regulation.
In sum, this proposal for the MTC is not well thought out, and its cited authorities are not all supportive. It would be unfortunate for an organization like the MTC to sponsor such a proposed model rule without a lot more work to come up with a valid definition of what is a distortion of true income (aside from non-arm’s-length pricing), other than just any transaction that reduces a corporation’s income reportable in one state.