United States: New Jersey Tax Court Allows Taxpayer To Revise Federal Adjusted Basis For Corporation Business Tax Purposes

The New Jersey Tax Court allowed an automobile leasing company to revise its federal adjusted basis when calculating gain from the sale of its assets for New Jersey corporation business tax (CBT) purposes to account for depreciation deductions that resulted in no state tax benefit.¹ Also, the Tax Court struck down a regulation promulgated by the New Jersey Division of Taxation to the extent that it purported to limit New Jersey's decoupling from federal bonus depreciation to property acquired on or after January 1, 2002. Finally, the Division's removal under the "throwout rule" of the taxpayer's receipts sourced to Nevada, South Dakota and Wyoming from the denominator of the sales factor was determined to be erroneous.

Background

The taxpayer, a California corporation which operated a vehicle leasing business in numerous states including New Jersey, facilitated the financing of lease transactions entered into by affiliated automobile dealers and their consumers. In a typical lease transaction, an automobile dealer entered into a lease agreement with a consumer for a vehicle. After the taxpayer bought the leased vehicle from the dealer, the taxpayer was assigned the lease agreement and collected the lease payments from the consumer. At the completion of the lease, the taxpayer sold the used vehicle.

For federal income tax purposes, the taxpayer subtracted the cost of its leased vehicles through depreciation deductions. To determine the taxpayer's gain when it sold a vehicle,² the basis of the vehicle was adjusted downward to reflect the depreciation deductions.³ The reduction of the basis had the effect of increasing the taxpayer's gain when the vehicle was sold because its gain was the excess of the proceeds over the adjusted basis. The lower basis provided for depreciation recovery when a vehicle was sold by increasing the gain realized from the sale by the amount of the used and allowable depreciation.

The taxpayer operated on a fiscal year basis, with its fiscal year commencing on October 1 of each year. During periods prior to fiscal year 2003 (which began on October 1, 2002), the taxpayer had been allowed substantial excess depreciation deductions that increased its net operating losses (NOLs). Because of a New Jersey statute that prohibited loss carryovers during the taxpayer's 2003 and 2004 fiscal years,⁴ the taxpayer could not use the losses for New Jersey CBT purposes during these years. However, the taxpayer disposed of vehicles and recognized depreciation recovery gain for federal income tax purposes. This gain was attributable to the excess depreciation deductions which provided the taxpayer with no CBT benefit. The taxpayer initially used its federal adjusted basis to determine its CBT gains, but subsequently filed amended returns for its 2003 and 2004 fiscal years so that the depreciation recovery gains would not be included in its entire net income used to determine its CBT liability.⁵ Also, the taxpayer argued that the state's bonus depreciation decoupling provision was not limited to property acquired on or after January 1, 2002 and that the Division should not have thrown out its sales in Nevada, South Dakota and Wyoming. The Tax Court considered cross-motions for summary judgment concerning the taxpayer's CBT obligations for its 2003 through 2006 fiscal years.

Taxpayer Could Revise Federal Adjusted Basis

The Tax Court agreed that the taxpayer could adjust the federal basis in its property to account for depreciation deductions for which it received no New Jersey CBT benefit.⁶ In reaching its decision, the Tax Court explained that the "entire net income" tax base under the CBT is coupled to federal taxable income. After discussing the CBT statute that imposes tax on "entire net income,"⁷ the Tax Court acknowledged that nothing in the statute expressly allows a taxpayer to depart from its federal taxable income to reflect depreciation deductions which benefitted the taxpayer for federal tax but not New Jersey tax purposes. However, other CBT statutory and regulatory provisions suggested that the New Jersey legislature intended to tax only an entity's actual economic gains from the sale of its property and not artificial gains from unused depreciation deductions.

To support its decision that the taxpayer could adjust its federal basis for CBT purposes, the Tax Court relied on New Jersey gross (personal) income tax (GIT) appellate decisions that established a "broad principle that State tax policy prohibits the assessment of a tax on 'phantom income' resulting from depreciation deductions used by the taxpayer for federal purposes but which resulted in no New Jersey tax benefit." In Koch v. Director, Division of Taxation,⁸ the New Jersey Supreme Court held that if a taxpayer's federal adjusted basis in a partnership interest reflects benefits under federal law, but not available under New Jersey law, the Division could not require a taxpayer to use the federal adjusted basis to calculate the gain from selling the partnership interest.

The taxpayer successfully relied on Moroney v. Director, Division of Taxation⁹ to support its argument that it could depart from its federal adjusted basis when calculating its gain. In Moroney, the Appellate Division followed Koch and allowed a taxpayer to adjust its federal basis when calculating gain for GIT purposes. The Tax Court acknowledged that there are differences between the CBT and GIT, but applied the Koch and Moroney decisions to the CBT. There were parallels between the GIT statutory provisions interpreted in Moroney and the CBT statutory provisions defining an entity's income that supported the taxpayer's position. Finally, the Tax Court rejected the Division's argument that application of Moroney to calculate the taxpayer's taxable income would contravene the CBT Act's prohibition on the carryforward of NOLs during the relevant tax years. The Tax Court concluded that a statutory ban on carrying forward NOLs does not by itself preclude an adjustment to federal basis. As a result, the Tax Court granted the taxpayer's motion for summary judgment.

State's Decoupling from Federal Bonus Depreciation

The taxpayer successfully argued that New Jersey's statute decoupling from federal bonus depreciation includes property purchased after September 10, 2001 and prior to the taxpayer's first fiscal year beginning on or after January 1, 2002. Under federal law, bonus depreciation applied to property acquired after September 10, 2001.¹⁰ In 2002, New Jersey enacted legislation that decoupled from federal bonus depreciation for property acquired after September 10, 2001 and before September 11, 2004.¹¹ On February 27, 2003, the Division promulgated a regulation that somewhat modified the dates contained in the statute, providing the state decoupled from bonus depreciation for property acquired on or after January 1, 2002 and during a fiscal year beginning on or after January 1, 2002.¹²

The taxpayer's 2003 fiscal year (which began on October 1, 2002) was the taxpayer's first fiscal year beginning on or after January 1, 2002. In that fiscal year, the taxpayer placed leased vehicles into service after September 10, 2001. The taxpayer argued that decoupling began in the taxpayer's 2003 fiscal year and applied to any property it purchased after September 10, 2001. Under this argument, decoupling from bonus depreciation applied to a more expansive subset of vehicles as a means to lower the amount of gain the taxpayer ultimately realized as a result of selling the vehicles, since the effect of federal bonus depreciation was to lower the basis of the vehicles and increase the amount of the gain on property that was sold. The Division argued that decoupling did not apply to vehicles the taxpayer purchased between September 10, 2001 and October 1, 2002.

The Tax Court concluded that the statute expressly provided that the decoupling from federal bonus depreciation applied to property acquired after September 10, 2001 and before September 11, 2004.¹³ The Division did not have the authority to alter the statutory language by promulgating a regulation applying the decoupling to property acquired on or after January 1, 2002 and during a fiscal year beginning on or after January 1, 2002. Therefore, this portion of the regulation was determined to be invalid and the decoupling provision applied to property the taxpayer acquired after September 10, 2001.

Throwout Rule Did Not Support Exclusion of Receipts

The Tax Court held that the Division should not have applied the "throwout rule" to remove the taxpayer's receipts from Nevada, South Dakota and Wyoming from the denominator of the sales factor. During the relevant tax years, New Jersey used a three-factor apportionment formula with a property, payroll and double-weighted sales factor.¹⁴ Under the throwout rule, sales made into foreign jurisdictions where a corporation was not subject to tax were excluded from the denominator of the sales factor.¹⁵ In Whirlpool Properties, Inc. v. Director, Division of Taxation,¹⁶ the New Jersey Supreme Court held that untaxed receipts cannot be thrown out if the taxpayer has nexus with a destination state which has chosen not to impose an income tax. In the instant case, the Tax Court held that the taxpayer's receipts in Nevada, South Dakota and Wyoming could not be thrown out, because the taxpayer had sufficient business activity in these states so that if a corporation income or business tax were adopted in these states, the taxpayer would have been subject to tax.

Commentary

The Tax Court's extension of the holdings in Koch and Moroney, cases involving the GIT, to allow taxpayers to adjust the federal basis when calculating gain for CBT purposes, provides valuable guidance for taxpayers. Under this decision, taxpayers are allowed to adjust the federal basis in their property to account for depreciation deductions for which they receive no New Jersey CBT benefit. Thus, under certain circumstances, taxpayers may ultimately be able to reduce their New Jersey gains on sales of property by increasing their New Jersey-specific basis of their property. Also, this case may create opportunities beyond the New Jersey CBT if the line of reasoning highlighted in Koch and Moroney is followed in other states.

The question of whether taxpayers can adjust their federal basis since the Koch decision has created some confusion in New Jersey, at least to the extent of inconsistencies found between the instructions for the GIT depreciation adjustment worksheet¹⁷ and Form NJ- 1065, the New Jersey partnership return.¹⁸ The depreciation worksheet provides for the computation of a New Jersey depreciation adjustment for taxpayers that have taken bonus depreciation. According to the instructions, New Jersey depreciation adjustments will affect an individual's determination of reportable income. Partnerships with a New Jersey filing requirement calculate the entity's adjustments to New Jersey depreciation and gain or loss from the disposition of the assets. The instructions for Form NJ-1065 provide express guidance for determining the gain or loss on the sale or disposition of a partnership and the Koch effect. The partnership must use the federal basis for partnership assets for New Jersey tax purposes. The Koch decision does not apply to the sale, disposition or liquidation of assets by a partnership. However, resident taxpayers that sell or dispose of a partnership interest may be entitled to make a Koch adjustment to their federal basis in the partnership when determining New Jersey gain or loss. Thus, the depreciation adjustment worksheet instructs partnerships to make adjustments, while the partnership return prohibits partnerships from making adjustments.

By invalidating the portion of the Division's regulation providing that New Jersey did not decouple from federal bonus depreciation for property acquired after September 10, 2001 and prior to a fiscal year beginning on or after January 1, 2002, the Tax Court emphasized that regulations cannot explicitly change statutory provisions. In this particular case, this decision allowed the taxpayer to decouple from bonus depreciation for property acquired after September 10, 2001 and prior to October 1, 2002. This was important because the taxpayer sold significant amounts of property after a relatively short holding period. For federal income tax purposes, the impact of bonus depreciation substantially reduced the taxpayer's federal basis in the property, resulting in greater gains when such property was sold than if normal depreciation methods (followed by New Jersey as a result of decoupling) were used.

Footnotes

1 Toyota Motor Credit Corp. v. Director, Division of Taxation, New Jersey Tax Court, Dkt. No. 002021- 2010, Aug. 1, 2014.

2 The taxpayer realized gain under Internal Revenue Code (IRC) § 1001.

3 The federal adjusted basis was calculated by deducting from the cost of the vehicle the cumulative amount of depreciation deductions that were available to the taxpayer.

4 N.J. REV. STAT. § 54:10A-4(k)(6)(E).

5 The taxpayer relied on Moroney v. Director, Division of Taxation, 868 A.2d 1132 (N.J. Super. Ct. App. Div. 2005).

6 Following its decision in Toyota Motor Credit, the New Jersey Tax Court decided a similar case, Ford Motor Credit Co. v. Director, Division of Taxation, New Jersey Tax Court, Dkt. No. 015751-2009, Aug. 5, 2014. Because the Ford Motor Credit case involved a fact pattern very similar to Toyota Motor Credit and concerned the same adjustment to federal basis argument, the Tax Court relied on this portion of the Toyota Motor Credit decision in Ford Motor Credit.

7 N.J. REV. STAT. § 54:10A-4(k).

8 722 A.2d 918 (N.J. 1999).

9 868 A.2d 1132 (N.J. Super. Ct. App. Div. 2005).

10 IRC § 168(k). This provision allowed the taxpayer to take an additional federal deduction equal to 30 percent of the cost of a leased vehicle in the year placed in service. Regular depreciation was computed on the remaining 70 percent over the course of the taxpayer's ownership of the vehicle.

11 Ch. 40 (A.B. 2501), Laws 2002, amending N.J. REV. STAT. § 54:10A-4(k)(12)(A). This legislation expressly applied to privilege periods and taxable years beginning on or after January 1, 2002. The statute was subsequently amended and the reference to September 11, 2004 was removed.

12 N.J. ADMIN. CODE § 18:7-5.2(a)(2)(iv).

13 Ch. 40 (A.B. 3111), Laws 2004, amending N.J. REV. STAT. § 54:10A-4(k)(12)(A).

14 N.J. REV. STAT. § 54:10A-6.

15 Prior N.J. REV. STAT. § 54:10A-6(B) (repealed for tax years beginning after June 30, 2010).

16 26 A.3d 446 (N.J. 2011). The New Jersey Supreme Court explained that throwing out receipts increases the sales factor and the taxpayer's CBT liability.

17 General Instructions, New Jersey Gross Income Tax Depreciation Adjustment Worksheet GITDEP.

18 Instructions for Form NJ-1065, Partnership Return and New Jersey Partnership NJK-1.

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