North Carolina Governor Pat McCrory recently signed into law several different bills that significantly change the state's corporation income and sales tax regimes. The corporate income tax provisions formally propose market-based sourcing concepts in the area of apportionment, reduce the allowable deduction for related party interest expense, and exclude certain receipts from financial transactions from the sales factor.1 In addition, Governor McCrory announced on August 2, 2016 that the state exceeded its general fund target amount, triggering a prospective corporate income tax rate reduction.2 Enacted sales tax provisions modify several key definitions and expand the grounds for compromise that may be employed by the North Carolina Department of Revenue.3 Finally, the legislation provides for the publication of written determinations by the Department regarding state tax matters.4
Corporate Income Tax
Proposed Market-Based Sourcing for Receipts from Services and Bank Receipts
On July 14, 2016, Governor McCrory signed legislation enacting the 2016 – 2017 state budget.5 The budget bill contains proposed provisions designed to enact market-based sourcing for services and bank receipts for corporate income tax apportionment purposes in the near future.6 Specifically, the proposed legislation requires the Department to draft related regulations to be submitted to the General Assembly Rules Review Commission on or before January 20, 2017.7 A public comment period of 90 days is required after publication of these rules. Upon approval by the Commission, the General Assembly may then convert the proposed legislation into law.8
The proposed rules generally provide that receipts are sourced to North Carolina if the taxpayer's market for the receipts is in the state. If the market for a receipt cannot be determined, the state or states of assignment must be reasonably approximated. For receipts that cannot be reasonably approximated, a throwout provision applies.9 For nonbank businesses, the following market-based sourcing principles will be applied:
- The sale of real property, and the rental, lease or license of real property or tangible personal property is in North Carolina to the extent the property is located in North Carolina.10
- The sale of tangible personal property is in North Carolina if and to the extent it is received by the purchaser in North Carolina.11
- The sale of a service is in North Carolina if and to the extent the service is delivered to a location in North Carolina.12
- The rental, lease or license of intangible property is in North Carolina if and to the extent it is used in North Carolina. Intangible property utilized in marketing a good or service to a consumer is considered to be used in North Carolina if the consumer of that good or service is in North Carolina.13
- Intangible property that is sold is in North Carolina if and to the extent the property is used in North Carolina. A contract right, license, or similar intangible that authorizes a holder to conduct an activity in a specific geographic area is considered to be used in North Carolina if the geographic area includes all or part of North Carolina. Sales of intangible property that are contingent on the productivity, use or disposition of the intangible property are treated as receipts from the rental, lease, or licensing of intangible property. All other receipts from a sale of intangible property are excluded from the sales factor calculation.14
Notably, these provisions closely mirror those included in a previously enacted requirement for certain taxpayers to report market-based sourcing apportionment information.15
Separate market-based sourcing provisions are provided for banks,16 which include both relevant definitions,17 certain exclusions from gross receipts,18 and sourcing requirements.19 For bank businesses, receipts are classified into 10 categories and are generally sourced based on the location of the property upon which the receipt is secured or to the location of the payor.20
Taxpayers may find the guidelines issued by the Department earlier this year (relating to the required market-based sourcing informational reports) useful in providing insight as to the potential content of the anticipated regulations.21 The Department has also issued a notice discussing the process for enacting the required regulations.22
Reduction of Related Party Interest Expense Deduction
Apart from the market-based sourcing proposal enacted in July, other legislation was enacted on May 11, 2016 that reduces the allowable corporate income tax deduction for interest expense paid to related parties from 30 percent of a taxpayer's taxable income to 15 percent of a taxpayer's taxable income.23 Under North Carolina law, a deduction for interest expenses paid or accrued to related parties is only allowed for qualified interest expense. The recently enacted legislation defines "qualified interest expense" as "the amount of the net interest expense paid or accrued to a related member during the taxable year, limited to the greater of 15 percent of the taxpayer's adjusted gross income or the taxpayer's proportionate share of interest paid or accrued to a person who is not a related member during the same taxable year."24 This section is effective for taxable years beginning on or after January 1, 2016.25
Further, the legislation defines "a taxpayer's proportionate share of interest" as "the amount of the taxpayer's net interest expense paid to an ultimate payer divided by the total net interest expense of all related members that is paid to the same ultimate payer, multiplied by the interest paid or accrued to a person who is not a related member by the ultimate payer."26 The term "ultimate payer" is defined as a related member that receives or accrues interest from related members directly or indirectly through a related member and pays or accrues interest to a person who is not a related member.27 Interest amounts eliminated by combined or consolidated return requirements do not qualify as interest in considering whether another state imposes an income or gross receipts tax on the interest income for purposes of determining applicability of the interest expense limitation.28
Exclusion of Financial Swaps and Similar Derivatives
New legislation excludes certain financial swaps and similar derivatives from the sales factor numerator.29 Specifically, it adds a section to the definition of gross receipts, effective for tax years beginning on or after January 1, 2016. This newly added section excludes from gross receipts "[t]he portion of receipts from financial swaps and other similar derivatives that represents the notional principal amount that generates the cash flow traded in the swap agreement."30 Also, the legislation adds a provision excluding receipts in the nature of dividends that are subtracted under N.C. Gen. Stat. Sec. 105- 130.5(b)(3a), (3b), and dividends excluded for federal tax purposes.31
Cancellation of Indebtedness Income
The legislation clarifies the effective date of the subtraction adjustment that taxpayers may claim against corporate income for the amount added to federal taxable income as income from the cancellation of indebtedness under IRC Section 108(i)(1). The change eliminates the explicit reference to the adjustment being applicable to taxable years beginning on or after January 1, 2014, and instead confirms that the provision is effective for taxable years beginning on or after January 1, 2009.32
Rate Reduction
Because the general fund target amount was exceeded for the 2016 fiscal year, the corporate income tax rate will decrease to 3 percent effective for the tax year beginning on or after January 1, 2017.33 Consistent with the prior procedure that resulted in the reduction of the corporation income tax from 5 percent to 4 percent, the rate reduction recently was communicated to taxpayers by the Secretary of Revenue.
Sales and Use Tax
The legislation contains a number of provisions clarifying the definitions and sales tax treatment of receipts related to the maintenance, repair, and installation of personal and real property.34 Most notably, the retail trade definition was removed, which allows a retailer to cease charging sales tax on repair, maintenance, and installation labor.35 This change was designed to allow larger retailers who also offer these services to compete with contractors who were not required to charge sales tax on similar labor. Further changes clarify that a contractor utilizing personal property to make repairs to real property is responsible for paying sales tax on the personal property, but is not required to charge sales tax on the entire contract.36 The changes also address the sales tax treatment of bundled service contracts. Specifically, with respect to bundled service contracts for multiple services, at least one of which is not subject to tax, a price for the taxable portion must be allocated based on a reasonable allocation of revenue that is supported by the person's business records kept in the ordinary course of business.37
Finally, the new law allows the Secretary of the Department of Revenue to compromise with taxpayers in settling liabilities that arise from the application of the sales tax regulations related to repair, installation and maintenance charges (along with the definitions of retailer-contractor and retail trade) if the taxpayer applied a good faith effort in attempting to collect tax and apply these rules.38 The Department is required to issue written guidance regarding implementation of all the enacted changes by November 15, 2016.39
Disclosure of Written Determinations
The North Carolina Department of Revenue is now required to publish redacted copies of written determinations, which include alternative apportionment rulings, private letter rulings, and redetermination private letter rulings, within 90 days of issuing the guidance directly to the taxpayer.40 Further, agreements of these types issued to taxpayers on or after January 1, 2010 are required to be redacted and published within 120 days of enactment.41 It should be noted that written determinations are applicable only to the individual taxpayer addressed and does not carry precedential value except to the taxpayer to whom the determination is issued.42
Contesting Denial of Refunds and Amended Returns Not Filed Within Statute of Limitation
Finally, legislation now allows taxpayers to appeal denied requests for refund or amended returns due to statute of limitation issues to the Office of Administrative Hearing.43 Previously, a taxpayer was not entitled to further administrative or judicial review of denials related to statute of limitation determinations by the Department. Taxpayers may request an administrative review within 60 days of the date of the denial. For denials issued prior to June 30, 2016, taxpayers may petition for review on or before August 29, 2016.
Commentary
The proposed market-based sourcing legislation continues North Carolina's tendency to follow business tax reform in various states, which began with several tax rate reductions and phased single sales factor souring.44 The requirement for draft regulations and subsequent review by the General Assembly Rules Review Commission will delay this possible law change until 2017, continuing North Carolina's recent use of contingent legislation that was used by tying recent tax rate reductions to budgetary revenue. Such contingent legislative items have generally been well-received by the business community, but have proven to be challenging for those trying to properly reflect the impact of the changes during the financial statement process.
North Carolina effectively lowered the qualified interest expense deduction for related parties from 30 percent to 15 percent, while simultaneously creating an unlimited deduction for payments that are ultimately paid to an unrelated member. The unlimited deduction for a taxpayer's proportionate share of interest paid to a person who is not a related member mirrors the typical conduit exception permitted by some states for related party interest payments. Conduit exceptions make sense because a taxpayer who receives an interest expense from a related party and then pays that same interest expense to an unrelated party typically does not have an unrestricted right to that money, and the traditional definition of gross income only includes amounts received with unrestricted rights. Instead, the person receiving the interest expense is merely serving as a conduit for a payment to an unrelated party. These types of transactions are common in corporations where there is a centralized cash management system in which related companies utilize a single bank account shared by multiple entities for ease of administration. Conduit exceptions like this one help prevent companies from improperly recognizing income. The sales and use tax legislation reflects a continued effort to clarify confusion that has arisen as a result of previously enacted legislation, particularly that focused on the taxation of repair and installation services and related tangible personal property. The newly enacted statutes are expected to help taxpayers and the Department resolve related issues. Finally, the required publication of written determinations and new appeal option with respect to refund claim denials continue the North Carolina legislature's welcome trend towards transparency. While the written determinations will not provide precedential authority for taxpayers to rely upon, the guidance will provide insight into the tax issues that are meaningful to taxpayers and the Department, and will give taxpayers a potential starting point and framework for dealing with their own uncertain tax positions as they arise.
Footnotes
1 S.L. 2016-94 (H.B. 1030), S.L. 2016-5 (S.B. 729), Laws 2016.
2 Important Notice, Corporate Tax Rate Reduction, North Carolina Department of Revenue, Aug. 4, 2016.
3 S.L. 2016-94 (H.B. 1030).
4 S.L. 2016-103 (S.B. 481), Laws 2016.
5 S.L. 2016-94 (H.B. 1030).
6 N.C. GEN STAT. § 105-130.4.
7 S.L. 2016-94, § 38.4(a).
8 S.L. 2016-94, § 38.4(b).
9 Proposed N.C. GEN STAT. § 105-130.4(l).
10 Proposed N.C. GEN STAT. § 105-130.4(l)(1), (2).
11 Proposed N.C. GEN STAT. § 105-130.4(l)(3).
12 Proposed N.C. GEN STAT. § 105-130.4(l)(4).
13 Proposed N.C. GEN STAT. § 105-130.4(l)(5).
14 Proposed N.C. GEN STAT. § 105-130.4(l)(6).
15 S.L. 2015-268, § 32.14A.(b)(1). See GT SALT Alert: North Carolina Mandates Informational Reporting of Market-Based Sourcing Apportionment Calculation.
16 Proposed N.C. GEN STAT. § 105-130.4A.
17 Proposed N.C. GEN STAT. § 105-130.4A(a).
18 Proposed N.C. GEN STAT. § 105-130.4A(b).
19 Proposed N.C. GEN STAT. § 105-130.4A(c)-(l).
20 N.C. GEN. STAT. § 105-130.4A.
21 For additional information, see Guidelines for Computing the Sales Factor Based on Market-Based Sourcing Principles, North Carolina Department of Revenue, Jan. 26, 2016 and Jan. 29, 2016.
22 For further information, see Important Notice: DOR to Adopt Rules Regarding Market-Based Sourcing, North Carolina Department of Revenue, Aug. 4, 2016.
23 S.L. 2016-5 (S.B. 729).
24 N.C. GEN. STAT. § 105-130.7B(b)(4).
25 S.L. 2016-5 (S.B. 729), § 1.8(c).
26 N.C. GEN. STAT. § 105-130.7B(b)(5).
27 N.C. GEN. STAT. § 105-130.7B(b)(6).
28 N.C. GEN. STAT. § 105-130.7B(b)(4)a, b. This provision is effective for taxable years beginning on or after January 1, 2017, and applicable to the calculation of franchise tax reported on the 2016 and later corporate income tax returns.
29 S.L. 2016-5 (S.B. 729), § 1.6(b).
30 N.C. GEN. STAT. § 105-130.4(a)(7)(e).
31 N.C. GEN. STAT. § 105-130.4(a)(7)(f).
32 N.C. GEN. STAT. § 105-153.5(b)(25). A similar provision was enacted with respect to the computation of personal income.
33 N. C. GEN. STAT. § 105-130.3C(a).
34 S.L. 2016-94 (H.B. 1030).
35 Former N.C. GEN. STAT. § 105-164.3(34a).
36 N.C. GEN. STAT. § 105-164.4. 37 N.C. GEN. STAT. § 105-164.4D(a)(6).
38 N.C. GEN. STAT.§ 105-237.1(a)(7). Note that this provision is applicable to assessments for any reporting period beginning on March 1, 2016 and ending December 31, 2022.
39 S.L. 2016-94 (H.B. 1030), § 38.5(l).
40 S.L. 2016-103 (S.B. 481); N.C. GEN. STAT. § 105-264.2.
41 S.L. 2016-103 (S.B. 481), § 8. The bill was enacted on June 30, 2016.
42 N.C. GEN. STAT. § 105-264.2(a).
43 S.L. 2016-76 (H.B. 533); N.C. GEN. STAT. § 105-241.15(b).
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