11.01.2012 SALT Alert: North Carolina Corporate Income and Franchise Tax Developments


Delhaize America, Inc. v. Lay, No. COA11-868 (Aug. 21, 2012)

The Court of Appeals has affirmed in part and reversed in part the decision of the North Carolina Business Court in Delhaize America, Inc. v. Lay (lower court decision: 2011 NCBC 2 (Jan. 12, 2011)).  Delhaize America, Inc. v. Lay concerned a corporate income tax assessment by the Department based on its determination that Delhaize America, Inc. (“Delhaize”) and certain of its affiliates should be required to file a combined North Carolina corporate income tax return, a remedy known as forced combination.


Delhaize challenged this determination in a claim for refund filed in superior court on constitutional and statutory grounds.  In January 2011, the Business Court granted summary judgment in favor of the Department of Revenue with respect to the corporate income tax assessment based on the forced combination.  However, the Business Court held that the Department had violated the Due Process Clause of the Fourteenth Amendment of the United States Constitution, the Power of Taxation Clause of the North Carolina Constitution, and G.S. 105-130.6 in assessing a large deficiency penalty.


Delhaize concerned a corporate restructuring of Food Lion, Inc. (“Food Lion”).  As part of this corporate restructuring, Food Lion formed a wholly owned subsidiary, FLI Holding Corp., which acquired Kash n’ Karry Food Stores, Inc., a retail grocery chain operating primarily in Florida.  Food Lion also incorporated FL Food Lion, Inc. as a subsidiary of FLI Holding Corp.  As part of the restructuring, Food Lion implemented the “Vision Project” to reduce its North Carolina tax obligation.  As stated in the opinion, the Vision Project had three elements:


(1) Plaintiff would transfer assets to a related company not principally located in North Carolina; (2) Plaintiff would pay fees and royalties to the related company for use of the assets, which would create a tax deduction in North Carolina; and (3) the company would return cash to Plaintiff in the form of tax free dividends.


As part of this restructuring, Food Lion, Inc. changed its name to Delhaize America, Inc.


After an audit, the Department concluded that Delhaize should be combined with the income of FL Food Lion, Inc. for the audit period and also imposed a large deficiency penalty.


The Court of Appeals affirmed the Business Court’s holding that the forced combination passed constitutional muster under the Due Process Clause and that the Department complied with G.S. 105-130.6 in issuing the assessment.  The Court of Appeals also rejected Delhaize’s argument that “the trial court erred in applying an ‘economic substance’ analysis” on the basis that, while economic substance was mentioned in the Business Court’s statement of facts, the court did not apply the economic substance doctrine.


The Court of Appeals reversed the Business Court’s determination that the large deficiency penalty was unconstitutional, based on the same reasoning as whether the assessment itself complied with due process.  The Court of Appeals held that “the record here contains documents that put Plaintiff on notice that the definition of ‘true earnings’ is not limited to a showing that all transactions were ‘arm’s length’ and for ‘fair compensation.’  These documents, we believe, foreclose any genuine issue of material fact on the procedural due process issue[.]”  On that basis, the Court of Appeals upheld the Department’s assessment of a large deficiency penalty.


Department of Revenue publishes Important Notice regarding the computation of net economic losses


On August 17, 2012, the Department published guidance concerning its revised interpretation of North Carolina’s net economic loss statute (G.S. 105-130.8) in the form of an Important Notice.  The net economic loss statute defines a net economic loss as “the amount by which allowable deductions for the year other than prior year losses exceed income from all sources in the year including any income not taxable under this Part.”  G.S. 105-130.8(a)(2).  A net economic loss sustained by the taxpayer during the fifteen years prior to the taxable year may be carried forward and is allowed as a deduction subject to certain statutory limitations.  The Department’s Important Notice states that


[h]istorically, the North Carolina Department of Revenue has interpreted this provision to require income items not taxable pursuant to N.C. Gen. Stat. § 105-130.5, such as U.S. Government interest and dividends to be considered in the computation of the loss in the year of creation.  After reconsideration of the plain language of the statute, the Department has revised its interpretation, recognizing that any allowable deduction, although not taxable, may not reduce a loss in the year the loss is created.  N.C. Gen. Stat. § 105-130.8(a)(2).  However, pursuant to N.C. Gen. Stat. § 105-130.8(a)(4), a loss carried forward to a subsequent year must first be offset by any income not taxable.  The interpretation of the application of a net economic loss carried forward and claimed as a deduction in a subsequent year has not been revised.” 


(Emphasis added.)  Pursuant to this revised interpretation, any deduction that is “allowable” in computing North Carolina taxable income, such as the federal dividends received deduction, is also allowable for the purpose of calculating whether the taxpayer incurs a net economic loss available as a carryforward in future years.  However, such a deduction would not be included in a determination of whether income that the Department categorizes as “income not taxable” reduces the amount of a net economic loss carried forward from a previous year.


Legislative Developments

a.      General Assembly passes new statute governing rule making under G.S. 105-130.5A.

The General Assembly has enacted a new statute, N.C. Gen. Stat. § 105-262.1 (citations to North Carolina General Statutes hereafter “G.S.”), that suspends the authority of the Department of Revenue to redetermine the State net income of a corporation under G.S. 105-130.5A until the Department enacts a rule pursuant to an expedited rule-making procedure.  New G.S. 105-262.1 also prohibits the Department from interpreting G.S. 105-130.5A in the form of a bulletin or directive under the authority of G.S. 105-264.

Background to the enactment of G.S. 105-262.1


G.S. 105-262.1 was enacted in response to three directives (CD-11-01, CD-12-01, and CD-12-02) that the Department issued in response to the passage of HB 619 (Session Law 2011-390, as amended).  HB 619 comprehensively revised the statutory framework governing the Department’s authority to require the filing of combined returns or to otherwise adjust a corporation’s net income.  Directive CD-11-01 was issued on November 16, 2011.  Directives CD-12-01 and CD-12-02, published on April 17, 2012, largely, though not entirely, restate the content of Directive CD-11-01.


Directive CD-11-01 originated in efforts by the Department to address taxpayer complaints about the lack of guidance as to when the Department would pursue forced combination of affiliated corporations.  Responding to these complaints, in late 2010, David Hoyle, the new Secretary of Revenue, began the process of promulgating rules in compliance with the Administrative Procedure Act (“APA”) by drafting and then releasing for public comment a draft of proposed rules.  Due in part to pending legislation concerning the forced combination remedy, which was subsequently enacted and signed into law by the Governor on June 30, 2011 (2011 N.C. Sess. Laws ch. 390), the proposed rules were never promulgated.  However, the draft regulations, substantially changed and expanded to reflect the new legislation, were largely incorporated into Directive CD-11-01.


Directive CD-11-01 was published purportedly pursuant to G.S. 105-264, which makes it the duty of the Secretary of Revenue to interpret all laws administered under the Secretary’s authority.  However, several groups representing taxpayers questioned whether the Secretary had the authority to publish Directive CD-11-01 without proceeding under the rule-making requirements of G.S. 105-262. 


Directive CD-11-01 set forth the Secretary’s interpretation of the Department’s discretionary authority to adjust corporate net income, including the authority to combine the returns of affiliated corporations, pursuant to G.S. 105-130.6, G.S. 105-130.15, and G.S. 105-130.16, as well as what the directive vaguely referred to as “other law,” for tax years beginning before January 1, 2012.  For tax years beginning on and after January 1, 2012, the Directive explained the Department’s authority and the standards it will follow under new G.S. 105-130.5A, enacted by HB 619 in 2011, to adjust intercompany transactions or require a corporation to file a combined return.


In addition to being an apparent response to taxpayer complaints, Directive CD-11-01 also implicitly responded to criticism of the Department by the North Carolina Business Court in Delhaize America, LLC v. Lay, 2011 NCBC 2 (Jan. 12, 2011), for the failure to provide guidance in the area of forced combination. 


There have been three major areas of concern with the directive raised by taxpayers and others: 


  • The Directive lacked clarity and predictability.   
  • The Directive erroneously interpreted certain aspects of the legislation passed by the 2011 session of the General Assembly and by prior sessions of the General Assembly. 
  • Publication of the Directive without undergoing formal rule making may have violated the APA.


Perhaps in response to these recent criticisms of Directive CD-11-01, the Department published two new corporate income tax directives on April 17, 2012.  The first directive, CD-12-01, restates without substantive changes the discussion in Directive CD-11-01 that addresses the Department’s authority to require the filing of a combined return or adjust net income for tax years beginning before January 1, 2012.


The second directive, CD-12-02, addresses the Department’s authority under G.S. 105-130.5A (eff. for tax years beginning on or after Jan. 1, 2012).  Directive CD-12-02 generally restates the discussion of G.S. 105-130.5A in Directive CD-11-01 but includes several changes from the earlier directive.  These changes respond to some of the concerns that taxpayers raised about Directive CD-11-01.


However, most of the problems raised by taxpayers about Directive CD-11-01 remain.  (See letter and memorandum jointly submitted by the Council on State Taxation, the North Carolina Retail Merchants Association, and the North Carolina Chamber of Commerce to the co-chairs of the Revenue Laws Study Committee on January 30, 2012, and available on the committee’s website.)


New procedure for adopting rules under G.S. 105-130.5A


In response to taxpayer concerns, the Revenue Laws Study Committee adopted a report on May 2 recommending that the General Assembly require the Department to follow formal rule-making procedures, pursuant to an expedited schedule, in order to adopt rules pertaining to G.S. 105-130.5A.  Based on this report, the General Assembly passed Senate Bill 824 (codifying G.S. 105-262.1), which requires the Department to follow an expedited rule-making procedure in promulgating interpretations of G.S. 105-130.5A. 


The expedited procedure in G.S. 105-262.1 is based on the procedure for adopting a temporary rule under the APA.  The Department is required to provide electronic notification of the adoption of the rule and accept written comments according to the timetable provided for the adoption of temporary rules in G.S. 150B-21.1(a3).  If the Department receives a written comment objecting to the proposed rule and requesting review by the Rules Review Commission, the proposed rule must proceed through the rules review process provided in G.S. 105-262.1(e) through (j).  Until rules are enacted, the Department may not exercise its authority to redetermine income under G.S. 105-130.5A.


SB 824 also supersedes Corporate Directive CD-12-02. 2012 N.C. Sess. Laws ch. 43 § 5.


Proposed regulations were made public on October 22. The proposed regulations largely, though not entirely, mirror provisions in Directive CD-12-02. The comment period for the proposed regulations will end on November 28, 2012, the date for which a public hearing has been scheduled regarding the proposed regulations. We will publish a bulletin on the developments soon.


b.      Internal Revenue Code reference updated


The reference to the Internal Revenue Code, which provides the starting point for determining North Carolina taxable income, has been updated to January 1, 2012.  G.S. 105-228.90(b)(1b) (codifying 2012 N.C. Sess. Laws ch. 79 § 1.7.(a)).


c.       Definition of “holding company” revised


The definition of “holding company” has been expanded for franchise tax purposes.  As revised, a holding company is an entity that “satisfies at least one of the following conditions:


“(1)        It has no assets other than ownership interests in corporations in which it owns, directly or indirectly, more than fifty percent (50%) of the outstanding voting stock or voting capital interests.


“(2)        It receives during its taxable year more than eighty percent (80%) of its gross income from corporations in which it owns directly or indirectly more than fifty percent (50%) of the outstanding voting stock or voting capital interests.”


G.S. 105-120.2(c) (codifying 2012 N.C. Sess. Laws ch. 79 § 2.3).  The first subsection above is a new category in the revised definition.


d.      General Assembly allows certain taxpayers to claim Article 3J tax credits under modified environmental standards


The General Assembly has extended the deadline for claiming Article 3J tax credits by taxpayers that would have been eligible for such credits had a revised environmental impact standard been in effect for tax years 2007 through 2010.  For 2007 through 2010, a taxpayer that satisfies all of the following conditions may claim a credit under Article 3J of Chapter 105 of the General Statutes on an amended return that is filed before January 1, 2013:


(1) The taxpayer did not timely claim an Article 3J credit.


(2) The taxpayer would have been ineligible to claim an Article 3J credit because it failed to meet the old environmental impact standard (G.S. 105-129.83(e) prior to the enactment of S.L. 2010-147).


(3) The taxpayer satisfies the new environmental impact standard (G.S. 105-129.83(e) after the enactment of S.L. 2010-147).


2012 N.C. Sess. Laws ch. 79 § 1.13(b).


e.      Sunset dates extended for one year.


Many North Carolina tax credits and other special tax provisions were scheduled to be repealed effective January 1, 2013 or January 1, 2014.  The sunset dates for the following tax provisions have been extended by one year under Session Law 2012-36:


  • Credit available for qualified commercial facilities for dispensing renewable fuel (G.S. 105-129.16D), now repealed effective for facilities placed in service on or after January 1, 2014
  • Credit available for biodiesel producers (G.S. 105-129.16F), now repealed for taxable years beginning on or after January 1, 2014
  • Credit available for taxpayers who qualify for the federal Work Opportunity Tax Credit (G.S. 105-129.16G), now repealed for taxable years beginning on or after January 1, 2014
  • Article 3J credits, now repealed effective for business activities that occur on or after January 1, 2014
  • Film production credits (G.S. 105-130.48), now repealed effective for taxable years beginning on or after January 1, 2014
  • Article 3D credit available for qualified rehabilitation expenditures and rehabilitation expenses, now repealed for qualified expenses incurred on or after January 1, 2015
  • Article 3H mill rehabilitation tax credit, now repealed for rehabilitation projects for which an application for an eligibility certification is submitted on or after January 1, 2015




There is considerable interest in the General Assembly in comprehensive tax reform next year.  House and Senate leaders are advocating that the General Assembly devote serious attention to tax reform.  While no specific plans have been circulated, proposals such as broadening the sales tax base and lowering the corporate income tax rate are under consideration.


For more information about this topic, please contact the authors or any member of the Williams Mullen State & Local Tax Team.