The Secretary of the Department of Revenue had the authority under prior North Carolina law to require the taxpayer to file a combined corporate income tax return with its unitary affiliates upon the Secretary’s finding that the taxpayer failed to disclose its true earnings in North Carolina on its separate entity return. In so holding, the court rejected the taxpayer’s contention that the Secretary had violated its procedural due process rights when the Secretary failed to provide notice and guidance concerning its change in its long-standing policy that it would not force the filing of a combined return unless affiliate transactions were not conducted at arm’s length or were not for fair compensation. The court also upheld the department’s authority to impose a large tax deficiency penalty.
Background
Upon advice received from the taxpayer’s accounting firm, the taxpayer underwent a corporate restructuring for the sole purpose of reducing its state income tax liability. Under the restructuring plan, the taxpayer transferred many of its operations and trademarks to its out-of-state affiliate, then paid fees and royalties to its affiliate for these services and trademarks, which costs were deducted on the taxpayer’s North Carolina corporate income tax return. In turn, the affiliate paid out dividends to the taxpayer, which were also deductible on the taxpayer’s return. By structuring the transactions in this manner, the taxpayer was able to shift a significant amount of its earnings to its out-of-state affiliate. Although the out-of-state affiliate reported these earnings as income apportionable to North Carolina on its return, the affiliate’s North Carolina apportionment factor was significantly less than the taxpayer’s North Carolina apportionment factor, thereby dramatically reducing the amount of income subject to North Carolina taxation.
After auditing the taxpayer’s return, the department concluded that the taxpayer’s return failed to disclose its true North Carolina earnings and required the taxpayer to file a combined return and pay tens of millions of dollars in back taxes, interest, and penalties. The taxpayer paid a portion of the assessment and filed a claim for refund, which the department denied. The taxpayer appealed the denial to the superior court. The superior court granted the department’s motion for summary judgment concerning the imposition of additional taxes and interest, but granted the taxpayer’s motion for summary judgment concerning the imposition of penalties.
Forced Combination
The Secretary’s determination that the taxpayer was required to file a combined return did not violate the taxpayer’s procedural due process rights. Over the course of the last two decades there had been several agency decisions, as well as a 1987 attorney general’s opinion, that clearly indicated that the department had implemented a much broader interpretation as to when a combined return might be required. Previously, the department had taken the position that it would require the filing of a combined return only upon a finding that inter-affiliate transactions failed to reflect fair compensation and did not satisfy the arm’s-length transaction standards. However, the department had expanded its interpretation of when it could require combined reporting to include those instances in which taxpayers failed to disclose their North Carolina true earnings on a separate return.
The court noted that at least one important agency decision had been issued three months prior to the taxpayer’s implementing its plan to shift income out of North Carolina and that even the taxpayer’s accounting firm had noted that there had been no court decision that explicitly stated that the filing of a combined return could only be required upon a showing that fees paid did not represent fair compensation and were not undertaken in an arm’s-length transaction. Consequently the taxpayer had adequate notice that the department’s position had changed and that it had shifted to the “disclosure of true earnings” standard that was eventually upheld by the court of appeal in Walmart Stores East v. Hinton, 197 N.C. App. 30, 676 S.E.2d 634 (2009). In fact the record indicated that numerous other taxpayers had sought private letter rulings on this question during the tax years at issue and were informed by the department that it was following the “disclosure of true earnings” standard.
The court also rejected the taxpayer’s argument that the court misread the governing statute in its Walmart decision and that the department could not retroactively exert its taxing power. Both these issues were raised and rejected by the court in Walmart, and the court was bound by the Walmart decision in the instant case. Finally, the court rejected the taxpayer’s contention that the lower court misapplied the economic substance doctrine. Although the lower court made mention of the doctrine, it did not apply the economic substance doctrine analysis in reaching its decision.
Large Tax Deficiency Penalty
The appellate court reversed the lower court’s granting of the taxpayer’s motion for summary judgment concerning the department’s imposition of the 25% penalty imposed against taxpayers with tax deficiencies of 25% or more. The lower court ruled in favor of the taxpayer, finding that although the department’s mandate to file a combined return did not violate the taxpayer’s procedural due process, the department’s failure to provide written guidelines to taxpayers as to when and how it would require the filing of combined returns did violate the taxpayer’s procedural due process in regards to the penalty imposition. However, the appellate court found that the same standards applied. The taxpayer had received adequate notice and guidelines as to when the department could require forced combination, and, therefore, the procedural due process argument was no defense to the imposition of the penalty.
Delhaize America, Inc. v. Lay, North Carolina Court of Appeals, No. COA11-868, August 21, 2012.
