North Carolina Court Strikes Down 25% Penalty for Failure to File Combined Return

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On January 12, 2011, the North Carolina Superior Court held that the imposition of a 25% penalty for failure to file a combined return, lacked adequate procedural due process and violated the North Carolina Constitution.1 The court began its opinion noting “this case demonstrates what happens when creative accounting meets creative revenue enforcement.” The court went on to hold that, under the Court of Appeals holding in Wal-Mart Stores East, Inc. v. Hinton, the North Carolina Department of Revenue (Department) could require a combined return where the taxpayer’s return does not disclose true earnings in North Carolina2 but the Department could not impose a 25% penalty on Delhaize.

I. Background

North Carolina has historically required taxpayers to file separate income tax returns for affiliated corporations.3 In the 1990s, in response to a number of tax-motivated corporate restructurings, the Department adopted a policy of requiring some taxpayers to file combined income tax returns. The Department did not, however, provide taxpayers with any guidance regarding when they would be required to file a combined return.

In 1998, Delhaize created an affiliated corporation in Florida, in part to lower its North Carolina tax liability. The Department audited Delhaize’s North Carolina corporate income tax return for the 2000 tax year and concluded Delhaize and its affiliates should have filed a combined income tax return to reflect Delhaize’s “true net earnings” in North Carolina.4 Despite Delhaize’s argument to the contrary, the Department found that the restructuring served no visible purpose, other than reducing Delhaize’s state income tax liability. Delhaize paid the assessment, interest and penalties and filed a claim for refund with the Department. The Department denied the refund and Delhaize filed suit in Superior Court.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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