On April 11, 2018, the General Assembly’s Revenue Laws Study Committee released a draft tax bill for possible introduction in the legislative session that convenes May 16. This Alert provides a summary of the more important provisions of the draft bill. A Fiscal Analysis Memorandum accompanying the draft bill estimates that the changes proposed would increase General Fund revenue by $312 million over four years. The draft bill’s provisions, if enacted, would generally be effective upon enactment or for tax years beginning in or after 2018.
Internal Revenue Code Conformity
Each year, the General Assembly updates the reference to the Internal Revenue Code (the “Code”) found in G.S. §105-228.90(b)(1b) to incorporate some or all of the changes made to the Code during the preceding year. The draft bill would update the Code reference from January 1, 2017 to February 9, 2018. This means that North Carolina would generally conform to the Code amendments included in the Tax Cuts and Jobs Act (the “TCJA”) and the Bipartisan Budget Act of 2018 (the “BBA”).
Because of the structure of the North Carolina tax law, conforming to these federal changes has relatively little impact on the calculation of individual North Carolina income tax liability. Specifically, North Carolina taxable income is based on federal adjusted gross income, the calculation of which is largely unaffected by the recent federal legislation. North Carolina also has its own standard and itemized deductions and personal exemptions and is not affected by changes to their federal counterparts. In addition, for both individual and corporate taxpayers, North Carolina decouples from federal bonus depreciation and expensing rules.
However, updating the Code reference would mean conforming to the following federal changes, among others:
Small Business Accounting Method Provisions. The TCJA provisions permitting taxpayers with average annual gross receipts not in excess of $25 million to use the cash method of accounting, not to keep inventories, not to comply with the uniform capitalization rules and not to use the percentage of completion method of accounting for small construction contracts.
Interest Expense Limitation. The TCJA provisions limiting the deduction of net interest expense to 30% of adjusted taxable income. Note that conforming to this limitation would apparently be in addition to the existing North Carolina restriction on the deduction of net interest paid to a related party. In addition, conforming to the new federal interest expense limitation ignores the fact that this federal limitation is linked to the federal 100% bonus depreciation rules to which North Carolina does not conform.
NOLs. The TCJA provisions limiting the use of NOLs to 80% of taxable income.
Like Kind Exchanges. The TCJA provisions restricting like kind exchanges to exchanges of real property.
Dividends Received Deductions. The TCJA provisions reducing the dividends received deduction. Note also that North Carolina will conform to the new participation exemption for the foreign source income of controlled foreign corporation subsidiaries, which is implemented through a new dividends received deduction.
The draft bill would decouple from several changes included in TCJA and BBA.
Qualified Opportunity Zones. The TCJA permits individual and corporate taxpayers to defer, and in some cases permanently exclude, gain from the sale of property that is reinvested in an investment vehicle that invests in designated low-income communities knowns as Qualified Opportunity Zones. Each state may nominate communities for Qualified Opportunity Zone designation by the Secretary of the Treasury. The draft bill would decouple from this provision by requiring such gains to be added back in the calculation of North Carolina taxable income. The General Assembly could consider creating a similar incentive for investment in low-income areas limited to low-income communities in North Carolina, but the draft bill does not include such a provision.
GILTI. Under the Code, as amended by the TCJA, certain U.S. shareholders of controlled foreign corporations must include in income their shares of the foreign corporation’s “global intangible low-taxed income” (“GILTI”). In addition, the U.S. shareholder is entitled to a deduction to reduce the effective federal tax rate on the GILTI income inclusions. GILTI essentially requires U.S. shareholders of controlled foreign corporations to pay a minimum tax on the foreign corporation’s income in excess of a hypothetical return on tangible assets. The draft bill would permit corporate taxpayers to exclude GILTI income inclusions net of the related deduction in computing state net income.
FDII. The TCJA also provides a deduction for corporations designed to lower the effective tax rate on income derived from sales of domestically produced services and intangibles into foreign markets (“foreign derived intangible income” or “FDII”). The draft bill purports to decouple from this provision (although the language included in the draft bill may need to be revised to achieve this result). Conforming to the federal FDII deduction would have helped make North Carolina a more attractive location for technology companies making sales of services and intangibles into foreign markets, especially since the TCJA should encourage the relocation of activities generating such income to the United States.
Other Decoupled Provisions. The BBA extended temporary Code provisions permitting income from the forgiveness of debt on primary residences to be excluded from federal gross income and permitting the deduction of mortgage insurance and certain qualified tuition and related expenses. North Carolina has historically decoupled from these provisions, and the draft bill would continue this policy by decoupling from the extensions.
Repatriation Tax. The TCJA causes a deemed repatriation of earnings held by controlled foreign corporations as an additional income inclusion under Subpart F of the Code (specifically, under Code §951). Because North Carolina exempts income inclusions under §951 from the calculation of state net income, North Carolina will not conform to this deemed inclusion. However, the TCJA also includes a deduction to lower the effective tax rate on the repatriated earnings. The draft bill does not appear to decouple from this deduction, with the result that corporations with repatriation amounts may realize the dual benefits of excluding the repatriation amounts from North Carolina income without having to add back the federal deduction related to such income in computing state net income.
Franchise Tax Changes
Electing Partnerships. Under current law, an LLC that elects to be classified as a corporation for tax purposes is subject to the franchise tax. The draft bill would extend this rule to partnerships that elect corporate classification.
Net Worth Tax Base. The draft bill also would clarify the calculation of the net worth franchise tax base. Under current law the net worth base is calculated under GAAP. If a corporation does not keep GAAP books, the base is calculated in accordance with the accounting method the corporation uses for federal tax purposes, provided that that method “fairly reflects the corporation’s net worth” for purposes of the franchise tax. The draft bill would remove this proviso, the vagueness of which had been of concern to taxpayers.
These changes would be effective for the 2018 franchise tax reported with 2017 corporate income tax returns.
Calculation of the Sales Factor
Beginning this year, North Carolina corporate income tax is calculated using single sales factor apportionment. In connection with this change, the General Assembly previously considered - but did not adopt - market-based sourcing for income from services and intangibles. The draft bill would revise the statutory sourcing rules for these types of income.
Income from Services. Under current law, income from services is sourced under an “income-producing activities test.” The draft bill would provide a statutory definition of this test similar to the definition now found in the Technical Bulletins issued by the Department of Revenue (the “Department”). Specifically, an income-producing activity would be defined as an activity “directly performed by the taxpayer or its agents for the ultimate purpose of generating the sale of the service.” The draft bill would go beyond the Technical Bulletin language in further providing that receipts from services are sourced to North Carolina if the services are performed in connection with the sale of tangible property located in North Carolina. (The proposed bill language on this issue is somewhat unclear.)
Income from Intangibles. The existing statutory language for sourcing income from intangibles is an unhelpful tautology. The statute provides that such income is sourced to North Carolina if such income “is received from sources within this State.” The Department’s Technical Bulletins provide more concrete rules based on the nature of the intangible. For instance, trademark royalties are sourced to North Carolina to the extent the trademarks are used in the state, while copyright royalties are sourced to North Carolina to the extent the printing or publication originates here, and royalties from patents and similar intellectual property are sourced to North Carolina to the extent the intellectual property is used in production functions carried out in the state. Interest and dividends, on the other hand, are sourced based on the commercial domicile of the payor. The draft bill would revise the statutory language to source all intangible income based on where the intangible is used. This language appears to codify the existing administrative rules for sourcing trademark, copyright and patent (and other IP) royalties and does not appear intended to work any substantive change in the law.
It is unclear, however, how the proposed language would apply to interest and dividends. Is the intangible giving rise to the interest and dividend income the promissory note or share of stock held by the taxpayer, or is it the debt or equity capital provided by the taxpayer? If the former, where is the promissory note or share of stock “used” by the taxpayer? If the latter, is the taxpayer required to ascertain where the capital is deployed by the payor of the interest or dividends?
Captive Insurance Company Tax Changes
The draft bill would clarify that a captive insurance company that is licensed and taxed by another state is not subject to the North Carolina corporate, franchise, income, captive insurance, gross premiums or local privilege taxes or to the insurance regulatory charge, notwithstanding that such a company may insure a risk located in North Carolina.
Former Historic Rehabilitation Tax Credit
North Carolina’s former tax credits for rehabilitating historic structures expired at the end of 2014 (new credits for restoring historic properties became effective in 2016). Specifically, the old credits expired with respect to rehabilitation expenditures incurred on or after January 1, 2015. The draft bill would provide additional clarity regarding the effective date of this sunset provision. Under the draft bill, if a taxpayer incurred rehabilitation expenditures before January 1, 2015, the credits would expire if the property is not placed in service by January 1, 2023.
Sales and Use Tax Changes
The draft bill would make numerous changes to the sales tax law, many of which are stylistic or clarifying. Among the more noteworthy changes are the following:
Renewals of Service Contracts on Prewritten Software. The draft bill would provide that gross receipts from the renewal of a service contract for prewritten software may generally be sourced to the address where the purchaser received the prewritten software, absent knowledge that location of the software has changed.
Admission Charges. The draft bill would add a list of activities that are not subject to the sales tax on admission charges. This change is intended merely to clarify the law with respect to certain activities the Department already views as exempt from the tax.
Prescription Drugs. The draft bill would clarify the sales tax exemption for prescription drugs by providing that the exemption does not cover pet food even if the manufacturer requires the food to be sold on prescription. In addition, the bill would provide that the exemption for over-the-counter drugs sold on prescription does not apply to purchases of over-the-counter drugs by hospitals or other medical facilities for the treatment of patients.
Worthless Accounts. The draft bill would provide that, for purposes of the sales tax exemption for worthless accounts, a worthless account would be defined by reference to the definition of “bad debt” under Code §166. The draft bill would also provide that the amount of the exemption does not include interest or finance charges, the sales tax charged on the sale price, uncollectible amounts on property that remains in the seller’s possession, repossessed property or collection expenses.
Qualifying Farmers. The draft bill would provide that various items such as vaccines, insecticides, defoliants and plant growth regulators, that are currently exempt only if purchased by a qualifying farmer, are also entitled to exemption if purchased by someone other than a qualifying farmer to fulfill a service for a qualifying farmer. The purchaser would be required to provide an exemption certificate to the retailer. This change would be effective retroactively to July 1, 2014.
Procedural and Administrative Changes
Forms NC-3. North Carolina employers are required to file an annual wage withholding reconciliation form with the Department on Form NC-3 by January 31 of each year. Before 2016, the due date of this form had been tied to the due date of the equivalent federal form rather than to a specific date. For federal purposes, an employer that goes out of business is required to file the federal reconciliation report with the IRS within thirty days from the last day the taxpayer has payroll. An unintended consequence of decoupling from the federal due date was the loss of this thirty-day “going out of business” provision. The draft bill would restore this rule.
ABC Permit Holders. The draft bill would require specified ABC permit holders (including wineries, wine producers, wine importers and wine wholesalers; breweries; distilleries; malt beverage importers and malt beverage wholesalers) to register with the Department and to notify the Department when they discontinue business. This change would become effective October 1, 2018.
Individual Income Tax Filing Threshold. Under current law an individual is required to file a North Carolina income tax return only if he or she is required to file a federal return. An individual is required to file a federal tax return if his or her gross income exceeds the federal standard deduction amount. The federal standard deduction is now higher than the North Carolina standard deduction. As a result, taxpayers with income below the federal standard deduction amount may owe North Carolina income tax. The draft bill would therefore decouple the state filing obligation from the federal filing obligation.
Federal Changes. Under current law, if a taxpayer's North Carolina tax liability is affected by a federal correction or other federal determination, the taxpayer must file an amended state return within six months of the federal correction or “final determination by the federal government.” The draft bill would define a federal “final determination” to mean “a change or correction of the amount of federal tax due arising from an audit by the Commissioner of Internal Revenue.”
The draft bill would also require a taxpayer who voluntarily files an amended federal return to file an amended state return within six months of filing the amended federal return. The Department would then have until the later of one year after the filing of the amended state return or three years after the filing of the original state return to propose an assessment. If the taxpayer failed to timely file an amended state return, the Department would be able to propose an assessment within three years of the filing of the amended federal return.
Franchisor Information Returns. The draft bill would require franchisors with at least one North Carolina franchisee to electronically file an annual informational return containing information to be prescribed by the Department. This change was requested by the Department to assist in the review of cash intensive businesses.
Sales Taxes on Prepaid Inventory. Recent changes in the sales tax law applicable to repair, maintenance and installation (“RMI”) services created the possibility that a taxpayer who had paid sales tax on the purchase of an item and then used the item in performing a taxable RMI service would have to collect a second tax on the item when it was transferred to the RMI customer. A temporary fix enacted last year allowed the taxpayer to offset the tax due on the RMI service by the amount of tax paid on the purchase of the item in question. This temporary fix is scheduled to expire on July 1 of this year. The draft bill would effectively make this fix permanent. It would also provide that, if the amount of the offset exceeded the tax due for the period in which the offset was claimed, the excess would not be eligible to be refunded but could be rolled forward and claimed in subsequent periods.
Sales Tax Filing Extensions. Under current law, the Department may extend the time for filing a sales tax return for up to thirty days. The draft bill would remove the thirty-day limitation. This change was prompted by the need to extend the time beyond the thirty day-period for taxpayers who were affected by Hurricane Matthew.
Sales Tax Compromises. The Department is authorized to compromise a taxpayer’s liability for sales tax assessments for failure to properly collect and pay sales taxes on admissions, service contracts, prepaid meal plans or aviation gasoline and jet fuel as long as the taxpayer made a good faith effort to comply with the law. Under current law, this provision expires for assessments issued after July 1, 2020. The draft bill would provide that the compromise authority covers any tax period ending before that date regardless of when the assessment is made.
Property Tax Exemptions. Taxpayers claiming property tax exemptions must file an annual exemption application unless the statute specifically provides that no application or only a single application is required. The draft bill would provide that several recently enacted exemptions qualify for a single rather than annual application. These exemptions are for real property occupied by charter schools, certain energy mineral interests, property located on lands held in trust by the United States for the Eastern Band of Cherokee Indians and mobile classrooms or modular units.
Revenue Suspensions. The draft bill would clarify that, if a corporation or LLC is suspended by the Secretary of State for failing to timely file a tax return or pay a tax, the suspension does not relieve the entity of tax compliance obligations (or the tax liabilities of responsible persons) during the period of suspension.