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Corporate Apportionment Issues in North Carolina Michael A. Hannah, Esq., CPA Bear Creek, North Carolina

North Carolina Corporate Franchise Tax

Apportionment Issues

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What is the Franchise Tax? • N.C.G.S. §105-122(a) imposes the franchise

tax on: (1) corporations organized under NC laws,

for the privileges and rights granted to them under NC law, and

(2) out of state corporations that conduct business in NC for the privilege of conducting business in the state and the protections of state law

When is the Franchise Tax Imposed? • Doing business means: “Each and every act,

power, or privilege exercised or enjoyed in this State, as an incident to, or by virtue of the powers and privileges granted by the laws of this State.”

• A corporation may be “doing business” in NC for franchise tax purposes but NOT for income tax purposes (different nexus standards)

• In reality, it is a state imposed property tax on investment in business assets in the state

Franchise Tax Curiosities

• Some corporations are subject to special franchise tax rules (holding companies)

• Franchise tax is due in full with the filing of the income/franchise tax return & is paid in advance for the ensuing fiscal year

• The tax brings in over $700 Million per year

Very difficult to replace the revenue if repealed

The Capital Stock, Surplus and

Undivided Profits Base

• Based on the corporate books and records on the last day of the year

• Includes book value of outstanding stock less any treasury stock PLUS

• Paid in capital in excess of par PLUS • Retained earnings (undivided profits) PLUS • Any other surpluses

The Capital Stock, Surplus and

Undivided Profits Base The capital stock base includes several items not normally

considered “surplus” under GAAP that must be added to this base, including:

• Capital stock subscribed • Reserves for bad debts • Deferred income (some exceptions) • Deferred taxes • Contingent liabilities (e.g. pension reserves) • Loans from affiliates

The Capital Stock, Surplus and

Undivided Profits Base The following items can be subtracted when computing

the capital stock base: • Definite & accrued liabilities • Accumulated depreciation and amortization (tax) • Cost of treasury stock • Accrued taxes • Declared dividends • Deferred taxes to the extent of any deferred tax

liabilities • Some other less common items

Appraised Value of Property in NC

Base • Includes 55% of the appraised value of all

taxpayer’s real and tangible personal property in NC as listed for county property tax purposes

• Start with amounts from the county property tax report and take 55%

• Must also include appraised value of all motor vehicles taxed by the county assessor

Investment in Tangible Property in NC Base

• The total original purchase price of all real and personal property less accumulated depreciation for income tax purposes

Base typically includes the following: • Inventory • Machinery & Equipment • Land & Buildings (less associated indebtedness) • Leasehold improvements (less associated

indebtedness)

Calculation of the Franchise Tax

• Once the apportioned capital stock base is calculated, it is compared to the other two bases

• The tax is computed on the highest of the three bases • Divide by 1000 and multiply by $1.50 to determine

amount of tax • Minimum tax of $35 • Maximum tax of $75,000 IF corporation meets Holding

Company test

Some Issues with the Franchise

Tax

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Affiliated Indebtedness • Indebtedness owed to a parent, subsidiary or affiliated

corporation must be included in the capital stock base of the debtor corporation

• That amount may be reduced by a ratio of the debt owed by the related entity to an outside, unrelated entity to its assets (“outside debt”)

• However, outside debt does not qualify for the reduction if the outside indebtedness is owed by a third tier or higher related entity

“Purchase Accounting” Adjustments to Tangible Property Base

• NCDOR requires an increase to the tangible property base when a merger or acquisition requires book value accounting adjustments that increase the value of the assets

• Sometimes these adjustments to book value are actually “accounting aberrations” that do not result in more capital actually being used in NC

• The same assets are being used in NC and their value was only increased because of the accounting adjustments

Inclusion of Reserves in Capital Stock Base

• The required inclusion of Reserves such as amounts estimated for future payments for pensions, health care, warranties, etc. in the capital stock base can seem unfair

• Estimates of reserves for future payments based on reasonable and scientifically justifiable actuarial methods cannot be excluded from the base despite the fact that these liabilities will be paid at some time in the future

Franchise Tax Apportionment

• Once the capital stock base is determined, it must be apportioned for taxpayers that conduct business both inside and outside of NC

• The same apportionment formula is used for both income tax and franchise tax

• That formula will change with the phase in of single sales factor starting in 2016

Obtaining Alternative Apportionment

• A taxpayer who believes the statutorily required apportionment method results in a “greater portion of its capital stock base being taxed in NC than is attributable to its business in the State” may petition the Secretary of Revenue for relief

• G.S. 105-122(c1)(2) lists the requirements for obtaining alternative apportionment for franchise tax

• Not common because of high burden of proof required for taxpayer to show “unfairness” of statutory apportionment

Issues We See on Audits

• Calculation of Reserves • Intercompany loans • Holding Company test • Treatment of related LLC’s • Definite and Accrued Liabilities Franchise tax has been a constant source of

consternation for NC taxpayers

2015 Changes to Franchise Tax Base • New Net Worth base replaces capital stock base

and is total assets less total liabilities as determined under GAAP

• If taxpayer does not use GAAP, then net worth is in accordance with accounting method for federal income tax purposes

• Add back for intercompany debt remains • Deduction for treasury stock remains • Minimum tax increased from $35 to $200 • Holding Company maximum tax increased to from

$75k to $150k 18

North Carolina Corporate

Income Tax

Apportionment Issues

Computing State Taxable Income

§ 105-130.2(5)(c) State net income. – The taxpayer's federal taxable income as determined under the Code, adjusted as provided in G.S. 105-130.5 and, in the case of a corporation that has income from business activity that is taxable both within and without this State, allocated and apportioned to this State as provided in G.S. 105-130.4.

Tax Formula for Multistate Corporate Taxpayers

Start with federal taxable income (either line 28 or line 30 of the federal form 1120)

+ state modifications = state tax base + allocable nonbusiness income = state apportionable income or (loss) x state’s apportionable percentage = state apportioned income or

(loss)

Tax Formula for Multistate Corporate Taxpayers

state apportioned income or (loss)

+ state’s allocable nonbusiness income = state’s taxable income (loss) x state tax rate = state tax liability before credits - state tax credits = net state income tax liability

Additions to Federal Taxable Income to Calculate NCTI

– Income taxes of any kind – Interest paid to create non-taxable income – Federal charitable contributions – Interest from other states’ bonds – Capital loss carryover – Federal NOL

Additions to Federal Taxable Income to Calculate NCTI

– Payments to subsidiaries in excess of fair compensation

– Total amount of any state tax credits – Percentage depletion – Royalty payments per 105-130.7A – Federal §199 deduction – The amount of Federal accelerated depreciation

and §179 deduction

Subtractions from Federal Taxable Income

– Interest income from U.S. obligations – NC Bond interest net of related expenses – Payments from subsidiaries disallowed under NC

law – NC NEL (years prior to 1/1/15) – State net loss (starting 1/1/15) – Contributions per 105-130.9 – Capital losses in year of disposition

Subtractions from Federal Taxable Income

– Excess basis of asset sold that was depreciated using Federal accelerated method

– Royalty payments received from related member who added payments to its income per 105-130.7A

– Prior required add back of federal accelerated depreciation

Filing Method • Separate entity (each company files its own

return) • Consolidated returns are not permitted in NC

without permission of the Secretary • The combined approach ignores legal entities

and geographical boundaries and focuses on the economic unit

• NCDOR authority to require a combined return was significantly limited in 2012

Allocation and Apportionment of Taxable Income

Allocation and Apportionment • Allocation refers to non-apportionable (non-

business in some states) income that is specifically allocated to a particular state in which the taxpayer is doing business.

• Apportionment refers to apportionable income ((business income in some states and formerly in NC) that is divided, or apportioned, among the states in which the taxpayer is doing business.

Defining “Business Income” • “Business income” means income arising from transactions

and activity in the regular course of the taxpayer’s trade or business

and includes • income from tangible and intangible property if the

acquisition, management and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations.

• Formerly considered two separate tests in North Carolina (prior law)

• All other income is non-business income

Apportionable Income in NC § 105-130.4. Allocation and apportionment of income

for corporations. (Starting in 2002) (a) As used in this section, unless the context

otherwise requires: (1) "Apportionable income" means all income that

is apportionable under the United States Constitution.

(5) "Nonapportionable income" means all income other than apportionable income.

Allocation of Non-apportionable Income

105-130.4(c) Rents and royalties from real or tangible personal

property, gains and losses, interest, dividends, patent and copyright royalties and other kinds of income, to the extent that they constitute nonapportionable income, less related expenses shall be allocated as provided in subsections (d) through (h) of this section.

Allocation of Non-apportionable Income

105-130.4(d)(1) & (2) Net rents and royalties from real property located in this

State are allocable to this State. Net rents and royalties from tangible personal property are

allocable to this State: If and to the extent that the property is utilized in this

State, or In their entirety if the corporation's commercial domicile

is in this State and the corporation is not organized under the laws of, or is not taxable in, the state in which the property is utilized.

Allocation of Non-apportionable Income

105-130.4(d)(3)

The extent of utilization of tangible personal property in a state is determined by multiplying the rents and royalties by a fraction,

the numerator of which is the number of days of physical location of the property in the state during the rental or royalty period in the income year and

the denominator of which is the number of days of physical

location of the property everywhere during all rental or royalty periods in the income year.

Allocation of Non-apportionable Income

105-130.4(d)(3)

If the physical location of the property during the rental

or royalty period is unknown or unascertainable by the

corporation, tangible personal property is utilized in the

state in which the property was located at the time the

rental or royalty payer obtained possession.

Allocation of Non-apportionable Income

105-130.4(e) (1) & (2) Gains and losses from sales or other disposition of real

property located in this State are allocable to this State. Gains and losses from sales or other disposition of

tangible personal property are allocable to this State if: The property had a situs in this State at the time of the

sale, or The corporation's commercial domicile is in this State

and the corporation is not taxable in the state in which the property has a situs.

Allocation of Non-apportionable Income

105-130.4(e)(3)

Gains and losses from sales or other disposition of

intangible personal property are allocable to this State

if the corporation's commercial domicile is in this State.

Allocation of Non-apportionable Income

105-130.4(f)

Interest and net dividends are allocable to this State if

the corporation's commercial domicile is in this State. For

purposes of this section, the term "net dividends" means

gross dividend income received less related expenses.

Allocation of Non-apportionable Income

105-130.4(g)(1)

Royalties or similar income received from the use of patents, copyrights, secret processes and other similar intangible property are allocable to this State:

If and to the extent that the patent, copyright, secret process or other similar intangible property is utilized in this State, or

If and to the extent that the patent, copyright, secret process or other similar intangible property is utilized in a state in which the taxpayer is not taxable and the taxpayer's commercial domicile is in this State.

Allocation of Non-apportionable Income

105-130.4(g)(2)

A patent, secret process or other similar intangible property is utilized in a state to the extent that it is employed in production, fabrication, manufacturing, processing, or other use in the state or to the extent that a patented product is produced in the state. If the basis of receipts from such intangible property does not permit allocation to states or if the accounting procedures do not reflect states of utilization, the intangible property is utilized in the state in which the taxpayer's commercial domicile is located.

Allocation of Non-apportionable Income

105-130.4(g)(3) A copyright is utilized in a state to the extent that

printing or other publication originates in the state. If the basis of receipts from copyright royalties does not permit allocation to states or if the accounting procedures do not reflect states of utilization, the copyright is utilized in the state in which the taxpayer's commercial domicile is located.

Allocation of Non-apportionable Income

105-130.4(h) The income less related expenses from any other

activities producing nonapportionable income or investments not otherwise specified in this section is allocable to this State if the business situs of the activities or investments is located in this State.

Formulas for Apportionable Income

NC Apportionment Statutes

• G.S.105-130.4 (i) All apportionable income of corporations other than

public utilities, excluded corporations and qualified intensive corporations shall be apportioned to this State by multiplying the income by a fraction, the numerator of which is the property factor plus the payroll factor plus twice the sales factor, and the denominator of which is four.

North Carolina Formula for Calculating Apportionment %

• 1989-2015: Double Weighted Sales Factor • NC apportionment % is the average of four

parts, the sales factor making up two of the parts:

NC Property NC Payroll NC Sales NC SalesTotal Property Total Payroll Total Sales Total Sales

+ + +

NC Apportionment Statutes

G.S.105-130.4 (i) (continued) If the sales factor does not exist, the denominator of

the fraction shall be the number of existing factors and where the sales factor exists but the payroll factor or the property factor does not exist, the denominator of the fraction shall be the number of existing factors plus one.

NC Property Factor

G.S. 105-130.4(j)(1)— The property factor is a fraction, the numerator of

which is the average value of the corporation's real and tangible personal property owned or rented and used in this State during the income year and the denominator of which is the average value of all the corporation's real and tangible personal property owned or rented and used during the income year.

NC Property Factor

• G.S. 105-130.4(j)(2) Property owned by the corporation is valued at its

original cost. Property rented by the corporation is valued at eight times the net annual rental rate. Net annual rental rate is the annual rental rate paid by the corporation less any annual rental rate received by the corporation from subrentals except that subrentals shall not be deducted when they constitute apportionable income.

NC Property Factor

G.S. 105-130.4(j)(2) (continued) Any property under construction and any property

the income from which constitutes nonapportionable income shall be excluded in the computation of the property factor.

NC Payroll Factor

G.S. 105-130.4(k)(1) The payroll factor is a fraction, the numerator of

which is the total amount paid in this State during the income year by the corporation as compensation, and the denominator of which is the total compensation paid everywhere during the income year.

NC Payroll Factor

G.S. 105-130.4(k)(1) (continued) All compensation paid to general executive officers

and all compensation paid in connection with nonapportionable income shall be excluded in computing the payroll factor. General executive officers shall include the chairman of the board, president, vice-presidents, secretary, treasurer, comptroller, and any other officers serving in similar capacities.

Payroll Factor Issues • If an employee works in more than one state:

– Allocate the compensation to the state in which most of the services are performed;

– If no one state has a majority assign the compensation to the • Employee’s base of operations • Location from which duties are directed

or controlled • Employee’s state of residency

NC Sales Factor

G.S. 105-130.4(l)(1) The sales factor is a fraction, the numerator of which

is the total sales of the corporation in this State during the income year, and the denominator of which is the total sales of the corporation everywhere during the income year.

NC Sales Factor

G.S. 105-130.4(l)(1) (continued) Notwithstanding any other provision under this

Part, the receipts from any casual sale of property shall be excluded from both the numerator and the denominator of the sales factor.

Where a corporation is not taxable in another state on its apportionable income but is taxable in another state only because of nonapportionable income, all sales shall be treated as having been made in this State.

NC Sales Factor

G.S. 105-130.4(l)(2)

Sales of tangible personal property are in this State

if the property is received in this State by the

purchaser.

NC Sales Factor G.S. 105-130.4(l)(2) In the case of delivery of goods by common carrier

or by other means of transportation, including transportation by the purchaser, the place at which the goods are ultimately received after all transportation has been completed shall be considered as the place at which the goods are received by the purchaser.

Direct delivery into this State by the taxpayer to a person or firm designated by a purchaser from within or without the State shall constitute delivery to the purchaser in this State.

NC Sales Factor

G.S. 105-130.4(l)(3) Other sales are in this State if: a. The receipts are from real or tangible personal

property located in this State; or b. The receipts are from intangible property and

are received from sources within this State; or c. The receipts are from services and the

income-producing activities are in this State.

Excluded Corporation

• “Any corporation engaged in business as a building or construction contractor, a securities dealer, a loan company, or a company that receives more than (50%) of its ordinary income from intangible property”

• “Intangible property” not defined by statute for purposes of apportionment

• Full phase in of SSF will eliminate need for definition of excluded corporation

Other Special Apportionment Rules

• railroad companies, • telephone companies, • motor carriers, • telegraph companies, • air and water transportation companies

Alternative Apportionment

105-130.4(t1) – A corporation that believes the statutory

apportionment method that otherwise applies to it under this section subjects a greater portion of its income to tax than is attributable to its business in this State may make a written request to the Secretary for permission to use an alternative method. The request must set out the reasons for the corporation's belief and propose an alternative method.

Alternative Apportionment

105-130.4(t1) (continued) The statutory apportionment method that otherwise applies to

a corporation under this section is presumed to be the best method of determining the portion of the corporation's income that is attributable to its business in this State. A corporation has the burden of establishing by clear, cogent, and convincing proof that the proposed alternative method is a better method of determining the amount of the corporation's income attributable to the corporation's business in this State.

Alternative Apportionment

105-130.4(t1) – (continued) The Secretary must issue a written decision on a

corporation's request for an alternative apportionment method. If the decision grants the request, it must describe the alternative method the corporation is authorized to use and state the tax years to which the alternative method applies.

A decision may apply to no more than three tax years.

Alternative Apportionment

105-130.4(t1) – (continued) A corporation may renew a request to use an alternative

apportionment method by following the procedure in this subsection.

A decision of the Secretary on a request for an alternative apportionment method is final and is not subject to administrative or judicial review.

Alternative Apportionment

105-130.4(t1) – (continued) A corporation authorized to use an alternative method may

apportion its income in accordance with the alternative method or the statutory method.

A corporation may not use an alternative apportionment method except upon written order of the Secretary, and any return in which any alternative apportionment method, other than the method prescribed by statute, is used without permission of the Secretary is not a lawful return.

Phase in of Single Sales Factor Apportionment

• 2016 – sales factor increased to 3 times sales • 2017 – sales factor increased to 4 times sales • 2018 – sales factor only

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Comparison of Double Weighted Sales to Single Sales 4% of property and payroll in NC, 2% of sales in NC

Use the average of four factors: NC share of (Property + payroll + sales + sales)/4 (4% property +4% payroll +2% sales +2% sales)/4 = 3% Apportionment

• Apportion based only on NC share of sales

• NC property and payroll investment is not considered in determining how much of multistate firm’s income and capital is taxed in NC

= 2% Apportionment

Double Weighted Sales Factor Single Sales Factor

Apportionment Percentage with $500 million NC investment & NC share of property/payroll increases

to 50%

Use the average of four factors: NC share of (Property + payroll + sales + sales)/4

(50% property +50% payroll +2% sales +2% sales)/4 = 26% Apportionment

• Apportion based only on NC share of sales

• NC property and payroll investment not considered in determining how much of multistate firm’s income is taxed in NC

= 2% Apportionment

Double Weighted Sales Factor Single Sales Factor

Franchise Tax Liability Comparison: $100 million in Income & $1 billion in Capital before

Apportionment

26% apportionment NC taxable income = $26M NC taxable capital = $260M

Income tax = $1,040,000 Franchise tax = $390,000 Total = $1,430,000

2% apportionment NC taxable income = $2M NC taxable capital = $20M

Income tax = $80,000 Franchise tax = $30,000 Total = $110,000

Double Weighted Sales Factor

Single Sales Factor

Impact of Market-Based Sourcing

• Sourcing sales of TPP won’t change much • Service income sourced to where the benefit

of services are received • Intangibles to where they are used • Most states that have adopted single sales

factor apportionment have adopted MBS for services

Fiscal Impact of Market Based Sourcing? • Informational pro forma report due April 15, 2016

based on MBS guidelines published by NCDOR for companies with $10 million or more in income before apportionment

• Will allow fiscal estimate revenue effect of market based sourcing and the impact on various industries

• NCDOR must utilize MTC draft regs • Public input into NCDOR draft regs crucial • General Assembly must decide whether to enact

MBS statutes

Apportionment for Financial Institutions

• States often have a special set of apportionment rules for Financial Institutions

• Financial Institutions with significant presence in NC may pay more tax under some Multistate Tax Commission recommendations

• Sales factor calculation for financial institutions

(or any industry) does not have to follow Multistate Tax Commission recommendations and can be customized for any industry

Source of Business Receipts In -State under current law? Multistate Tax Commission Recommendation

Receipts from loans secured by real property (interest, fees, sale)

if real property is in NC No Change

Receipts from loans not secured by real property

if borrower is in NCNo Change

Receipts from credit/debit cards if the cardholder is in NC No Change

Receipts from merchant discounts if the merchant is in NC No Change

Receipts from investment assets and trading activities If payer is in NC

if bank management of assets is in NC

Rules of Thumb for Calculating North Carolina portion (numerator) of Sales Factor*Financial Institution Issues*

*Receipts of Financial Institutions not addressed here are subject to same market based sourcing rules as other industries*

Other Industry Issues

• How to source services provided to companies that operate in multiple states

• How to categorize companies that perform various types of services

• How to source income from use of intangibles if used in multiple states

• Inconsistencies between states • What is “reasonable approximation”?

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Fiscal Impact of Market Based Sourcing?

• Companies using North Carolina more as a

customer base than as a core place for workforce/investment will tend to pay more tax under market based sourcing

• Fiscal impact of apportionment including market

based sourcing becomes less significant as the corporate income tax rate drops

Focus of NCDOR on Corporate Tax Audits

• Apportionment factors • Sourcing of income • Intercompany transactions • Apportionable v. Non-Apportionable Income • Credits • Net Economic Losses

??Questions??

Michael A. Hannah, Esq., CPA 919-837-0048 (o) 919-614-1522 (c)

mikeh@mhannahlaw.com

Thank You For Attending

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