On June 30, 2020, North Carolina Gov. Roy Cooper signed legislation advancing the Internal Revenue Code (IRC) conformity to May 1, 2020, in order to incorporate provisions in the CARES Act.1 Though conformity is advanced, North Carolina will decouple from certain provisions including changes to the interest deduction limitation under IRC Sec. 163(j), the five-year net operating loss (NOL) carryback, and the suspension of the 80% limitation upon the deduction of NOLs. The enacted legislation also makes changes to the computation of affiliated debt for purposes of the franchise tax base.
Advancement of IRC conformity
North Carolina employs static conformity to the IRC. Prior to enactment of the recent legislation, North Carolina conformed to the IRC as of January 1, 2019. In response to the COVID-19 pandemic, Congress passed a sweeping aid package (the “CARES Act”) which made numerous substantial modifications to the IRC.2
Effective June 30, 2020, North Carolina’s IRC conformity is advanced to May 1, 2020, including any provisions enacted as of that date which become effective either before or after that date.3 Though broadly adopted, North Carolina does decouple from certain important tax provisions of the CARES Act, as further discussed below.
Interest limitation
The 2017 Tax Cuts and Jobs Act (“TCJA”) enacted changes to IRC Sec. 163(j) which imposed a limitation on the deductibility of business interest. In general, the deduction for business interest was limited to 30% of adjusted taxable income. The CARES Act temporarily reduces the limitation by increasing the cap from 30% to 50% of adjusted taxable income for the 2019 and 2020 tax years, and allowing for an election to use 2019 adjusted taxable income instead of 2020 adjusted taxable income in calculating the cap. North Carolina will decouple from the expanded interest deduction provisions for purposes of the corporation and individual income tax, and continue to apply the more restrictive 30% limitation, without the ability to make the adjusted taxable income election.4 The decoupling is achieved through an addition modification to North Carolina taxable income.
Since the state has only provided for an addition modification, with no provision for a corresponding subtraction modification in subsequent years, the CARES Act changes to the IRC Sec. 163(j) interest limitation are permanently disallowed for North Carolina tax purposes under the current law. For federal income tax purposes, the disallowed portion of the interest deduction is available for carryforward indefinitely, and as such becomes a deferred tax asset for financial accounting purposes. As the current North Carolina adjustment results in permanent disallowance of the incremental interest deduction, the adjustment does not result in a deferred tax asset for state income tax purposes, and therefore may impact the effective tax rate. The June 30 enactment causes this change to be a second quarter event for purposes of income tax accounting under ASC 740.
Franchise tax affiliated debt adjustment
North Carolina imposes an annual franchise tax which is computed on the highest of three bases: apportioned net worth, net investment in property, or 55% of the appraised value as computed for property tax purposes.5 When computing the net worth base under prior law, taxpayers were required to add back debts owed to a parent, subsidiary, or affiliate.6 To the extent the affiliated creditor maintained third-party debt, the taxpayer may reduce the addback proportionately based upon the creditor’s borrowed capital ratio.7
Under the new law, the affiliated debt addback is retained, but incorporates the related-party interest expense addback rules for purposes of defining “affiliate” and determining the amount subject to addback. Debt owed to a related party must be added back to the extent the debt results in net interest expense, but not qualified interest expense.8 In other words, the amount of affiliated debt is subject to addback to the extent the related interest deduction is limited in computing North Carolina taxable income.
Under the related-party interest expense provisions, net interest expense is the excess of interest paid or accrued by the taxpayer to each related member over the amount of interest received from each related member and included in gross income for the year.9 Qualified interest is net interest limited to the proportionate share of interest paid or accrued to an unrelated member during the same taxable year.10 The limitation does not apply when the related member receiving the interest is: (i) subject to income or gross receipts tax in North Carolina or another state; (ii) organized under the laws of another country having a comprehensive treaty with the U.S. and imposing a tax on the interest income at a rate higher than North Carolina; or (iii) a bank.
By incorporating the related-party interest deduction rules, the definition of “affiliate” is also significantly expanded. Prior to the change, affiliated debt was any indebtedness owed to a parent, subsidiary, affiliate, or noncorporate entity in which the corporation or an affiliated group of corporations owned at least 50% of the interest.11 The new law applies various federal concepts found in IRC Secs. 318 and 1563, and may apply to individual shareholders, family members, pass-through entities, and other entities with direct or indirect common control greater than 50%.12 The changes are effective for franchise tax years beginning on or after January 1, 2021, as reported on the income tax returns for 2020 and later tax years.13
NOL carryback and carryforward
For individual income tax purposes, North Carolina will decouple from the five-year NOL carryback established under the CARES Act.14 The decoupling is achieved through an addition modification for the amount of loss carried back. Additionally, North Carolina will decouple from the 80% NOL limitation suspension provided under the CARES Act.15 Individual taxpayers will be required to compute the federal NOL deduction as though the 80% limitation applied, and make a corresponding addition modification to taxable income. Individual taxpayers will recover the disallowed deductions prospectively as five equal deductions in computing North Carolina taxable income for the 2021 through 2025 tax years.16
For corporate income tax purposes, North Carolina’s state net loss statutes are independent of the federal NOL provisions contained in IRC Sec. 172, and therefore, the CARES Act had no impact on corporate loss carryforwards.17 North Carolina does not allow losses to be carried back for corporate income taxes, and does not impose an 80% limitation on the utilization of loss carryforwards.18
Covered loan forgiveness
Under the CARES Act, the Paycheck Protection Program was established to provide loans to eligible small businesses. The loans could be forgiven provided the borrower satisfied certain criteria. Further, the CARES Act provided that such forgiveness may be excluded from gross income, provided the proceeds were used to pay certain eligible expenses. However, the IRS subsequently issued guidance indicating that while the forgiveness may be excluded from gross income, the expenses paid using the loan proceeds would be nondeductible under IRC Sec. 265.19 Members of Congress have indicated this was not the intent of the CARES Act legislation and would seek to implement a correction (which has not been completed to date). North Carolina preemptively decoupled from this provision to avoid any uncertainty from a state corporation and individual income tax perspective, requiring an addition modification for any expenses deducted under the IRC to the extent that payment of the expense results in forgiveness of a covered loan and such forgiveness is excluded from gross income.20
Procedural changes
The legislation also made numerous administrative or procedural changes, including provisions related to the filing of nonresident affirmations and the timing for issuance of refunds when arising from adjustments by the North Carolina Department of Revenue related to intercompany transactions.
Pass-through entities with nonresident owners are required to pay tax on the North Carolina income distributable to a nonresident owner, unless the owner has provided the entity with a completed nonresident affirmation and agreed to pay the tax.21 The legislation now requires the entity to submit the affirmation annually with its tax return. Otherwise, the entity (through its manager) must pay tax on the owners’ distributable share of income.
The Department has the authority to make adjustments in the event intercompany transactions lack economic substance or otherwise give the Department reason to believe state net income is not fairly reported or representative of the business conducted in the state.22 The legislation now provides that in the event of a refund arising from adjustments made under N.C. Gen. Stat. Sec. 105-130.5A, refunds will not be issued until the determination is final and the time limit for appeal has expired.23
Commentary
In what is seemingly becoming an annual event, North Carolina and other states are scrambling to quickly respond to sweeping changes to the IRC. The varied approaches taken by the states adds a great deal of complexity for taxpayers and their advisers. Fortunately, North Carolina managed to provide taxpayers some level of certainty as they prepare 2019 tax returns, which in many cases will contain elements on the CARES Act in determining taxable income.
Though unrelated to the CARES Act or IRC conformity, the changes to the North Carolina franchise tax base are significant. The alignment of the franchise tax adjustments with the related-party interest expense provisions applicable to income taxes does create some uniformity between the two tax regimes. The changes may also create opportunities to exempt certain intercompany liabilities from the addback provisions, resulting in a potential reduction to the net worth tax base. Under prior law, the only mechanism to provide relief was the application of the borrowed capital ratio.
However, not all of the affiliated debt changes are taxpayer-favorable. The expanded definition of “affiliate” may result in additional liabilities now subject to the affiliated debt provisions, such as debt owed to an S corporation’s individual shareholders, or between commonly owned brother-sister S corporations. Further, the “may” language of the former borrowed capital adjustment no longer applies. Previously, taxpayers could choose whether to apply the borrowed capital exclusion depending upon which method yielded the most favorable result, but this flexibility has been eliminated.
1 S.L. 2020-58 (H.B. 1080), Laws 2020.
2 Coronavirus Aid, Relief, and Economic Security Act, P.L. 116-136, March 27, 2020.
3 N.C. GEN. STAT. § 105-228.90(b)(1b).
4 N.C. GEN. STAT. §§ 105-130.5(a)(31); 105-153.5(c2)(17).
5 N.C. GEN. STAT. § 105-122(d).
6 N.C. GEN. STAT. § 105-122(b)(2).
7 Id.
8 Id.
9 N.C. GEN. STAT. § 105-130.7B(b)(3).
10 N.C. GEN. STAT. § 105-130.7B(b)(4).
11 N.C. GEN. STAT. § 105-122(b)(2).
12 N.C. GEN. STAT. § 105-130.7A(b)(4)-(5).
13 S.L. 2020-58 (H.B. 1080), § 5.1.(b).
14 N.C. GEN. STAT. § 105-153.5(c2)(8)-(11).
15 N.C. GEN. STAT. § 105-153.5(c2)(13).
16 N.C. GEN. STAT. § 105-153.5(c2)(14)-(16).
17 N.C. GEN. STAT. § 105-130.8A(b).
18 Id.
19 IRS Notice 2020-32.
20 N.C. GEN. STAT. §§ 105-130.5(a)(32); 105-153.5(c2)(20).
21 N.C. GEN. STAT. § 105-154(d).
22 N.C. GEN. STAT. § 105-130.5A(a).
23 N.C. GEN. STAT. § 105-130.5A(k).
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