On Nov. 29, 2021, the Delaware Supreme Court upheld a lower court decision invalidating an internal Delaware Division of Revenue (Division) policy that limited a corporation’s Delaware net operating loss (NOL) deduction to the corporation’s federal consolidated group NOL.1 While the Delaware Superior Court found that the policy violated the Uniformity Clause of the Delaware Constitution, the Delaware Supreme Court affirmed the lower court on alternate grounds, concluding that the policy violated Delaware tax law.
Delaware requires corporations to file separate company corporate income tax returns and to calculate their income and deductions on a standalone basis.2 However, in the case of corporate taxpayers filing federal income tax returns as part of a consolidated group, the Division enforced a long-standing policy detailed in its internal manual for auditors that limited a corporation’s NOL deduction to the consolidated NOL deduction reported on the federal consolidated return in which the taxpayer participated. The policy exempted taxpayers that filed a federal consolidated return with other Delaware taxpayers.
Verisign, Inc. (Verisign), a Delaware Corporation, filed as a member of a consolidated group for federal income tax purposes and filed standalone Delaware corporate income tax returns. In accordance with Delaware law, Verisign calculated its income and NOL deduction on a separate company basis. In prior tax years, Verisign utilized prior year NOLs to reduce its taxable income to zero, but during the 2015 and 2016 tax years its separate company NOLs exceeded the federal consolidated group NOLs. Verisign claimed the larger separate company NOL, reducing its income to zero during those years.
After an audit, the Division assessed Verisign approximately $1.7 million in additional tax and penalties. Following its internal policy, the Division explained that Verisign’s NOL deduction should have been limited by the amount available at the federal consolidated level and not calculated on a separate company basis. Verisign did not qualify for any exception to the policy because the company filed a federal consolidated return with at least one non-Delaware taxpayer.
After filing a protest that was denied by the Division, Verisign petitioned the Delaware Tax Appeal Board and later removed the case to the Delaware Superior Court. Finding in favor of Verisign, the Superior Court ruled that the Division’s NOL limitation policy was consistent with Delaware law and did not discriminate against interstate commerce. However, the court invalidated the policy on the grounds that it violated Delaware’s uniformity clause.3 On January 20, 2021, the Division appealed the decision to the Delaware Supreme Court.
Supreme Court decision
The Court first considered whether the Division’s policy is consistent with Delaware law. Reviewing the relevant corporate tax statutes for the tax years at issue, the Court noted that the law required every corporation to annually pay tax on its taxable income, which is defined as the portion of entire net income of a corporation that is allocated and apportioned to the state.4 Acknowledging that the relevant statutory provisions are “hardly beach reading,” the Court noted that they clearly established that each Delaware corporate taxpayer pays income tax as a “singular entity.” Further, the Court explained that the provisions “did not authorize the use of a consolidated deduction, which by definition takes into account the income and deductions of multiple entities.”
Next, the Court consulted the Division’s 2015 corporate income tax instructions, which directed taxpayers to use federal separate company taxable income as the starting point to calculate Delaware taxable income, and to include a federal pro forma Form 1120 with their Delaware return.5 The Court pointed out that all other aspects of the Division’s instructions required taxpayers to report separate-company income and deductions on their returns, with the exception of NOL calculations. The Court determined that the resulting disconnect between the calculation of income and NOLs causes corporations to pay tax on an amount of income that was not taxable income as defined under Delaware law.
Turning to the policy itself, the Court observed that the Division was unable to point to any statutory text to support the NOL limitation policy or explain how or why the policy was adopted. According to the Court, the Division merely stated that the policy “has been in place for at least 30 years and in any event longer than any current employee of the division can remember,” with a Division witness admitting that the policy “[is] not in the statute.” Noting that Delaware law clearly imposes tax on “each eligible corporation’s standalone income,” the Court concluded that the Division’s NOL policy violated the plain meaning of the statute.
Court rejects division arguments
The Court next addressed four main arguments advanced by the Division in defense of its policy. First, the Division claimed that the relevant statutes should be read as requiring standalone filers to apply on their Delaware return whatever NOL was claimed on the federal return in which they were included. Next, the Division argued that the NOL deduction was discretionary, meaning that it can be applied or even eliminated as the Division sees fit. The Court rejected both arguments because they were unable to reconcile the Division’s interpretations with a plain reading of the statutory provisions.
The Division next argued that the Superior Court previously approved the NOL policy in Cluett, Peabody & Co. v. Director of Revenue.6 In response, the Supreme Court noted that it is not bound by Superior Court decisions, and distinguished Cluett on its facts.7 Finally, the Division claimed that Verisign lacked the grounds to challenge the NOL policy because it originally reported positive federal taxable income in 2015 and 2016. However, the record revealed that the Division stipulated to Verisign reporting zero taxable income for those years. In any event, the Court reasoned that the critical issue in the litigation centered on the application of the NOL policy.
Concluding that the Division’s NOL policy was inconsistent with Delaware law, the Court found it unnecessary to address Verisign’s constitutional arguments. The court stated that the Superior Court offered a “thoughtful and well-reasoned analysis” on how the NOL policy violated Delaware’s uniformity clause. However, in accordance with Delaware case law, the Court explained that constitutional arguments should be decided only if they are “essential to the disposition of the case.”8 Concluding that an analysis of the constitutional arguments would not change the result of the case, the Court invalidated the Division’s NOL policy solely on the basis that it violated Delaware law.
While the Verisign litigation was pending before the Court, the Delaware legislature amended the relevant income tax statute to codify the Division’s NOL policy, effective July 30, 2021.9 However, the legislation does not specify the tax years to which the statutory NOL limitation now applies. While the legislative change was not directly addressed by the Court, the newly amended law limits the impact of the Court’s decision on a prospective basis. The Court analyzed the version of the statute as it applied to Verisign during the 2015-2016 tax years, finding that the language did not support the Division’s policy. The codification of the Division’s policy is intended to provide that statutory support.
Despite the legislative change, the Verisign decision presents potential refund opportunities for taxpayers that limited their NOL deductions in accordance with the Division’s policy for open tax years prior to 2021. In other words, the decision arguably applies to tax years for which a return is due before the bill’s July 30, 2021 effective date. For example, a taxpayer filing as part of a federal consolidated group that limited its Delaware NOL deduction to the portion reported on the federal return may consider filing prior year amended returns to utilize the separate company NOL deduction to offset taxable income. Taxpayers should also consider any resulting impact on the use of NOLs as deferred tax assets for financial statement reporting purposes.
Declining to address Verisign’s constitutional arguments, the Court left open the question of whether the policy violates Delaware’s uniformity clause.10 The Superior Court earlier concluded that the policy violated Delaware uniformity principles because it treated taxpayers differently depending on their federal filing status, thus creating two separate classes of taxpayers. However, the Superior Court invalidated the policy on the basis that it was created by an administrative agency, which is not afforded the same level of deference as a state legislature in determining the reasonableness of tax classifications under Delaware case law.11 Indeed, the Superior Court suggested that it would have given greater deference to the policy if it were promulgated by the state legislature. Since the policy has now been codified into law, it remains to be seen whether the policy will be challenged on a constitutional basis and withstand scrutiny under the Delaware uniformity principles.
1 Director of Revenue v. Verisign, Inc., No. N19C-08-093, Delaware Supreme Court, Nov. 29, 2021.
2 DEL. CODE ANN. tit. 30, § 1903(a).
3 Verisign, Inc. v. Director of Revenue, No. N19C-08-093, Delaware Superior Court, Dec. 17, 2020. For a discussion of the Delaware Superior Court’s decision in Verisign, see GT SALT Alert: Delaware rules against NOL limitation policy.
4 30 DEL. CODE ANN. tit. 30, §§ 1902(a), 1903(b) (emphasis added). “Entire net income” is defined as the amount of a corporation’s federal taxable income for such year as computed for federal income tax purposes. 30 DEL. CODE ANN. tit. 30, § 1903(a).
5 2015 Delaware Corporate Income Tax Return Instructions, Delaware Division of Revenue.
6 1985 Del. Super. LEXIS 1089 (Del. Super. Ct. Jan. 22, 1985).
7 In Cluett, the taxpayer tried to claim an NOL deduction but in that case, the taxpayer’s losses had been previously offset against the taxpayer’s taxable income.
8 Citing Downs v. Jacobs, 272 A.2d 706 (Del. 1970).
9 H.B. 171, Laws 2021, amending DEL. CODE ANN. tit. 30, § 1903(a)(2)(i). As amended, the statute allows for “[a]ny deduction for a net operating loss carryforward calculated in accordance with the provisions of the Internal Revenue Code, provided however that the deduction may not exceed the amount claimed on the federal return filed for the taxable year in which the taxpayer was included as a party.”
10 Verisign also argued that the policy violated the U. S. Constitution but neither the Delaware Supreme Court nor the Superior Court addressed these arguments.
11 See Wilmington Medical Center, Inc. v. Bradford, 382 A.2d 1338 (Del. 1978).
Matthew D. Melinson
Matthew Melinson is a partner in Grant Thornton's Philadelphia office and the national leader of the SALT practice's indirect tax services. Melinson is responsible for all aspects of multistate tax consulting and planning and compliance related to income tax, franchise tax, sales and use tax, credits and incentives, real estate tax, and personal property tax.
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Drew VandenBrul has over 26 years of experience as a state & local tax professional advising companies across all industries on complex Pennsylvania and multistate tax planning, tax controversy, transaction and compliance matters, including income, franchise, realty transfer and sales & use taxes.
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Jamie C. Yesnowitz
Jamie Yesnowitz, principal serving as the State and Local Tax (SALT) leader within Grant Thornton's Washington National Tax Office, is a national technical resource for Grant Thornton's SALT practice. He has 22 years of broad-based SALT consulting experience at the national and practice office levels in large public accounting firms.
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