New Jersey guidance updates various tax reform provisions

During October and November 2023, the New Jersey Division of Taxation (Division) continued to issue new and revised Technical Bulletins to reflect tax reform legislation enacted earlier this year and provide guidance on Corporation Business Tax (CBT) issues such as the dividend exclusion, ordering of deductions, net operating losses (NOLs) and inclusion of certain captive entities in combined groups.¹ The Division also issued guidance discussing the application of CBT apportionment and sourcing provisions to business receipts subject to gross income tax (GIT).

Dividend exclusion and ordering rules 

The Division issued new guidance on the amended CBT statutes related to: (i) the dividend exclusion (DRD), and (ii) the ordering of NOLs, the DRD and the international banking facility (IBF) deduction.² The guidance applies to privilege periods ending on and after July 31, 2023.

Dividend exclusion    

As amended by A.B. 5323, for privilege periods ending on and after July 31, 2023, the DRD is applied to entire net income (ENI) after New Jersey additions but before New Jersey deductions and before the allocation of ENI.³ Dividends from 80% or more owned separate entity subsidiaries are 100% excluded.⁴ Dividends from more than 50% but less than 80% owned separate entity subsidiaries are 50% excluded. However, New Jersey law requires the exclusion to be reduced by 5% of all dividends received by the taxpayer during the privilege period.⁵ Dividends distributed between combined group members that are included in the same New Jersey combined return are eliminated.⁶

The guidance clarifies the treatment of dividends received by a non-U.S. corporation, which varies based on how such corporation files for CBT purposes. In the case of separate return, water’s-edge and affiliated group filers, the DRD cannot be taken by a non-U.S. corporation that receives dividends from its separate return subsidiaries in two cases. First, if the non-U.S. corporation was formed in a foreign nation that has an income tax treaty with the U.S. that excludes the dividends from income, the DRD cannot be utilized. Second, if the non-U.S. corporation’s dividends are not part of its effectively connected income, the DRD cannot be used. When dividends are not included in the non-U.S. corporation’s ENI, the non-U.S. corporation cannot include them as part of the DRD. For worldwide group filers, if a non-U.S. corporation receives dividends from its separate return subsidiaries, the DRD is applicable to these dividends on a return in which the non-U.S. corporation is a member of a combined group that elected to file on a worldwide basis.⁷

Ordering rules

Effective for privilege periods ending on and after July 31, 2023, the DRD and IBF deduction are calculated on a pre-allocation basis. The prior NOL conversion carryover deduction (PNOLs) and the NOLs are calculated on a post-allocation basis. The historic ordering limitation that prevented the DRD and IBF deduction from increasing NOLs is not applicable to newly generated NOLs. Because the change in historic ordering is prospective only, taxpayers cannot adjust NOLs and PNOLs from privilege periods ending before July 31, 2023.

As amended, PNOLs and NOLs are subtracted after deducting the current year exclusions and deductions if the allocated ENI is greater than zero. Due to the change in the ordering rules, there no longer is an income limitation for applying either the DRD or IBF deduction. The DRD and the IBF deduction may exceed ENI, which may generate or increase the current year loss.

NOL guidance revised and expanded

The Division revised existing guidance on the NOL regime as well as NOLs and combined groups to reflect the statutory changes enacted by A.B. 5323.⁸ The guidance has been expanded to discuss the treatment of NOLs and PNOLs for privilege periods ending on and after July 31, 2023.

NOL general guidance

New Jersey prospectively applies the 80% limitation outlined in IRC Sec. 172(a)(2) to NOLs generated in privilege periods beginning after July 31, 2023.⁹ The Division’s guidance indicates that the Form 500 (NOL form) has been revised to effectuate the changes. The guidance also was expanded to include a discussion of non-U.S. corporation losses and expenditures that is consistent with prior guidance.¹⁰

NOLs and combined groups

As amended by A.B. 5323, the remaining balance of the unused and unexpired PNOLs of the group members are pooled to be used by the combined group against the group’s allocated ENI. The combined group must still apply the PNOLs before applying a combined group post-allocation NOL conversion carryover. Since the PNOLs are pooled, combined group members are no longer permitted to buy and sell PNOLs to each other.

In the context of a combined return, the 80% deduction limitation in IRC Sec. 172(a)(2) applies at the combined group level. When the combined group uses the NOLs of the members or the group generated in privilege periods beginning after July 31, 2023, these NOLs can only be deducted up to 80% of the remaining allocated ENI after first deducting the PNOLs and pre-Aug. 1, 2023, NOLs.¹¹ The 80% deduction limitation does not apply to PNOLs or NOLs generated in periods beginning before Aug. 1, 2023.

The guidance has a new section on pooling combined group NOLs. It describes that any combined group post-allocation NOLs¹² and any NOLs of the taxable members of the combined group¹³ are pooled together with the combined group NOL carryover¹⁴ for use by the combined group. Alternatively, the taxable member that generated the NOL carryover may use it for such member’s activities that are independent of the combined group’s unitary business. When a new taxpayer joins an established combined group that is filing New Jersey combined returns, the new member’s post-allocation NOL carryovers are pooled with the combined group’s post-allocation NOL carryovers. The taxable members of the combined group must track their proportionate share of the combined group NOL carryovers used. If the taxable member leaves the combined group and continues to be a taxpayer subject to CBT, the taxable member is entitled to take its respective portion of the combined group NOL carryover.¹⁵ Also, a new section provides an extensive discussion of the calculation of NOLs in relation to the combined group filing method used.¹⁶

Captive entities in combined groups

The Division issued new guidance on the inclusion of certain captive entities in combined groups.¹⁷ Effective for privilege periods ending on and after July 31, 2023, the CBT was amended to require that investment companies (ICs), regulated investment companies (RICs) and real estate investment trusts (REITs) meeting the statutory definition of “captive” be included in the combined group and taxed as C corporations.¹⁸ Also, the captive entities must add back any deductions and expenses that are only permitted to ICs, RICs and REITs under the IRC. Prior to this amendment, ICs, RICs, and REITs were required to file separate returns and could use the benefits provided to these entities under the law.¹⁹

The amended statute provides an exception from inclusion in the combined group for ICs, RICs and REITs if at least 50% of the shares, by vote or value, are owned or controlled, directly or indirectly, by a state or federally chartered bank, savings bank, or savings and loan association (financial institution) with assets of $15 billion or less. If the financial institution has assets that exceed $15 billion during the group privilege period, the ICs, RICs and REITs that meet the definition of “captive” must be included in the combined group. However, ICs, RICs and REITs that are not “captive” or whose parent meets the exception for a financial institution with assets of $15 billion or less will continue to file separate returns and receive the statutory benefits. The exception for a financial institution with assets of $15 billion or less does not apply to the financial institution itself.²⁰

In determining whether the financial institution’s assets exceed $15 billion for the group privilege period, the Division is requesting that the entity use an annual average value of its assets. The collective asset values must be reported and measured following the same method of accounting used for financial and regulatory reporting to the authorities governing financial institutions. In most instances, this means the annual average assets based on the bank’s quarterly reports. However, the guidance notes that there may be some circumstances where an average value of the assets may not be the best measure for determining whether the IC, RIC, or REIT must be included as a “captive.”²¹

To the extent that financial institutions and the captive ICs, RICs, and REITs will now be required to file on a combined reporting basis instead of separate reporting, a financial institution which filed separately from these captive entities (and is not part of another combined group) must register as the managerial member of this group. In this case, the group’s privilege period will be the financial institution’s 12-month privilege period.²²

GIT allocation and sourcing of business receipts 

As amended by A.B. 5323, for taxable years beginning in 2023 and thereafter, taxpayers subject to GIT must use the CBT sourcing rules for business receipts to the extent that New Jersey sources cannot be readily or accurately ascertained.²³ The Division issued guidance explaining the application of this new requirement.²⁴

Allocation formula and sourcing rules

Prior to Jan. 1, 2023, GIT statutes allocated receipts from business income using a three-factor method and sourced receipts based on costs of performance. On or after Jan. 1, 2023, business receipts are allocated for GIT purposes using the CBT’s single factor method and market-based sourcing.²⁵ However, the legislation only prescribes uniform sourcing and does not extend to deductions and exemptions that are allowed for CBT purposes. Allowable deductions and exemptions continue to be prescribed by GIT law. The new sourcing rules apply to all taxpayers subject to GIT that engage in a business, such as a sole proprietor, a partner in a partnership, or shareholder of an S corporation that conducts business both inside and outside New Jersey. Receipts other than business income such as a taxpayer’s salary, wages, tips, fees, commissions, bonuses and other remuneration continue to be sourced under GIT provisions rather than the CBT rules.

Pass-through entity tax

The new uniform sourcing rules also apply to the Pass-Through Business Alternative Income Tax (BAIT). A group of pass-through entities under common control which elect to pay the BAIT and to file a consolidated pass-through entity tax return may follow the sourcing methods for a combined group but is not required to do so.

Temporary penalty and interest relief

For the 2023 tax year, taxpayers will not be assessed any penalties or interest on the underpayment of tax resulting from A.B. 5323 that may have generated additional tax liability. No interest will be assessed for not making sufficient installment payments of estimated tax. To qualify for this relief, all additional estimated tax payments must be made by the date on which the original 2023 GIT return is due (April 15, 2024, for calendar-year taxpayers).

Commentary

The tax reform legislation enacted by New Jersey earlier this year was extensive and the recently released or revised Technical Bulletins provide expedited guidance for prospective CBT filings. As discussed in our SALT Alert for the guidance released in September, the Division may promulgate regulations on some of these topics that are likely to further elaborate on what the Division has released to date. The changes to the dividend exclusion and ordering rules are noteworthy and should be closely considered. Also, the treatment of NOLs and PNOLs in New Jersey is complex and substantially amended. Many of the most significant items in the tax reform legislation such as changes to allocation, combined reporting, the treatment of income protected by treaties, and NOLs are interrelated and need to be considered together. The guidance is useful by explaining the application of these changes as they relate to each other.

Entities that receive DRDs should be aware of New Jersey’s unique 50% and 80% ownership thresholds that create two categories of DRD, the 5% exclusion (which applies to both categories), and the change in placement and ordering in the taxable income calculation that will apply going forward. This should be taken into consideration when calculating provisions and upcoming extensions. Also, taxpayers anticipating the generation of NOLs in the future should be aware of the conformity to the 80% federal limitation and ensure those assets are properly valued. Combined taxpayers with members that have PNOLs should review the new pooling rules to determine if the statutory change will allow them to free up PNOLs that had been “trapped” and apply them to offset combined group income. Taxpayers may also want to review their valuation allowances.

Regarding post-allocation NOLs, taxpayers should note the distinction between the “sharing” of NOLs that was allowed for privilege periods ending before July 31, 2023 and the “pooling” that is allowed for subsequent periods. Taxpayers with NOLs need to ensure they have procedures to track the proportionate share of NOLs so that if a taxable member departs the group it takes its share of NOLs with it. Also, taxpayers should be aware of the Division’s ability to adjust NOLs for closed years.²⁶

The inclusion of certain captive ICs, RICs and REITs in combined groups also is addressed. This change may substantially increase the tax liability of certain taxpayers, but captive entities owned by smaller financial institutions still file separate returns. The guidance explains exactly which entities should be included in the combined report, provides additional clarification on the $15 billion asset test exception to combination and the return filing procedures. Groups with ICs, RICs and REITs should revisit their year-end provision calculations to reflect the new guidance on how to calculate the $15 billion asset test.

Finally, the GIT guidance discusses the application of CBT apportionment and sourcing provisions to business receipts. This major change must be considered by taxpayers subject to GIT that engage in businesses operating in New Jersey and other states. However, the guidance clarifies that non-business receipts continue to be allocated and sourced under the existing GIT provisions.²⁷