South Carolina enacts alternative apportionment framework

South Carolina recently enacted legislation to provide the Department of Revenue with procedures to follow in requiring taxpayers to use alternative apportionment or file combined reports to accurately reflect their business activity in the state.¹ The new procedures encompass notice requirements, taxpayer requests for advice, net income adjustments, combined returns, proposed assessments, written statements of finding, agreements between taxpayers and the Department, and appeals. The legislation is effective March 11, 2024 and applies to all open tax periods except for assessments that were under judicial review on that date.

Existing law 

In cases where the allocation and apportionment provisions do not fairly represent the taxpayer’s business activity in South Carolina, the law continues to preserve the ability of the taxpayer to petition for, or the Department to require an alternative method of allocation and apportionment. These methods may include: (i) separate accounting; (ii) the exclusion of one or more of the factors; (iii) the inclusion of one or more additional factors which will fairly represent the taxpayer’s business activity in the state; or (iv) the employment of any other method to effectuate an equitable allocation and apportionment of the taxpayer’s income.² The recent legislation adds new procedures for the Department to follow in employing other methods to equitably allocate and apportion income.³

New procedures 

Notice requirements and advice

The statute provides new notice requirements if the Department has reason to believe that a taxpayer conducts its trade or business in a manner that fails to fairly represent the extent of the taxpayer’s business activities in South Carolina by using transactions that lack economic substance⁴ or are not at fair market value between members of an affiliated group⁵ of entities.⁶ In this situation, the Department may issue written notice to the taxpayer requiring information reasonably necessary to determine whether the taxpayer’s intercompany transactions have economic substance and are at fair market value to accurately determine income properly attributable to the taxpayer’s business activity in South Carolina. The taxpayer must provide the information within 90 days of the date of the notice.

A taxpayer may request in writing from the Department specific advice concerning whether a redetermination of the taxpayer’s state net income or a combined return would be required under certain facts and circumstances.⁷ The Department may request additional information from the taxpayer and must provide specific advice within 120 days of receiving the requested information.

Net income adjustment

If the Department reviews the information and finds that the taxpayer’s intercompany transactions lack economic substance or are not at fair market value, the Department may redetermine the taxpayer’s net income properly attributable to the state by adding back, eliminating, or otherwise adjusting intercompany transactions to accurately compute the taxpayer’s state net income.⁸ If these adjustments are not adequate to redetermine the taxpayer’s state net income, the Department may require the taxpayer to file a combined return, including all the affiliated group members that are conducting a unitary business. The Department is directed to consider and use any reasonable method proposed by the taxpayer for redetermining its income attributable to business activity in South Carolina. In determining whether the taxpayer’s intercompany transactions lack economic substance or are not at fair market value, the Department must consider each tax year separately.⁹ In determining whether transactions between members of the affiliated group are not at fair market value, the Department is directed to apply the regulations adopted under Internal Revenue Code (IRC) Sec. 482.¹⁰

In cases where the Department redetermines the taxpayer’s state net income by adjusting the income or requiring a combined return, the Department must issue a proposed assessment or refund after making the redetermination.¹¹ When a refund is determined by a proposed assessment to an affiliated group member, the refund may not be issued until the proposed assessment to the affiliated group member has become “collectable.”¹²

Following an adjustment or combined return determination, the Department must provide the taxpayer with a written statement providing details of the facts, circumstances, and reasons for which it has found that the taxpayer did not fairly represent its income properly attributable to its business activity in the state.¹³ The statement must include the Department’s proposed method for computing the taxpayer’s state net income and be sent within 90 days following issuance of the proposed assessment.

The legislation envisions situations where the Department has reason to believe that a taxpayer’s income properly attributable to its business activity in South Carolina is not fairly represented on a separate return because of intercompany transactions but does not make a finding that the transactions lack economic substance or are not at fair market value. In these situations, the Department and the taxpayer may determine and agree to an alternative filing methodology that fairly represents state net income.¹⁴

Combined returns

If the department finds that a combined return is necessary, the Department may, upon written notice to the taxpayer, require the taxpayer to submit the combined return.¹⁵ The taxpayer’s submission of the combined return is not deemed to be a return or an agreement by the taxpayer that an assessment based on the combined return is correct or that additional tax is due. The Department or the taxpayer may propose a combination of fewer than all members of the unitary group. Although the Department is authorized to consider whether the proposed combination is a reasonable means to redetermine state net income, the Department may not require a combination of fewer than all members of the unitary group without the taxpayer’s consent. The Department may require a combined return regardless of whether the members of the affiliated group are doing business in South Carolina.¹⁶

The following entities may not be included in a combined return:

• A taxpayer not required to file a federal income tax return
• An insurance company, other than certain captive insurance companies¹⁷
• A taxpayer exempt from tax under IRC Sec. 501
• A foreign taxpayer as defined in IRC Sec. 7701, other than a domestic branch
• A taxpayer with at least 80% of its gross income from all sources in the tax year being active foreign business income as defined in IRC Sec. 861(c)(1)(B) as in effect on July 1, 2021, or
• Any other entity not subject to South Carolina corporate income tax¹⁸

If the Department requires a combined return, the combined state net income of the taxpayer and the members of the affiliated group must be apportioned to South Carolina by using an apportionment formula that fairly represents the extent of business activity in the state and which fairly reflects the state’s statutory apportionment formula.¹⁹ Taxpayers that fail to timely submit a combined return are subject to the general statutory penalty provisions.²⁰

Appeals

Taxpayers may appeal a final determination to the South Carolina Administrative Law Court.²¹ The administrative law judge is directed to review the following issues on a de novo basis: (i) whether the taxpayer’s separate income tax returns fail to fairly represent the extent of the taxpayer’s business activity in the state through the use of intercompany transactions that lack economic substance or are not at fair market value between members of an affiliated group; (ii) whether the Department’s method of determining the taxpayer’s state net income is appropriate; and (iii) if a combined return is required, whether adjustments other than requiring the taxpayer to file a combined return are adequate under the circumstances to redetermine state net income.

Commentary

The legislation providing guidelines for the Department to follow when adjusting income or requiring combined reporting could be a positive development for many taxpayers looking for more certainty on how their corporate structures should be filing in South Carolina. In the past, the Department often used its broad discretionary authority to aggressively audit taxpayers and require combined reporting even though South Carolina generally requires taxpayers to file on a separate reporting basis. The Department is now required to follow specific procedural requirements before adjusting a taxpayer’s income or forcing a combined report. By including a detailed definition of “economic substance” and adopting the federal provisions for determining when a transaction between group members is not made at fair market value, the legislation is providing clear standards for the Department to follow. Also, the Department must provide taxpayers with notice and explain why an income adjustment or combined return is necessary. The legislation also specifies the type of review that the South Carolina Administrative Law Court must perform when considering appeals of income adjustments or combined reports.

The Department retains the authority to adjust income and require combined reporting, but these new requirements for the Department should make the process more equitable for taxpayers. As the legislation takes immediate effect with the exception of matters that were under judicial review when the law was enacted, taxpayers currently under audit by the Department in which alternative apportionment and/or filing methods are at issue should consider the new process that will accompany disposition of these types of matters. Finally, the legislation may effectively provide a template for other traditional separate reporting states to follow, in order to ensure that state tax authorities and taxpayers alike have more clarity as to what to expect from a procedural perspective when alternative apportionment and filing method disputes arise.