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North Carolina passes tax reform response to TCJA

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On June 12, 2018, the North Carolina legislature overturned Gov. Roy Cooper’s veto of S.B. 99, the state budget bill that includes major tax reform provisions, resulting in enactment of the bill into law.1 The legislation updates North Carolina’s Internal Revenue Code (IRC) conformity date, thereby conforming the state’s tax law to many of the federal tax reform provisions. The law also clarifies the sourcing of service revenue for apportionment purposes and addresses various sales tax topics.

Income tax

IRC conformity updates

Effective June 12, 2018, the legislation updates North Carolina’s IRC conformity date from Jan. 1, 2017, to Feb. 9, 2018.2 As a result, North Carolina will generally conform to the federal tax reform provisions contained in H.R. 1, commonly referred to as the Tax Cuts and Jobs Act (TCJA), as well as H.R. 1892, commonly referred to as the Bipartisan Budget Act of 2018. 3

The legislation contains the adjustments necessary to decouple North Carolina from many of the international provisions included in the TCJA, including the treatment of deemed repatriation income under IRC Sec. 965, global intangible low-taxed income (GILTI) under IRC Sec. 951A, and the deduction for foreign derived intangible income (FDII) under IRC Sec. 250.4

As for other TCJA and Bipartisan Budget Act provisions, North Carolina decouples from the deferral of inclusion in gross income for capital gains reinvested in an Opportunity Fund under federal law.5 The law does not specifically address other major items of federal tax reform such as the new provisions for full expensing, IRC Sec. 179 expensing, the interest deduction limitation, net operating losses, or the IRC Sec. 199A pass-through deduction. Because the law is silent on the matter, North Carolina will conform to the new interest deduction limitation. However, North Carolina will not conform to the new net operating loss provisions since it already requires taxpayers to calculate a state-specific net operating loss.6 Regarding the new IRC Sec. 199A pass-through deduction, North Carolina did not specifically decouple from the deduction, but it appears the deduction will not be included as a component of taxable income for individuals due to the mechanics of the individual tax return.7 North Carolina will continue to decouple from bonus depreciation (and thus full expensing) and IRC Sec. 179 expensing, as this new legislation did not alter the previous law that provides for those decoupling modifications.8

With respect to individual income tax provisions, North Carolina now decouples from the federal filing requirement as well as the federal standard deduction and itemized deduction, opting instead for a state-specific filing requirement and state-specific standard and itemized deductions.9 North Carolina conforms to the expanded benefits permitted under IRC Sec. 529 that allow funds to be withdrawn for payment of tuition for elementary and secondary education, not just post-secondary education.10

Sourcing of revenue from items other than tangible personal property

Effective June 12, 2018, the legislation makes several changes to provisions governing the sourcing of revenue from items other than tangible personal property. Receipts from real or tangible personal property located in the state now include receipts from incidental services sold as part of, or in connection with the sale of tangible personal property in the state.11 Receipts from intangibles will be sourced to North Carolina to the extent the intangible property is used within the state (formerly, such receipts were sourced to North Carolina when “received from sources within” the state).12 Finally, with respect to receipts from services, the legislation clarifies the meaning of “income-producing activity.” The law now defines “income-producing activity” as an activity directly performed by the taxpayer or its agents for the ultimate purpose of generating the sale of the service.13 Receipts from income-producing activities performed within and outside the state are attributed to North Carolina in proportion to the income-producing activities performed in North Carolina to the total income-producing activities performed everywhere that generate the sale of the service.14

Franchise tax updates

The legislation updates the definition of a “corporation” for franchise tax purposes to include partnerships that elect to be taxed as a corporation for income tax purposes.15 Previously, the definition included limited liability companies that elect to be taxed as corporations, but did not include partnerships.

Other changes to the franchise tax include clarifying that a corporation that does not maintain its books and records in accordance with generally accepted accounting principles (GAAP) must compute its net worth in accordance with the method it uses for federal tax purposes.16 Thus, if a corporation uses a method for federal tax purposes other than GAAP, then asset valuation, depreciation, depletion and amortization must be calculated for franchise tax purposes using the same method used for federal income tax purposes.

These franchise tax updates are effective beginning on or after Jan. 1, 2019, and apply to the calculation of franchise tax reported on 2018 and prospective corporate income tax returns.17

Foreign captive insurance companies

Effective June 12, 2018, the law clarifies that non-North Carolina captive insurance companies (those licensed and taxed in another state, described as “foreign”) are not subject to the tax on captive insurance companies, the corporate income tax, the franchise tax, or the gross premiums tax.18 However, this does not apply to foreign captive insurance companies required to be included in a combined return.19

Federal determinations

The legislation clarifies when a taxpayer must notify the secretary of the North Carolina Department of Revenue of a federal determination that affects the amount of state tax payable. Under previous law, a taxpayer was required to notify the secretary within six months of being notified of a “federal determination” by the federal government, whether or not the state tax payable increased or decreased. Effective June 12, 2018, and applicable to federal amended returns filed on or after that date, the new law defines the term “federal determination” to mean a change or correction of federal tax due arising from an audit of the Commissioner of Internal Revenue.20 The new law also provides that if a taxpayer voluntarily files an amended federal return, the taxpayer must file an amended state return if it results in an increase in the state tax payable.21 An amended state return is optional if the adjustment results in a decrease in the state tax payable.22

Automatic extension of time to file

Effective for taxable years beginning on or after Jan. 1, 2019, the law provides for an automatic extension of time to file a state income tax return to all taxpayers who are granted an extension of time to file a federal income tax return.23 Previously, all taxpayers had to file a state-specific extension form in order to receive an extension of time to file their North Carolina return.

Electronic filing of returns

The legislation includes a framework for the North Carolina Department of Revenue to offer and prescribe the format for the electronic filing of returns. The law includes authority to waive an electronic filing requirement and requires the Department to publish on its Web site by Dec. 1 of each year the list of returns that are required and/or permitted to be electronically filed.24

Sales and use tax

The sales and use tax changes outlined below are effective as of the date of enactment, June 12, 2018, unless otherwise noted.

Computer software service contract renewals

The legislation provides that gross receipts from the renewal of a service contract related to prewritten software should be sourced to the address where the purchaser originally received the software. The exception to this sourcing treatment occurs when the service provider has knowledge of a change in address of the software. 25

Treatment of credits originating from sales tax paid on inventory held for sale

Recent changes in the taxability of repair, maintenance, and installation (RMI) services have created a situation whereby service providers who had paid tax on materials used in the provision of these services at the time of purchase, would now potentially have to collect tax on the materials when they were transferred to their customers, creating double taxation of the materials in question. A temporary solution was enacted in 2017 that provided RMI service providers with the ability to offset the tax due on the services provided by the amount of tax paid at the time of purchase. This new legislation essentially makes this credit option permanent. It also provides for treatment of credits that exceed the tax due for a given filing period. In the event that credits exceed tax due in a filing period, the excess credit must be carried forward to a subsequent filing period. These amounts are not eligible to be refunded by the Department. 26

Prescription drugs exemption clarified

The new legislation provides additional clarification related to the exemption for prescription drugs. In an attempt to eliminate taxpayer confusion, purchases of over-the-counter drugs by hospitals and other medical facilities for use and treatment of patients are specifically excluded from this exemption.27

Bad debts

The legislation provides that for sales tax purposes, “bad debts” are to be calculated pursuant to IRC Sec. 166. Furthermore, the following are excluded from the calculation of the bad debt amount: financing charges, interest, sales or use taxes charged on the sales price, uncollectible amounts on property that remains in the seller’s possession, collection expenses, and repossessed property.28

Extension of grace period

Due to extensive taxpayer confusion related to the relatively new treatment of RMI/real property contractor transactions, an enforcement grace period was previously established prohibiting the Department from assessing taxpayers on these transactions. The original grace period was for qualifying transactions occurring on or after March 1, 2016, and ending prior to Jan. 1, 2018. The new legislation both extends this grace period by a year to Dec. 31, 2018, and expands the list of transactions covered to include the following:

  • Transactions where a person failed to collect sales tax on the taxable portion of a mixed transaction contract that exceeds 25% for a transaction on or after Jan. 1, 2017, and prior to Jan. 1, 2019.
  • Transactions where a person failed to collect sales tax on the taxable portion of a bundled transaction that included a contract for two or more services, only one of which was subject to tax, for transactions on or after March 1, 2016, and prior to Jan. 1, 2017.
  • Transactions where a person failed to collect sales tax on repair, maintenance, and installation services for tangible personal property, motor vehicles, and digital property.29

Property management contracts

The legislation adds a new sales tax exemption for receipts derived from the sale of a property management contract. A property management contract is defined as a written contract to provide specified management services related to real property used for business, commercial, educational or income-producing purposes, and excludes contracts for RMI services for real property. This exemption will become effective Jan. 1, 2020.30

Commentary

S.B. 99 was vetoed by Gov. Cooper, but the veto was overturned by both chambers of the North Carolina state legislature and passed into law on June 12, 2018. It should be noted, however, that this tax legislation was part of a broader state budget bill. Gov. Cooper’s veto is understood to be due to other aspects of the state budget, not specifically due to the tax provisions contained therein.

The new legislation provides taxpayers with some clarity as to which federal tax reform provisions apply for North Carolina state tax purposes. The legislation specifically addresses the international tax reform provisions such as the treatment of deemed repatriation income under IRC Sec. 965, GILTI under IRC Sec. 951A, and the deduction for FDII, which is helpful since these provisions have proven to be some of the most complex federal tax reform provisions for taxpayers to navigate. However, the legislation stays silent on many other major items of federal tax reform, such as the new provisions for full expensing, IRC Sec. 179 expensing, the interest deduction limitation, net operating losses, and the IRC Sec. 199A pass-through deduction. Although many provisions of federal tax reform were not addressed in S.B. 99 including bonus depreciation, net operating losses, and IRC Sec. 199A, existing legislation covers the conformity of these provisions under North Carolina law. The clarification of “income-producing activity” as it relates to service revenue sourcing is interesting, given that legislators chose to keep the cost of performance methodology for the sourcing of service revenue, rather than transitioning the state to market-based sourcing. This is especially relevant given that the state has already transitioned to a single sales factor apportionment formula, since most states that have transitioned to single sales have also adopted market-based sourcing.

From a sales and use tax perspective, this new legislation is not driving substantial reform but instead includes a number of clarifications or extensions of existing law, including making permanent the credit available to RMI service providers for tax paid on materials used in the performance of an RMI service. This serves as an example of the continuing evolution of how North Carolina treats RMI services since expanding the sales tax base to include these services.

 

1 S.L. 2018-5 (S.B. 99), Laws 2018.
2 N. C. GEN. STAT. § 105-228.90(b)(1b).
3 P.L. 115-97, P.L. 115-123. For a discussion of the TCJA, see GT Alert: Tax Reform Law Transforming Business and Tax Planning.
4 N. C. GEN. STAT. § 105-130.5(a)(28), (29), (b)(3b).
5 N. C. GEN. STAT. §§ 105-130.5(a)(26), (27); 105-153.5(b)(29).
6 N. C. GEN. STAT. § 105-130.8A.
7 N. C. GEN. STAT. § 105-153.5(c)(7).
8 N. C. GEN. STAT. § 105-130.5B.
9 N. C. GEN. STAT. §§ 105-153.5(a)(1); 105-153.8(a).
10 N. C. GEN. STAT. § 116-209.25.
11 N. C. GEN. STAT. § 105-130.4(l)(3).a.
12 N. C. GEN. STAT. § 105-130.4(l)(3).b.
13 N. C. GEN. STAT. § 105-130.4(l)(3).c.
14 Id.
15 N. C. GEN. STAT. § 105-114(b)(2).
16 N. C. GEN. STAT. § 105-122(b).
17 S.B. 99, § 38.2.(j).
18 N. C. GEN. STAT. § 105-228.4A.
19 N. C. GEN. STAT. § 105-130.5A.
20 N. C. GEN. STAT. § 105-130.20.
21 Id.
22 Id.
23 N. C. GEN. STAT. § 105-263.
24 N. C. GEN. STAT. § 105-241A.
25 N. C. GEN. STAT. § 105-164.4B(i).
26 N. C. GEN. STAT. § 105-164.11B.
27 N. C. GEN. STAT. § 105-164.13(13).
28 N. C. GEN. STAT. § 105-164.13(15).
29 N. C. GEN. STAT. § 105-244.3.
30 N. C. GEN. STAT. § 105-164.3(30b).



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