May 16, 2016
From KPMG TaxWatch
On May 11, 2016, Senate Bill 729 was signed into law in North Carolina. In addition to several personal, sales and use, and excise tax changes, Senate Bill 729 makes changes to North Carolina’s corporate income tax provisions, many of which relate to the related party interest addback requirement adopted last year.
Royalty Reporting Option
North Carolina provides taxpayers with options for reporting and paying tax on royalties when the recipient and the payor are related members. Specifically, (i) the recipient can opt to pay tax on the royalty income and the payor can deduct the royalty or (ii) the payor can add back the royalty payment and the royalty recipient can exclude the royalty from its income. Senate Bill 729 provides that exercising the royalty reporting option does not prevent a taxpayer from having nexus in the state and the recipient of the income cannot exclude the royalty payments from its sales factor. Thus, it appears the recipient would be required to include the royalties in its sales factor even if the payor had added back the royalty income.
Interestingly, this issue was addressed by the New Jersey Tax Court last year. In the Spring Licensing case, the court held that a recipient of royalty income had New Jersey nexus despite the fact that its related member added back the royalties in computing New Jersey entire net income.
Changes to the Related Member Interest Disallowance Provisions Adopted in 2015—New Conduit Exception
Historically, North Carolina taxpayers were required to add back royalty payments made to a related member. Legislation enacted in 2015 and effective for tax years beginning on or after January 1, 2016, provides for an additional addback to federal taxable income in the amount of “net interest expense” paid to a related member. “Net interest expense” is defined as the excess of interest paid or accrued by the taxpayer to each related member during the taxable year over the amount of interest from each related member includible in the gross income of the taxpayer for the taxable year.
A deduction will be allowed for “qualified interest” paid or accrued to a related member. As originally enacted, “qualified interest” was defined as the net interest expense paid or accrued to a related member subject to a limitation of 30 percent of the taxpayer’s “adjusted taxable income.” Under Senate Bill 729, the 30 percent limitation is removed and a new limitation added that is the greater of (1) 15 percent of the taxpayer’s adjusted taxable income, or (2) the taxpayer’s proportionate share of interest paid or accrued to a person who is not a related member during the same taxable year. “Proportionate share of interest” is defined as the taxpayer’s net interest expense paid or accrued directly to or through a related member to an ultimate payer divided by the net total interest expense of all related members that is paid or accrued directly to or through a related member to the same ultimate payer, multiplied by the interest paid or accrued to a person who is not a related member by the ultimate payer. Any amount that is distributed, paid, or accrued directly or through a related member that is not treated as interest under the law does not qualify. An “ultimate payer” is a related member that receives or accrues interest from related members directly or through a related member and pays or accrues interest to a person who is not a related member.
The revised limitations do not apply if one of the following exists:
In sum, to compute the net interest disallowance, a taxpayer will: (1) add back all interest expense paid or accrued to each related member to the extent it exceeds the interest that is received from each related member that is included in the taxpayer’s gross income; and (2) deduct “qualified interest” which is all interest paid or accrued to a related member limited to the greater of 15 percent of the taxpayer’s adjusted taxable income, or the proportionate share of interest paid or accrued to a person who is not a related member during the same taxable year UNLESS the qualified interest meets one of the four exceptions.
New Exclusions from the definition of Sales
Under North Carolina law, “sales” means all gross receipts of a corporation except for certain specified types of receipts, including receipts from a casual sale of property, receipts otherwise allocated, receipts exempt from tax, and the portion of receipts realized from the sale or maturity of securities or other obligations that represents a return of principal.
Senate Bill 729 adds two new categories of receipts to the list of those that are excluded from the sales factor. The first is the portion of receipts from financial swaps and other similar financial derivatives that represents the notional principal amount that generates the cash flow traded in the swap agreement. The second is receipts in the nature of dividends subtracted under G.S. 105-130.5(b)(3a) and dividends excluded for federal income tax purposes.
Qualified Air Freight Forwarder
Senate Bill 729 provides guidance on how a “qualified air freight forwarder,” which is defined as a corporation that is an affiliate of an air carrier and whose air freight forwarding business is primarily carried on with the affiliated air carrier, should apportion its income to the state. A qualified air freight forwarder should use the revenue ton mile fraction of its affiliated air carrier.
Please contact Nikki Emanuel 704.335.5344 with questions on Senate Bill 729.
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The following information is not intended to be "written advice concerning one or more federal tax matters" subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.
The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.