United States

North Carolina: Income on the Disposition of U.S. Bonds Not Deductible Interest

Aug 28, 2017
From KPMG TaxWatch

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Recently, the North Carolina Supreme Court held that market discount income was not interest that could be deducted for North Carolina tax purposes. On its 2001 North Carolina corporate income tax return, the taxpayer deducted U.S. government bond “market discount” income from federal taxable income in determining North Carolina net taxable income. The Department of Revenue subsequently disallowed the deduction. After the North Carolina Business Court ruled in the Department’s favor, the taxpayer appealed.

Under North Carolina law, interest upon the obligations of the United States is deductible to the extent included in federal taxable income. However, there is a limitation on the deduction—it is allowed only if interest from obligations of North Carolina or its political subdivisions are likewise exempt from federal income taxes. Thus, for the taxpayer’s market discount income to be deductible from North Carolina taxable income as U.S. bond interest two conditions had to exist. First, the income had to be interest upon the obligations of the United States. Secondly, interest on North Carolina bonds must likewise be exempt from federal income taxes.  On appeal, the court focused on the first condition—whether the market discount income was “interest” upon United States obligations. Under IRC section 1276(a)(4), the market discount income was specifically treated as interest, rather than ordinary income. North Carolina adopts federal taxable income as the starting point in computing North Carolina taxable income. Thus, the taxpayer argued that the federal treatment should be followed for North Carolina tax purposes. The Department, on the other hand, argued that the term “interest” which was not defined, must be understood in accordance with its plain meaning. The Department also asserted that the definitions contained in the IRC were not adopted on a “wholesale basis” and had the General Assembly intended to incorporate the IRC section 1276 treatment, it would have expressly done so. The court agreed with the Department and held absent a specific reference to IRC section 1276, the term “interest” must be defined in accordance with its plain meaning—“periodic payments received by the holder of a bond.” In other sections of North Carolina law, the General Assembly had selectively incorporated certain IRC definitions; there was no specific reference to IRC section 1276 in the subsection of the modifications statute allowing the deduction for U.S. bond interest. In the court’s view, if all the provisions of the Code were binding throughout the North Carolina Revenue Act, the specific references to various Code sections in other portions of the modifications statute would be superfluous. Please contact Nikki Emanuel at 704-335-5344 with questions on The Fidelity Bank v. N.C. Department of Revenue.

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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.