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July 17, 2012
Transparency in North Carolina: Portrait of a State in Flux

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by Amy Hamilton

It might be hard to identify the North Carolina Department of Revenue's largest misstep when forcing combination of separate entity returns. Some corporate tax advisers may point to the DOR's persistent use of the cost standard in evaluating intercompany transactions as indicative of a fundamental problem.

"Intercompany transactions in excess of cost indicate that true earnings are not reported," the DOR wrote in a proposed draft regulation circulated last year. The DOR had been defining distortive transactions that way for years, but it had never before been announced as a policy statement.

The department's refusal to publish any guidelines for when taxpayers could expect the revenue secretary to require a combined return even though transactions were at arm's length already had been the subject of litigation. In Wal-Mart Stores East, Inc. v. Hinton and Delhaize America, Inc. v. Lay, the North Carolina courts allowed the DOR the discretion to force combination without publicly articulating a standard for when it could require a combined return.

The General Assembly has since repealed, for tax years beginning on or after January 1, 2012, the state statute from which the DOR was deriving its broad discretionary authority. In its place is a more limited discretionary authority for forcing combination, as a last resort, when the secretary finds as a fact that a corporation's intercompany transactions lack economic substance or are not at fair market value.

The lack of guidance is one reason the original statute was repealed. But a remaining question for taxpayers with open years preceding 2012 is whether the fair market value is the appropriate standard for evaluating intercompany transactions.

Forced combination of separate entity returns drives discussion of transparency in the way the North Carolina DOR administers the tax law. What started out as the DOR's focus on tax planning has raised questions about how the department administers its discretionary authority. To say that the situation has been adversarial would be an understatement.

Delhaize and Forced Combination

Five years ago, in public comments that have since become the stuff of legend, then-Revenue Secretary Norris Tolson flatly declared that no guidance on forced combinations would be forthcoming because taxpayers would only use it as "a roadmap to tax avoidance."

Last year, more problems came to light when the North Carolina Business Court issued its opinion in Delhaize America Inc. v. Lay. (For Delhaize, see Doc 2011-1227 or 2011 STT 14-22.) According to the court, Tolson and the director of the department's Examination Division developed their rationale for a policy of secrecy in 2005 without seeking legal advice or approval.

But that was far from the worst of it. After accounting firms aggressively marketed strategies in the 1990s for shifting assets and income among affiliated corporate entities and North Carolina experienced a budget shortfall, the DOR responded by initiating a compliance project and changing its policies without providing notice to taxpayers.

The department actively worked to conceal the standards its decision-makers were using when exercising their authority to combine returns. The DOR never issued any information in response to requests from taxpayers, practitioners, or accountants for guidance on when it would require a combined return.

Further, the agency never trained its own auditors on when to require consolidation, and it refused to provide them with any guidelines, bright-line tests, or key criteria for evaluating cases. The court documented how auditors repeatedly asked for guidelines -- by the mid-2000s, there were some 900 corporate audit cases open, and most had the potential to be combination. But the DOR feared that if it provided its audit staff with guidelines, they would wind up in the hands of taxpayers and their advisers, who would use them against the department.

The Delhaize court found that the DOR had no established rules or criteria that would apply to all taxpayers. The director of the Examination Division had the authority to make a final determination on a case-by-case basis regarding whether a consolidation would be ordered. That approach forced taxpayers to guess whether they would be compelled to combine, risking substantial penalties when they guessed wrong, the court found.

The Delhaize court inadvertently addressed other guidance issues at the agency. Tax bulletins hadn't been updated. Private letter rulings, which the DOR doesn't publish, showed inconsistent policies from the late 1980s to the mid-2000s.

"It's just not a satisfactory system, because we don't know if similarly situated taxpayers are being dealt with the same way," said Senate Finance Committee member Daniel Clodfelter (D). "We don't want to have different tax policies for companies that are competing for the same customers."

Clodfelter said the fight over guidance on forced combinations marks "the first time in years anybody had paid any attention to the practices of the department in the publication of guidance."

Lawmakers Reassert Their Role

With the DOR unwilling to provide guidance, lawmakers are increasing oversight of the DOR rulemaking process, passing a series of laws requiring the department to adopt formal rules on forced combinations.

In 2010 Clodfelter co-chaired the Senate Finance Committee and led the effort to enact a law requiring the department to adopt rules on combined reporting before it could impose related penalties. The next year, the state limited the department's discretionary authority to force combination by repealing the statute under which it had derived its broad authority and enacting HB 619. (For HB 619, see Doc 2011-14486 or 2011 STT 128-22.)

In November 2011 the DOR issued its first published guidance regarding forced combination and its authority to make other discretionary adjustments, which it has since replaced with superseding directives.

The Council On State Taxation, the North Carolina Chamber of Commerce, and the North Carolina Retail Merchants Association all praised the DOR's first attempt at providing such guidance. But they also raised concerns about the directive with the General Assembly's interim Revenue Laws Study Committee. They argued that the directive didn't provide the certainty lawmakers had intended and that it erroneously interpreted the comprehensive 2011 law revising the DOR's discretionary authority. Those issues may have resulted from the DOR's failure to use the state's formal rulemaking process.

Clodfelter described the directive as "only superficially in compliance" with the legislative directive to provide guidance on when it would force combination.

"There was a lack of openness and definitiveness in the directive that came back, where the department said, 'We'll take into account the following factors, but these are not all of the factors, and we're not listing them all here,'" Clodfelter said. "We considered that not to be a satisfactory response."

Jasper L. Cummings Jr. of Alston & Bird LLP in Raleigh wrote guidance during his time as IRS associate chief counsel (corporate). He said the DOR's latest directive containing a long list of factors reflects the approach the IRS uses in applying the economic substance doctrine. But he disagreed that the factors provided useful guidance. "You couldn't derive anything from it other than that you should have something to fear, because you always have a few of the factors," Cummings said.

The General Assembly acted again, passing legislation this year sponsored by Sen. Bob Rucho (R), co-chair of the Senate Finance Committee and the General Assembly's Revenue Laws Study Committee. The study committee had found that the DOR rarely issues formal rules, preferring instead to publish nonbinding directives and bulletins, in part because the state's formal rulemaking process can be lengthy.

Rucho's bill, SB 824, requires the DOR to adopt formal rules on forced combination through an expedited process that allows for public comment. Gov. Bev Perdue (D) signed the measure on June 20, suspending the DOR directive. (For SB 824, see Doc 2012-13485 or 2012 STT 123-15 .)

"We found a way for the rulemaking process to take 45 days," Rucho said. "We worked with the Department of Revenue and taxpayers to come up with a plan for an expedited rulemaking process that allows for public comment. This is a very open and transparent process that can be done in a very rapid manner and allow for clarity for taxpayers."

Delhaize and its fallout highlight various problems in previous revenue secretaries' exercise of their authority to force combination, according to Robert Shaw, an attorney in Williams Mullen's state and local tax practice group in Raleigh.

"These issues included the need for better statutory guidance for both taxpayers and the Department of Revenue, which the General Assembly addressed in HB 619, passed last year," Shaw said. "However, the department's directives raise questions as to how aggressively it may attempt to interpret that legislation."

DOR Aversion to Rulemaking

Despite the calls for more guidance, the DOR is standing by the substance of the directive.

"It is our intention to essentially convert the directive in the proper form for rules and to go forward with that," said DOR General Counsel Canaan Huie.

Huie said the department started working on a formal rule in 2010. The DOR can't impose related penalties until formal guidance is adopted. But because of pending legislation on the DOR's discretionary authority, along with changes to the state's rulemaking process generally, the DOR shifted its focus to issuing a directive to provide more timely guidance in the interim.

Huie said the DOR circulated the directive among select accounting firms and taxpayers and received mostly positive feedback.

"With any controversial matter, you're going to have some people that don't like the guidance that was given," Huie said. "Certainly there were some people that didn't like the guidance given, and they were successful in taking that to the General Assembly."

Huie said the list of factors for evaluating a transaction in the directive is as comprehensive as can be expected.

"We tried to get a long list of factors that would be considered on this particular issue," Huie said. "I don't think there is a yes/no answer or checklist we can give to taxpayers, but we certainly will try to give an exhaustive list of factors that will be considered. We tried to be as thorough as possible, but I don't think we could anticipate every scenario that would come up."

Rucho said he believes the DOR tried to provide guidance once lawmakers told the department it was important.

"Unfortunately, that directive really is a rule, and they need to go through a formal rulemaking process that allows for public comment," Rucho said.

He and the Republican majority that took over after the 2010 election have been focused more broadly on rulemaking and regulatory reform.

"If we find any agency calling a rule by any other name so that it doesn't have to go through the formal rulemaking process, when what they've issued is designed to give rules and is supposed to let our taxpayers know how they're supposed to act, then that's a rule and the agency should be following the Administrative Procedure Act," Rucho said.

North Carolina's formal rulemaking process was long ago designed to make the adoption of rules as difficult as possible so that only those that are truly necessary are on the books. The obstacles in the process make it especially difficult to adopt a complicated or controversial rule.

Sabra Faires, a former DOR assistant secretary for tax administration now in private practice at Bailey & Dixon LLP, Raleigh, said she believes the department's last serious attempt at rulemaking was on nexus and financial institutions in 1997. When that attempt failed, the DOR essentially abandoned efforts to provide guidance through formal rulemaking.

"It generally has been easier to get a law passed than to get a rule passed if the topic has been the least bit controversial," Faires said.

Cummings said a 1992 rule on intellectual property holding companies might represent the DOR's last important corporate tax rulemaking. Because of that simple administrative rule, the DOR was able to assert nexus over trademark holding companies, culminating in a victory in A&F Trademark Inc. et al. v. Tolson, et al., a case Cummings litigated. (For A&F Trademark, see Doc 2004-23413 or 2004 STT 239-18.)

"That proves it is good government to have formal rules, which in North Carolina requires administrative rulemaking," Cummings said, adding that not only does guidance provide clarity for taxpayers, but in that instance the rule helped the state win its case.

Huie noted that the department recently issued rules on the process for requesting an alternative apportionment formula, though he acknowledged that the DOR typically uses directives and bulletins instead.

"On a controversial issue it can take quite a while for a rule to become effective, even if it is adopted in accordance with the statute, receives approval of the Rules Review Commission, and the legislature decides not to overturn it," he said. "In some cases it certainly is more expedient for either the taxpayer or the department to try to get a law changed rather than go through the rules review process."

Rucho said lawmakers are waiting to see whether the expedited rulemaking process works well on forced combinations. "And if it does work, as we anticipate, then we look forward to all of the significant and more controversial rules going through the expedited process," he said.

Rulemaking Through Litigation

While they were all but abandoning formal rulemaking, revenue officials were relying more on litigation and collections.

"The way they've tended to proceed is interesting," Clodfelter said. "It's often by litigation precedent. The attorney general's office presence would take on a high-profile case and litigate. Instead of having published rules or published guidance, that court decision would become the operating guide by which taxpayers would ascertain a rule."

Upper management appears to have abdicated responsibility for setting tax policy to its auditors and litigators. "The Examination Division and the attorney general's office are driving the policy," Faires said.

Asked for comment, Noelle Talley, public information officer for the Department of Justice, said her department only provides advice "as required by state law."

"It is up to the client to decide whether or not to follow that advice," Talley said. She further noted that policy on administration of state tax laws is determined by DOR officials.

Others disagreed.

"There is some long-standing concern that the legal advisers to the department have been engaged in more than simply providing legal advice," Clodfelter said.

In other words, practitioners say, the attorney general's office appears to be pursuing something of a scorched-earth enforcement policy, aggressively litigating based on novel or expansive theories.

Regardless of how aggressive the litigators and auditors are, delegating policy to them can cause other problems: Lower-level employees may lack the perspective of more experienced executives with a broader understanding of how a policy can indirectly affect other stakeholders. And, of course, waiting for the courts to set policy is bound to consume time and resources that the state and the taxpayer could more productively spend elsewhere.

One place those resources could have been better focused, Clodfelter said, was on the backlog of assessments and audits that accumulated over the years because the department was too busy litigating to develop formal procedures.

"There were no rules of the road," Clodfelter said. "They made it up on an ad hoc basis."

Cummings agreed: "It's not that the revenue department has some rules it's not telling people. It's like the Wizard of Oz. They were making it up as they go along. And then they won the Wal-Mart case, at least through the Court of Appeals, which saddled the forced combination statute with a quite unusual interpretation."

Although A&F Trademark may have suggested to the DOR that publishing formal rules could be the key to successful enforcement, the message didn't stick.

"Then came the next generation of tax shelters," Cummings said, "the ones where finding nexus doesn't work."

In those cases, the DOR sought to deal with income shifting by turning to general statute section 105-130.6 to find discretionary authority to require a combined return of affiliated entities when the revenue secretary determined that the corporate return did not disclose "the true earnings" of the corporation on its business performed in North Carolina. The DOR never defined what "true earnings" were or provided guidance to auditors to help them determine what it meant.

Cummings concluded that the terminology had been extracted from a federal statute from the 1920s regarding consolidated returns, which he said "had essentially nothing to do with this," because consolidated filing is voluntary at the federal level but not in North Carolina. The DOR interpreted one sentence in that statute to give the DOR carte blanche to force combinations.

Auditors would see a year-to-year decline in a group's taxable income in North Carolina, and if a taxpayer had transferred assets, or workforce, or an intellectual property holding company to affiliates, resulting in more business being done out of state, the auditors would call that a shifting in income.

"And that was the end of the analysis," Cummings said. The DOR would force the taxpayer to combine because "that constituted a failure to properly reflect true income in the state," he said.

The typical tax bill was in the tens of millions of dollars, with penalties of 40 to 60 percent and high interest; for taxpayers with 10 years of returns, proposed assessments reached hundreds of millions, Cummings said. Most businesses weren't going to roll the dice by litigating such a huge assessment -- but Wal-Mart did. And it lost, though its case never reached the North Carolina Supreme Court. (For Wal-Mart Stores East Inc. v. Hinton, see Doc 2009-11461 or 2009 STT 95-22.)

After years of legal wrangling, the DOR was able to impose its assessment without providing any guidance. And taxpayers couldn't even use the court opinion for direction, because it simply deferred to the department's undefined assertion of discretionary authority.

Although the victory in A&F Trademark suggested that having guidance could be the key to upholding major assessments, Wal-Mart proved the opposite -- that the department was better off without published guidance.

The Delhaize court found that the DOR held the threat of litigation over taxpayers to "coerce" them into paying assessments rather than facing the prospect of steep penalties. Depending on whose figures are used, the DOR quickly brought in $300 million to $430 million in assessments.

"You can call that a transparency issue," Cummings said. "I call it running roughshod over the taxpayer."

Private Letter Rulings

Efforts to keep taxpayers from figuring out how to correctly pay their taxes have also manifested in the department's refusal to release its private letter rulings.

Letter rulings are not published -- with or without redactions -- so taxpayers looking to them for guidance are again forced to wait for litigation, when the rulings can become part of the public court record.

The Delhaize opinion demonstrated that shielding letter rulings from public scrutiny not only kept taxpayers from figuring out how to pay their taxes, but it also protected the DOR from defending rulings that were inconsistent and sometimes even self-contradictory.

In the context of forced combinations, letter rulings from the late 1980s to the mid-2000s demonstrated the variability in determining what constituted true earnings.

The DOR told one corporation it could deduct payments to affiliated companies if the payments satisfied the arm's-length standard in IRC section 482. An attorney general's opinion later laid out a broader standard. And then a later letter ruling said that arm's-length dealings may not preclude a forced combination after all.

The Delhaize court also noted that technical bulletins as late as 2008 stated that deductions between affiliates should be limited to amounts that "are reasonable in relation to the goods or services received therefor," even though it had been almost a decade since the DOR had stopped eliminating payments in excess of fair compensation and determining whether affiliated companies' charges to each other satisfied the arm's-length standard of section 482.

Tom Dixon, the DOR's assistant secretary for tax administration, blamed the discrepancy on large budget cuts in recent years. He said that the DOR's approach to updating its bulletins has been to give priority to areas with unresolved issues and release updated bulletins as those matters are resolved.

"We're in the process of rewriting the corporate income and franchise tax bulletins," Dixon said. "We know that we're lagging behind. Frankly, it's a resource issue."

He said it has been the department's long-standing practice not to publish redacted private letter rulings.

"Often, the information in the private letter ruling is very specific to a particular taxpayer," Dixon said. "Even if you redacted information, in many cases it would be very clear to those in the know who that taxpayer was, and so we have chosen not to publish those."

Still, the Senate Finance Committee has become aware of odd scenarios in recent years that might force the issue.

"We learned a number of taxpayers were getting oral advice from the department that was one way, and the taxpayer would follow it, but then there'd be an assessment or audit completely contrary to the advice they had relied on," Clodfelter said.

"So we required the department to start recording any telephonic advice they gave to taxpayers," Clodfelter said. "They were very resistant to that. We said, 'If you're not going to be giving them letter rulings, that's fine, but you're going to have to maintain a log of your advice because we have no record of what actually happened.'"

Clodfelter said those incidents, combined with the issue of forced combinations, would probably focus more attention on the DOR's general practice regarding letter rulings and guidance.


The DOR's lack of resources is in turn reducing taxpayers' resources for navigating the complexities of the state's system.

Taxpayers who use publicly available technical bulletins may find themselves using guidance that's been outdated for years. And those who seek out more specific advice may find themselves with a binding letter ruling that contradicts the guidance their competitors have been given.

The last source of reliably up-to-date guidance from the department -- final determinations published as a result of DOR administrative tax hearings -- may soon be going away as well. Those determinations are now being made by the Office of Administrative Hearings, raising questions about whether it or the DOR should publish the rulings, as well as the possibility that neither will.

That could mean that updated, binding guidance from the department may come only in the form of an opinion from a court considering an appeal of an administrative decision, forcing the state and taxpayers to spend still more time and money before they can figure out how to pay their taxes.

Alternatively, the state could provide more clarity by adopting mandatory unitary combined reporting, a recommendation made in the past decade by the Revenue Laws Study Committee, the Governor's Commission to Modernize State Finances, and the North Carolina Budget and Tax Center. But the General Assembly hasn't acted. And multistate corporate taxpayers oppose adoption of a statute, which gives rise to accusations like Tolson's -- that although it might be an exercise in good government to make the DOR go through a formal rulemaking process, taxpayers could use it to engineer around the law.

"In fact, they will," Faires said. "But the law is what it is; you can't not tell people what the law is."

There are also concerns that businesses might not really want a rule at all, hoping instead to stall until the arrival of a new administration that won't pursue forced combination.

"That's true," Clodfelter said. "But I would say even that leaves taxpayers with a high degree of uncertainty. Any informal agreement about the department's interpretation of the law could be subject to change in subsequent administrations."

Despite those difficulties, practitioners are pleased with some of the changes being made since the 2010 arrival of Revenue Secretary David Hoyle, a former co-chair of the Senate Finance Committee. They believe that his appointment of Huie as general counsel filled a vacancy that enabled the attorney general's office to wield the influence it has.

Clodfelter and Rucho both said they believe Hoyle is trying to move the department in the right direction.

"But he's tasked with changing some habits that have been ingrained over many, many years," Clodfelter said.

A year after Hoyle was sworn in, the governor announced that she wouldn't stand for reelection, meaning Hoyle and Huie may not get a chance to institutionalize the progress that has been made so far.

Amy Hamilton

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