Wal-Mart Stores, Inc. (“Wal-Mart”) structured its corporate organization such that an indirect subsidiary (the “Wal-Mart REIT”) owned the Wal-Mart stores located in North Carolina. These stores were operated by a different Wal-Mart entity, which paid rent to the Wal-Mart REIT.
The Wal-Mart entities did not pay North Carolina income taxes on the store rent for two reasons. First, the Wal-Mart REIT distributed its income to its shareholders (REITs generally do not pay an entity-level tax if they distribute their earnings to shareholders). Second, Wal-Mart REIT’s distributions of income were received by its ultimate shareholders, other Wal-Mart entities, as dividends that were not subject to North Carolina income taxes. Thus, the Wal-Mart entities claimed a tax deduction for the rent paid to the Wal-Mart REIT, but neither the Wal-Mart REIT nor the REIT’s ultimate shareholders (other Wal-Mart entities), paid North Carolina income taxes on the rent paid by the Wal-Mart stores.
All of this would appear consistent with North Carolina’s separate return reporting regime (i.e., each entity files its own separate, stand-alone income tax return). However, in this case, the State required that the earnings of the separate Wal-Mart entities be combined for income tax reporting purposes in order to present the “true earnings” of Wal-Mart’s business in the State.
The North Carolina Appellate Court’s Decision:
While North Carolina generally does not permit affiliated corporations to file a consolidated return, the State may require it where it is necessary to reflect the true earnings in the State. The relevant statutory language at issue in Wal-Mart Stores provides that:
The net income of a corporation doing business in this State that is a parent, subsidiary, or affiliate of another corporation shall be determined by eliminating all payments to or charges by the parent, subsidiary, or affiliated corporation in excess of fair compensation in all intercompany transactions of any kind whatsoever. If the State finds as a fact that a report by a corporation does not disclose the true earnings of the corporation on its business carried on in this State, the Secretary may require the corporation to file a consolidated return of the entire operations of the parent corporation and of its subsidiaries and affiliates, including its own operations and income. N.C. Gen. Stat. §105-130.6 (1999).
Authority to Require Combined Reporting. The overarching issue in Wal-Mart Stores was the ability of the State to force the combined reporting of taxable income of the Wal-Mart entities. Wal-Mart argued that the statute first required a finding that the corporation engaged in intercompany transactions in excess of fair value before the State could force combined reporting. However, the Court of Appeals held that the plain language of the statute does not limit the State’s authority to require combined reporting by first requiring a determination that intercompany transactions were conducted at amounts other than fair value. The Court found that the statutory language was broad, allowing the State to require combined reporting if it finds as a fact that a corporation’s tax return does not disclose its true earnings on its North Carolina business.
True Earnings. Wal-Mart argued that “true earnings” of a corporation must be construed as “what the taxpayer’s income would be if it had no affiliates and dealt with all parties on an arm’s length basis.” Accordingly, Wal-Mart argued that a corporation’s separate return will reflect true earnings if dealings are at arm’s length. The Court of Appeals rejected Wal-Mart’s proposed definition of true earnings and relied upon a line of cases from the United States Supreme Court that hold that “true earnings” refers to the limit on state taxation found in the United States Constitution. Under this definition, true earnings are calculated differently depending on whether the entity’s activities represent a discrete business enterprise or if the entire enterprise is a unitary business. If an entity’s intrastate activities amount to a discrete business enterprise, the net income of that discrete business enterprise represents the true earnings. However, if the entire enterprise is a unitary business, true earnings may be calculated by apportioning earnings of the entire enterprise. Accordingly, the Court held that in cases such as Wal-Mart Stores, where the business is concededly unitary, and where there are attempts to reclassify income as nonbusiness or nonapportionable, the reclassification has the potential to distort true earnings even if all intercompany transactions are accounted for at fair value, and thus rejected Wal-Mart’s proposed interpretation of the statute.
In affirming the North Carolina Superior Court’s Wal-Mart Stores decision, the North Carolina Court of Appeals affirmed the State’s broad statutory authority to force combined reporting if it is determined that a corporation’s tax return does not disclose the true earnings of the corporation on its North Carolina business. All corporations that operate their businesses through one or more related entities should consider the impact of this decision on the taxation of these entities in North Carolina and the issues that may be raised upon the audit of any of their entities.
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