In a decision released July 20, the Tax Court of New Jersey ruled that a company included in a federal consolidated income tax return could not adjust its entire net income (ENI) for New Jersey Corporation Business Tax (CBT) purposes to reverse the impact of a reduction in tax attributes required by Internal Revenue Code (IRC) Section 108(b) and the federal consolidated return regulations.1
Background
The taxpayer, MCI Communication Services, Inc. (MCIC), was a wholly-owned subsidiary of MCI, Inc. (MCI), the surviving entity after a 2004 corporate reorganization. In 2002, MCI's predecessor, Worldcom, Inc. (Worldcom) filed a Petition for Reorganization pursuant to Title 11 of the U.S. Bankruptcy Code on behalf of itself and its subsidiaries. Upon emerging from bankruptcy in April 2004, Worldcom merged into MCI, and a substantial amount of the debt of MCI and its affiliated entities (MCI Group) was cancelled. For federal income tax purposes, the income from the cancellation of indebtedness (CODI) which resulted from the bankruptcy was excluded from the income of the members of the MCI Group. As required by the IRC, members of the MCI Group reduced some of their federal tax attributes by the aggregate amount of the excluded CODI. Because Worldcom itself had limited tax attributes, "lower-tier" members of the group, including MCIC, were required to take into account a portion of the CODI of "upper-tier" members and to reduce their tax attributes with respect to the "pushed down" CODI.
For the 2005 tax year, MCIC consented to file consolidated returns for federal income tax purposes with the MCI Group and recognized $271,144,051 in income solely as a result of the pushed-down CODI. On its 2005 CBT return, MCIC reported a $1,142,454 refund, based on a deduction of $271,144,051 included as an other deduction and labeled "Reversal of Federal Attribute Reduction Turn."
The New Jersey Division of Taxation disallowed the deduction and issued a final determination on July 24, 2007 that was ultimately upheld, and MCIC appealed the final determination to the Tax Court.
Division's Disallowance of Deduction to Reverse Effect of Reduction in Tax Attributes
MCIC argued that if ENI were reflected "as if it had filed its Federal return on its own separate basis" as required by New Jersey law, the adjustments to basis for CODI of upper-tier members would not have been made and MCIC's income would not have been increased as a result. Therefore, MCIC was compelled to calculate its ENI for CBT purposes as if the CODI of the upper-tier members had not been attributed to MCIC, and the "federal attribute reduction turn" deduction reflected this calculation. Alternatively, MCIC argued that disallowance of the deduction for the federal attribute reduction turn created and taxed phantom income. Finally, MCIC argued that there were no provisions in the CBT or the related regulations requiring the reduction of tax attributes in connection with the discharge of indebtedness and, therefore, it should have been permitted to adjust the IRC Section 108(b) tax attribute reductions created by the allocation of upper-tier members' CODI.2
ENI Calculation
The New Jersey CBT requires that all non-exempt domestic and foreign corporations pay an annual franchise tax for the privilege of having or exercising a corporate franchise in New Jersey, or for the privilege of deriving receipts from sources within New Jersey, or for the privilege of doing business, employing capital or owning capital or property, or maintaining an office in New Jersey.3 The franchise tax is generally based on the greater of an alternative minimum assessment or a percentage of the corporation's ENI, which is a measure of federal taxable income.4
Generally, for federal income tax purposes, gross income includes income from the discharge of indebtedness.5 However, an exclusion from income is provided for CODI otherwise includable in income where the discharge occurs as part of a Title 11 bankruptcy.6 If the CODI is excluded from income, a reduction of certain tax attributes of the discharged taxpayer is required to the extent of the excluded CODI.7 As a result, a discharged taxpayer generally takes the excluded CODI into income through the reduction of tax attributes such as net operating losses, tax credits, or the basis in assets which would otherwise generate deductions such as depreciation.
In the case of a taxpayer filing a consolidated federal income tax return, if the parent company has limited tax attributes, the federal consolidated return regulations in effect during the tax year at issue required the parent company to effectively "push down" the CODI that exceeded its tax attributes to reduce its subsidiaries' attributes to the full extent of the CODI, or until there were no remaining attributes left to absorb.8
In this case, both MCIC and the Division agreed that the result of the CODI attributed to the taxpayer from upper-tier members of the MCI Group and the resulting reduction in tax attributes was an increase in taxable income of $271,144,051. The taxpayer contended that its New Jersey ENI should be reduced by an equal amount, but the Division disagreed.
New Jersey does not allow for the filing of consolidated income tax returns, but instead generally requires each entity in a corporate group with activity in New Jersey to file a separate corporate business tax return.9 Specifically, where a taxpayer is a member of a group that files a consolidated income tax return for federal income tax purposes, the taxpayer must complete and file its own return under the CBT and must reflect ENI as if it had filed its federal income tax return on a separate basis.10
In this case, MCIC included in its unconsolidated federal taxable income, before net operating loss deductions and special deductions, the attribute reduction amount of $271,144,051. On its CBT return, MCIC claimed such amount as a deduction to reverse the "federal attribute reduction turn."
MCIC argued that, but for the filing of a consolidated return for federal income tax purposes, there would have been no required reduction of its tax attributes by the amount of the CODI pushed down to it from upper-tier members. Noting that "ENI for New Jersey CBT purposes is inextricably linked to federal taxable income," the Court rejected MCIC's position.
For support, the Court turned to a previous case which considered whether an election to treat a stock sale as an asset sale11 available to federal consolidated income tax filers was recognizable for New Jersey CBT purposes. At issue was whether the "deemed sale" of a subsidiary's assets to itself was a taxable event. In that instance, the Court ruled that the taxpayer was required to recognize the election and the gain, noting that New Jersey's prohibition against consolidated returns "merely requires that the tax consequences be independently reported."12 Thus, the Court determined that the gain from the deemed sale must be independently reported and recognized by the subsidiary at issue, noting that "the parties made the...election and are bound to accept the consequences which flow from it...."13
Finding no perceptible difference between that issue and the current case, the Tax Court found that as MCIC consented to the federal consolidated return filing, MCIC was required to take into account the excess CODI from upper-tier members of the group which increased MCIC's federal taxable income.
Phantom Income
MCIC further argued that the disallowance of the deduction for the "federal attribute reduction turn" created and taxed so-called "phantom income," contradicting reasoning previously applied by the Tax Court. In the referenced case, the Tax Court permitted a corporate taxpayer to increase its basis by the amount of the bonus depreciation allowed under federal law which was not permitted under the New Jersey CBT and for which the plaintiff had received no benefit, when calculating the gain on a sale of depreciable assets.14 In that instance, the Tax Court had depended upon a New Jersey Supreme Court decision which held that where a taxpayer's federal adjusted basis reflected losses allowed under federal income tax law which were not allowed under the New Jersey Gross Income Tax, the taxpayer was entitled to determine gain by increasing its basis by the amount of unutilized losses.15 In that decision, the Supreme Court relied upon its interpretation of the provision defining net gains for New Jersey Gross Income Tax purposes, and the concept that a taxpayer may not be taxed on the return of capital, noting that the legislature intended to tax only income.16
Both cases referenced by MCIC involved the determination of how to treat the gain on a sale of assets and the potential taxation of a return of capital. Distinguishing between those cases and the current issue, the Tax Court noted that "in those cases, there was an inequality of treatment between federal and New Jersey law, while in the matter now before the court the same benefit (or lack thereof) accorded to plaintiff under federal law is identical to that being accorded plaintiff under New Jersey law." Thus, the Tax Court rejected MCIC's application of the "phantom income" rationale.
No New Jersey Requirement to Reduce Tax Attributes
MCIC's final argument focused on the fact that no specific New Jersey provision requires the reduction of tax attributes as a result of "pushed down" CODI. Instead, MCIC suggested decoupling from the tax attribute calculation by referencing a position stated in a New Jersey newsletter, which stated: "[t]he New Jersey net operating loss deduction is calculated independently of the Federal tax attributes,17 and at the present time there is no provision to reduce tax attributes connected with discharge of indebtedness. Thus, New Jersey would not require the corporation to reduce New Jersey net operating loss with respect to discharge of indebtedness for corporation business tax purposes."18
Rejecting MCIC's position, the Tax Court distinguished the reduction referenced in the Division's newsletter from the reduction at issue. Specifically, the reduction in the newsletter dealt with net operating losses while the reductions at issue for the taxpayer related to the tax basis of certain assets. Since ENI is defined with reference to federal taxable income, before the net operating loss deduction, net operating losses are excluded from the determination of a taxpayer's ENI. In contrast, the tax effect of the reductions in basis required by IRC Section 108(b) are taken into account in computing ENI. Although New Jersey does not separately require any IRC Section 108(b) reduction to any tax attributes, the Division's newsletter was found to have no bearing on the effect of the federal requirement that taxable income be calculated with reference to all reductions in tax attributes required by IRC Section 108(b).
Commentary
The Tax Court's divergence from the general notion that in a separate reporting state, the starting point in determining ENI is federal taxable income computed on a separate entity basis is somewhat troubling. The impact of this decision could be significant, potentially extending to many of the required adjustments for federal consolidated income tax return purposes. The Tax Court may see further controversies in this area seeking reconciliation of this decision with the cases referenced by the taxpayer that distinguished between consolidated concepts and the need to adjust in a separate reporting environment. Barring a successful appeal, this decision certainly leaves taxpayers filing federal consolidated returns with some uncertainty regarding the correct calculation of ENI.
Taxpayers who received CODI in privilege periods ending before or on June 30, 2014 and have taken the position that their New Jersey CBT attributes should not be reduced at all because of the Division's guidance in its newsletter regarding net operating losses should consider reviewing that position in light of the Tax Court's willingness to limit such guidance to the net operating loss attribute. It should be noted that for privilege periods ending after June 30, 2014, any newly created NOL or carryovers are specifically required to be reduced if CODI is received, superseding the Division's guidance in its newsletter.19
Footnotes
1 MCI Communication Services, Inc. v. Director, Division of Taxation, New Jersey Tax Court Dkt. No. 013905-2010, Jul. 20, 2015.
2 Id.
3 N.J. REV. STAT. § 54:10a-2.
4 N.J. REV. STAT. § 54:10a-5. Specifically, ENI is defined as "total net income from all sources, whether within or without the United States, and shall include the gain derived from the employment of capital or labor, of from both combined, as well as profit gained through a sale or conversion of capital assets. For the purpose of this act, the amount of a taxpayer's entire net income shall be deemed prima facie to be equal in amount to the taxable income, before net operating loss deduction and special deductions, which the taxpayer is required to report, or, if the taxpayer is classified as a partnership for federal tax purposes, would otherwise be required to report, to the United States Treasury Department for the purpose of computing its federal income tax." N.J. REV. STAT. § 54:10a-4(k).
5 IRC § 61(a)(12).
6 IRC § 108(a)(1)(A).
7 IRC § 108(b)(1).
8 TEMP. TREAS. REGS. § 1.1502-28T(a). Final regulations which include certain exceptions and available elections [§ 1.1502-28(d)] were adopted March 22, 2005, applicable to discharges of indebtedness that occur after March 21, 2005.
9 N.J. ADMIN. CODE tit. 18, § 7-11.15.
10 Id.
11 Such election is commonly referred to as an IRC § 338(h)(10) election, referencing the relevant authority granting the ability to make the election.
12 General Building Products Corp. v. New Jersey, Division of Taxation, 14 N.J. Tax 232 (Tax 1994), aff'd., 15 N.J. Tax 213 (App. Div. 1995).
13 Id.
14 Toyota Motor Credit Corp. v. Director, Division of Taxation, New Jersey Tax Court Dkt. No. 002021- 2010, Aug. 1, 2014. For further details, see GT SALT Alert: New Jersey Tax Court Allows Taxpayer to Revise Federal Adjusted Basis for Corporation Business Tax Purposes.
15 Koch v. Director, Division of Taxation, 722 A. 2d. 218 (N.J. 1999).
16 N.J. REV. STAT. § 54A:5-1(c), which defines net gains for New Jersey Gross Income Tax purposes.
17 N.J. REV. STAT. § 54:10a-4(k)(6).
18 New Jersey State Tax News, Corporation Business Tax – Forgiveness of Debt, Winter 1996.
19 N.J. REV. STAT. § 54:10A-4(k)(6)(F).
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