United States: NJ Court: Consolidated Rules Apply To Separate-Company Return

Last Updated: June 20 2018
Article by David J. Gutowski, Kyle O. Sollie and Matthew L. Setzer

At a Glance...

The Tax Court of New Jersey's decision in MCI Communication Services, Inc. v. Director, Division of Taxation,1 which involved the coordination of federal cancellation of indebtedness and consolidated return rules with the corporation business tax, has been affirmed by the New Jersey appellate court.

Background

The taxpayer at issue ("Taxpayer") was a corporate subsidiary of MCI, Inc. ("MCI"). For federal income tax purposes, Taxpayer filed as part of the MCI consolidated group. As a result of Chapter 11 bankruptcy proceedings, MCI had cancellation of indebtedness income ("CODI") of $25 billion. Although MCI was able to exclude that CODI from its federal consolidated income, it was required under I.R.C. § 108(b) to reduce its tax attributes by the same amount. Of the $25 billion of CODI, only $71 million was related to debt owed directly by Taxpayer. But because its upper-tier affiliates' tax attributes were insufficient to absorb the CODI, the federal consolidated return rules required Taxpayer to reduce its tax attributes by $3.6 billion. For the 2005 tax year, this resulted in Taxpayer having $271 million less depreciation deductions for consolidated federal income tax purposes. 

In reporting its 2005 New Jersey corporation business tax ("CBT"), Taxpayer started with its share of consolidated federal taxable income as reflected on the consolidated MCI return—which excluded the $271 million of depreciation deductions. New Jersey is a separate-company state, however. And under N.J.A.C. 18:7–11.15, a taxpayer subject to CBT that files as part of a consolidated return for federal income tax purposes "must reflect its entire net income . . . as if it had filed its Federal return on its own separate basis." Accordingly, Taxpayer computed its separate company taxable income by claiming the $271 million of depreciation deductions that had been disallowed on the consolidated return solely because of the federal consolidated return rules.

The New Jersey Division of Taxation ("Division") rejected this computation and Taxpayer appealed. In July 2015, the New Jersey Tax Court ruled in favor of the Division,2 reasoning that Taxpayer had to incorporate in its separate-company computation the amounts used in its consolidated return. In effect, the court applied federal consolidated return rules to a state income tax that specifically prohibits taxpayers from filing on a consolidated basis. To resolve this clear contradiction, Taxpayer appealed the Tax Court's decision to the appellate court.

Appellate Court Decision and Takeaways

The appellate court heard oral argument in early 2017. Because over a year had passed without a decision from the court, some observers were anticipating a reversal or at least a detailed analysis of the issues. Instead, the appellate court affirmed the Tax Court decision without any additional explanation. It merely stated that: "We affirm substantially for the reasons expressed by Judge Kathi F. Fiamingo in her letter opinion dated July 20, 2015." 

Because the appellate court's decision provided no additional analysis, it's worth revisiting the implications of the Tax Court's July 2015 decision:

  1. Federal Taxable Income's Link to Entire Net Income: The Tax Court noted that the tax base for New Jersey's CBT is "inextricably linked" to federal taxable income.3  Because the legislature did not permit an "adjustment" to federal taxable income on account of CODI, the court ruled against the taxpayer.4 But this rationale ignores the Division's own regulations,5 which require a taxpayer that is included in a federal consolidated return to complete its CBT returns as if it had filed its federal income tax return on a separate basis. In light of recent decisions,6 it's not surprising that the court reasoned that taxpayers cannot adjust their federal taxable income without express statutory authorization. (Adjusting as-reported federal taxable income—that is adjusting what appears on Line 28—is permitted only through statutory authorization in New Jersey.) But this begs the question whether—in this case—Taxpayer's as-reported federal taxable income was correct in the first place. Indeed, the rhetoric in the Tax Court's opinion focused on the mechanics of return presentation more than the mechanics of the legal distinction between separate and consolidated taxable income. If tax-return presentation was the underlying motivation for the decision, a taxpayer in a consolidated group may still be able to follow the Division's regulation, and prepare its New Jersey return—including the reporting of its federal taxable income on that return—"as if" it had filed its federal return on a separate basis.  
  2. Is MCI's loss a win for other taxpayers? In MCI, applying the federal consolidated return rules resulted in a tax increase for the taxpayer at issue. But in some instances, taxpayers may be able to benefit from applying the consolidated return rules in computing their entire net income for purposes of the CBT. For example, taxpayers may be able to defer intercompany gain8 or increase their basis in the stock of a disposed-of subsidiary.
  3. Impact on Interest Limitation Under the Tax Cuts and Jobs Act. Under I.R.C. § 163(j), as amended by the Tax Cuts and Jobs Act, the deduction for business interest is limited to the sum of the taxpayer's: business interest income; 30% of adjusted taxable income; and floor plan financing interest. In Notice 2018–28, the IRS stated that it intends to apply the business interest limitation rules at the level of the consolidated group. As a result, for purposes of the limitation, a consolidated group's taxable income will be its consolidated taxable income and intercompany obligations will be disregarded. Arguably, in light of MCI, the federal taxable income that a taxpayer must use to compute its New Jersey CBT should reflect the business interest limitation on a consolidated basis rather than on a separate-company basis. 

Footnotes

1 See Docket No. A–5735–14T3 (June 15, 2018).

2 MCI Communication Servs., Inc. v. Director, Division of Taxation, 2015 WL 4537743, at *5 (N.J. Tax July 20, 2015).

3 Id.

4 See N.J.S.A. 54:10A–4(k)(2).

5 See N.J.A.C. 18:7–11.15.

6 See generally Infosys Limited of India Inc. v. Director, Division of Taxation, 2017 WL 5907704, at *4 (N.J. Tax Nov. 28, 2017); International Business Machines Corp. v. Director, Division of Taxation, 26 N.J. Tax 102 (N.J. Tax 2011).

7 N.J.A.C. 18:7–11.15.

8 See Treas. Reg. 1.1502–13.

9 See Treas. Reg. 1.1502–32.

This article is presented for informational purposes only and is not intended to constitute legal advice.

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