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COA Issues Significant Tax Decision Upholding Secretary's Authority To Force A Combination Of Corporate Entities For Tax Purposes

By Sean E. Andrussier

Today the Court of Appeals (COA) issued a significant tax decision for corporations that stratify their operations into multiple entities. The case dealt with the power of the Secretary of Revenue to force a combination of the corporate entities for purposes of reporting taxable income. The COA ruled in favor of the Secretary. The case is Wal-Mart Stores East, Inc. v. Hinton. (A related ruling today is Sam's East, Inc. v. Hinton, which simply relies on the Wal-Mart ruling to uphold the Secretary's forced combination.)

The case concerned Wal-Mart. In 1996 Wal-Mart reorganized its corporate structure, fracturing into multiple entities. Plaintiff is one such entity. It operates Wal-Mart Stores stores in North Carolina and in 29 other states. Plaintiff owns companies that own Wal-Mart Property Company (PC), which in turn owns all the voting units of Wal-Mart Real Estate Business Trust (REIT), which came to own all real property for Wal-Mart store premises. Plaintiff leased land and buildings from the REIT for store premises, and for tax purposes Plaintiff deducted those rents that it paid the REIT. The REIT's rental income passed upstream to PC in the form of dividends. The REIT deducted those dividend payments from its income on its N.C. tax returns. PC then paid dividends to Plaintiff, which Plaintiff subtracted from its business income. PC didn't file returns in N.C. because it doesn't do business here.

Plaintiff reported corporate income tax separately. After an audit, however, the Secretary determined that the earnings of Plaintiff must be combined with REIT and PC in order to present true earnings in N.C. The combination approach substantially increased Plaintiff's tax and the aggregate N.C. tax owed by the three companies separately (one of which, PC, didn't even do business in N.C. and thus had no prior reported tax liability here).

Plaintiff filed an action demanding a refund of taxes paid: about $30 million. The gravamen of the complaint was that the Secretary had no authority to force a combination of Plaintiff with the other two affiliates for the purpose of reporting taxable income.

Plaintiff complained that the Secretary had never published any guidance indicating that a corporation may not deduct rents it pays to a related real estate trust. Plaintiff argued that "[a] combined return effectively treates multiple corporations, which are viable and separate legal persons, as a single unit and thus eliminates the effects of transactions between those separate legal entities; this occurs because the income and deduction items for the two sides of a transaction cancel each other or are disregarded. Plaintiff maintained that "no North Carolina court had ever held that related entities may be required to file a combined return if intercompany transactions are performed at arm's length."

The COA, however, held that the Secretary had the power to force the combination: "where a taxpayer's business is concededly unitary, and where, as here, the taxpayer attempts to reclassify income as nonbusiness or nonapportionable, the reclassification has the potential to distort true earnings in North Carolina even if all intercompany transactions are accounted for at arm's length, or fair value, prices," the COA concluded. After concluding that the Secretary didn't exceed his statutory authority, the COA rejected Plaintiff's numerous constitutional challenges to the forced combination.

Today's decision upholding the Secretary's combination authority may have significant consequences for a number of businesses using fragmented corporate structures.

Full post as published by North Carolina Appellate Blog on May 19, 2009 (boomark / email).