North Carolina Tax Reform (2015 Edition)
North Carolina’s General Assembly is continuing the overhaul of the State’s tax system that it began in 2013. That year, the General Assembly slashed corporate and individual tax rates, eliminated many income tax deductions and credits and repealed numerous sales tax exemptions, special rates, holidays and refunds. It was all part of a plan to lower rates, expand the tax base and move N.C. decisively toward a consumption-based tax system.
The tax legislation enacted by the 2015 General Assembly is modest only in comparison with the 2013 sea change. This year, the General Assembly has further reduced the corporate and personal income tax rates, phased-in single sales factor apportionment for multistate corporations, simplified the franchise tax base, increased the standard and itemized deductions for individual taxpayers, expanded the sales tax base to include repair, maintenance and installation services and adopted tax incentives for datacenters, interstate air businesses, motorsports and historic preservation.
This Tax Alert summarizes the more important tax provisions enacted thus far in the General Assembly’s 2015 Regular Session. Most of the changes discussed below were included in the 2015 Appropriations Act signed by the Governor on September 18 and the N.C. Competes Act, which was ratified on September 24. The General Assembly is still in session and additional tax legislation could be enacted. In particular, a technical corrections bill is still being considered, as well as a bill creating an Employee Classification Division within the Department of Revenue tasked with investigating and penalizing worker misclassification cases.
Outline of Contents
Corporate Income Tax Changes
Repeal of Obsolete Adjustments
Affiliate Interest Expense Limitation
Limits on Adjustment for Expenses Related to Untaxed Dividends
Single Sales Factor Phase-in
Market-based Sourcing Study
Franchise Tax Changes
Replacement of Capital Stock Base
Minimum and Maximum Tax Increases
Personal Income Tax Changes
Restoration of Medical Expense Deduction
Increase Standard Deduction
Sales Tax Changes
Taxation of Repair, Maintenance and Installation Services
Sales Taxes on Aircraft and Qualified Jet Engines
Service Contracts, Parts and Labor on Qualified Aircraft and Qualified Jet Engines
Aviation Fuel Incentives
Historic Preservation Tax Credit
NC Wage Statement
Bankruptcy Interest Waivers
Selected Additional Changes
Repeal of Bank Privilege Tax
New Property Tax Exclusion
Grandfathered Mill Rehabilitation Projects
Grandfathered Renewable Energy Projects
What Did Not Happen
Corporate Income Tax Changes
Rate Reduction. In 2013, the General Assembly lowered the corporate income tax rate from 6.9% to 6% for 2014 and to 5% for 2015. At the same time, the General Assembly provided for further automatic rate reductions to 4% if general fund revenues hit a target of $20.2B in the 2014-15 fiscal year and to 3% if general fund revenues hit a target of $20.975B in the 2015-16 fiscal year. The general fund target for 2014-15 was exceeded, and the rate reduction to 4% for 2016 has been codified. In addition, the 3% rate trigger has been made permanent, so that the rate will drop to 3% for the year following the attainment of the $20.975B revenue target, whenever that may occur.
Repeal of Obsolete Adjustments. A number of adjustments required to be made to federal taxable income in computing state net income have been eliminated as obsolete, beginning in 2016. These repealed adjustments are the deductions for (1) excess amortization on sewage or waste treatment plants and certain solid and hazardous waste reduction and recycling equipment, (2) depreciation of pre-1955 emergency facilities, (3) commercial reforestation and recultivation expenses, (4) certain income of international banking facilities, (5) marketing assessments with respect to N.C.-grown tobacco, (6) tobacco settlement trust income, (7) payments received from the N.C. Hurricane Floyd Reserve Fund, (8) payments received from the N.C. Disaster Relief Reserve Fund, (9) interest earned by S&L associations on FHLB deposits and (10) amortization of certain air-cleaning devices, waste treatment facilities and recycling facilities.
Affiliate Interest Expense Limitation. Beginning in 2016, a new limitation will be placed on deductions for net interest paid to affiliates. A corporation may not deduct net interest paid to affiliates that exceeds 30% of the taxpayer’s adjusted taxable income. Exceptions are provided where the affiliate is a bank or is taxable on the interest received in N.C., in another state or (if the affiliate is a foreign entity) in its country of residence, provided that country has an income tax treaty with the U.S. Note that there is no general exception for conduit arrangements where one member of the affiliated group borrows from outside lenders and re-lends to other members of the group.
Limits on Adjustment for Expenses Related to Untaxed Dividends. N.C. does not allow corporations to deduct expenses related to income that is exempt from N.C. tax. With respect to untaxed dividends received, N.C. has historically limited the required expense adjustment to 15% of the dividend amount. However, different limitations have applied to bank and electric power holding companies. These special limitations have been repealed, beginning in 2016. As a result, these holding companies, like other corporations, will be subject to the general 15% limitation.
Single Sales Factor Phase-in. N.C. will phase in single sales factor apportionment over a three-year period beginning in 2016. Under current law, a multistate corporate taxpayer apportions its business income to North Carolina by multiplying such income by the average of three factors representing the proportion of its total property, payroll and sales that are located in or sourced to N.C. In 1989, N.C. began to double-weight the sales factor in an effort to reduce the implicit penalty on taxpayers with substantial investment and employees in the State. Under the single sales factor phase-in, the sales factor will be given triple weight in 2016 and quadruple weight in 2017. In 2018, the property and payroll factors will be repealed altogether, and business income will be apportioned solely by reference to the sales factor. For more information about single sales factor, click here.
Market-based Sourcing Study. Increasing the weight given to the sales factor in the apportionment formula naturally focuses attention on the rules for determining the source of sales revenue. Indeed, the sourcing rules become the centerpiece of the entire apportionment system. The General Assembly has directed the Revenue Laws Study Committee to study the adoption of market-based sourcing rules.
N.C. has long followed market-based sourcing rules to source receipts from sales of tangible personal property by sourcing such receipts to the place where the property is ultimately received by the purchaser. With respect to sales of services, however, N.C. currently sources the taxpayer’s income from such sales based on where the taxpayer performs the activities that generate the revenue. This usually means the place where the taxpayer’s property and employees are located. This rule arguably defeats the whole purpose of the sales factor by sourcing revenue to the location of the taxpayer’s property and workforce rather than the location of its customers. With respect to income from intangibles, North Carolina’s tax statutes provide no clear guidance, and the Department has issued rules that in some cases attempt to identify the place where intangibles are used and in other cases look to the commercial domicile of the payor.
The General Assembly considered enacting market-based sourcing rules for sales of services and income from intangibles to compliment the move to single sales factor apportionment. Drafting rules that work for taxpayers in different industries proved to be difficult, and, in the end, the legislature decided to leave the existing rules in place until the matter could be studied more thoroughly. The study to be undertaken by the Revenue Laws Study Committee is expected to recommend adoption of rules based on guidelines drafted by the Multistate Tax Commission.
To help the Revenue Laws Study Committee determine the impact of market-based sourcing rules, multistate corporations filing in N.C. that have more than $10M in apportionable income will be required to attach to their 2015 returns an informational report showing what their 2014 sales factors would have been under market-based sourcing principles. The Department is required to promulgate a form to be used by taxpayers for this purpose. Taxpayers who fail to file the informational report are subject to a $5,000 fine. For more information about market-based sourcing, click here.
Franchise Tax Changes
Replacement of Capital Stock Base. The franchise tax capital stock base has been replaced by a net worth base, effective for 2017.
Net worth is defined as total assets less total liabilities computed in accordance with GAAP or, for non-GAAP filers, in accordance with the taxpayer’s federal tax accounting methods. In calculating its net worth, the taxpayer may deduct depreciation and amortization as computed for federal tax purposes and the cost of treasury stock and must add back debt owed to affiliates.
All other adjustments required under current law in computing the capital stock base will no longer apply in computing net worth. For instance, taxpayers will no longer be required to add back billings in excess of costs or reserves for liabilities that are not considered “definite and accrued legal liabilities.”
Both the existing capital stock base and the new net worth base require adjustments for affiliated indebtedness. Under current law, affiliated indebtedness generally must be added back to the capital stock base, but an exception is provided to the extent the creditor corporation borrowed a portion of its own capital from third parties. Under the new net worth base, the add-back has been expanded to cover the indebtedness owed to unincorporated affiliates.
Minimum and Maximum Tax Increases. Beginning in 2017, the minimum franchise tax will be increased from $35 to $200, and the maximum franchise tax on holding companies will be increased from $75K to $150K.
Apportionment. Like the current capital stock base, the net worth base must be apportioned using the same apportionment formula used for income tax purposes. As a result, the move to single sales factor apportionment should reduce the N.C. franchise tax liability of multistate taxpayers with substantial investment and payroll in North Carolina.
Personal Income Tax Changes
The General Assembly has enacted three personal income tax relief provisions: restoration of the medical and dental expense deduction for itemizers in 2015, an increase in the standard deduction in 2016 and a rate reduction in 2017.
Restoration of Medical Expense Deduction. Before the 2013 tax reform legislation, the N.C. itemized deduction was based on the federal itemized deduction amount. As part of the base expansion enacted in 2013, N.C. itemized deductions were limited to charitable deductions and mortgage interest and real property taxes paid with respect to a qualified residence (with the deduction for mortgage interest and real property taxes limited to $20,000 in the aggregate). The inability to include federally deductible medical expenses in computing the N.C. itemized deduction left some, especially older, taxpayers with higher tax bills despite the drop in the tax rate. Beginning with the 2015 tax year, N.C. itemizers may once again include the amount allowed under IRC sec. 213 for medical and dental expenses in their N.C. itemized deduction.
Increase in Standard Deduction. Beginning in 2016, the N.C. standard deduction will increase from $15,000 to $15,500 for married taxpayers filing jointly, from $12,000 to $12,400 for heads of households, and from $7,500 to $7,750 for single taxpayers and married taxpayers filing separately.
Rate Reduction. Beginning in 2017, the personal income tax rate will drop from 5.75% to 5.499%.
Withholding. To help reduce the incidence of employee underwithholding, the Secretary is authorized to issue new withholding tables beginning in 2016 that assume a tax rate equal to 100.1% of the actual rate.
Sales Tax Changes
Taxation of Repair, Maintenance and Installation Services. Beginning March 1, 2016, the sales tax base is expanded to include repair, installation and maintenance services (“RMI services”). RMI services are services performed to determine what needs to be done to keep tangible personal property in working order, to keep such property in working order and to restore such property to working order. Tangible personal property for this purpose specifically includes motor vehicles. RMI services also include services to install or apply tangible personal property. The base expansion legislation includes a number of exceptions and special rules, not all of which are entirely clear:
Persons Not Otherwise Engaged in Retail Trade. The definition of a “retailer” liable for sales tax is amended to exclude a person whose only business activity is performing such services and who otherwise derives less than half of its revenue from retail sales. The General Assembly apparently intended this provision to limit the base expansion to persons who are already retailers and thus already in the sales tax system. While the scope of the exception is unclear, it may permit some taxpayers to segregate their RMI services into separate entities in order to avoid becoming subject to the tax.
Real Property Contractors. The definition of a “retailer” has also been amended to exclude a person that solely operates as a real property contractor. Thus, a person who operates as a real property contractor by installing tangible personal property onto real property and who does not also sell tangible personal property at retail will not become a retailer and so will not be swept into the sales tax system. In addition, RMI services specifically exclude installation services performed by a real property contractor pursuant to a real property contract. Thus, even a real property contractor who also makes retail sales of tangible personal property (and who is therefore already in the sales tax system) will not be required to pay tax on receipts from installation services performed as part of a real property contract.
Other Specific Exemptions. The following services that would otherwise be taxable as RMI services are specifically exempt:
- services purchased for resale;
- services (along with replacement and repair parts) provided under dealer or manufacturer warranties;
- services performed with respect to property (other than a motor vehicle) that is exempt from sales tax;
- services performed on utility network assets;
- services performed on certain motorsports racing team property;
- services performed on property subject to the 1% mill machinery privilege tax; and
- services performed on certain jet aircraft and jet engines.
Motor Vehicles. There are several special rules relating to motor vehicle services and service contracts:
- RMI services performed on motor vehicles are taxable even though motor vehicles are subject to the Highway Use Tax rather than the sales tax.
- Service contracts on motor vehicles are exempt from the sales tax beginning March 1, 2016. Motor vehicle owners will therefore be incentivized to purchase service contracts to avoid sales tax on maintenance and repairs.
- Service contracts on motor vehicles remain exempt from the Highway Use Tax as long as the charge for the service contract is separately stated on the bill of sale or similar documentation.
- Services as well as repair and replacement parts provided pursuant to a dealer’s or manufacturer’s warranty are exempt. This provision applies specifically to motor vehicle warranties as well as warranties on other types of tangible personal property.
Sales Taxes on Aircraft and Qualified Jet Engines. Under current law, sales of aircraft are subject to tax at a 3% rate with a $1,500 cap. Effective October 1, 2015, aircraft sales will be taxed at the general rate with a cap of $2,500. In addition, sales of qualified jet engines (i.e., jet engines certified pursuant to Part 33 of Title 14 of the CFR) will also be taxed at the general rate, but the tax will be capped at $2,500 if the purchaser obtains a direct pay permit.
Service Contracts, Parts and Labor on Qualified Aircraft and Qualified Jet Engines. Service contracts on a qualified aircraft (i.e., those with a maximum takeoff weight of between 9,000 and 15,000 pounds) and qualified jet engines are exempt from the sales tax effective October 1, 2015. In addition, parts and accessories used in the repair and maintenance of qualified aircraft and qualified jet engines are exempt from sales tax effective October 1, 2015.
Compliance Provisions. Adjusting to the taxation of RMI services will prove difficult for many taxpayers and will doubtless result in delinquencies and assessments especially in the first few years after the new law becomes effective. The Secretary is authorized to compromise a tax liability arising from a failure to collect the tax on RMI services provided that the taxpayer made a good faith effort to comply with the law. This compromise authority applies only to assessments made on or before July 1, 2020.
In addition to North Carolina’s incentive grant programs (JDIG and ONE NC), the General Assembly has revived, extended or enacted several tax-based incentives for datacenters, interstate air businesses, motorsports teams and owners of historic structures.
Datacenter Incentives. Under prior law, datacenter machinery and equipment was exempt from sales tax and subject instead to the 1% mill machinery privilege tax with a per-article cap of $80. These provisions expired on July 1, 2015.
The General Assembly has enacted a new set of incentives for “qualifying datacenters.” Effective January 1, 2016, sales of electricity and datacenter support equipment to a qualifying datacenter will be exempt from sales tax as long as the electricity or equipment is used or located at the datacenter. In addition, these items will not be subject to the mill machinery privilege tax.
A “qualifying datacenter” is a datacenter that satisfies the Department of Commerce’s wage standard and health insurance requirements and that involves an investment of at least $75M in private funds over a five year period. (Under prior law, the required investment ranged from $150M to $225M depending on the development tier in which the datacenter was located.) Investments made after January 1, 2012 may be counted in determining whether the investment requirement has been met.
Aviation Fuel Incentives. Under current law, interstate passenger air carriers are entitled to an annual refund of sales taxes paid on fuel in excess of $2.5M. The refund request is made for the period coinciding with the State’s fiscal year ending June 30. This refund provision is set to expire on January 1, 2016, half way through the 2015-16 fiscal year. The General Assembly has clarified that the refund may be claimed for the first half of the fiscal year for taxes on fuel in excess of $1.25M.
Effective January 1, 2016, sales of aviation gasoline and jet fuel to interstate air businesses for use in commercial aircraft are exempt from sales tax. An interstate air business is an air courier, air freight or air passenger business operating in interstate commerce. The exemption expires in 2020.
Motorsports Incentives. The lease of an engine to a professional motorsports racing team (or a related member of the team) for use in a competition in a sanctioned race series is now exempt from sales tax if the engine is furnished with an operator. This provision expires January 1, 2020.
Two sales tax refund provisions for motorsports that were set to expire in 2016 have been extended to 2020. The first entitles professional motorsports racing teams to claim refunds for half the sales tax paid to N.C. on tangible property (other than tires or accessories) that comprise any part of a professional motorsports vehicle. The second entitles a professional motorsports racing team or sanctioning body (or a related member of either) to claim a refund of sales tax paid on aviation fuel used to travel to or from certain motorsports events.
Finally, under existing law, if a motorsports racing team is entitled to a sales tax refund with respect to an item of property, a service contract on that property is exempt from sales tax. This exemption has been expanded retroactive to 2014 specifically to cover transmissions, engines and rear-end gears and to cover service contracts on qualifying items purchased by related members of the racing team. A sunset also has been added so that the provision expires in 2020.
Historic Preservation Tax Credit. North Carolina’s tax credits for rehabilitating income and non-income producing historic structures expired in 2015. These credits have been revived, effective January 1, 2016, and will sunset again in 2020. The revived credits differ in some important ways from the former credits:
- The new credit for both income- and non-income-producing historic structures generally is equal to 15% of the rehabilitation expenditures. The new credit for income-producing structures is reduced to 10% for rehabilitation expenditures over $10M, and creditable expenditures are capped at $20M. In addition, the new credit for income-producing property may be enhanced if the structure is in a development tier one or two area or is a targeted investment site (i.e., a former manufacturing facility, agricultural warehouse or utility that has been at least 65% vacant for at least two years). The old credit percentages were 20% for income-producing structures and 30% for non-income-producing structures.
- The new credit for any one income-producing historic structure is capped at $4.5M. The old credit was uncapped, but, unlike the new credits, had to be taken in five annual installments.
- The new credits may be applied against the franchise tax, the corporate or personal income tax or the gross premiums tax. The old credits were available only against corporate or personal income taxes.
- The new credits may be carried forward for nine years. The old credits could only be carried forward for five years.
N.C. Wage Statements. Under current law, N.C. employers are required to provide N.C. wage statements to their employees showing the employee’s name and identifying number and the total wages paid during the prior year. The employer must also file an information return with the Secretary summarizing the information on the wage statements.
Beginning with the statements and information returns filed in 2016 for the 2015 tax year:
- Wage statements must include the employee’s address and any non-wage remuneration.
- The Secretary is authorized to require additional information to be included on the information return filed with the Secretary, provided that employers are given at least 90 days’ notice.
- The information return filed with the Secretary must be filed electronically, although the Secretary may waive the electronic filing requirement on a showing of good cause.
- Information returns are due January 31 rather than the later filing dates of their federal equivalents.
Commencing in 2017 with respect to information returns for the 2016 tax year, a $50 penalty is imposed on each failure to timely file the information return with the Secretary.
Information Requests. The Secretary has been granted authority to demand information from occupational licensing boards and alcohol vendors (ABC stores, wine wholesalers, malt beverage wholesalers, winery permit holders, brewery and distillery permit holders) about their licensees and permittees that the Secretary determines to be necessary to determine the licensee’s or permittee’s tax liability.
Bankruptcy Interest Waivers. The Secretary has been granted authority to reduce or waive interest on taxes imposed before or during a period for which a taxpayer has declared bankruptcy.
Selected Additional Changes
IRC Conformity. The Internal Revenue Code reference has been updated from December 31, 2013 to January 1, 2015. The 2014 amendments to the IRC included the Tax Increase Prevention Act of 2014, which retroactively extended a number of otherwise expiring tax provisions, including increased business expensing limits and bonus depreciation. N.C. continues to decouple from both provisions.
Repeal of Bank Privilege Tax. Banks and other financial institutions operating in N.C. are currently subject to an annual privilege tax of $30 on each $1M of assets payable on July 1 of each year. This tax has been repealed effective July 1, 2016.
New Property Tax Exclusion. A new property tax exclusion has been enacted for real property improvements constructed on land owned by a builder and held for sale. The exclusion is effective July 1, 2016 and applies to improvements made on or after July 1, 2015.
For residential real property, the exclusion applies to any increase in value attributable to the subdivision of the property, land improvements or the construction of a single family home or duplex on the property. The exclusion lasts for up to three years as long as the property is held for sale by the builder.
For commercial real property, the exclusion applies to any increase in value attributable to the subdivision of the property or improvements to the property. The exclusion lasts until the property is sold or a building permit is issued, but in no event will the exclusion last for more than five years.
Grandfathered Mill Rehabilitation Projects. North Carolina’s mill rehabilitation credit expired in 2015, but projects for which eligibility certification applications had been submitted before 2015 were grandfathered. The General Assembly has clarified that grandfathered applications expire January 1, 2023.
Grandfathered Renewable Energy Projects. North Carolina’s renewable energy tax credits expire in 2016. Although the General Assembly did not extend these credits, the sunset was extended to January 1, 2017 for 65 megawatt or larger projects that were 50% complete by January 1, 2016 and for smaller projects that were 80% complete by such date.
What Did Not Happen
A number of important tax proposals that were discussed in the General Assembly this year have not been enacted. These include:
- Market-based sourcing rules (although, as discussed above, the Revenue Laws Study Committee has been instructed to study this issue and propose rules based on Multistate Tax Commission guidelines).
- A throw-out rule under which untaxed sales would be excluded from the numerator and denominator of the sales factor.
- A one-third reduction in the franchise tax rate.
- Additional expansion of the sales tax base to include veterinary and other animal care services and advertising services.
- A phase-out of nonprofit sales tax refunds.
- An increase in the mill machinery privilege tax rate and cap from 1% and $80 to the general rate and $500.
- An extension or replacement of the R&D and renewable energy tax credits, which expire in 2016.
While not on the scale of the sweeping reforms enacted in 2013, this year’s N.C. tax legislation includes many important changes. Taxpayers should especially consider the following:
- The phasing-in of single sales factor apportionment is a major change for corporate taxpayers. While it should benefit taxpayers with significant investment and payroll in N.C., it will also increase the tax burden on out-of-state corporations selling into N.C. These corporations may respond by avoiding nexus with N.C. to eliminate any filing requirement at all.
- Multistate taxpayers should carefully monitor the Revenue Laws Study Committee’s consideration of market-based sourcing rules. In particular, taxpayers should study the Multistate Tax Commission’s market-based sourcing rules, since these will be the basis for the Committee’s study.
- Corporate taxpayers should review their intercompany lending arrangements in light of both the limitation on related party interest deductions for income tax purposes and the add-back of related party debt for franchise tax purposes.
- The expansion of the sales tax base will raise significant issues for taxpayers who buy or sell repair, maintenance or installation services. The new provisions are confusing and details of their application remain uncertain.
For more information about any of these legislative changes, contact a member of Smith Anderson’s Tax Group, business lawyers who understand taxation.