N.C. Business Court Holds that (Federal) Dividends Received Deduction Must Offset (State) Net Economic Loss Tax Deduction
In N.C. Dep’t of Revenue v. Graybar Elec. Co., Inc., 2019 NCBC 2 (N.C. Super. Ct. Jan. 9, 2019), the Business Court addressed the interplay between the federal dividends received deduction and the (now repealed) North Carolina net economic loss deduction. The issue, in particular, was whether the respondent corporation was required to reduce its North Carolina net economic loss deduction by the amount of the dividends received deduction it had claimed on its federal taxes. Chief Judge Bledsoe concluded that because the State had not taxed the dividend income, the dividends were “income not taxable” and applied to reduce the respondent’s net economic loss deduction accordingly.
The court further concluded that the State’s treatment of the dividend income was constitutional (under both the North Carolina and U.S. Constitution), but left open the question of whether that treatment had imposed a “double tax” on the same income.
- Any income that is not taxed by the State of North Carolina, including dividend income deducted under the dividends received deduction, constitutes “income not taxable” for purposes of reducing a corporation’s North Carolina net economic loss deduction.
- Subjecting corporate income to a “double tax” is both well-accepted and constitutional.
- Regardless of constitutionality, a question is raised whether the State’s treatment of the dividend income resulted in double (or perhaps triple) taxation.
In Graybar Electric, the respondent corporation (“Graybar”) received from its subsidiaries two large dividends for which it claimed a dividends received deduction (“DRD”) on its federal income tax return. Graybar did not apply this DRD to “offset” the net economic loss (“NEL”) deduction that it claimed on its North Carolina state tax return, which would have reduced the NEL deduction to zero.
The North Carolina Department of Revenue (the “Department”) disallowed the NEL deduction, asserting that the dividends were “income not taxable” and therefore applied to reduce the NEL deduction (to zero, in this instance) under G.S. § 105-130.8(a)(3) (providing that NEL deductions may be claimed only to the extent that they exceed any “income not taxable” received for the year). Graybar Elec. Co., Inc., 2019 NCBC 2 ¶¶ 11-13.
Graybar thereafter filed a contested case with the Office of Administrative Hearings (“OAH”), which agreed with Graybar that the dividends were not “income not taxable” and therefore should not have been applied by the Department to reduce Graybar’s NEL deduction. The OAH further noted that, while not necessary to its decision, it agreed with the premise that “the Department’s position created a[n unconstitutional] double taxation on the same income.” Id. ¶ 15.
The Department exercised its right to appeal the OAH’s decision to the North Carolina Business Court. (Yes, the Business Court hears tax cases, too.) See G.S. § 7A-454(b)(1) (providing that “[a]n action involving a material issue relating to tax law that has been the subject of a contested tax case for which judicial review is requested under G.S. 105-241.16…shall be designated as a mandatory complex business case”).
On appeal, the Business Court addressed two issues: (1) whether the dividend income was “income not taxable” such that it applied to reduce Graybar’s NEL deduction; and (2) whether such a reduction, if allowed, amounted to a constitutional violation.
The court also touched on—but did not decide—whether the Department’s treatment of the DRD resulted in a “double tax” on the same income.
- “Income Not Taxable”
The Business Court first considered whether the dividends received by Graybar (for which it had claimed a DRD) constituted “income not taxable.”
Chief Judge Bledsoe consulted the text of G.S. § 105-130.8(a)(5) (repealed 2014), which identified two categories of “income not taxable” as follows:
For purposes of this section,  any income item deductible in determining State net income under the provisions of G.S. 105-130.5 and  any nonapportionable income not allocable to this State under the provisions of G.S. 105-130.4 shall be considered as income not taxable….
There was no dispute that the dividend income fell outside the two categories identified in the statute – the dividends were not deductible under G.S. § 105-130.5 (which specifies certain adjustments to arrive at net income) and were not allocable to other states. The dispute, instead, was whether the two categories represented an exhaustive list of the types of income that could qualify as “income not taxable” (as Graybar contended), or whether there were other types of income—such as deducted dividends—that could also qualify as “income not taxable” (as the Department contended).
Applying principles of statutory construction, the court concluded that G.S. § 105-130.8(a)(5) was intended to be “exemplary—not exclusive or exhaustive,” as “the statute’s plain words do not purport to provide a complete list or otherwise limit ‘income not taxable’ to only the types of income referenced there.” Graybar Elec. Co., Inc., 2019 NCBC 2 ¶ 28.
The court then proceeded to address the next logical question in the analysis: If the two categories identified in the statute were not exhaustive, then what other types of income might also qualify as “income not taxable?”
The answer, as it turned out, was that pretty much any income could be considered “income not taxable,” if the State did not tax it.
The court observed that the North Carolina Supreme Court had previously defined “income not taxable” as any “income on which the State does not levy a tax.” Id. ¶ 30-32 (citing Dayco Corp. v. Clayton, 269 N.C. 490, 498, 153 S.E.2d 28, 33 (1967), for the proposition that “‘taxable income’ clearly means income on which the State of North Carolina, by the Revenue Act, levies a tax” and that “[a]ll other income is ‘income not taxable.’”).
Applying this (broad) definition, the court concluded that the dividends in question qualified as “income not taxable” under Dayco because Graybar had deducted the dividends (via the DRD) in determining its federal taxable income—the starting point for calculating its North Carolina state net income—and the dividends were not “added back in” to Graybar’s state net income via any of the adjustments under G.S. § 105-130.5. The dividends were therefore not included in Graybar’s North Carolina state net income and, consequently, “were not income upon which the State levied a tax.” Id. ¶¶ 24, 31.
In reaching this conclusion, the court rejected Graybar’s attempt to distinguish Dayco on the grounds that Dayco had involved income that was not apportionable to North Carolina and thus was outside the State’s authority to tax. Dayco, according to Graybar, stood only for the proposition that income was “income not taxable” where the State lacked the authority to tax; and since there was no dispute that the State here did have the authority to tax the dividend income, Dayco was not controlling. The court declined to adopt this distinction, however, opting instead for a bright line rule that any income not taxed by the State was “income not taxable” and that, accordingly, “[b]ecause the Dividends [were] income on which the State did not levy a tax, the Dividends were ‘income not taxable’….” Id. ¶ 35.
The dispositive question, therefore, was not whether the State had the authority to tax the dividends, but whether the State had actually taxed them. And because the State had not actually taxed this income, it was “income not taxable” and applied to reduce Graybar’s NEL deduction accordingly.
- Constitutional Issues
The court next addressed Graybar’s contention that the Department’s treatment of the dividend income—and specifically, its use of the DRD to offset Graybar’s NEL deduction—resulted in an unconstitutional “double tax” on the same income.
Chief Judge Bledsoe concluded that no constitutional violation had occurred, even if the income had been subjected to a double tax, because “nothing in either the United States Constitution or the North Carolina Constitution prevents the State from imposing double taxation, provided the tax is imposed without arbitrary distinction,” and “Graybar has failed to show that its tax burden resulting from the State’s determination—i.e., the reduction of Graybar’s NEL deductions by the apportioned amount of the Dividends received—is the product of discriminatory or arbitrary taxation….” Id. ¶¶ 49-50.
The court thus acknowledged the parties’ dispute over “whether the Department’s treatment has resulted in a double tax,” but concluded that it “need not resolve this dispute to determine Graybar’s constitutional challenges.” Id. ¶ 50, n. 8.
This question left open by the court—i.e., whether the Department’s treatment resulted in a double tax—is an intriguing one, even if “academic” in light of the court’s ruling, because it cuts right to the heart of the DRD and its underlying purpose. It is therefore considered in some detail below.
- Double (or Triple?) Taxation
A hallmark of corporate taxation is the “double tax” that applies to income generated by the corporate entity – the income is taxed first when earned by the corporation, and second when it is distributed to the company’s shareholders. Hence, the same income is taxed twice; and this concept is well understood and accepted in the corporate tax world.
What the tax law has long disfavored, however, is the idea that income earned by a corporation (or any entity, for that matter) could be taxed more than twice.
This concern of triple taxation (or more) creeps up in the case of affiliated entities – where, for example, a subsidiary corporation earns income that it later distributes to its parent company. In that situation, the potential for more than double taxation arises because:
- The subsidiary is taxed on the earned income (first level of tax);
- The same income is distributed to the parent in the form of a taxable dividend (second level of tax); and
- The parent eventually distributes the same income to its shareholders in the form of a taxable dividend (third level of tax).
In the case of longer chains of parent and subsidiary corporations, these multiple layers of tax on the same income can be extended well beyond the feared triple taxation.
To protect against this, Congress enacted the DRD, which provides a parent company receiving a dividend from its subsidiary with a deduction in the amount of the dividend received. The result is that the income is taxed twice – but only twice: once when earned by the subsidiary, and once when distributed by the parent company to its shareholders.
Applying these concepts to Graybar, there is no question that the dividend income was subject to two layers of tax – first when earned by Graybar’s subsidiaries, and second when Graybar distributed the income to its shareholders (whenever it chose or chooses to do so). The question, really, was whether a third layer of tax was introduced when the Department applied the DRD to offset the NEL deduction. And since the DRD, to that point, had effectively shielded Graybar from tax on the dividends it received from its subsidiaries, it is not difficult to see how “negating” that DRD—by using it to offset the NEL deduction—might arguably have resulted in a triple tax.
To be clear, there is nothing in and of itself unconstitutional about imposing two (or even three) layers of tax on the same income. The point is that these additional layers of tax are disfavored, and the DRD represents an attempt to alleviate the impact of an already relatively burdensome corporate tax regime. But as the Business Court aptly noted in its ruling, all deductions—whether in the form of a DRD or the NEL deduction—“are privileges, not rights,” Graybar Electric, 2019 NCBC 2 ¶ 51; and the General Assembly “permit[ted] a net economic loss or losses deduction . . . purely as a matter of grace.” Id. ¶ 48 n.7.
In sum, Graybar Electric answers an interesting (and difficult) question of corporate taxation, holding that the federal dividends received deduction must yield to a North Carolina statute that effectively negates that deduction. Given that Graybar has now appealed this decision to the North Carolina Supreme Court, it will be interesting to see whether the state’s highest court addresses the question left unanswered by the Business Court – that is, whether the Department’s treatment of the dividend income resulted in a double (or the much feared triple) tax.
Matt Krueger-Andes is a litigation associate in Fox Rothschild’s Charlotte office. He regularly represents clients in the Business Court and advises on Business Court and other business litigation-related matters. He is also a former law clerk to the Honorable Louis A. Bledsoe, III, Chief Judge of the North Carolina Business Court.