On May 11, 2016, North Carolina Governor Pat McCrory signed Senate Bill 729 (the Bill), provisions of which modify the corporate income tax, franchise tax, and sales tax. Most notably, the Bill reduces the deductible interest expense limitation from 30% to 15% but provides an exception if the interest expense can be traced to an unrelated party. House Bill 97, passed by the North Carolina General Assembly during Session 2015, previously allowed a deduction only for qualified interest expense paid or accrued to a related member for tax years beginning on or after January 1, 2016. "Qualified interest expense" was defined as the amount of net interest expense paid or accrued to a related member in a taxable year not to exceed 30% of the taxpayer's adjusted taxable income.

This Alert will highlight the significant corporate income, franchise and sales tax modifications resulting from enactment of Senate Bill 729.

Corporate income/franchise tax

Royalty income reporting option

Pursuant to N.C.G.S. Section 105-130.7A, royalty payments between related members can be either (i) deducted by the payer and included in the income of the recipient, or (ii) added back to the income of the payer and excluded from the income of the recipient. The Bill adds a provision indicating that exercising the royalty reporting income option does not prevent the taxpayer from having nexus in the State nor does it permit the recipient of the income to exclude royalty payments from the calculation of the sales factor.

Interest expense disallowance — conduit exception

House Bill 97 previously allowed a deduction only for qualified interest expense paid or accrued to a related member for tax years beginning on or after January 1, 2016. "Qualified interest expense" was defined as the amount of net interest expense paid or accrued to a related member in a taxable year not to exceed 30% of the taxpayer's adjusted taxable income. As a result of the Bill, the deduction is now limited to the greater of (1) 15% of the taxpayer's adjusted taxable income, or (2) the taxpayer's proportionate share of interest paid or accrued to a nonrelated person during the same taxable year. "Proportionate share of interest" is defined as the amount of a taxpayer's net interest expense paid or accrued directly to or through a related member to an ultimate payer divided by the total net interest expense of all related members that is paid or accrued directly to or through a related member to the same ultimate payer, multiplied by the interest paid or accrued to a person that is not a related member by the ultimate payer. The term "ultimate payer" is defined as a related member that receives or accrues interest from related members directly or through a related member and pays or accrues interest to a person that is not a related member.

There were originally four exceptions to the limitation on the deduction of interest expense paid or accrued to a related member: (1) tax is imposed by North Carolina on the related member with respect to the interest; (2) the related member pays a net income tax or gross receipts tax to another state with respect to the interest income; (3) the related member is organized under the laws of a foreign country that has a comprehensive income tax treaty with the United States, and that country taxes the interest income at a rate equal to or greater than the rate imposed by North Carolina; or (4) the related member is a bank. The Bill revises the second exception by indicating that the limitation does not apply if another state imposes an income tax or gross receipts tax on the interest income of the related member.

Additionally, amounts eliminated by combined or consolidated return requirements do not qualify as interest that is subject to tax.

Sales factor receipts

For taxable years beginning on or after January 1, 2016, the definition of sales has been updated to exclude: receipts from financial swaps and other similar financial derivatives that represent the notional principal amount that generates the cash flow traded in the swap agreement, and receipts in the nature of dividends excluded for federal tax purposes and North Carolina corporate income tax purposes.

Apportionment factor of a qualified air freight forwarder

For taxable years beginning on or after January 1, 2016, a qualified air freight forwarder is required to use the revenue ton mile fraction of its affiliated air carrier to determine income apportioned to North Carolina.

Franchise tax

The Bill provides that the effective date of changes to the corporate franchise tax base enacted through House Bill 97 is for taxable years beginning on or after January 1, 2017, and will apply to the franchise tax calculation reported on the taxpayer's 2016 and later year income tax returns. Previously, the changes were effective January 1, 2017, for taxes due on or after January 1, 2017.

Sales and use tax

Definitional updates

The Bill makes various updates to the definitions provided under the sales and use tax provisions, including:

— Streamlined Agreement: The definition of "Streamlined Agreement" is revised to mean the Streamlined Sales and Use Tax Agreement as amended as of September 17, 2015.

— Storage: The Bill removes various exceptions to the term "storage."

— "Retailer" for purposes of an admission charge to an entertainment activity is broadened to include a person who receives gross receipts derived from an admission charge sold at retail.

Taxability updates

The Bill explains the sales tax treatment of various transactions. Significant updates include:

— The term "conditional service contract" was restated as "conditional contract." In addition, an explanation is provided to determine the presumed sales price of an item when a portion of the conditional contract is taxable and a portion is not taxable. The presumed sales price is equal to the percentage of the service in the contract that is not taxable at the combined general rate.

— Effective for sales made on or after January 1, 2017, the sales tax exemption is repealed for items sold by a nonprofit civic, charitable, educational, scientific, or literacy organization when net proceeds will be given or contributed to the State of North Carolina or certain other entities.

— Effective for sales made on or after January 1, 2017, a new exemption is created for food, prepared food, soft drinks, candy and other items of tangible personal property sold not-for-profit for or at an event that is sponsored by an elementary or secondary school when the net proceeds of the sales will be given or contributed to the school or to a nonprofit charitable organization, one of whose purposes is to serve as a conduit through which the net proceeds will flow to the school.

— Effective January 1, 2017, the exemption for fuel and electricity sold to a manufacturer for use in connection with the operation of a manufacturing facility is expanded to include piped natural gas.

Other sales and use tax updates

The Bill makes various additional sales tax changes, including:

— A record keeping requirement for retailers, wholesale merchants and consumers to establish their sales and use tax liability.

— A person that relies on the information provided by a state database developed to provide information on the boundaries of taxing jurisdictions and applicable tax rates is not liable for underpayments of tax attributable to erroneous information provided by the Secretary until 10 business days after the date of notification by the Secretary. This provision also applies to matrices developed by the Secretary to provide information on the taxability of certain items or certain tax administration practices.

— Local tax rate increases will be effective on the first day of a calendar quarter after a minimum of 60 days' notice to sellers by the Secretary.

Other changes

The Bill makes various other updates to provisions relating to:

— Personal income tax deductions and withholding

— Tax bond requirements for tobacco products

— The filing frequency for wine excise tax reporting

— Tax on severance of energy minerals

— Tax on motor carriers

— Motor fuel tax refund and exemption

— Disclosure of confidential information

— Statute of limitation for assessing a responsible person

Implications

The Bill affects various corporate income, franchise and sales and use tax provisions. Of significance to corporate income taxpayers, the Bill reduces the deductible interest expense limitation from 30% to 15% but provides an exception if the interest expense can be traced to an unrelated party. The reduction in the percentage limitation may reduce deductions for some corporations while the new conduit exception may increase deductions for other taxpayers. Taxpayers with intercompany interest expense deductions should review these changes in conjunction with N.C. Gen. Stat. Section 105-130.7B to evaluate the potential implications. Additionally, taxpayers with intercompany royalty payments should evaluate if and how they exercise the royalty reporting option provided under N.C. Gen. Stat. Section 105-130.7A to ensure proper compliance with the Bill. Taxpayers should consider potential implications on prior year returns as well as current and future filings.

The list of updates provided above is not intended to be comprehensive listing of all of the changes in the Bill but rather is intended only to highlight the significant changes that would affect most taxpayers. Accordingly, taxpayers should review the full version of the Bill to evaluate how any of its many changes may affect their business.

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