Update: On August 31, 2016, the Maryland Tax Court granted the Maryland Comptroller of Treasury's motion to withdraw the court's August 12, 2016, Memorandum of Grounds for Decision and Order. In its motion to withdraw, the Comptroller argued that the decision only addressed the legal issue in the case and not the factual issue of whether the taxpayer met its burden of substantiating the amount of refund claimed. The Comptroller's motion did not address the legal question that was resolved by the court - that the Comptroller's policy of not allowing a carryforward of unsubtracted exempt federal obligation interest discriminates against holders of federal obligations in favor of similarly situated holders of Maryland obligations.

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In Branch Banking and Trust Company v. Comptroller of the Treasury,¹ the Maryland Tax Court (Court) found that the denial of refunds associated with a carryforward subtraction of federal bond interest was unconstitutional. In so holding, the Court held that the Maryland Comptroller of the Treasury's (Comptroller) policy of not allowing a carryforward of unsubtracted exempt federal obligation interest discriminates against holders of federal obligations in favor of similarly situated holders of Maryland obligations. After the ruling was issued, the Comptroller filed a motion to withdraw the decision, arguing that the decision only addressed the legal issue in the case and not the factual issue of whether the taxpayer met its burden of substantiating the amount of refund claimed.

Background

Under Maryland's corporate income tax, a corporation must first add back to federal taxable income any interest earned from obligations of the US or an instrumentality of the US; in contrast, there is no requirement to add back interest from Maryland obligations. The federal obligation interest reported on the Maryland return is then subtracted up to the point that it increases or creates a net operating loss. The Maryland return instructions do not allow a carryforward subtraction for the unclaimed remainder of the federal obligation interest.

Branch Bank & Trust Company (BB&T) filed Maryland refund claims for 2007 and 2008 and subtracted federal obligation interest that was left unsubtracted on its Maryland returns in the years that the interest was earned (between 1998 and 2008). BB&T created a federal interest subtraction modification carryforward to reflect and use the unsubtracted interest amounts. As support for its position, BB&T relied on Comptroller Administrative Release 18, which allows a subtraction carryforward for foreign source dividends as a result of Kraft General Foods, Inc. v. Comptroller of the Treasury.²

The Comptroller denied the refund requests of $2,623,240 and $2,048,909, respectively, based on there being no statutory provision that allows for a carryover of unsubtracted exempt federal obligation interest.

BB&T challenged the denial, raising three issues: (1) whether the Comptroller's policy of denying the carry forward of previously unsubtracted tax-exempt interest violates Md. Code Ann., Tax-Gen. Section 10-307(f), (2) whether the Comptroller's policy to not allow a carryforward violates 31 U.S.C. Section 3124;³ and (3) whether this policy is prohibited by the Supremacy Clause of the US Constitution.

Court finds Comptroller's policy violates the Supremacy Clause

The Court's analysis considered only the third issue. BB&T maintained that the Comptroller's policy places a larger burden on holders of federal obligations than it does on similarly situated holders of state obligations. It contended that state obligations were allowed a full deduction on the Maryland return based on the starting point for computing the Maryland tax being federal taxable income. This policy was discriminatory and violates the Supremacy Clause. In response, the Comptroller focused on only whether its policy made the federal bond interest less attractive and that its policy did not as evidenced by BB&T's continual purchase of those obligations.

The Court stated that it had " … chosen to tackle the constitutionality question first … [s]ince the issue is whether the Comptroller's policy violates the Supremacy Clause and not whether the state and federal statutes violate the Supremacy Clause … " If the Comptroller's policy violates the Supremacy Clause, the Court noted, then the policy inherently violates both the state and federal statutes that are at issue.

The Court determined that it must echo its decision in Kraft General Foods. The Court explained that, in the Kraft case, foreign-source dividends were added back to income reported for state purposes and, similar to the instant case, the Comptroller only permitted the foreign-source dividends to be subtracted from taxable income in the year received up to the point that the subtraction created or increased a loss. The disallowed amounts were lost to Kraft. State-source dividends, however, were not required to be added to the Maryland income tax returns and thus were not considered in computing the Maryland income tax. In Kraft, theCourt determined that the Comptroller's policy treated "two taxpayers (one receiving domestic-source dividends and the other foreign-source dividends) in identical situations (in the years following a loss year) differently. This discriminated against foreign commerce because it resulted in a higher State tax on the taxpayer with the foreign source dividend income."

Accordingly, in keeping with its decision in Kraft, the Court ruled for BB&T. It held that the Comptroller's policy of not allowing carryforwards of unsubtracted exempt federal obligation interest discriminated against holders of federal obligations in favor of similarly situated holders of Maryland obligations. In reaching that conclusion, the Court noted that the Comptroller's policy clearly places a greater burden on holders of federal obligations. Maryland obligation interest, the Court explained, is subtracted in its entirety; when a loss occurs, the loss can be carried forward in Maryland, which is unlike the Comptroller's tax treatment of federal obligation interest. Thus, "[t]he disparate treatment between these two obligations and those similarly situated taxpayers who hold them creates a higher Maryland corporate income tax per non-exempt taxable dollar on those who have federal obligation interest than on those who hold state obligations."

Implications

This decision may create a refund opportunity for taxpayers that received federal interest that was not fully subtracted on their Maryland return. In this case, the Court struck down a long-standing policy decision of the Comptroller to allow a subtraction for federal interest attributable to an obligation of the US or an instrumentality of the US only up to the point that it creates or increases a loss. The Comptroller did not allow carryover subtraction. Instead, the Comptroller considered the statutory subtraction modification to only apply in the year that the interest was earned.

The Comptroller filed a motion with the Court to withdraw the Court's decision based on it not addressing the factual issue of whether BB&T had satisfied its burden to substantiate the amount of refund being claimed. The Comptroller's motion included that the Court did not specify the amount of the refund claim that BB&T was entitled to receive and that BB&T had on numerous occasions revised the refund amount asserted. The Comptroller's motion did not address the legal question that was resolved by the court. A decision has not yet been made by the Court with respect to this motion (filed August 23).

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ENDNOTES

¹ Branch Banking and Trust Co. v. Comptroller of the Treas., Case No. 13-IN-OO-0076 (Md. Tax Ct. Aug. 12, 2016).

² Kraft General Foods, Inc. v. Comptroller of the Treasury, No. 98-IN-OO-0353, 2001 WL 699558 (Md. Tax Ct. 2001).

³ Under 31 U.S.C. Section 3124, stocks and obligations of the US Government are exempt from taxation by a State or political subdivision of a State. The exemption applies to each form of taxation that would require the obligation, the interest on the obligation, or both, to be considered in computing a tax, with certain exceptions.