In MCI Communication Services, Inc. v. Director, Division of Taxation (MCI II),¹ the New Jersey Superior Court, Appellate Division (appellate division) affirmed the decision of the New Jersey Tax Court (tax court) in MCI Communication Services, Inc. v. Director (MCI I).² The tax court in MCI I upheld, for Corporation Business Tax (CBT) purposes, the Director's basis adjustments relating to attribute reduction for excluded cancellation of indebtedness income (CODI) under Internal Revenue Code (IRC) Section 108(b).

The appellate division in a short, three page opinion, did not provide a separate analysis for its decision. Instead the appellate division "affirm[ed] substantially for the reasons expressed by [the tax court]."³

Background

In 2004, WorldCom, Inc. (which had recently emerged from Title 11 bankruptcy protection) merged into MCI, Inc. (MCI). WorldCom, Inc.'s bankruptcy and subsequent merger into MCI resulted in the cancellation of a substantial amount of MCI's debt. Under IRC Section 108(a), MCI excluded the CODI recognized from the Title 11 bankruptcy from its federal taxable income. To the extent that MCI excluded CODI from its income, IRC Section 108(b) required it to reduce certain of its tax attributes in the order prescribed by that section. Additionally, because MCI joined in the filing of a consolidated return with its affiliates, Treas. Reg. Section 1.1502-28T required the affiliated members to reduce certain of their tax attributes to the extent MCI had excluded CODI that had not yet been used to reduce its own tax attributes. Since WorldCom, Inc. had limited tax attributes, the IRC required "lower-tier" members of the group (such as MCI, a consolidated group filer in 2005) to take into account a portion of the CODI of "upper-tier" members and reduce their tax attributes (in this case, basis in depreciable assets) with respect to the "pushed-down" CODI. Consequently, for tax year 2005, MCI recognized income solely as a result of the pushed down CODI.

MCI filed its 2005 New Jersey CBT return reporting "other deductions and additions," consisting of a "Reversal of Federal Attribute Reduction Turn" on the basis that the New Jersey statutes and regulations required a re-computation of New Jersey entire net income (ENI) as though MCI filed its federal return on a separate-company basis, rather than a consolidated basis, effectively reversing the adjustments required under the Treas. Reg. Section 1.1502-28T consolidated CODI attribute reduction rule. The New Jersey Division of Taxation (DOT) disallowed MCI's adjustment.

The tax court granted summary judgment in favor of the DOT's adjustment of MCI's CBT return.⁴ In its opinion, the tax court concluded that, since New Jersey is a separate reporting state, the taxpayer "must reflect its [ENI] … as if it had filed its Federal return on its own separate basis."⁵ Citing General Building Products v. Director, Division of Taxation,⁶ the tax court interpreted New Jersey's separate reporting regime as still requiring an adherence to consolidated filing rules (in the case of General Building Products, an IRC Section 338(h)(10) election). Accordingly, the tax court determined that MCI was required to take into account the excess CODI from upper-tier members of the group, which increased its federal taxable income as a consequence of its consent to file a consolidated return with the MCI group and correspondingly, resulted increased ENI for NJ CBT purposes.

The tax court also rejected MCI's other arguments for reversing the CODI attribute reduction, including that the New Jersey statute does not mandate attribute reduction pursuant to pushed-down CODI, that the CODI push-down creates non-taxable phantom income, and that the DOT previously released guidance that CODI would not affect New Jersey net operating loss carryforward deductions (given that the instant case involved the reduction of depreciable basis).

Implications

The appellate division's affirmation of the tax court's decision establishes a precedent insofar as the application of the IRC Section 108(b) / Treas. Reg. Section 1.1502.28T consolidated-group-depreciable-basis-attribute-reduction requirement to the calculation of ENI. But the decision, if broadly interpreted, may have significant CBT effects on intercompany transactions among members of federal consolidated groups. For example, current rules governing such intercompany sales (that give rise to deferred federal recognition but current-year CBT recognition) may be dead letter if ENI is to be computed, in all instances, utilizing the federal consolidated regulations.

The decision is also inconsistent with previous New Jersey decisions disallowing a New Jersey basis adjustment when taxpayers did not enjoy a corresponding tax benefit.⁷

The taxpayer could appeal this matter to the New Jersey Supreme Court, which has jurisdiction to review the matter.

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ENDNOTES

¹ No. A-5735-14T3 (N.J. Tax 2015), aff'd (N.J. Super. Ct. App. Div. June 15, 2018) (Not for publication).

² MCI Communication Services, Inc. v. Director, Division of Taxation, No. 013905–2010 (N.J. Tax Ct. July 20, 2015).

³ MCI II, No. A-5735-14T3.

⁴ Given that the appellate division adopts the tax court's reasoning in whole, this Tax Alert summarizes the tax court's ruling.

⁵ MCI I, quoting N.J.A.C. 18:7-11.15.

⁶ 14 N.J. Tax 232 (1994).

⁷ See e.g. Koch v. Director, Division of Taxation, 157 N.J. 1 (1998); Toyota Motor Credit Corporation v. Director, Division of Taxation, 28 N.J. Tax 96 (2014); Ford Motor Credit Company v. Director, Division of Taxation, No. 015751–2009 (N.J. Tax Ct. August 5, 2014).