South Carolina enacts standards for forced combination

In brief

What happened?

Legislation (S.B. 298) enacted on March 11 in South Carolina provides that the Department of Revenue may only force a corporate taxpayer to file a unitary combined return when it finds that the taxpayer’s intercompany transactions lack economic substance or are not at fair market value. Judicial review of the Department’s determination is de novo, and the Administrative Law Court is directed to decide whether adjustments other than requiring combined filing are adequate to redetermine state net income attributable to the taxpayer’s business activity in the state. 

Why is it relevant? 

The Department’s authority to force combination and the standards for determining when intercompany adjustments or combination are warranted have been areas of audit controversy and litigation for many years. This legislation, which is modeled on North Carolina’s statute, may provide more certainty for taxpayers, including the opportunity to proactively seek advice on the treatment of transactions from the Department of Revenue.  

Actions to consider 

The legislation applies to all open tax periods, excluding assessments under judicial review by the South Carolina Administrative Law Court, Court of Appeals, or Supreme Court as of the date of enactment. Therefore, taxpayers should consider the potential impact of this legislation on open tax periods, planned transactions, and current audits and administrative controversies. 

Economic substance 

A transaction has economic substance if the transaction, or the series of transactions of which the transaction is a part:  

1. has one or more reasonable business purposes other than the creation of state income tax benefits; and  
2. has economic effects beyond the creation of state income tax benefits.  

In determining whether to require a combined return, whether the transaction has economic effects beyond the creation of state income tax benefits may be satisfied by demonstrating material business activity of the entities involved in the transaction. 

The legislation specifically provides that centralized cash management of an affiliated group does not constitute evidence of an absence of economic substance. However, achieving a financial accounting benefit will not be viewed as a reasonable business purpose for entering into a transaction if the origin of such financial accounting benefit is a reduction of state income tax. 

Affiliated group composition 

The legislation defines “affiliated group” and lists entities that must not be included in a combined return: 

1. a taxpayer not required to file a federal income tax return; 
2. certain qualifying insurance companies, other than a captive insurance company; 
3. a taxpayer exempt from tax under Section 501; 
4. a foreign taxpayer as defined in Section 7701, other than a domestic branch thereof; 
5. a taxpayer with at least 80% of its gross income from all sources in the tax year being active foreign business income; and 
6. any other entity not subject to South Carolina corporate income tax. 

Standard of review 

If the taxpayer appeals a final determination by the Department under these provisions to the Administrative Law Court, the administrative law judge must review de novo (1) whether the separate income tax returns submitted by the taxpayer fail to fairly represent the extent of the taxpayer’s business activity in the state through the use of intercompany transactions that lack economic substance or are not at fair market value; (2) whether the Department’s means of determining the taxpayer’s state net income is appropriate; and (3) if a combined return is required by the Department, whether adjustments other than requiring the taxpayer to file a return on a combined basis are adequate under the circumstances to redetermine state net income.