North Carolina Business Court: Department Of Revenue Violated State Constitution In Attempting To Collect A Tax Penalty

The Business Court spanked the Department  of Revenue again last week, just after a ruling two weeks ago when it said in another case that the DOR's position was "harsh, and potentially fatal. . . ."  This time, in Delhaize America, Inc. v. Lay, 2011 NCBC 2, Judge Tennille ruled that the attempted imposition of a $1 million tax penalty by the DOR not only violated the taxpayer's due process rights, but also a provision of the state Constitution which requires the power of taxation to be exercised in "a just and equitable manner." 

Delhaize, the North Carolina operator of Food Lion grocery stores, was audited by the DOR after it restructured its operations by placing its trademarks, trade names, service marks, and other assets in an out of state subsidiary named Food Lion Florida (FLFL).  Delhaize paid royalties and fees to FLFL, and those were repaid to Delhaize in the form of non- taxable dividends. This resulted in "income distortions," Op. ¶23, and the payment of less tax by Delhaize

Given the North Carolina statute saying that a corporation "shall not file a consolidated return" (N.C. Gen. Stat §105-130.14), and the lack of clear guidelines to taxpayers about when a combined return might be accepted, the penalty was ruled to be unconstitutional.  Judge Tennille said on the due process issue that taxpayers were individuals with a property interest who "must receive notice and an opportunity to be heard before the government may deprive them of their property." Op. ¶73.  The guidelines for when a combined return would be allowed were, as the Court put it, "so elusive" that "ordinary taxpayers 'exercising ordinary common sense' [could not] sufficiently understand or predict when a penalty will be assessed." Op. ¶75.

As for the penalty running afoul of the the North Carolina Constitution's requirement that it be "just and equitable," Judge Tennille held:

When a corporation is charged a significant penalty for complying with the law, the result of which is an automatic, non-negligence, punitive penalty assessed by the Department of Revenue, the state’s power of taxation is being exercised in a manner that is unjust and inequitable.

 Op. ¶87. It was constitutionally unjust to allow this penalty without published guidelines as to when the penalty was warranted. 

Judge Tennille also found distasteful the DOR's program, operated before the amendment of the penalty statute, by which it offered amnesty to corporate taxpayers which had engaged in restructurings.  It agreed in those negotiations to waive the 25% penalty in exchange for the payment of the lost tax revenue.  This resulted in collection of an additional $300 million in tax.  Judge Tennille referred to the threat of a penalty in this program as "deft use" by the DOR of "a club." Op. ¶77.

The Business Court's First Opinion in 2011

I have been puzzling for the last three days on what to write about the Business Court's first opinion of the year, in Technocomm Business Systems, Inc. v. North Carolina Department of Revenue, 2011 NCBC 1.  It involves an opinion about the sales and use tax and whether the taxpayer (Technocomm) was entitled to a refund.

You might be wondering: what is The Business Court doing writing about sales and use taxes?  The answer is that in 2008, the Business Court became the route of review for tax cases decided in the Office of Administrative Hearings by an Administrative Law Judge.  This was the first opinion from the Court acting in its judicial review capacity in a tax case. 

What standard of review applied?  Since it was a question of law, the standard of review was de novo.  That meant that Judge Tennille could "freely substitute [his] own judgment for the [ALJ's] judgment." Op. ¶28.  And he did that.

Who won?  The Department of Revenue or the taxpayer? Judge Tennille  reversed the determination by an ALJ and remanded the case for the ALJ to determine the amount of a tax credit due Technocomm which the DOR had refused to allow.  Along the way, he condemned the Department's position as "harsh at best and potentially fatal at worst." Op. ¶25 

What was the basis for the credit claim?  Technocomm said it was due a credit against use taxes as a result of sales taxes it had collected from its customers in error, and which it had remitted to the DOR. The sales taxes had been collected in connection with service agreements sold by Technocomm simultaneously with the sale of office equipment.  The agreements included parts and supplies estimated by Technocomm to be necessary for it to fulfill its maintenance obligations.

Technocomm had been told by the DOR in 1999 following an audit that it should not collect sales tax on its service agreements.  The Department said that Technocomm should pay a use tax based on the dollar value of the actual parts and supplies used to meet its service obligations.  But Technocomm disregarded that instruction, and continued to charge its customers the estimated sales tax in what it conceded to be "bad business practice." Op. ¶23.

The department and Technocomm were at war over which section of the state tax law applied: section 105-164.41 (titled Excess payments; refunds) or section 105-164.11 (titled excessive and erroneous collections).  After some statutory construction of how to deal with the conflict between a general and specific statute, and the obligatory Latin phrase generalia specialibus non derogant (general words do not derogate from special), the Court applied the more general provisions of 164.41 which says that when excess tax is paid "then the amount in excess shall be credited against any tax . . . then due from the taxpayer."

Now, wait a minute, you might say.  Isn't Technocomm generating  this credit from money paid by its own customers?  Shouldn't they, as opposed to Technocomm, get the credit since they provided the dollars that will result in the credit? Judge Tennille covered that point extensively, in Paragraphs 40 through 53 of the Opinion.  The bottom line, as I saw it, was that the service agreements allocated the risks and costs of repair in advance between Technocomm and its customers.  Technocomm carried the risk of having to provide more parts and supplies than it had anticipated and built into the cost of the service agreement.

Part of the cost of that repair risk flows from a human trait observed by Judge Tennille in my favorite part of the Opinion:

Some employees display a tendency to punish technological devices when  frustrated by their complicated displays and complex workings despite well crafted corporate policies designed to encourage the ethical treatment of office equipment.

Op. . ¶48.  I did not punish any computers in writing this post.

An Important Procedural Point For Contested Tax Cases In The North Carolina Business Court

Read this if you litigate with the North Carolina Department of Revenue over tax matters, or know someone who does. The subject is a Business Court decision which makes clear an important prerequisite for obtaining review of a tax case in the Court.

The Business Court has jurisdiction over parties seeking judicial review of a contested tax case decided in the Office of Administrative Hearings by an Administrative Law Judge. It has had such jurisdiction since 2008 amendments to the General Statutes, including Section 7A-45.4(a)(7) and Section 105-24.16, which says that:

A taxpayer aggrieved by the final decision in a contested case commenced at the Office of Administrative Hearings may seek judicial review of the decision in accordance with Article 4 of Chapter 150B of the General Statutes. Notwithstanding G.S. 150B-45, a petition for judicial review must be filed in the Superior Court of Wake County and in accordance with the procedures for a mandatory business case set forth in G.S. 7A-45.4(b) through (f). A taxpayer who files a petition for judicial review must pay the amount of tax, penalties, and interest the final decision states is due.

The statute says that the taxpayer must pay the tax with penalties and interest, but it doesn't say when the payment is to be made and says nothing about payment being a prerequisite to judicial review .

In Franklin County Board of Education v. North Carolina Department of Revenue, 2009 NCBC 28 (N.C. Super. Ct., December 23, 2009), the first case in the Business Court seeking judicial review pursuant to the statute, Franklin County hadn't paid the tax and interest before filing its Petition. The Department of Revenue pointed this out to the County, and the County promptly paid in full. Nevertheless, DOR moved to dismiss because the payment had not been made before the filing in the Business Court.

Judge Tennille denied the Motion based on his power under G.S. §150B-45 to allow an untimely Petition "for good cause shown." He said that the statute "is not a model of clarity," and that it "should have made it clear that the tax, penalties, and interest had to be paid before or contemporaneously with the filing of the Petition." He also pointed out that DOR had not said in the Notice of Appeal Rights provided to the County that it was required to pay the tax before seeking judicial review. 

That pass given to Franklin County won't extend to future cases, and that's the important part. The Court said "[n]ow that the Statute has been clarified by the Court, attorneys are on notice of the requirement." DOR will presumably provide notice of this requirement to taxpayers, because the Court said that DOR "would be well advised to make the payment requirement clear in its notice of appeal procedures."