NJ Court: Consolidated Rules Apply To Separate-Company Return

At a Glance...

The Tax Court of New Jersey's decision in MCI Communication Services, Inc. v. Director, Division of Taxation,1 which involved the coordination of federal cancellation of indebtedness and consolidated return rules with the corporation business tax, has been affirmed by the New Jersey appellate court.

Background

The taxpayer at issue ("Taxpayer") was a corporate subsidiary of MCI, Inc. ("MCI"). For federal income tax purposes, Taxpayer filed as part of the MCI consolidated group. As a result of Chapter 11 bankruptcy proceedings, MCI had cancellation of indebtedness income ("CODI") of $25 billion. Although MCI was able to exclude that CODI from its federal consolidated income, it was required under I.R.C. § 108(b) to reduce its tax attributes by the same amount. Of the $25 billion of CODI, only $71 million was related to debt owed directly by Taxpayer. But because its upper-tier affiliates' tax attributes were insufficient to absorb the CODI, the federal consolidated return rules required Taxpayer to reduce its tax attributes by $3.6 billion. For the 2005 tax year, this resulted in Taxpayer having $271 million less depreciation deductions for consolidated federal income tax purposes.

In reporting its 2005 New Jersey corporation business tax ("CBT"), Taxpayer started with its share of consolidated federal taxable income as reflected on the consolidated MCI return—which excluded the $271 million of depreciation deductions. New Jersey is a separate-company state, however. And under N.J.A.C. 18:7–11.15, a taxpayer subject to CBT that files as part of a consolidated return for federal income tax purposes "must reflect its entire net income . . . as if it had filed its Federal return on its own separate basis." Accordingly, Taxpayer computed its separate company taxable income by claiming the $271 million of depreciation deductions that had been disallowed on the consolidated return solely because of the federal consolidated return rules.

The New Jersey Division of Taxation ("Division") rejected this computation and Taxpayer appealed. In July 2015, the New Jersey Tax Court ruled in favor of the Division,2 reasoning that Taxpayer had to incorporate in its separate-company computation the amounts used in its consolidated return. In effect, the court applied federal consolidated return rules to a state income tax that specifically prohibits taxpayers from filing on a consolidated basis. To resolve this clear contradiction, Taxpayer...