NJ Tax Court Disallows $271 Million Business Deduction to MCI

In a recent decision, the New Jersey Tax Court ruled that a $271 million business deduction for MCI Communication Services Inc. was disallowed. The ruling is significant because it creates potential conflict between state and federal tax laws. However, it could also cause confusion for corporate taxpayers in other states that require companies to file separate tax returns. New Jersey requires corporations to file separate corporate income tax returns despite filing as part of a consolidated group for federal income tax purposes. This disconnect between federal and New Jersey taxation is a significant irritant to many.

The background of the case

In 2002, Worldcom filed a petition for reorganization under Chapter 11 of the Bankruptcy Code, according to a Bloomberg Law report. Upon emerging from bankruptcy, Worldcom merged with MCI Group in 2004, the parent company of MCI Communications Services Inc. (the “Taxpayer”). As a result of the bankruptcy, much of the indebtedness was forgiven, resulting in cancelation of indebtedness income (“COD”).  The discharge in bankruptcy allowed MCI to avoid recognizing COD provided MCI reduced its tax attributes, such as net operating losses and basis in assets, to offset the COD for tax purposes. Where a parent company, such as MC Group, has insufficient tax attributes to offset COD, some of the COD is passed down to its subsidiary, in this case, the Taxpayer.

Whereupon the Taxpayer had the $271 million in COD income passed down to it to help MCI Group. The subsidiary tried to claim the amount as a corporate business deduction. However, the NJ Division of Taxation disallowed the deduction, which prompted the Taxpayer to appeal the decision.

The Tax Court passes down its decision in favor of the NJ Division of Taxation

According to a Law 360 report, the Tax Court ruled that the Taxpayer was not eligible to write off $271 million of cancelation of debt income on its state taxes. The Court disallowed the deduction due to the fact that MCI Group included the cancelation of debt income amount in income calculations on a consolidated federal return for the parent company and its subsidiaries.

In its decision, the Court cited that New Jersey requires each corporate entity with activity within state borders to file separate corporate business tax returns. However, because the Taxpayer was a subsidiary of a corporate entity that filed a consolidated income tax return for federal income tax purposes, the Taxpayer must file its state corporate business tax return using the net income of the Taxpayer as it appeared on the consolidated federal income tax return. The court rejected the Taxpayer’s other arguments, the first of which was that taxpayer attribute reduction required by consolidated return rules did not apply in the context of a separate state return. Second, the attribute reduction would cause the taxpayer to recognize income in circumstances where the taxpayer’s investment capital is being returned to it rather than income.

The Court claims that the cancelation of debt income exclusion is inapplicable to NJ

The Court claimed that while federal law allows the income from cancelation of debts occurring in bankruptcy to be excluded for tax purposes, New Jersey does not draw such distinctions that apply to the COD income exclusion. Therefore, the Court cited the fact that the federal exclusion of COD income by the Taxpayer was not applicable in New Jersey. The Court cited New Jersey’s tax statutes that claimed that taxpayers are required to include the taxable income reported on federal returns as the basis for New Jersey’s entire net income reported on state corporate business tax returns. The Court noted that the Taxpayer filed as part of a consolidated return with MCI Group, which means it was subject to New Jersey tax based upon the income reported in the consolidated return. The Taxpayer’s consent, to be included in the consolidated return for federal tax purposes, permitted the state to require that the Taxpayer use the income attributed to it on the federal consolidated return as the basis for state taxation.

The potential significance of the decision

The repercussions of this case are potentially massive, as 18 states currently ban consolidated reporting for tax purposes. However, more locally to New Jersey, the ruling blurs the state Division of Taxation’s previous guidance on corporate business taxes. This was due to the fact that the starting point for calculating entire net income on state returns was previously a separate company tax return, and not its federal consolidated return.

Further, the decision creates the potential for uncertainties regarding the types of income and expenses that are required to be included under “entire net income.”

The decision is disappointing because the tax community believed the starting point for corporate taxable income had always been separate income, not consolidated income. The message for businesses is that there are 18 states that require separate reporting and the state tax impact of a bankruptcy discharge does not walk in lockstep with the treatment for federal purposes. Some consideration before filing bankruptcy must be given by parent corporations as to whether its subsidiaries should be excluded from the federal consolidated return in order to avoid harsh state tax consequences.