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Delaware Supreme Court invalidates Division’s NOL limitation policy
December 2021
In brief
The Delaware Supreme Court on November 29 found that the Division of Revenue’s policy limiting a corporate income taxpayer’s net operating loss (NOL) deduction to the amount of its federal consolidated group’s NOL violated Delaware statutory law requiring corporate taxpayers to report as stand-alone entities.
The takeaway. Although the decision is a taxpayer-favorable outcome, a July 30, 2021, Delaware law change codifies much of the Division’s policy. The new law does not provide an effective or applicable date. Accordingly, it is uncertain to which tax years the law change will be deemed to apply. However, taxpayers that previously have been assessed tax based on the Division’s NOL limitation policy, or filed original returns based on the Division’s policy, may consider filing refund claims. Refund claims must be made by the later of three years from the last date prescribed for filing the return or two years from the time that the tax was paid.
[Director of Revenue v. Verisign, Inc., Del. Sup Ct., C.A. No. N19C-08-093 (11/29/21)]
In detail
Facts
Verisign, Inc. claimed NOL deductions on its 2015 and 2016 Delaware income tax returns, which reduced its taxable income to zero in both years. The Division took the position that Verisign’s use of NOLs violated a longstanding, but non-statutory, Division policy. Under the policy, a corporate taxpayer that filed its federal tax returns with a consolidated group could not claim an NOL deduction in Delaware that exceeded its federal consolidated NOL deduction. The Division applied the policy, determined that Verisign had underreported its income, and assessed the company unpaid taxes and fees.
After Verisign’s administrative protest of the assessment was denied, it appealed to the Superior Court. The Superior Court held that the policy violated the Uniformity Clause of the Delaware Constitution — the provision requiring that “[a]ll taxes shall be uniform upon the same class of subjects.” Click here for our Insight summarizing the Superior Court’s decision.
The Division appealed to the Delaware Supreme Court.
Division policy limiting NOL
Based on policy outlined in the Division’s audit manual, a Delaware taxpayer claims an NOL deduction by taking the following two steps:
- It computes its NOL on a separate-company basis under IRC Sec. 172.
- It caps its NOL “at the size of the consolidated NOL deduction reported by its federal filing group.”
NOL limitation held inconsistent with Delaware law
During the years at issue, Del. Stat. Sec. 1902(a) provided that “[e]very domestic or foreign corporation that is not exempt . . . shall annually pay a tax . . . on its taxable income.” Section 1903(b) then provided that “‘[t]axable income’ subject to taxation under this chapter means the portion of entire net income of a corporation which is allocated and apportioned to this State.” Finally, Section 1903(a) defined the “‘entire net income’ of a corporation [as] the amount of its federal taxable income for such year as computed for the purposes of the federal income tax.”
The Delaware Supreme Court found that Sections 1902 and 1903 obligated each eligible corporation to pay Delaware tax as a stand-alone entity, rather than on a consolidated basis. The Court concluded that the Division’s use of an aggregate NOL deduction corresponding to the losses of multiple members was “flatly inconsistent” with the “plain meaning” of Delaware law.
Constitutional arguments not addressed
The Delaware Superior Court ruled that the Division’s policy violated Delaware’s Uniformity Clause. Additionally, Verisign asserted the policy discriminated against interstate commerce. Because the Delaware Supreme Court ruled in favor of Verisign on statutory grounds, it did not reach Verisign’s constitutional arguments.
Law change
Enacted on July 30, 2021, H.B. 171 provides an addition modification for “[a]ny deduction for a net operating loss carryforward calculated in accordance with the provisions of the Internal Revenue Code, provided however that the deduction may not exceed the amount claimed on the federal return filed for the taxable year in which the taxpayer was included as a party.”
According to the bill’s original synopsis, this new language “codifies the long-standing practice of the Division of Revenue to limit Net Operating Loss deductions to those deductions that were claimed on a federal return. Because Delaware tax law starts with the income reported and deductions available at the federal level, any net operating loss that exceeds that claimed on a federal return is not permitted in the calculation of Delaware tax.”
Observation: H.B. 171 does not provide an effective or applicable date. Accordingly, it is uncertain to which tax years the law change will be deemed to apply. Due to the absence of retroactive language, taxpayers may argue that the new law should not apply to tax years prior to enactment. Taxpayers should note that the Superior Court invalidated the policy under Delaware’s Uniformity Clause and that the Delaware Supreme Court did not reach a constitutional review.
Accordingly, even if the Division seeks to apply H.B. 171, taxpayers may want to raise constitutional challenges under the Delaware Uniformity Clause or the federal Commerce Clause.
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