Is North Carolina's tax break that lets in-state corporations deduct dividends from majority-owned subsidiaries (but denies the same deduction to out-of-state corporations) constitutional under the U.S. Commerce Clause?

Plain-English summary

NC's corporate income tax statute (§ 105-130.7) included several subsections that gave preferential treatment to NC-domiciled corporations. Subsection (4) said: a corporation that has its commercial domicile in NC at the close of its taxable year may deduct from its taxable income "all dividends received from corporations in which it owns more than 50% of the outstanding voting stock." A corporation domiciled in some other state could not take that deduction even on the same subsidiary dividends.

In 1996, the U.S. Supreme Court decided Fulton Corp. v. Faulkner, striking down NC's intangibles tax taxable-percentage deduction as facially discriminatory against interstate commerce. After Fulton, the NC General Assembly repealed subsections (1), (2), (3a), and (5) of § 105-130.7, but left subsection (4) in place. The Department of Revenue asked the AG whether (4) would survive a Fulton-style challenge.

The AG's answer was no. The opinion walked through the dormant Commerce Clause analysis the Supreme Court has applied to state taxes:

Step 1: facial discrimination. A state tax law facially discriminates against interstate commerce when it treats in-state and out-of-state economic interests differently to benefit the former. Subsection (4) is plainly facially discriminatory: it draws the line based on the taxpayer's commercial domicile, with NC domiciliaries getting the deduction and out-of-state corporations not.

Step 2: virtually per se invalid. State laws that discriminate on their face against interstate commerce are "virtually per se invalid" (Fulton; Oregon Waste Systems). The state has the burden to justify the discrimination, typically by showing it advances a legitimate local purpose unrelated to economic protectionism that cannot be achieved by reasonable nondiscriminatory alternatives. The AG found no such justification available.

Step 3: not a valid compensatory tax. Sometimes a facially discriminatory tax can be saved as a "compensatory tax" that offsets a roughly equal burden imposed on in-state economic actors. The AG's footnote n2 explicitly rejects this defense for § 105-130.7(4).

The AG also catalogued parallel cases striking down similar tax preferences in other states: Delta Air Lines (Florida tax credit only for Florida-based carriers) and Perini Corporation (Massachusetts net-worth deduction for in-state subsidiaries only) were both struck down. Kraft General Foods struck down Iowa's worse treatment of foreign vs. domestic subsidiary dividends. The pattern is consistent: state corporate income tax preferences based on the taxpayer's or subsidiary's commercial domicile facially discriminate and fail dormant Commerce Clause review.

The Department's Corporate Tax Division had already recommended repeal of subsection (4) (along with the others) in informal discussions with the AG's office. The Revenue Laws Study Committee had recommended a different fix: amend subsection (4) to extend the deduction to all corporations regardless of domicile, while limiting it to net amounts (disallowing expense deductions tied to the now-deducted income). The AG's recommendation lined up with the Corporate Tax Division: the statute as written would not survive challenge, so the General Assembly needed to act.

Currency note

This opinion was issued in 1997. Subsequent statutory amendments, court decisions, or later AG opinions may have changed the analysis. Treat this page as historical context, not current legal advice. Verify current law before relying on any specific rule, deadline, or remedy mentioned here.

Following this opinion, the General Assembly did revise § 105-130.7. The current dividend-received rules for NC corporate income tax are materially different. Anyone advising on current NC corporate tax should pull current Chapter 105 provisions and check post-1997 case law on dividends-received deductions. The dormant Commerce Clause framework cited in this opinion remains controlling federal doctrine, with later refinements from cases like South Dakota v. Wayfair (2018) (sales tax nexus) and others.

Common questions

Q: What is "commercial domicile"?
A: For corporate income tax purposes, commercial domicile is the corporation's principal place of business, usually the headquarters location where the central management decisions are made. It is not the same as the state of incorporation. A Delaware-incorporated corporation with its headquarters in Charlotte has commercial domicile in NC, even though it is "incorporated" in Delaware. § 105-130.7(4) drew the line at NC commercial domicile, not NC incorporation.

Q: What is a "dividends-received deduction" and why is it usually allowed?
A: When a parent corporation receives dividends from a subsidiary it owns, those dividends represent income that has already been taxed at the subsidiary's level. Taxing the same income again at the parent level would be double taxation of the same earnings. Both federal and state tax law typically allow some kind of dividends-received deduction or exclusion to mitigate that double tax. The constitutional problem in § 105-130.7(4) was not that NC offered such a deduction; it was that NC offered it only to in-state-domiciled corporations.

Q: How does this relate to the U.S. Supreme Court's Fulton Corp. v. Faulkner decision?
A: Fulton (1996) struck down NC's intangibles tax taxable-percentage deduction, which let NC residents reduce their tax on stock holdings by the percentage of the issuing corporation's income that was apportioned to NC. The Supreme Court called it facial discrimination against out-of-state corporations. After Fulton, every similar provision in NC tax law was suspect. § 105-130.7(4) was one of those provisions.

Q: Could NC have justified the preference as a way to attract corporate headquarters to the state?
A: That kind of "economic development" rationale has never worked in dormant Commerce Clause cases. The Supreme Court has repeatedly held that the desire to favor local economic interests is the precise evil the Commerce Clause prevents states from pursuing through their tax codes. New Energy Co. v. Limbach (1988) put it bluntly: regulatory measures "designed to benefit in-state economic interests by burdening out-of-state competitors" are forbidden.

Q: What was the practical impact of leaving subsection (4) in place after Fulton?
A: Any out-of-state corporation that paid NC corporate income tax on subsidiary dividends could file a refund claim arguing it should have been allowed the same deduction as an NC-domiciled corporation. If the courts agreed, the state would owe refunds plus interest. The AG was essentially warning the Department of Revenue and the legislature that this exposure was building.

Background and statutory framework

The dormant Commerce Clause (also called the "negative Commerce Clause") is judge-made doctrine inferred from the affirmative grant of commerce power to Congress in Art. I § 8. The doctrine forbids states from enacting laws that discriminate against, or unduly burden, interstate commerce, even in the absence of conflicting federal legislation. State tax laws are subject to this doctrine.

The modern framework comes from cases like Complete Auto Transit v. Brady (1977, four-prong test for state tax constitutionality) and the more recent line of cases striking down facially discriminatory tax preferences (Oregon Waste Systems, Kraft General Foods, Fulton, etc.). NC has been a recurring defendant in this case law line because of its 1990s vintage of in-state preferences.

Citations

• N.C. Gen. Stat. § 105-130.7(4) (in-state subsidiary dividend deduction at issue)
• N.C. Gen. Stat. § 105-130.7 (corporate income tax deductions generally; subsections (1), (2), (3a), (5) repealed by 1996 N.C. Sess. Laws (Second Extra Sess.) c. 14, s. 3)
• U.S. Const. Art. I, § 8 (Commerce Clause)
• Fulton Corp. v. Faulkner, 511 U.S. ___, 133 L.Ed.2d 796 (1996) — striking down NC intangibles tax taxable-percentage deduction
• Kraft General Foods, Inc. v. Iowa Department of Revenue, 505 U.S. 71 (1992) — foreign vs. domestic subsidiary dividend treatment
• Boston Stock Exchange v. State Tax Commission, 429 U.S. 318 (1977) — bedrock dormant Commerce Clause tax case
• New Energy Co. of Indiana v. Limbach, 486 U.S. 269 (1988) — protectionist motive forbidden
• Westinghouse Electrical Corp. v. Tully, 466 U.S. 388 (1984) — discriminatory tax credit forbidden

Source

• Landing page: https://ncdoj.gov/opinions/constitutionality-of-subsidiary-deduction-for-north-carolina-domiciled-corporations/

Original opinion text

July 14, 1997

Muriel K. Offerman
Secretary of Revenue
North Carolina Department of Revenue
501 North Wilmington Street
Raleigh, North Carolina 27604

Re: Advisory Opinion: Constitutionality of Subsidiary Deduction for North Carolina Domiciled Corporations under N.C.G.S. § 105-130.7(4)

Dear Secretary Offerman:

You have requested our opinion regarding the constitutionality of N.C.G.S. § 105-130.7(4) which provides: "A corporation that, at the close of its taxable year, has its commercial domicile within North Carolina shall be allowed to deduct all dividends received from corporations in which it owns more than 50% of the outstanding voting stock."

The question you pose is not new. In Richmond Food Stores, Inc. v. Jones, 22 N.C.App. 272, 206 S.E.2d 346 (1974), the Court of Appeals held that a statutory scheme which effectively imposed a higher rate of tax on nonresident distributors of bottled soft drinks than on resident distributors violated the Commerce Clause of the United States Constitution. The court found the rate differential to be "clearly arbitrary and discriminatory," holding that the lower tax rate and less burdensome method of payment afforded only to resident distributors under an alternative method of payment was discriminatory and an undue burden on interstate commerce. "The implied exclusion of non-resident distributors from the act has the same effect as if [it] were boldly stated in express terms and is equally noxious to the Constitution of the United States. It is void." Id. at 275, 206 S.E.2d at 348.

The Commerce Clause of the United States Constitution ("Commerce Clause"), n1 phrased as an affirmative grant of regulatory power to Congress, has long been interpreted as containing a negative aspect which denies states the power to interfere with the free flow of commerce. See Northwestern States Portland Cement Co. v. Minnesota, 358 U.S. 450, 458 (1959). In its negative aspect, the Commerce Clause "prohibits economic protectionism — that is, 'regulatory measures designed to benefit in-state economic interests by burdening out-of-state competitors.'" Fulton Corp. v. Faulkner, 511 U.S. , , 133 L.Ed.2d 796, 804 (1996) (quoting New Energy Co. of Indiana v. Limbach, 486 U.S. 269, 273-274 (1988)).

n1 "The congress shall have power … to regulate commerce with foreign nations, and among the several states, and with the Indian tribes…." U.S. Const. Art. I, § 8.

The United States Supreme Court has held that the first step in analyzing any law subject to judicial scrutiny under the negative Commerce Clause is to determine whether it "regulates evenhandedly with only incidental effects on interstate commerce, or discriminates against interstate commerce." Oregon Waste Systems v. Department of Environmental Quality, 511 U.S. , , 128 L.Ed.2d 13, 21 (1994). For these purposes, "'discrimination' simply means differential treatment of in-state and out-of-state economic interests that benefits the former and burdens the latter." Id. "State laws discriminating on their face are 'virtually per se invalid.'" Fulton, 511 U.S. at , 133 L.Ed.2d at 805 (quoting Oregon Waste Systems, 511 U.S. at , 128 L.Ed.2d at 21).

A fundamental principle under the Commerce Clause is that "no state may, consistent with the Commerce Clause, 'impose a tax which discriminates against interstate commerce … by providing a direct commercial advantage to local businesses.'" Boston Stock Exchange v. State Tax Commission, 429 U.S. 318, 329 (1977) (quoting Northwestern States Portland Cement Co. v. Minnesota, 358 U.S. at 458). "A state tax that favors in-state businesses over out-of-state businesses for no other reason than the location of its business is prohibited by the Commerce Clause." American Trucking Associations v. Scheiner, 484 U.S. 266, 286 (1987). Similarly, in Kraft General Foods, Inc. v. Iowa Department of Revenue, 505 U.S. 71 (1992), the United States Supreme Court held that a statute that treated dividends received from foreign (international) subsidiaries less favorably than those received from domestic subsidiaries facially discriminated against foreign commerce in violation of the Foreign Commerce Clause.

In Delta Air Lines, Inc. v. Department of Revenue, 455 So.2d 317 (1984), the Florida Supreme Court held that a tax credit granted to only Florida-based carriers violated the Commerce Clause because the credit provided a direct commercial advantage to Florida-based common carriers over non-Florida-based carriers. The court found that the credit provision conferred an artificial economic advantage on those interstate air carriers who maintained their corporate headquarters in Florida over those competing air carriers who based their corporate headquarters outside the state.

In Perini Corporation v. Commissioner of Revenue, 419 Mass. 763, 647 N.E.2d 52 (1995), the Massachusetts Supreme Court held that a corporate excise tax provision allowing a domestic parent corporation to deduct from its taxable net worth the value of a subsidiary of which it owned 80% or more voting stock, but only if that subsidiary is incorporated in the state, facially discriminated against interstate commerce since the provision drew a distinction solely on the basis of the commercial domicile of the subsidiary and treated a domestic corporation more favorably if it chose to acquire a domestic rather than foreign subsidiary.

Recently, the United States Supreme Court ruled that the taxable percentage deduction of North Carolina's intangibles tax facially discriminated against interstate commerce in violation of the Commerce Clause, failed justification as a valid compensatory tax and therefore could not stand. Fulton Corp. v. Faulkner, 511 U.S. ___, 133 L.Ed.2d 796. In the wake of Fulton, the various tax preferences in N.C.G.S. § 105-130.7 and other similar provisions received close scrutiny.

In its recommendations to the General Assembly, the Corporate Tax Division, based in part on informal discussions with the Attorney General's Office, recommended repeal of subsection (4) of N.C.G.S. § 105-130.7, along with subsections (1), (2), (3a) and (5). The Report of the Revenue Laws Study Committee to the Legislative Research Commission recommended repeal of subsections (1), (2), (3a) and (5). The Report further recommended amending subsection (4) to extend the deduction to all corporations, regardless of state of commercial domicile and limiting the deduction to the net amount, i.e., disallowing the deduction of expenses relating to the untaxed income. The General Assembly repealed subsections (1), (2), (3a) and (5). 1996 N.C. Sess. Laws (Second Extra Sess.) c. 14, s. 3. The legislature took no action regarding subsection (4), however.

The deduction afforded by N.C.G.S. § 105-130.7(4) is only available to corporations commercially domiciled in North Carolina. Thus, the provision provides a direct commercial advantage to local businesses, benefiting in-state corporations at the expense of their out-of-state competitors. Moreover, the deduction favors in-state corporations over out-of-state corporations based solely on the location of the taxpayer's business. The Commerce Clause prohibits such preferential treatment which "'forecloses tax-neutral decisions and … creates … an advantage' for corporations operating in [North Carolina]…." Westinghouse Electrical Corp. v. Tully, 466 U.S. 388, 406 (1984) (quoting Boston Stock Exchange, 429 U.S. at 331). See also Oregon Waste Systems v. Department of Environmental Quality, 511 U.S. ___, 128 L.Ed.2d 13; New Energy Co. of Indiana v. Limbach, 486 U.S. 269; American Trucking Associations v. Scheiner, 484 U.S. 266; Boston Stock Exchange v. State Tax Commission, 429 U.S. 318. It is therefore our opinion that N.C.G.S. § 105-130.7(4) facially discriminates against interstate commerce in violation of the Commerce Clause and would not survive a judicial challenge. n2

n2 We do not believe N.C.G.S. § 105-130.7(4) can be justified as a valid compensatory tax under Fulton.

We hope the foregoing is helpful. If we can be of further assistance, please let us know.

Sincerely yours,

Reginald L. Watkins
Senior Deputy Attorney General

Kay Linn Miller Hobart
Assistant Attorney General