Corporate Close-Up: New Jersey Court Rules That State Cannot Impose Corporate Business Tax on Foreign-Source Income Not Subject to United States Federal Income Tax

The Tax Court of New Jersey (Tax Court) recently ruled that a foreign corporation’s foreign-source income that is not taxable for United States federal income tax purposes is also not subject to New Jersey’s Corporate Business Tax (CBT) for that income. This ruling is an example of how courts will not let state agencies use regulatory authority to reach beyond the scope of their underlying statutes. It also highlights New Jersey’s adherence to International Business Machines Corp. v. Director, Division of Taxation (IBM), where the Tax Court limited CBT liability for foreign-source income to only that which is subject to U.S. federal corporate income tax.

In Infosys Limited of India, Inc. v. Director, Division of Taxation, the Tax Court ruled in favor of Infosys Limited of India (Infosys), finding that Infosys’ foreign-source income that was not taxable for federal income tax purposes was not subject to the CBT, and ordered the New Jersey Division of Taxation (Division) to issue Infosys a refund of $5,831,788 plus interest. 

Infosys, a corporation headquartered and incorporated in India, had a U.S. branch and was a foreign corporation for federal income tax purposes. In December 2007, Infosys entered into a pre-filing agreement with the IRS, resulting in only its U.S.-source income being subject to federal income tax. Its foreign-source income, on the other hand, was exempt from federal income tax due to a tax treaty between the U.S. and India. Under the treaty, Infosys’ only income that was subject to U.S. federal income taxation was income attributable to a business in the U.S. conducted through a permanent establishment, such as a branch office. Infosys also filed timely CBT returns with the Division. The tax base for Infosys’ New Jersey income was its Entire Net Income (ENI). During an IRS audit in 2011, Infosys realized that it mistakenly included its worldwide income, rather than its ENI, on its New Jersey CBT returns. In June 2012, Infosys filed amended New Jersey CBT returns with its recalculated ENI, which resulted in an overpayment. The Division then audited Infosys’ New Jersey CBT returns and made adjustments that resulted in additional tax assessed. Infosys filed an administrative appeal in December 2014 that was denied in May 2016 and subsequently filed a complaint with the Tax Court.

The issue that the Tax Court addressed was whether Infosys’ ENI for the CBT should have adopted federal taxable income as its tax base, subject only to the listed adjustments, or whether the Division could determine Infosys’ ENI by adding Infosys’ worldwide income that was not taxable for federal income tax purposes to Infosys’ federal taxable income.

N.J.S.A. 54:10A-4(k) imposes the CBT on foreign corporations for the privilege of conducting business activity in New Jersey. The income that is subject to the CBT is the ENI, which is apportioned pursuant to N.J.S.A. 54:10A-6. N.J.S.A. 54:10A-4(k) provides that the ENI is the total net income from all sources, within or without the United States. However, N.J.S.A. 54:10A-4(k) also limits ENI to federal taxable income before net operating loss deductions and special deductions.

The Division claimed that N.J.S.A. 54:10A-4(k) allowed it to add back Infosys’ worldwide income to Infosys’ federal tax base. This was the same claim that the Division made in IBM in 2011, where the Tax Court held that a corporation’s ENI for CBT purposes was its federal taxable income before net operating loss and special deductions.

The Tax Court used the same analysis that it did in IBM. First, the Tax Court considered the definition of ENI in N.J.S.A. 54:10A-4(k) and emphasized the plain language of the statute. In addition, the Tax Court emphasized that the Legislature could have amended N.J.S.A. 54:10A-4(k) to allow exempt foreign-source income to be included in ENI if it intended to do so, and that if the Legislature did intend to include all foreign-source income in ENI, then it would not have needed to amend N.J.S.A. 54:10A-4(k) previously to account for changes in the Internal Revenue Code. 

The Division claimed that N.J.A.C. 18:7-5.2(a)(1)(xi) allowed it to determine Infosys’ ENI by adding Infosys’ worldwide income to its federal taxable income, because N.J.A.C. 18:7-5.2(a)(1)(xi) provided that all income from sources outside of the U.S. which was not included in computing taxable income needed to be added to Federal taxable income in order to determine ENI. However, the Tax Court determined that the Division could not use N.J.A.C. 18:7-5.2(a)(1)(xi) to extend the CBT to income that the Legislature did not intend to reach with N.J.S.A. 54:10A-4(k). This prevented the Division from imposing the CBT on Infosys’ worldwide income that was exempt from federal taxable income.

Next, the Division claimed that Toyota Motor Credit Corp. v. Director, Division of Taxation (Toyota) prevented Infosys from reducing its taxable income without an expressly enumerated adjustment. In Toyota, the Tax Court ruled that a taxpayer could add back depreciation claimed for federal income tax purposes to its New Jersey tax base if the taxpayer did not receive any New Jersey tax benefit for the depreciation claimed. There was no statutory basis for the adjustment, but it was permissible for the tax policy reason of avoiding taxation of “‘phantom income’” in New Jersey. The Division claimed that IBM and Toyota were inconsistent, because Toyota allowed a taxpayer to reduce its tax base without a statutory adjustment, while IBM required the Division to have a statutory adjustment to increase a taxpayer’s tax base.

The Tax Court ruled that IBM and Toyota addressed separate issues and were reconcilable, because IBM addressed the determination of income for purposes of the CBT, while Toyota addressed the taxation of gain from the sale of property. Because of this, the Tax Court ruled that they were consistent, and that Infosys’ situation was more like that in IBM. In 2011, the Tax Court ruled in IBM that worldwide income not otherwise taxable for federal income tax purposes should not be included in ENI. The Tax Court followed its precedent from IBM and ruled that Infosys was not subject to the CBT for its worldwide income that was exempt from federal income tax. The Tax Court applied the analysis from IBM, and ruled that Infosys’ tax base should match its federal taxable income.  

This ruling is an example of how New Jersey courts have determined that the income subject to its CBT is federal taxable income with specified, enumerated exceptions, in addition to how courts will not allow agencies to use regulatory authority to expand their tax base beyond what was statutorily intended.

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: Should Infosys’ federal tax-exempt foreign source income have been subject to New Jersey’s Corporate Business Tax, and did the New Jersey Division of Taxation try to use its regulatory authority to reach beyond what was permissible by statute?

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