Comptroller of the Treasury v. Colonial Farm Credit, ACA

KENNEY, J. The Comptroller of the Treasury, appellant, denied claims for refunds in amended tax returns filed by Colonial Farm Credit, ACA, 1 appellee, and the Maryland Tax Court affirmed that decision. After the Circuit Court for Baltimore City reversed the Maryland Tax Court, the Comptroller noted this appeal and presents one question: Did the Circuit Court for Baltimore City err in concluding that a settlement reached between Colonial and the Internal Revenue Service, which provided that 60% of Colonial’s income from certain long-term real estate mortgage loans was exempt from tax, was binding on the Comptroller for determining Maryland taxable income for state income tax purposes? Colonial states the question somewhat differently: Whether the Circuit Court correctly determined that Colonial’s federal taxable income, as finally determined pur ¹⁷⁶ suant to IRC § 7121 Closing Agreements On Final Determinations Covering Specific Matters, serves as Colonial’s federal taxable income for Maryland income tax purposes pursuant to MD Code Ann., Tax-Gen. §§ 10-304 and 10-107. For the following reasons, we shall affirm the judgment of the circuit court.

FACTUAL AND PROCEDURAL HISTORY The facts of this case are undisputed. 2 A corporation’s Maryland income tax liability is based on its “federal taxable income for the taxable year as determined under the Internal Revenue Code.” Md.Code (1988, 2004 RepLVdL), § 10-304(1) of the Tax-General Article (“Tax-Gen.”). In 2002, Colonial filed amended Maryland tax returns for 1991 and 1993-2000 on the ground that it had reached an agreement with the Internal Revenue Service that its federal taxable income for those years was lower than originally reported. In a letter dated November 6, 2002, the Comptroller denied Colonial’s amended returns. Colonial filed a protest, and an informal hearing was held on January 23, 2003.

The Comptroller affirmed its denial in a Notice of Final Determination dated March 31, 2004. Colonial appealed the Comptroller’s decision to the Maryland Tax Court. After a hearing on December 8, 2004, the Tax Court affirmed the Comptroller’s denial of the amended tax returns. Colonial petitioned for judicial review in the Circuit Court for Baltimore City.

After a hearing, the court reversed the decision of the Tax Court. Thereafter, the Comptroller noted this timely appeal. 3 Additional facts will be provided as necessary for our discussion of the issues. ¹⁷⁷ STANDARD OF REVIEW “The scope of our review is substantially the same as that of the circuit court. That is, we review the Tax Court’s decision and not the decision of the circuit court.” Pleasants Investments Ltd. P’ship v. State Dept. of Assessments & Taxation, 141 Md.App. 481, 489 , 786 A.2d 13 (2001). “[A] reviewing court is under no statutory constraints in reversing a Tax Court order which is premised solely upon an erroneous conclusion of law.” Supervisor of Assessments of Anne Arundel County v. Hartge Yacht Yard, Inc., 379 Md. 452, 461 , 842 A.2d 732 (2004). “On the other hand, where the Tax Court’s decision is based on a factual determination, and there is no error of law, the reviewing court may not reverse the Tax Court’s order if substantial evidence of record supports the agency decision.” Id. The Court of Appeals has explained that, under this standard of review, “our scope of review remains narrow if a reasoning mind could have reached the Tax Court’s conclusion based on the evidence.

We will not broaden our scope of review and overturn the Tax Court’s decision unless it was based on an error of law.” Dept. of Assessments & Taxation v. Consol. Coal Sales Co., 382 Md. 439, 455 , 855 A.2d 1197 (2004). ¹⁷⁸ DISCUSSION Agricultural Credit Associations Colonial is an Agricultural Credit Association within the federal “Farm Credit System,” which was created by Congress in 1916. It serves the purpose “of improving the income and well-being of American farmers and ranchers by furnishing sound, adequate, and constructive credit and closely related services to them, their cooperatives, and to selected farm-related businesses necessary for efficient farm operations.” 12 U.S.C.A. § 2001 (a). In response to economic difficulties in the 1980s, Congress enacted the Agricultural Credit Act of 1987 “to provide credit assistance to farmers, to strengthen the Farm Credit System, to facilitate the establishment of secondary markets for agricultural loans, and for other purposes.” Act of Jan. 6, 1988, Pub.L. No. 100-233, 101 Stat. 1568.

Among other things, the Act provided for voluntary “Merger of Like and Unlike Associations” within the Farm Credit System. Id. at § 416. Under 12 U.S.C.A. § 2279e-l(a), “[t]wo or more associations within the same district ... may merge into a single entity,” if the merger is approved by the Farm Credit Administration Board, the boards of directors of the merging associations, the majority of the shareholders of each association, and the Farm Credit Bank. The resulting association is known as an “Agricultural Credit Association” (“ACA”).

See, e.g„ 12 C.F.R. § 611.1040 . Among the associations within the Farm Credit System are Federal Land Bank Associations (“FLBAs”) and Production Credit Associations (“PCAs”). The principal function of FLBAs is to facilitate long term real estate mortgage loans from Farm Credit Banks, 12 U.S.C.A. § 2093 , and they are exempt from federal and state income taxation, 12 U.S.C.A. § 2098 . The general purpose of PCAs is to “make, guarantee, or participate with other lenders in short- and intermediate-term loans and other similar financial assistance” to qualified agriculture-related borrowers. 12 U.S.C.A. § 2075 .

PCAs are not tax exempt. 12 U.S.C.A. § 2077 . ¹⁷⁹ FLBAs and PCAs can merge under 12 U.S.C.A. § 2279c-l to create an ACA. “The idea [of the Agricultural Credit Act of 1987] was to streamline the System, reduce costs and increase efficiency, and ultimately to assist member institutions to provide competitive interest rates. Thus a PCA and an FLBA could merge, creating an ACA, and offer short, intermediate and long-term loans within its chartered territory.” Buckeye Production Credit Ass’n v. Farm Credit Admin., 997 F.2d 11, 13-14 (4th Cir.1993) (citations omitted). Colonial was formed in 1989 through the merger of The Colonial, PCA, and Colonial, FLBA. With respect to the nature of ACAs, 12 U.S.C.A. § 2279c-1(b) states: “Except as otherwise provided by this subchapter, a merged association shall — (A) possess all powers granted under this chapter to the associations forming the merged association; and (B) be subject to all of the obligations imposed under this chapter on the associations forming the merged association.” Thus, an ACA may continue to conduct the transactions that were previously conducted by the various associations that were merged to form the ACA.

After the creation of ACAs by Congress, disputes arose between ACAs and the Internal Revenue Service (“IRS”) regarding whether lending activities that would have previously been conducted by FLBAs remained tax exempt after the merger of an FLBA into an ACA. In United States v. Farm Credit Servs. of Fargo, ACA, 89 A.F.T.R.2d (R.I.A.) 2002-334-36 (1998), the United States District Court for the District of North Dakota considered one such dispute. Fargo had paid income taxes on all of its lending activities, but then sought a refund of taxes paid on lending activities that would have previously been performed by the merged FLBA. The IRS initially granted the refund, but later requested repayment, leading to the litigation before the federal district court.

The court concluded that the lending services at issue are tax exempt: 12 U.S.C. § 2098 specifically grants an income tax exemption to FLBAs whose income is derived from providing and servicing long term real estate loans. This Court holds that ¹⁸⁰ this exemption from taxation applies equally to the restructured Fargo-ACA which has been formed by merger pursuant to 12 U.S.C. § 2279c-l. Fargo-ACA is merely the continuation of the local FLBA and PCA with identical powers and obligations. Section 2279c-l provides that the restructured ACA shall “possess all powers granted under this chapter,” and likewise is “subject to all the obligations imposed under this chapter on the Associations forming the merged association.” Since no corporate powers or obligations unique to the ACA are provided, it is obvious that the ACA can only function under the auspices of the incorporated sections of the chapter explicitly referenced, specifically those sections applicable to the pre-merger entities.

This would clearly include the taxation provisions for FLBAs pursuant to 12 U.S.C. § 2098 . To conclude that Congress intended to deny the continuance of the exemption from federal income tax on income earned from long term lending activities, which has been exempt since 1916, would be illogical and absurd. See The Federal Farm Loan Act, Pub.L. No. 158, § 26, 39 Stat. 360 , 380 (1916). This is especially so upon a simple reading of the Act of 1987: Congress means to provide financial assistance to the agricultural industry, not create obstacles.

Fargo, 89 A.F.T.R.2d at 2002-336-37. According to Colonial, the Fargo decision resulted in “closing agreements” between the IRS and all ACAs as to the taxable income for FLBA-like lending activities for certain years. The IRS entered into a closing agreement with Colonial, which entitled Colonial to a refund of 60% of its “long-term taxable income” for the years 1991 and 1993-1999, and a second closing agreement to the same effect for the year 2000. Those closing agreements, which adjusted Colonial’s federal taxable income for the years at issue, are the basis for Colonial’s contention that it is entitled to a refund of state income taxes for the years at issue. ¹⁸¹ State Income Tax Maryland income tax liability is dependent, to some extent, on the taxpayer’s federal income tax liability.

Tax-Gen. § 10-107 provides that, “[t]o the extent practicable, the Comptroller shall apply the administrative and judicial interpretations of the federal income tax law to the administration of the income tax laws of this State.” With respect to state corporate income tax, Tax-Gen. § 10-301 provides: “The Maryland taxable income of a corporation is its Maryland modified income as allocated to the State under Subtitle 4 of this title.” Tax-Gen. § 10-304 states: Except as provided in Subtitle 4 of this title, the Maryland modified income of a corporation, including a real estate investment trust or regulated investment company, is: (1) the corporation’s federal taxable income for the taxable year as determined under the Internal Revenue Code and as adjusted under this Part II of this subtitle ____ The Court of Appeals has explained the doctrine of conformity between state and federal tax law as follows: [T]he whole thrust of the Maryland Act is to impose a tax on the amount determined under the Internal Revenue Code as the adjusted gross income of an individual or the taxable income of a corporation. This is a formula or yardstick objectively derived which initially takes no account of the source, nature or composition of the funds; it is simply a figure developed by the federal return. Katzenberg v. Comptroller of Treasury, 263 Md. 189, 204-205 , 282 A.2d 465 (1971). As a result, “[wjhereas federal law must enumerate and define items of income in a wide variety of factual situations, Maryland law, by virtue of its adoption of the federal law, need not.” Comptroller of the Treasury v. Chesapeake Corp. of Virginia, 54 Md.App. 208, 214 , 458 A.2d 459 (1983). “[T]he essential, initial determination which must be made before a corporation may be subjected to Maryland tax is whether that corporation has federal taxable income” and the amount of that taxable income.

Ford Motor Land ¹⁸² Dev. Corp. v. Comptroller of Treasury, 68 Md.App. 342, 353 , 511 A.2d 578 (1986). Nevertheless, Maryland tax law looks only to the total federal taxable income generated on the federal tax return, without regard to other aspects of federal law that might ultimately affect the taxpayer’s federal tax liability. For example, the “taxable income” figure cannot be modified for Maryland tax purposes based on federal tax breaks.

Marco Assocs. v. Comptroller of the Treasury, 265 Md. 669 , 291 A.2d 489 (1972). In Marco, which was decided before Maryland recognized Subchapter S corporations, the Court of Appeals held that Marco Associates could not deduct from its state taxable income the amount of its income that, under federal tax law, “passed through” to its shareholders. The Court reasoned: [The] focus [of Maryland income tax law] is on the taxable income of a corporation, or the adjusted gross income of an individual, as the same is developed in the taxpayer’s federal income tax return, subject to the modifications permitted by the Act, whether a federal tax is or is not generated by the return. The fact that a gain recognized by a Subchapter S corporation and reflected in its taxable income may be attributed to the corporation’s shareholders under federal law does not alter the fact that it remains within the concept of taxable income under the Act — a figure upon which the Maryland tax is based.

Id. at 678 , 291 A.2d 489 . Similarly, in NCR Corp. v. Comptroller of the Treasury, 313 Md. 118 , 544 A.2d 764 (1988), the Court of Appeals held that NCR was not permitted to deduct certain amounts from its taxable income that had been added to the income figure for federal income tax purposes only. NCR had claimed credits on its federal income tax return for foreign taxes paid by its foreign subsidiaries. The credits appeared on its federal return as “grossed-up” dividend income.

The Court of Ap ¹⁸³ peals concluded that NCR was not entitled to deduct the “grossed-up” dividend income from its state taxable income: As we have seen, § 280A(a) instructs, as it did in 1976, that “[t]he net income of a corporation shall be the taxable income of such taxpayer as defined in the laws of the United States ... for the corresponding taxable period.... ” The purpose of that provision is “to bring the State taxation system in conformity with the federal scheme.” Comptroller v. American Satellite Corp., 312 Md. 537, 545 , 540 A.2d 1146,1150 (1988). Since NCR’s 1976 federal taxable income included the gross-up, and since the Maryland statutes applicable to 1976 contained no authority to adjust or deduct that figure, it should, one would think, be included in Maryland taxable income. NCR Corp., 313 Md. at 123 , 544 A.2d 764 . On the other hand, the Comptroller is not required to accept the federal taxable income figure provided on a taxpayer’s federal tax return merely because that figure was accepted by the IRS.

To the contrary, the doctrine of conformity presupposes a truthful and accurate federal taxable income figure: “Obviously the Maryland law contemplates the truthful reporting of income on the federal return; otherwise a defrauding taxpayer, while subject to federal prosecution, would escape state prosecution, a result hardly contemplated by the legislature.” Winters v. State, 301 Md. 214, 236 , 482 A.2d 886 (1984). The Comptroller therefore has the authority to adjust a taxpayer’s taxable income to ensure that it is truthful and accurate under the IRC: If a taxpayer failed to report certain income on its federal tax return that the I.R.C. mandated it to report, and the IRS accepted that figure, [the Comptroller] should be permitted to recalculate the Maryland modified income because the federal taxable income figure it relies on would be incorrect. Likewise, if the IRS exercised its discretion to create mandatory regulations that required the taxpayer to report certain income, and the taxpayer failed to do so, [the Comptroller] could follow those IRS regulations in recalcu ¹⁸⁴ lating the Maryland modified income. In both cases, the statute or regulation are rigid and objective in their determination of what is taxable income.

If we were to hold that [the Comptroller] could never apply such provisions, then taxpayers who evade their federal income taxes would be free, without considering criminal sanctions, to evade their Maryland income tax obligation as well. We should not attribute such an illogical intent to the Legislature’s 1967 revision of the state tax code. Comptroller of the Treasury v. Gannett Co., 356 Md. 699, 716 , 741 A.2d 1130 (1999) (footnote omitted). In Gannett, the Comptroller had argued that he had authority to make a discretionary determination to impute to a parent company certain interest income from intercompany accounts with its subsidiaries because the Secretary of the IRS has such authority under the IRC.

The Court held that, although the Comptroller may enforce mandatory reporting requirements under the IRC, he may not exercise discretionary authority under the IRC. Id. at 719-20 , 741 A.2d 1130 . Closing Agreements There are two methods by which a taxpayer may enter into a binding agreement with the IRS on a disputed issue: (1) a closing agreement under 26 U.S.C.A. § 7121 , or (2) a compromise under 26 U.S.C.A. § 7122 . Matter of Avildsen Tools & Machine, Inc., 794 F.2d 1248, 1253 (7th Cir.1986); Combs v. United States, 790 F.Supp. 850, 852 (S.D.Ind.1992); Jacob Mertens, Jr., Law of Federal Income Taxation § 54:135 (Supp.2006). 26 U.S.C.A. § 7121 provides: (a) Authorization. — The Secretary is authorized to enter into an agreement in writing with any person relating to the liability of such person (or of the person or estate for whom he acts) in respect of any internal revenue tax for any taxable period.

(b) Finality. — If such agreement is approved by the Secretary (within such time as may be stated in such agreement, or later agreed to) such agreement shall be final and ¹⁸⁵ conclusive, and, except upon a showing of fraud or malfeasance, or misrepresentation of a material fact— (1) the case shall not be reopened as to the matters agreed upon or the agreement modified by any officer, employee, or agent of the United State, and