Comptroller of Treasury v. Gannett Co.

CATHELL, Judge. The Comptroller of the Treasury, appellant, appeals a ruling from the Circuit Court for Montgomery County that appellant lacked the authority to assess additional income tax against Gannett Company, Inc., appellee, by imputing interest income ⁷⁰² from certain intercompany debt not reported on appellee’s federal income tax returns. We agree with the circuit court and, accordingly, affirm the lower court. I. Background Appellee is a Delaware corporation, headquartered in Virginia, with computer support facilities in Silver Spring, Maryland.

A leading corporation in the media industry, appellee is the parent company to many wholly-owned subsidiary media companies. Appellee maintains four centralized, intercompany accounts with its subsidiaries. 1 The subsidiaries deposit their proceeds in the appropriate account and then draw on that account to pay their related individual expenses. If a subsidiary deposits more proceeds than it withdraws, appellee maintains an interest-free debit with the subsidiary. If the subsidiary spends more money than it deposits, appellee maintains an interest-free credit with the subsidiary.

For the tax years 1990-92, appellee maintained with its subsidiaries a credit in three of the four intercompany accounts. The parties stipulated to the Maryland Tax Court below, in writing, that these credits were a form of interest-free debt. Appellant claims that, under two federal tax code provisions, it may assess income tax against these credits by imputing interest income from them. ⁷⁰³ The first provision, I.R.C. § 482 (1999), states in relevant part: § 482. Allocation of income and deductions among taxpayers In any case of two or more ... businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such ... businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such ... businesses.

The second provision, I.R.C. § 7872 (1999), states in relevant part: § 7872. Treatment of loans with below-market interest rates (a) Treatment of gift loans and demand loans.— (1) In general.—For purposes of this title, in the case of any below-market loan to which this section applies and which is a gift loan or a demand loan, the foregone interest shall be treated as— (A) transferred from the lender to the borrower, and (B) retransferred by the borrower to the lender as interest. (b) Treatment of other below-market loans.— (1) In general.—For purposes of this title, in the case of any below-market loan to which this section applies and to which subsection (a)(1) does not apply, the lender shall be treated as having transferred on the date the loan was made (or, if later, on the first day on which this section applies to such loan), and the borrower shall be treated as having received on such date, cash in an amount equal to the excess of— (A) the amount loaned, over ⁷⁰⁴ (B) the present value of all payments which are required to be made under the terms of the loan. (2) Obligation treated as having original issue discount.—For purposes of this title— (A) In general.—Any below-market loan to which paragraph (1) applies shall be treated as having original issue discount in an amount equal to the excess described in paragraph (1).

(B) Amount in addition to other original issue discount.—Any original issue discount which a loan is treated as having by reason of subparagraph (A) shall be in addition to any other original issue discount on such loan (determined without regard to subparagraph (A)). (c) Below-market loans to which section applies.— (1) In general.—Except as otherwise provided ... this section shall apply to— (C) Corporation-shareholder loans.—Any below-market loan directly or indirectly between a corporation and any shareholder of such corporation. (D) Tax avoidance loans.—Any below-market loan 1 of the principal purposes of the interest arrangements of which is the avoidance of any Federal tax. (E) Other below-market loans.—To the extent provided in regulations, any below-market loan which is not described in subparagraph (A), (B), (C), or (F) if the interest arrangements of such loan have a significant effect on any Federal tax liability of the lender or the borrower.

(h) Regulations.— (1) In general.—The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this section, including— (C) regulations exempting from the application of this section any class of transactions the interest arrange ⁷⁰⁵ ments of which have no significant effect on any Federal tax liability of the lender or the borrower. For the tax years in question, 1990-92, appellee, as it was allowed to do, filed a consolidated federal tax return on behalf of itself and all of its subsidiaries with the Internal Revenue Service (IRS). Appellee did not report the intercompany account credits on its federal tax return because any interest income that could have been imputed from the credits under I.R.C. §§ 482 and 7872 would have been offset by the reciprocal imputed interest deduction attributed to each subsidiary. In other words, any interest income appellee would have had to report on its consolidated federal tax return would presumably have been eliminated by any interest expense deduction that appellee could have claimed on behalf of its subsidiaries.

The IRS, which conducted an audit on other grounds, accepted the returns as filed. 2 The Maryland income tax code bases “the Maryland modified income of a corporation” on “the corporation’s federal taxable income for the taxable year as determined under the Internal Revenue Code....” Md.Code (1988, 1997 Repl.Vol.), § 10-304(1) of the Tax-General Article. 3 The Maryland Code, however, does not allow related corporations to file consolidated returns. See id. § 10-811. The Maryland income tax code thus required appellee to base its Maryland modified income on the portion of its reported federal consolidated taxable ⁷⁰⁶ income earned by it in Maryland. Because appellee did not report the three intercompany account credits on its consolidated federal return, it did not report them on its individual Maryland tax form.

Appellant alleges that not reporting the intercompany credits allowed appellee to understate its portion of the consolidated federal taxable income on its separate Maryland income tax return. 4 Believing that I.R.C. §§ 482 and 7872 allowed it to impute interest income from appellee’s intercompany credits, appellant recalculated appellee’s Maryland modified income. It originally assessed $2,216,066 in additional income tax against appellee. Appellee sought a revision of the assessment before an administrative hearing officer, who upheld the assessment but reduced it to $1,279,785. Appellee appealed that ruling to the Maryland Tax Court, arguing that the intercompany account credits were not debt and that, if they were, appellant had no authority to impute interest income from that debt unless the IRS had required it on appellee’s federal tax return.

The Maryland Tax Court disagreed and affirmed. Appellee sought judicial review in the Circuit Court for Montgomery County, which reversed, ruling that appellant did not have the authority to impute interest income based on the I.R.C. provisions. Appellant appealed that ruling to the Court of Special Appeals and this Court granted a writ of certiorari prior to that court’s hearing the matter. Appellant presents the following question: Does the Maryland requirement of a separate corporate tax return require a restatement of federal taxable income from the amount that appears on a consolidated return to the amount required by I.R.C. § 482 or § 7872 for taxpayers that file a separate federal return?

Appellee presents a slightly different version of the question: Did the Circuit Court for Montgomery County correctly rule that the Tax Court erred as a matter of law in holding ⁷⁰⁷ that [appellant] had authority under Maryland’s tax laws to impute interest income on intercompany account balances that [appellee] maintained with its subsidiaries?

II

Discussion A. Standards of Review The facts of this case generally are not in dispute; the issue before us is strictly a question of law. “The lower court’s interpretations of law enjoy no presumption of correctness on review: the appellate court must apply the law as it understands it to be.” Rohrbaugh v. Estate of Stern, 305 Md. 443 , 447 n. 2, 505 A.2d 113 , 115 n. 2 (1986) (citing Elza v. Elza, 300 Md. 51, 55-60 , 475 A.2d 1180 (1984); Davis v. Davis, 280 Md. 119, 124-31 , 372 A.2d 231 , cert. denied, 434 U.S. 939 , 98 S.Ct. 430 , 54 L.Ed.2d 299 (1977); Sica v. Retail Credit Co., 245 Md. 606, 611-21 , 227 A.2d 33 (1967)); see also Cassell v. Pfaifer, 243 Md. 447, 453 , 221 A.2d 668, 672 (1966) (“The trial court’s conclusions of law based upon the facts ... are reviewable by this Court.”); Pallace v. Inter City Land Co., 239 Md. 549, 558 , 212 A.2d 262, 266 (1965) (“The conclusions of law based upon the facts are reviewable by this Court.”); Porter v. Schaffer, 126 Md.App. 237, 259 , 728 A.2d 755, 766 (“[P]ure conclusions of law are not entitled to any deference.” (quoting Oliver v. Hays, 121 Md.App. 292, 306 , 708 A.2d 1140 (1998)) (alteration in original)), cert. denied, 355 Md. 613 , 735 A.2d 1107 (1999). Regarding questions of law answered by the Maryland Tax Court, we have said that “a reviewing court is under no statutory constraints in reversing a Tax Court order which is premised solely upon an erroneous conclusion of law.” Ramsay, Scarlett & Co. v. Comptroller, 302 Md. 825, 834 , 490 A.2d 1296, 1301 (1985) (citing Supervisor of Assessments v. Carroll, 298 Md. 311 , 469 A.2d 858 (1984); Comptroller v. Mandel, Lee, Goldstein, Burch Re-election Comm., 280 Md. 575 , 374 A.2d 1130 (1977)). When ambiguities arise in construing tax statutes, Maryland courts must interpret tax code provisions that aid in determining taxable income in the taxpayer’s favor. We noted ⁷⁰⁸ in Comptroller v. John C. Louis Co., 285 Md. 527, 539 , 404 A.2d 1045, 1053 (1979), that when ... the applicability of a tax statute and not a tax exemption is being construed, it is the established rule not to extend the tax statute’s provisions by implication, beyond the clear import of the language used, to cases not plainly within the statute’s language, and not to enlarge the statute’s operation so as to embrace matters not specifically pointed out.

In case of doubt, tax statutes are construed “most strongly against the government, and in favor of the citizen.” Comptroller of the Treasury v. Mandel Re-Election Comm., 280 Md. 575, 580 , 374 A.2d 1130, 1132 (1977); Comptroller of the Treasury v. M.E. Rockhill, Inc., 205 Md. 226, 234 , 107 A.2d 93, 98 (1954). See also Scoville Serv., Inc. v. Comptroller, 269 Md. 390, 396 , 306 A.2d 534, 538 (1973) (“[W]here there is doubt as to the scope of the statute, ... it should be construed most strongly in favor of the citizen and against the state.”) (citing F. & M. Schaefer Brewing Co. v. Comptroller, 255 Md. 211 , 257 A.2d 416 (1969); McConihe v. Comptroller, 246 Md. 271 , 228 A.2d 432 (1967); Fair Lanes, Inc. v. Comptroller, 239 Md. 157 , 210 A.2d 821 (1965); Comptroller v. M.E. Rockhill, Inc., 205 Md. 226 , 107 A.2d 93 ). We noted this distinction further in Xerox Corp. v. Comptroller, 290 Md. 126, 136-37 , 428 A.2d 1208, 1214 (1981): The determination of whether Xerox’s interest income is taxable under [former Article 81,] § 280A [ (currently § 10-304) ] necessitates consideration of whether § 280A(c)(4) is a “definition” of taxable income, and therefore to be construed strictly against the State, or an “exemption” from taxable income, to be construed in favor of the State. In Balto.

Foundry v. Comptroller, 211 Md. 316 , 127 A.2d 368 (1956), ... the Court said: “It may be observed that the exclusion of tangible personal property purchased for the purpose of resale in its original form, or for the purpose of incorporation into a finished product, is by force of the definition and not by ⁷⁰⁹ inclusion in the exemptions set out in sec. 322. Sales in the categories mentioned are simply not within the scope of the taxing statute. Thus the rule of strict construction of an exemption does not apply, but the rule is applicable, that, where there is doubt as to its scope, a tax statute should be construed most strongly in favor of the citizen and against the State.” 211 Md. at 319-20 , 127 A.2d at 369 . B. Authority to Impute Income Under I.R.C. § 482 Appellee’s main argument is that “[t]he Maryland Tax Code does not expressly authorize [appellant] to impute interest income” and that appellant “is not granted that discretionary authority by Federal law.” Further, appellee contends that if appellant wishes to have such authority, appellant should seek it from the Legislature, not this Court.

Appellant argues that section 10-304’s equation of Maryland modified income to federal taxable income and section 10-811’s requirement of separate returns for each affiliated corporation together “mandate a restatement of taxable income from the number that appears on the federal consolidated return” to determine the Maryland modified income of each separate business entity. It implies that its statutory mandate empowers it to utilize the income-determining provisions of the I.R.C. in their entirety, as necessary. The Legislature, however, has not bestowed such authority upon appellant. Appellant correctly notes that, under section 10-304, the Maryland modified income is equal to the federal taxable income.

Appellant’s error, however, is in assuming that section 10-304 provides it with the full panoply of powers provided to the IRS by the I.R.C. to help define federal taxable income. Our previous interpretations of section 10-304 reflect that the legislative intent behind the provision was for appellant to accept the taxable income figure reported on the federal return as the Maryland modified income, subject to certain statutorily prescribed modifications; namely, the additions and subtractions listed in sections 10-305 through 10-308. ⁷¹⁰ Comptroller v. American Satellite Corp., 312 Md. 537 , 540 A.2d 1146 (1988), provides a strong argument for interpreting such an intent behind the state tax code. In American Satellite, appellant argued that a state tax statute allowed it to allocate, as taxable income, certain capital gains earned in Maryland to a corporation that had filed a consolidated federal return reporting no taxable income. This Court disagreed, holding that the state capital gains provision in question could not increase the state modified income figure, because only sections 10-305 through 10-308 authorize appellant to adjust the federal taxable income figure.

In doing so, we discussed the legislative intent behind this system of Maryland income tax reporting: [Legislative committee reports clearly indicate that the purpose in enacting ch. 142 in 1967 [, the current tax code,] was to bring the State taxation system in conformity with the federal scheme. Report of the Committee on Taxation and Fiscal Reform (Report) (February 1, 1967). See also Katzenberg v. Comptroller, 263 Md. 189, 204-05 , 282 A.2d 465 [, 473] (1971); Evans v. Comptroller, 273 Md. 172, 175 , 328 A.2d 272 [, 274] (1974); Marco Assoc. v. Comptroller, 265 Md. 669, 674 , 291 A.2d 489 [, 492] (1972); 66 Op. Att'y Gen. 242, 247 (1981); 52 Op.

Att’y Gen. 451, 452-53 (1967). As the report indicates, such conformity was thought to foster enforcement. Report at 8. This effort to simplify the taxation system might not fulfill its purpose if, after using federal taxable income as the base for determining State tax liability, the Maryland statutes then imposed additional adjustments which significantly altered the base, other than the simple modifications provided by [Article 81,] § 280A(b) and (c) [now embodied in sections 10-305 through 10-308].

Id. at 545, 540 A.2d at 1150 (emphasis added). We have interpreted the state tax code in a similar manner in cases where taxpayers sought to modify their income based on federal tax provisions. For instance, in Marco Associates, Inc. v. Comptroller, 265 Md. 669 , 291 A.2d 489 (1972), the taxpayer corporation had paid no federal income tax on a large ⁷¹¹ portion of its reported income because it filed with the IRS as a “Subchapter S” corporation. It subsequently deducted that portion of its income on its Maryland tax return.

Maryland, at the time, did not recognize Subchapter S corporate filings. We agreed with appellant that it was the total federal taxable income figure upon which Maryland income tax was based, not the portion of that income that was actually taxed after the federal tax break. Since our Act does not accord Subchapter S treatment to a corporate taxpayer which elects to be treated as such for federal tax purposes, it follows that such a taxpayer is looked upon for purposes of the Maryland tax as if it were an ordinary business corporation, and its Maryland stockholders as if they were the holders of shares in such a corporation, see § 280(b)(5), § 280(c)(2). This may not be fair, but it is a fact of life.

Id. at 675-76, 291 A.2d at 498 (citation omitted). Marco Associates further argued that its having to report the untaxable federal income was because of “a technical requirement of the Internal Revenue Code, rather than because of any real change in the situation of the parties.” Id. at 678 , 291 A.2d at 494 . We replied: This argument ... overlooks the manner in which the Maryland income tax is structured. Its focus 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 federal 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. (emphasis added). In other words, the portion of Marco Associates’ income earned in Maryland was derived from the ⁷¹² taxable income figure provided on its federal income tax return regardless of how that income was actually taxed under the I.R.C. We reached a similar conclusion in NCR Corp. v. Comptroller, 313 Md. 118 , 544 A.2d 764 (1988).

In that case, the taxpayer had claimed on its 1976 federal tax return a credit for certain foreign income taxes paid on foreign-earned dividends. I.R.C. § 78 required that the company “gross-up” the income reported on its federal return by the amount of the credit. Prior to 1977, the Maryland Code did not allow the company to subtract that gross-up amount from its Maryland income, even though the gross-up served no relevant state income tax purpose. We nonetheless held that appellant could tax NCR based on the grossed-up figure reported on its federal income tax form.

In doing so, we stated: 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. Id. at 123, 544 A.2d at 766 (emphasis added) (alteration in original). Finally, in Katzenberg v. Comptroller, 263 Md. 189 , 282 A.2d 465 (1971), we reviewed the effect of the 1967 overhaul of the Maryland income tax code on capital gains taxes.

Prior to 1967, capital gains were not taxed in Maryland as income. When the Legislature adopted the federal taxable income figure as the Maryland modified income, capital gains, which were taxed by the federal government, became taxable in Maryland. The taxpayers in Katzenberg argued that the new ⁷¹³ tax provisions did not apply to their 1967-68 capital gains because they were earned on pre-1967 investments. Examining the use of the federal taxable income figure, we reasoned: [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. Id. at 204-05 , 282 A.2d at 478 . We added: It is undoubtedly true that the General Assembly, had it seen fit to do so, could have imposed a tax on a taxpayer’s gross income, without considering the source from which it came, whether it be earnings, investment income or profits realized from the sale of capital assets, and without granting exemptions, allowing deductions or permitting any other adjustments. If it could validly do this, and we think it could, there is no reason to doubt that it could select some other figure, objectively arrived at, upon which the tax could be based, Tawes v. Strouse, 182 Md. 508, 512-13 , 35 A.2d 233 [, 235] (1943).

It did this when it chose to base the tax on the figures for adjusted gross income and taxable income, as developed by the federal returns. Id. at 205-06, 282 A.2d at 473 (emphasis added). Ultimately, we upheld the assessment against the taxpayers, rejecting their argument, inter alia, that the new law was unconstitutionally arbitrary in its application: It seems to us that the State has the better of this argument when it says that the Act uses as a base an individual taxpayer’s adjusted gross income reported for federal income tax purposes, with certain additions and subtractions. The Act is not directed at payments received from installment sales before the date of its enactment.

Neither does it purport to be a tax on capital gains as such or a tax on installment payments as such. It is rather a tax measured by the yardstick of income reported for federal ⁷¹⁴ tax purposes, whether capital gains be reflected in this figure or not. Id. at 203-04 , 282 A.2d at 472 . American Satellite, Marco Associates, NCR Corp. and Katzenberg all lead to the same interpretation of section 10-304: the figure reported as federal taxable income on a federal return