Financial institutions with business operations in South Carolina are facing significant uncertainty over a basic question: how are they taxed in the Palmetto State?
South Carolina imposes a “bank tax” on financial institutions operating in the state, in lieu of a corporate income tax. The calculation of the tax was recently thrown into doubt as a result of a ruling by an administrative law judge in Synovus Bank v. South Carolina Department of Revenue.
Background on the Tax
The South Carolina bank tax was first enacted in 1937 and is imposed on the “entire net income” of a financial institution. While it is not uncommon for states to impose a separate tax on banks, what makes South Carolina’s unique is the lack of guidance regarding the base of tax. Neither the statutes nor the regulations define “entire net income” or explain how it is calculated.
Although the tax is specifically referred to as an “Income Tax on Banks,” the South Carolina Department of Revenue has long taken the position that the tax is a franchise tax—not an income tax. This characterization allows the department to include interest on U.S. government obligations in “entire net income,” which is permitted for franchise taxes but not income taxes. For example, a departmental regulation calls the bank tax a franchise tax and states the term “entire net income” includes income derived from any source, including interest on obligations of the U.S.
An opinion of the South Carolina Attorney General similarly asserts that “the bank tax is a franchise tax for the privilege of operating, or doing business in this State, the amount thereof being measured by entire net income.” The opinion further states that, in calculating entire net income, banks are permitted to deduct all expenses incurred in the operation of their banks, including federal and state income taxes.
Synovus Bank’s Challenge
The Synovus case started with a narrow question: Can a bank deduct net operating losses to reduce its bank tax liability? The first point of disagreement between the parties was whether the tax was an income tax or a franchise tax. Because of the implications of that fundamental question, Chief Administrative Law Judge Ralph Anderson ruled on this issue first. After reviewing the history of the bank tax, the court agreed with the department that the tax was a franchise tax. In particular, the court found persuasive the fact that the department’s regulation defined the tax as a franchise tax and that it had been treated as a franchise tax since its inception in 1937. The court found the General Assembly had acquiesced to this interpretation by failing to enact legislation to contradict the long-standing interpretation.
Synovus next argued that, even if the bank tax was characterized as a franchise tax, it was permitted to deduct net operating losses as a result of South Carolina’s conformity to the federal tax code. To answer this question, the court looked to the overall statutory scheme to determine to what extent the bank tax conforms to the federal tax code. The court found significant that the bank tax is imposed on entire net income while the corporate income tax is imposed on taxable income, the calculation of which comprises net operating loss deductions. It further determined there was a distinction between adopting the federal tax code for purposes of administering a tax and calculating a tax.
The court concluded the General Assembly intended for banks to be taxed differently from corporations, the bank tax was not based on “taxable income” and that the provisions of the corporate income tax did not entitle Synovus to deduct net operating loss carryovers.
‘A Factual Contrivance of the Department’
Judge Anderson then looked to the provisions of the bank tax to determine how “entire net income” should be calculated—and this is where the case morphed into something much larger.
The court first observed that the applicable statutes and regulations did not define the term “entire net income.” And, despite the department’s authority to prescribe rules and regulations, it had not provided any formal guidance as to how it calculates entire net income. The department asserted the tax is based on financial accounting income—or book income—rather than federal income tax accounting, and it should normally be computed using generally accepted accounting principles (GAAP). In response, Synovus argued that reliance on book income was an unconstitutional delegation of the legislative taxing power to the Financial Accounting Standards Board, which establishes standards under GAAP.
The court framed the question before it as whether it was reasonable for the department to rely on book income as determined under GAAP to define entire net income (including whether it periodically reviewed the definition to ensure it remained a good method of calculating income) and whether this was consistent with the applicable regulation.
“In sum,” Judge Anderson wrote, “equating ‘book income’ to ‘entire net income’ is a factual contrivance of the department—not an interpretation of law.”
But despite his strong language, Judge Anderson stopped short of ruling on this question. He said there are factual issues that must be resolved before the court could determine whether the department’s use of “book income” as a proxy for “entire net income” is appropriate. This will occur in later proceedings before the administrative law court.
Implications for Banks
Financial institutions that operate in South Carolina should closely monitor this case, both at this level and through any appeals.
The South Carolina bank tax has existed virtually unchanged since 1937. During this time, there has been very little if any guidance by the department regarding the calculation of the tax. A ruling from the South Carolina courts could fill this void. Of course, the South Carolina General Assembly could also step in and provide needed clarity.
One potential benefit is certainty regarding the meaning of the term “entire net income.” Even if entire net income is determined to be based on book income, the department itself has not been consistent in how it interprets this term, as demonstrated by the court’s opinion. Hopefully any decision will address this fundamental point.
Although Judge Anderson ruled the tax is a franchise tax, that could change in any appeal and would have significant consequences. If the tax is determined to be an income tax, interest from obligations of the U.S. could not be included in the base.
In summary, what began with a fairly narrow issue concerning net operating losses has thrown open the entire calculation of the South Carolina bank tax and created uncertainty in the Palmetto State.
Kay Hobart, partner with Parker Poe, has more than 20 years of experience in state tax controversy matters and tax litigation at all levels of state and federal court. As the former lead tax counsel for the State of North Carolina, she has litigated numerous high profile, complex multimillion-dollar cases before the North Carolina Business Court, Court of Appeals, and Supreme Court. She can be reached at email@example.com.