New Jersey rules against closed-year NOL adjustment

On May 27, 2021, the New Jersey Tax Court ruled that the New Jersey Division of Taxation may not disallow net operating losses (NOLs) generated in closed tax years and carried forward to an open tax year under an audit examination.¹ The Court found that the Division’s adjustment of NOL carryforwards created in closed years was tantamount to the adjustment of income reported in those years, thus constituting an impermissible “audit” for closed years outside the state’s four-year statute of limitations. Finding the Division’s NOL audit adjustment to be time-barred, the Court granted the taxpayer’s motion for partial summary judgment.

Background

The taxpayer, R.O.P. Aviation (R.O.P.) leases aircraft to its affiliate, MacAndrews & Forbes Group, LLC, and sub-leases aircraft to its parent, McAndrews & Forbes Holdings. R.O.P. does not provide any services to the lessees such as pilot, ground crew, fuel or maintenance. For the 2007-2011 tax years, R.O.P. reported NOLs on its Corporation Business Tax (CBT) returns, which amounted to over $18 million in total. The Division did not audit R.O.P.’s 2007-2011 CBT returns. On its 2014 tax return, R.O.P. used the NOLs that were carried forward to offset income reported in that year.

In 2017, the Division initiated an audit of R.O.P.’s CBT returns for the 2012-2015 tax years. Specifically, the Division reviewed R.O.P.’s aircraft leases to affiliate members, concluding that the leases were at a rate below the company’s total costs. As a result, the Division adjusted R.O.P.’s returns for the open tax years by adjusting the transfer pricing related to aircraft leases between the taxpayer and related entities.² The adjustment increased R.O.P.’s income in the 2012-2015 tax years to account for the difference in income that would have been realized had the correct transfer pricing methodology been applied.

The Division also disallowed the carryforward of NOLs from the 2007-2011 tax years under the same transfer pricing principles. The Division determined that R.O.P. would have had higher taxable income for those years but for the transfer pricing arrangement. Relying on the auditor’s informal transfer pricing analysis, the Division adjusted the NOLs because the prior returns did not reflect arm’s-length transactions, and there should have been “some percentage of profits” in the years in which the NOLs were incurred.

The elimination of the NOLs resulted in an additional assessment of approximately $8.5 million (including interest) for the audit period. Accordingly, R.O.P. appealed the assessment to the New Jersey Tax Court. As to the Division’s elimination of the NOLs that had been carried forward, R.O.P. filed a motion for partial summary judgment, alleging that the Division incorrectly made a transfer pricing adjustment to tax years that fell outside of the audit by disallowing prior year NOLs.

Tax Court decision

In its analysis, the Court weighed the statutory provisions granting the Division broad audit powers against the statute of limitations for audits. On the one hand, the Court noted that the Division is given broad statutory authority to adjust a taxpayer’s taxable income “as may be necessary to make a fair and reasonable determination of the amount of tax payable.”³ To that end, the Division has the power to audit returns and assess additional taxes upon the determination of a tax deficiency.⁴ However, there are statutory limitations regarding closed tax years. Specifically, “no assessment of additional tax shall be made after the expiration of more than four years from the date of the filing of a return.”⁵

NOL adjustment precluded for closed tax years

Reading the audit statutory provisions together, the Court concluded that an audit must be performed within the same four-year period in which the assessment of additional tax must be made. However, the Court noted, it was undisputed that the 2007-2011 tax years were outside the statute of limitations at the time of the 2017 audit. The Court observed that the lack of an assessment of additional tax in a closed tax year did not mean the return could be audited “at any time” and then be used to adjust returns for open tax years. Rather, the Court agreed with R.O.P. that the Division should be required to analyze R.O.P.’s transactions and income in each of the earlier tax years to determine whether income was distorted to reduce or eliminate reported NOLs for those years. According to the Court, allowing the Division to change the components of the NOLs at any time, despite the fact that it is not imposing additional tax in the closed year, “would render the existence of this statute of limitations illusory as to any item of carryforward (NOL or other permitted carryforwards) under the CBT Act.”

In conclusion, the Court determined that the Division’s adjustment of R.O.P.’s NOL carryforward from a closed tax year in an open tax year amounted to “an indirect additional assessment of tax for the closed year.” Although the Division viewed its audit adjustment as applicable to an open year, the Court noted that in reality, the adjustment was made to a closed year. The Court concluded that auditing a closed year and applying the revisions from that closed year to an open, audited year “is doing indirectly what the statute does not permit directly: bypassing the four-year statute of limitations.”

Tax Court not bound by IRS construction of audit authority

The Court next addressed the Division’s argument that the Internal Revenue Service (IRS) routinely revises the amount of NOL carryforwards by revising the NOL of the source year as outlined in its audit manual, even if that year is closed.⁶ However, the Court determined that it is not bound by the IRS’ construction of a federal income tax statute for purposes of the CBT as to the statute of limitations or audit procedures. Based on a plain reading of the applicable statute, IRC Sec. 7602(a), the Court did not interpret the provision to permit the opening of closed years. In refusing to follow IRS practice and procedure, the Court noted that the IRS’ broad interpretation of the Internal Revenue Code (IRC) could not be applied to circumvent the New Jersey statute of limitations for an audit.

Recognizing the tension between the statute of limitations and the Division’s broad statutory authority to adjust tax returns, the Court determined that the tension should be resolved in favor of the taxpayer, also noting that statutes of limitations are strictly construed. For these reasons, the Court found that the Division’s disallowance of NOL carryovers from the 2007-2011 tax years was impermissible under the statute of limitations. As such, the Court granted R.O.P.’s partial motion for summary judgment and reversed the assessment.

Commentary

R.O.P. Aviation confirms that the Division may not adjust NOLs generated in tax periods falling outside the four-year statute of limitations and carried forward to offset income in open tax years that are audited. The principles outlined in the decision should provide further clarity that NOLs from tax years that are otherwise closed cannot be disallowed even when they impact the calculation of income for open years. Ultimately, the Court was unwilling to disturb a strict construction of the statute of limitations in favor of the Division’s broad statutory authority to make income adjustments during open audit years.

Interestingly, the Court’s decision may have broader implications based on its conclusion that it was not bound by the IRS’ broad interpretation of federal law to adjust NOLs from closed years. The Court noted that the IRS audit manual permits the agency to review NOLs in closed tax years where they have relation to an open tax year, but an audit manual is not binding or persuasive authority that by itself would be enough to circumvent the New Jersey limitations period for an audit.

Further, the Court’s statement that it is not bound to IRS construction of federal law for audit purposes may have potential application to tax attributes other than NOLs, including basis calculations and credits. Taxpayers should consider the potential ASC 740 implications of this case in the event the decision becomes final. For example, taxpayers that have carried forward NOLs from closed tax years may have booked a reserve in recognition of an uncertain tax position if they have historically followed IRS rules regarding audit adjustments. A final decision rejecting federal rules allowing NOL adjustments from closed years may be an event for releasing such reserves. Taxpayers may also evaluate whether the decision has potential application to other states. However, it is possible that the Division may still appeal the decision to the Appellate Division of the New Jersey Superior Court, in which case the decision would not be considered final.

1 R.O.P. Aviation, Inc. v. Director, Division of Taxation, N.J. Tax Court, No. 01323-2018, May 27, 2021.
2 Under N.J. REV. STAT. § 54:10A-10(b), the Division is provided with statutory authority to examine and adjust a taxpayer’s entire net income where the taxpayer’s transactions are entered “at more or less than a fair price,” or the transactions with a related party are “on such terms as to create an improper loss or net income.”
3 N.J. REV. STAT. § 54:10A-10(a).
4 N.J. REV. STAT. § 54:49-6(a).
5 N.J. REV. STAT. § 54:49-6(b).
6 The IRS audit manual points to IRC § 7602(a) for the authority to revise NOLs from closed years in order to determine the correct NOL deduction for open years. Under IRC § 7602(a)(1), the IRS is authorized to “examine any books, papers, records, or any other data” that may be relevant or material to ascertaining the correctness of a filed tax return.

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