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New Jersey Tax Court Rules on Exclusion of Extraterritorial Income for Corporation Business Tax Returns

Publisher: Day Pitney Alert
February 11, 2011

In a recent consolidated decision, International Business Machines Corporation v. Director, Division of Taxation / Creston Electronics, Inc. v. Director, Division of Taxation, 011630-2008 / 011795-2009, _____ N.J. Tax _____ (Tax 2011), the New Jersey Tax Court held that for the periods at issue, the Director, Division of Taxation (the "Director") exceeded his statutory authority when he included extraterritorial income excluded from federal taxable income under Section 114(a) of the Internal Revenue Code of 1986 (the "Code") in the taxpayer's entire net income for New Jersey corporation business tax ("CBT") purposes.

The court's decision was based on two similar sets of facts. From 2002 through 2004 Plaintiff International Business Machines Corporation ("IBM") received extraterritorial income from sources outside of the United States, which it properly excluded when calculating its "taxable income before net operating loss deduction and special deductions" at line 28 of its federal income tax return. IBM reported the exact amounts shown on line 28 of the federal return on its New Jersey CBT return. After an audit, the New Jersey Division of Taxation (the "Division") added back to IBM's New Jersey CBT return the extraterritorial income excluded for federal tax purposes.

In 2004 and 2005 Plaintiff Creston Electronics, Inc. ("Creston"), filed CBT returns on which it added back the extraterritorial income it excluded on its federal return. Creston later filed amended returns for 2004 and 2005 and excluded the extraterritorial income it had previously added back. After audit, the Division added back the extraterritorial income.

The CBT is imposed on a corporation's "entire net income," which is statutorily defined to include "total net income from all sources, whether within or without the United States." However, the statute couples entire income for CBT purposes to line 28 of the federal income tax return, as the statute limits the definition of "entire net income" to be "equal in amount to the taxable income, before net operating loss deduction and special deductions, which the taxpayer is required to report ... to the United States Treasury Department for the purposes of computing its federal income tax."

The court found the statute's coupling language unambiguous. It rejected the Director's reliance on the all-encompassing provision of the statute that defines entire net income as "income from all sources, whether within or without the United States" by likening it to the kind of sweeping declaration provided in Section 61 of the Code, which defines income subject to federal tax as "all income from whatever sourced derived[.]" Like Section 61 of the Code, the New Jersey statute is followed by more detailed statutory provisions that must be read in conjunction with the broad language that precedes it.

Congress repealed the extraterritorial income exclusion in 2004 and replaced it with a "qualified production activities income" deduction. The New Jersey Legislature responded by providing for a partial exception to the "qualified production activities income" exclusion when determining entire net income for New Jersey CBT purposes. Taxpayers who added extraterritorial income to their New Jersey CBT returns may still file a refund claim for years in which the statute of limitation has not closed.