Client Alert: Market Discount Income not Deductible under North Carolina Tax Law

Banking & Financial Institutions Client Alerts Tax

By Todd H. Eveson and Thomas H. Cook Jr.

On August 18, 2017, the North Carolina Supreme Court held that taxpayers may not exclude market discount income on federal government bonds in computing North Carolina taxable income.  “Market discount income” results from the difference between the purchase price of a bond and the amount received from the bond at maturity.  That is a common occurrence when bonds or other debt obligations are purchased on the open market at a discount to par.

In The Fidelity Bank v. North Carolina Department of Revenue, a North Carolina bank took the position that market discount income qualified as interest on federal government obligations and thus excluded the income on its state income tax return.  North Carolina tax law generally treats “interest” on federal government obligations as not being taxable.  The federal tax code states that market discount income “shall be treated as interest.”  The North Carolina Supreme Court held, however, that in the context of bonds, the term “interest” is more narrowly defined for purposes of North Carolina law and includes only income resulting from “periodic payments received by the holder of a bond.”  In addition, while there does not appear to be specific authority from the State on this point, it might take a similar position with respect to original issue discount income (on bonds purchased below par) from federal government obligations, and not allow that income to be tax-exempt either.

As a result of this case, North Carolina taxpayers should consult their tax adviser before excluding market discount or original issue discount income from their state taxable income.  The Supreme Court’s decision is available here: https://appellate.nccourts.org/opinions/?c=1&pdf=35904.

Please let us know if you have questions about this recent development in North Carolina tax law.

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Thomas H. Cook Jr. is the practice group leader for the firm’s tax practice.  His practice focuses on income taxation (including corporate and LLC mergers, acquisitions and reorganizations), state and local taxation, and partnership and limited liability company law.  Before joining Wyrick Robbins he was a partner with another law firm in Raleigh, an attorney-advisor at the United States Tax Court in Washington, D.C., and a CPA with a Big Eight accounting firm.

Todd H. Eveson is the practice group leader for the firm’s banking & financial institutions practice group.  His practice is focused on securities law, bank regulatory matters and mergers and acquisitions.  He is in his 18^th year of practice dedicated to serving the needs of banks and bank holding companies.

The purpose of this Client Alert is to provide general information, and it is not intended to provide, and should not be relied upon as, legal advice.