South Carolina Supreme Court Holds Non-Taxable Dividend Income And Related Interest Expenses Were Allocable

The South Carolina Supreme Court has held that a taxpayer's interest expenses that were related to nonbusiness (and ultimately, nontaxable) dividend income were not deductible.1 The Court determined that the South Carolina allocation statute that sourced these expenses to the taxpayer's principal place of business (outside South Carolina) did not violate the Commerce Clause as applied to the corporation because it did not discriminate against interstate commerce.

Background

The taxpayer, a major publicly-traded corporation engaging in worldwide manufacturing activities, conducted much of its business through many foreign and domestic wholly-owned subsidiaries and received dividends from these subsidiaries. For fiscal years 1999 through 2002, the taxpayer and its subsidiaries timely filed consolidated income tax returns in South Carolina. In its initial returns, the taxpayer did not claim deductions for expenses related to its receipt of dividends from subsidiary corporations. The taxpayer subsequently filed amended returns claiming the deductions and seeking a refund. The South Carolina Department of Revenue disallowed the expense deductions. After the Administrative Law Court (ALC) upheld the Department's decision, the taxpayer directly appealed the case to the South Carolina Supreme Court.

Expense Deductions Allocated to Taxpayer's Principal Place of Business

The Court affirmed the ALC and held that the taxpayer's interest expense deductions must be allocated to Missouri, the taxpayer's principal place of business. As a result, the taxpayer could not use these deductions for South Carolina income tax purposes.

In reaching its decision, the Court initially agreed that the taxpayer properly excluded from its taxable income the dividends received from its wholly-owned subsidiaries. For both federal and South Carolina income tax purposes, dividends received by a parent corporation from a wholly-owned subsidiary generally are not subject to income tax.2 Qualifying dividend income is not taxable because the dividends received deduction (DRD) allows a 100 percent deduction against this income. Therefore, for the tax years in question, the DRD permitted the taxpayer to claim no taxable income for federal or South Carolina purposes as a result of the dividends that it received from its wholly-owned subsidiaries.3

However, the Court disagreed with the taxpayer's treatment of the corresponding expense deductions arising from the dividends paid to...