Could Covenant use New Mexico NOLs from subsidiaries' prior separate returns after switching to a combined unitary return, or retroactively switch back?

Plain-English summary

Covenant Transportation Group could not use net operating losses established on subsidiaries' earlier separate New Mexico returns after electing a combined unitary return for 2012. New Mexico required the federal NOL deduction to be added back and allowed only the state carryovers specified by statute; the applicable regulation expressly barred moving separate-return losses into a combined group.

Covenant also could not retroactively return to separate-entity reporting. But the hearing officer abated penalty because Covenant's losing interpretation resulted from a careful, good-faith legal analysis on reasonable grounds.

This amended decision replaced original D&O 14-45 after the Department's motion for reconsideration was granted.

Federal NOL treatment was only a starting point

Covenant owned a unitary transportation group. Before 2012, Covenant Transport, CTG Leasing, and Southern Refrigerated Transport filed separate New Mexico corporate returns; the first two accumulated net operating losses.

For 2012, Covenant elected combined unitary reporting and claimed those earlier subsidiary losses against combined income. It argued that federal Internal Revenue Code Section 172 treatment flowed into New Mexico's base-income and NOL definitions.

The amended decision rejected that reading. Section 7-2A-2(C) defined New Mexico base income as federal taxable income plus the federal Section 172 NOL deduction. The federal deduction therefore had to be added back.

Section 7-2A-2(H) then supplied New Mexico's own limited NOL carryover exclusion. Because it did not authorize a group to use a different taxpayer's previously separate losses, federal consolidated treatment did not fill the gap.

The regulation validly prohibited the transfer

Regulation 3.4.1.11(A) stated that an NOL established for a corporation filing separately could not be excluded from another corporation's base income or a combined or consolidated group return.

The original decision had treated that regulation as exceeding the statute. On reconsideration, the hearing officer found it consistent with the statutory scheme because New Mexico had not adopted federal Section 172 treatment and had created only the carryover deduction described in Section 7-2A-2(H).

Regulation 3.4.1.9(C)(1) contained language that appeared more favorable when corporations were acquired or otherwise included through a reporting-method change. But Covenant had always owned the subsidiaries, and its switch in filing format did not avoid the state addback and carryover rules.

The reporting-method election could not be undone retroactively

New Mexico offered a three-step reporting “ladder”: separate entity, combined unitary corporations, and federal consolidated group.

A taxpayer could move upward without permission but could not step back down without the Secretary's approval. Covenant moved from separate returns to combined unitary reporting in 2012 and never sought permission to return.

Even if permission later were granted, Regulation 3.4.10.8(E) barred a retroactive method change for 2012.

A reasonable mistake of law removed penalty

Covenant's interpretation was wrong, but it showed a detailed review of statutes, regulations, return instructions, and federal law. Regulation 3.4.1.9(C)(1) offered some support, and the 2012 CIT instructions did not warn that a combined group could not claim losses previously reported by a member on a separate return.

That evidence rebutted penalty under Section 7-1-69(B)'s good-faith mistake-of-law exception. The Department did not reestablish negligence after the burden shifted.

Interest remained mandatory from the original due date until principal was paid.

Result: protest GRANTED IN PART AND DENIED IN PART. Penalty was abated. As of hearing, Covenant owed $74,313 corporate income tax and $3,273.89 interest, with interest continuing to accrue.

What this means for you

Corporate groups changing New Mexico filing methods

Model the tax attributes before electing a higher reporting method. Do not assume federal consolidated NOL treatment carries into New Mexico.

Groups with subsidiary NOLs

Identify which legal entity established each loss, the return method used, the state carryover window, and whether a regulation restricts use by another taxpayer or group.

Taxpayers considering a reporting-method reversal

Seek Secretary permission before attempting to step down. Approval, if available, may be prospective rather than retroactive.

Businesses taking a difficult legal position

Preserve research, return instructions, professional analysis, and ambiguous regulatory language. A well-grounded but incorrect interpretation can support penalty relief even when tax remains due.

Common questions

Q: Why could the combined group not use the subsidiaries' old NOLs?
A: New Mexico's statute did not authorize the transfer, and Regulation 3.4.1.11(A) expressly prohibited it.

Q: Did New Mexico adopt federal Section 172 NOL treatment?
A: No. It required the federal NOL deduction to be added back before applying the state's own carryover rule.

Q: Could Covenant simply amend 2012 back to separate returns?
A: No. It needed Secretary permission to step down, and the change could not apply retroactively.

Q: Why was penalty abated?
A: Covenant's careful analysis, unclear regulatory interaction, and incomplete return instructions established a good-faith mistake of law on reasonable grounds.

Q: What remained due?
A: $74,313 tax plus $3,273.89 interest as of hearing, with further interest until payment.

Citations and references

Statutes and regulations:

• NMSA 1978, §§ 7-2A-2(C), (H), (J) and 7-2A-3 — base income, net income, NOL carryover, and corporate income tax
• NMSA 1978, §§ 7-2A-8.3 and 7-2A-8.4 — combined-unitary and federal-consolidated methods
• NMSA 1978, §§ 7-1-67 and 7-1-69(B) — mandatory interest and good-faith mistake-of-law penalty relief
• Regulations 3.4.1.9(C)(1), 3.4.1.11(A), and 3.4.10.8 NMAC — NOL treatment and reporting-method elections

Cases cited:

• Mountain States Telephone & Telegraph Co. v. New Mexico State Corporation Commission, 1986-NMSC-019 — federal law as a starting point, not wholesale adoption
• Regents of the University of New Mexico v. New Mexico Federation of Teachers, 1998-NMSC-020 — harmonizing statutory provisions
• Wing Pawn Shop v. Taxation and Revenue Department, 1991-NMCA-024 — strict construction of deductions
• MPC Ltd. v. New Mexico Taxation and Revenue Department, 2003-NMCA-021 — burden shifting after rebuttal
• Marbob Energy Corp. v. New Mexico Oil Conservation Commission, 2009-NMSC-013 — mandatory interest language

Source

• Listing: New Mexico Decisions & Orders
• Decision post: Covenant Transportation Group Inc.
• Decision PDF: D&O 15-11

Original ruling text

BEFORE THE HEARING OFFICER
OF THE TAXATION AND REVENUE DEPARTMENT
OF THE STATE OF NEW MEXICO

IN THE MATTER OF THE PROTEST OF
COVENANT TRANSPORTATION GROUP INC. No. 15-11
TO ASSESSMENT ISSUED UNDER LETTER
ID NO. L1907135952

AMENDED DECISION AND ORDER

A protest hearing occurred on the above captioned matter on September 4, 2014 before

Brian VanDenzen, Esq., Hearing Officer, in Santa Fe. Loren Chumley and Blair Norman, CPA,

of KPMG appeared in person, representing Covenant Transportation Group, Inc. (“Taxpayer”).

Paul Bunn, Chief Accounting Officer, and Kerry Finley, Senior Corporate Tax Manager, of

Taxpayer appeared telephonically. Staff Attorney Peter Breen appeared representing the State of

New Mexico, Taxation and Revenue Department (“Department”). Protest Auditor Tom Dillon

appeared as a witness for the Department. Taxpayer Exhibits #A-O and Department Exhibit #1

were admitted into the record, as described more thoroughly in the Administrative Protest

Hearing Exhibit Log. Without objection, the undersigned hearing officer takes notice and admits

the “2012 New Mexico Instructions for Form CIT-1 Corporate Income and Franchise Tax

Return” into the record.

The original Decision and Order in this matter, No. 14-45, was issued on December 29,

2014. On January 28, 2015, the Department filed a Motion for Reconsideration. On February 6,

2015, Taxpayer objected to the Department’s Motion for Reconsideration. Through an order

issued concurrently with this decision, the Department’s Reconsideration was granted and the

original Decision and Order No. 14-45 was withdrawn in favor of this Amended Decision and
Order. Based on the evidence and arguments presented, IT IS DECIDED AND ORDERED AS

FOLLOWS:

FINDINGS OF FACT

1. On February 12, 2014, the Department assessed Taxpayer for $74,313.00 in

corporate income tax, $7,431.30 in penalty, and $2,003.45 in interest for a total assessment of

$83,747.75 for the reporting period ending on December 31, 2012. [Letter id. no. L1907135952].

2. On April 25, 2014, Taxpayer protested the Department’s assessment.

3. On May 20, 2014, the Department acknowledged receipt of Taxpayer’s protest.

4. On June 12, 2014, the Department requested a hearing in this matter with the

Hearings Bureau.

5. On June 16, 2014, the Hearings Bureau sent Notice of Administrative Hearing,

scheduling this matter for a hearing on July 21, 2014.

6. On July 14, 2014, Taxpayer moved to continue the July 21, 2014 protest hearing.

The Department did not oppose Taxpayer’s motion.

7. On July 14, 2014, the Hearings Bureau issued a Continuance Order and Amended

Notice of Administrative Hearing, rescheduling the July 21, 2014 protest hearing to September 4,

2014.

8. On August 28, 2014, Taxpayer moved with the Department’s agreement to have

witness Paul Bunn and Kerry Finley appear telephonically at the September 4, 2014 hearing.

Taxpayer’s request was granted because the matter involved a dispute of law rather than a

genuine dispute of fact.

In the Matter of the Protest of Covenant Transportation Group, Inc., page 2 of 18

9. Taxpayer, Covenant Transportation Group, Inc., is the parent corporation of a

group of affiliated corporate entities specializing in transportation services across the United

States and Canada.

10. Taxpayer is headquartered in Chattanooga, Tennessee.

11. At all relevant times, three entities wholly owned by Taxpayer did business in

New Mexico: Covenant Transport, Inc.; CTG Leasing Company, Inc.; and Southern Refrigerated

Transport, Inc. [09-04-14 CD 0:22:30-39].

12. Before 2012, all three entities—Covenant Transport, Inc., CTG Leasing

Company, Inc., and Southern Refrigerated Transport, Inc.—filed New Mexico Corporate Income

Tax (“NM CIT or CIT”) returns as separate corporate entities. [Taxpayer Ex. A-N; 09-04-14 CD

0:21:08-59].

13. Covenant Transport, Inc. and CTG Leasing Company, Inc. generated net

operating losses on their separate corporate entity returns before 2012. [Taxpayer Ex. A-N; 09-

04-14 CD 0:29:40-56].

14. For the first time in 2012, Taxpayer elected to file NM CIT returns as a combined

group for all entities it owned and controlled, including the three entities that had previously filed

separate returns: Covenant Transport, Inc., CTG Leasing Company, Inc., and Southern

Refrigerated Transport, Inc. [Taxpayer Ex. O; 09-04-14 CD 0:22:00-10 & 0:24:40-0:25:05].

15. The same entities reflected on Taxpayer’s 2012 combined group New Mexico

CIT return are the same entities contained on Taxpayer’s federal 1120. Taxpayer and its entities

were a unitary group. Taxpayer was the reporting entity for 2012 New Mexico CIT tax returns

and the reporting entity for the federal 1120 in 2012. [09-04-14 CD 22:10-23:28].

In the Matter of the Protest of Covenant Transportation Group, Inc., page 3 of 18

16. Taxpayer elected to switch to the combined group reporting method because it is

simpler to file one return than multiple returns and because it believed it could use the tax

benefits and attributes of the three entities that had previously filed separately when switching to

the combined consolidated group. [09-04-14 CD 0:25:10-56; 0:23:18-0:24:00].

17. In its 2012 combined group CIT return, Taxpayer claimed the net operating loss

carryover first reported in previous years by Covenant Transport, Inc. and CTG Leasing

Company, Inc. as separate entities. [09-04-14 CD 0:30:10-23].

18. Although ultimately an incorrect interpretation of law, Taxpayer established

through its careful review and analysis of the various statutes, regulations, and instructions that it

made a mistake of law made in good faith and on reasonable grounds when it claimed the net

operating loss deductions first claimed by separate entity filings in previous years.

19. Taxpayer’s 2012 CIT-1 Return shows how Taxpayer was to calculate base and net

income in New Mexico. On Line 1, Taxpayer was required to enter the federal taxable income

before federal net operating losses. This amount becomes the New Mexico base income on line 4

unless there were any additions for municipal bond interest (line 2) or subtractions for other federal

special deductions (line 3), neither of which occurred in this case. From the base income amount on

line 4, a taxpayer then can subtract the New Mexico net operating loss carryover amount listed on

line 5 to calculate the New Mexico net taxable income on line 9. [Taxpayer Ex. O].

20. The Department disallowed Taxpayer’s attempt to claim the net operating losses

of Covenant Transport, Inc. and CTG Leasing Company, Inc. in Taxpayer’s 2012 combined CIT

return. [09-04-14 CD 0:30:23-35].

21. Taxpayer has not petitioned the Secretary for permission to return to filing as

separate corporate entities. [09-04-14 CD 0:30:45-0:31:19].

In the Matter of the Protest of Covenant Transportation Group, Inc., page 4 of 18

22. As of the date of hearing, the Department alleged that Taxpayer owed $74,313.00

in corporate income tax, $14,862.60 in penalty, and $3,273.89 in interest for a total outstanding

liability of $92,449.49. [Department Ex. #1].

23. At the request of Taxpayer, and over the Department’s objection, the parties were

ordered to submit post-hearing legal briefing by October 6, 2014. On October 6, 2014, Taxpayer

submitted its Post Hearing Memorandum in Support of the Protest. On October 6, 2014, the

Department submitted its Post Hearing Brief. Both briefings are part of the administrative record

in this matter.

24. On December 15, 2014, the undersigned hearing officer provided notice of intent

to take notice of 2012 CIT instructions and any worksheets/schedules/instructions addressing net

operating losses in that year. The parties did not object by the specified deadline. The “2012 New

Mexico Instructions for Form CIT-1 Corporate Income and Franchise Tax Return” is made part

of the record.

25. The “2012 New Mexico Instructions for Form CIT-1 Corporate Income and

Franchise Tax Return,” page 8, does not contain any advisement or instruction that a combined

consolidated group cannot claim a net operating loss carryover from a member entity that

previously claimed the net operating loss in a separate entity return.

26. On December 15, 2014, the undersigned hearing officer ordered further briefing

in this matter. On December 22, 2014, the Department filed its Second Post-Hearing Briefing

(with attachments), which is incorporated into the administrative record in this matter. On

December 23, 2014, Taxpayer filed its Second Post-Hearing Memorandum in this matter, which

is also incorporated into the record.

In the Matter of the Protest of Covenant Transportation Group, Inc., page 5 of 18

27. The original Decision and Order No. 14-45 in this matter was issued on December

29, 2014.

28. On January 28, 2015, the Department filed a Motion for Reconsideration of the

original Decision and Order. On February 6, 2015, Taxpayer filed an Objection in Opposition to

the Department’s Motion for Reconsideration. Both pleadings are part of the record in this

matter.

29. On March 23, the Hearings Bureau issued an order concurrently with this decision

granting Taxpayer’s motion for reconsideration and withdrawing the original Decision and

Order, No. 14-45, in favor of this Amended Decision and Order.

DISCUSSION

There are no disputes of fact in this matter. There are three legal issues at protest. The

main issue in this case is whether Taxpayer, filing as combination of unitary corporations, may

claim a deduction from New Mexico Corporate Income Tax (“CIT”) for net carryover losses first

reported in previous years by its wholly owned members filing on separate corporate entity basis.

Alternatively, if not allowed to claim the net operating losses, Taxpayer asked to be allowed to

change its CIT reporting method back to separate entities. The final issue is whether civil

negligence penalty should be abated.

Presumption of Correctness.

Under NMSA 1978, Section 7-1-17 (C) (2007), the assessment issued in this case is

presumed correct. Consequently, Taxpayer has the burden to overcome the assessment. See

Archuleta v. O'Cheskey, 1972-NMCA-165, ¶11, 84 N.M. 428. Unless otherwise specified, for the

purposes of the Tax Administration Act, “tax” is defined to include interest and civil penalty. See

NMSA 1978, §7-1-3 (X) (2013). Under Regulation 3.1.6.13 NMAC, the presumption of

In the Matter of the Protest of Covenant Transportation Group, Inc., page 6 of 18
correctness under Section 7-1-17 (C) extends to the Department’s assessment of penalty and

interest. Moreover, “[w]here an exemption or deduction from tax is claimed, the statute must be

construed strictly in favor of the taxing authority, the right to the exemption or deduction must be

clearly and unambiguously expressed in the statute, and the right must be clearly established by the

taxpayer.” Wing Pawn Shop v. Taxation and Revenue Department, 1991-NMCA-024, ¶16, 111

N.M. 735 (internal citation omitted); See also TPL, Inc. v. N.M. Taxation & Revenue Dep't, 2003-

NMSC-7, ¶9, 133 N.M. 447. However, once a taxpayer rebuts the presumption of correctness, the

burden shifts to the Department to show the correctness of the assessed tax. See MPC Ltd. v. N.M.

Taxation & Revenue Dep't, 2003 NMCA 21, ¶13, 133 N.M. 217.

CIT, the Net Operating Carryover Deduction, and CIT Reporting Methods

The main dispute in this protest is the net operating loss carryover deduction that Taxpayer

claimed in the combination of unitary corporations 2012 CIT return. In Taxpayer’s combination of

unitary corporations 2012 CIT return, Taxpayer claimed net operating loss carryover deductions

against its net income from net operating losses first reported in previous years by its wholly owned

subsidiary entities Covenant Transport, Inc. and CTG Leasing Company, Inc., which had filed as

separate corporate entities before 2012. Taxpayer argues that such a deduction is allowable under

Section 172 (a) of the Internal Revenue Code, and thus incorporated into state law through the “base

income” and “net operating loss” definitions. The Department argues that such a net operating loss

is excluded by Regulation 3.4.1.11 (A) NMAC and argues that rather than adopting federal

treatment of net operating losses under Section 172 (a) of the Internal Revenue Code, the “base

income” definition in fact requires a taxpayer to add back the amount of any claimed federal net

operating loss deductions allowable under Section 172 in order to determine New Mexico base

income.

In the Matter of the Protest of Covenant Transportation Group, Inc., page 7 of 18
Under the Corporate Income and Franchise Tax Act, New Mexico imposes a tax on the net

income of every domestic corporation and every foreign corporation engaged in the transaction of

business in New Mexico. See NMSA 1978, § 7-2A-3 (1986) (emphasis added).

In pertinent part, NMSA 1978, Section 7-2A-2 (H) (1999) defines “‘net income’ as base

income adjusted to exclude1:

(4) for taxable years beginning on or after January 1, 1991, an
amount equal to the sum of any net operating loss carryover
deductions to that year claimed and allowed, provided that the
amount of any net operating loss carryover from a taxable year
beginning on or after January 1, 1991 may be excluded only as
follows:

(a) in the case of a timely filed return, in the taxable year
immediately following the taxable year for which the return is filed;
or

(b) in the case of amended returns or original returns not
timely filed, in the first taxable year beginning after the date on
which the return or amended return establishing the net operating
loss is filed; and

(c) in either case, if the net operating loss carryover exceeds
the amount of net income exclusive of the net operating loss
carryover for the taxable year to which the exclusion first applies, in
the next four succeeding taxable years in turn until the net operating
loss carryover is exhausted; in no event may a net operating loss
carryover be excluded in any taxable year after the fourth taxable
year beginning after the taxable year to which the exclusion first
applies.

In other words, Section 7-2A-2 (H) (4) allows a net operating loss carryover deduction only as

specified (the carryover may not extend past five years and there are no carrybacks after 1991). This

is confirmed by Section 7-2A-2 (J), where the Legislature defines a “net operating loss carryover”

as “the amount, or any portion of the amount, of a net operating loss for any taxable year that,

1
Section 7-2A-2 (H) (3) also addresses net operating losses, but only for taxable years before January 1, 1991, a
period not at issue in this matter.

In the Matter of the Protest of Covenant Transportation Group, Inc., page 8 of 18
pursuant to Paragraph (3) or (4) of [Section 7-2A-2 (H)] of this section, may be excluded from base

income.”

In New Mexico, under NMSA 1978, Section 7-2A-2 (C) (1999), "base income"

means that part of the taxpayer's income defined as taxable income
and upon which the federal income tax is calculated in the Internal
Revenue Code for income tax purposes plus, for taxable years
beginning on or after January 1, 1991, the amount of the net
operating loss deduction allowed by Section 172(a) of the Internal
Revenue Code, as that section may be amended or renumbered,
and claimed by the taxpayer for that year; "base income” also
includes interest received on a state or local bond.

As the Department argues in its reconsideration and the hearing officer now agrees, the term

“plus” in Section 7-2-2 (C) requires that a taxpayer add back the amount of net operating losses

claimed on the federal return to derive a New Mexico base income. That is, rather than adopting

Section 172(a) of the Internal Revenue Code’s treatment of net operating loss deductions, the

New Mexico Legislature requires a taxpayer to add that amount back in order to arrive at the

New Mexico base income.

The reason why this interpretation is persuasive is because it harmonizes Section 7-2A-2

(C) with Section 7-2A-2 (H). See Regents of the Univ. of New Mexico v. New Mexico Fed'n of

Teachers, 1998-NMSC-20, ¶28, 125 N.M. 401(Statutes are also to be interpreted in a manner to

give the entire statute effect and not render portions of the statute superfluous). Reading the base

income definition in harmony with Section 7-2A-2 (H), once a taxpayer adds the claimed federal net

operating losses back to establish the New Mexico base income, Section 7-2A-2 (H)(4) allows a

taxpayer then to exclude (or subtract out) the net operating loss carryovers expressly allowed under

that section to derive the taxable net income.

This calculation is seen in the structure of the 2012 CIT Return, admitted into the record as

Ex. O. Line 1 on the return requires Taxpayer to enter the federal taxable income before federal net

In the Matter of the Protest of Covenant Transportation Group, Inc., page 9 of 18
operating losses had been subtracted out on the federal return. Unless there is an addition for

municipal bond interest (line 2) or subtractions for other federal special deductions (line 3), neither

of which occurred in this case, the federal taxable income before the federal net operating losses

becomes the New Mexico base income on line 4 of the CIT return. From the base income amount

on line 4, a taxpayer then can subtract the New Mexico NOL carryover listed on line 5 to calculate

the New Mexico net taxable income on line 9.

Rather than adopt Section 172(a)’s treatment of net operating loss deductions, the

Legislature in Section 7-2A-2 (H) determined the extent of an allowable net operating loss

carryover deduction in New Mexico. Anything not included in Section 7-2A-2 (H)’s allowance for a

net operating loss carryover deduction, even if allowed federally under Section 172(a) as a net

operating loss deduction, was not expressly contemplated by the Legislature as a deduction in New

Mexico. See Wing Pawn Shop, ¶16, 111 N.M. 735 (deductions from tax must construed narrowly in

favor of taxing authority and the right to such deduction must be clearly established by the

taxpayer). There is nothing in Section 7-2A-2 (H) (4) that suggests that the Legislature intended to

adopt Section 172 (a) of the Internal Revenue Code’s treatment of a net operating loss stemming

from another taxpayer’s separate entity return. In fact, because the Legislature requires taxpayers to

add back the federal net operating loss deduction permitted by Section 172 (a) before then

establishing a specific exclusion in New Mexico for net operating loss carryovers under Section 7-

2A-2 (H) (4), the Legislature did not intend to adopt Section 172 (a)’s treatment of net operating

losses. See Mt. States Tel. & Tel. Co. v. N.M. State Corp. Comm'n (In re Rates & Charges of Mt.

States Tel. & Tel. Co.), 1986-NMSC-019, ¶31, 104 N.M. 36 (while the Internal Revenue Code

establishes a starting point for calculating New Mexico corporate income tax, New Mexico “does

not incorporate or adopt the Internal Revenue Code and Treasury Regulations word for word”).

In the Matter of the Protest of Covenant Transportation Group, Inc., page 10 of 18
Turning from the statutes to the regulations at issue, agency regulations interpreting a statute

are presumed proper and are to be given substantial weight See Chevron U.S.A., Inc. v. State ex rel.

Dep't of Taxation & Revenue, 2006-NMCA-50, ¶16, 139 N.M. 498. However, an administrative

agency's discretion in promulgating regulations may not justify altering, modifying or extending

the reach of a law created by the Legislature. See State ex rel. Taylor v. Johnson, 1998-NMCA-

015, ¶ 22, 125 N.M. 343. In Rainbo Baking Co. v. Commissioner of Revenue, 1972-NMCA-139,

¶11, 84 N.M. 303, the New Mexico Court of Appeals found that the Department cannot use a

regulation to restrict a statutorily created deduction when the Legislature did not prescribe such a

limitation: “[t]he Commissioner exceeds this interpretative authority when he attempts by

regulation to impose a limitation on the deduction which the Legislature did not prescribe.”

In this case, the Department disallowed the net operating loss carryover deductions from

income on Taxpayer’s 2012 CIT return pursuant to Regulation 3.4.1.11 (A) NMAC and issued the

assessment. In pertinent part, Regulation 3.4.1.11 (A) NMAC reads2:

Net operating loss carryovers and carrybacks shall be in accordance with
Subsections A through E of Section 3.4.1.9 NMAC but in no case shall a net
operating loss established for the corporation reporting on a separate
corporation basis be excluded from the base income of any other corporation
or from the base income reported on any combined or consolidated return for
any group of corporations.

Given that Section 7-2A-2 (H) (4) does not expressly allow any net operating loss other than the net

operating carryover articulated in that section, Regulation 3.4.1.11 (A) NMAC’s prohibition of the

deduction at issue does not conflict with that statute or create an arbitrary limitation on a deduction

expressed by the legislature. Therefore, the undersigned Hearing Officer’s conclusion that

2
The rest of the regulation establishes a method of calculating base income by preparing a pro forma, simulated
federal return.

In the Matter of the Protest of Covenant Transportation Group, Inc., page 11 of 18
Regulation 3.4.1.11 (A) NMAC is ultra vires in the original Decision and Order was incorrect3, as

that regulation is a proper interpretation of the statutes allowing only for net operating loss

carryovers as described in Section 7-2A-2 (H).

Taxpayer cited a case from Florida, Golden W. Fin. Corp. v. Fla. Dep't of Revenue, 975 So.

2d 567 (Fla. Dist. Ct. App. 1st Dist. 2008), to support its argument. The taxpayer in Golden W. Fin.

Corp., 568, sought a refund of corporate income tax paid under a consolidated group return. The

refund claim was premised on the net operating loss carryover deduction stemming from previous

years when members of the consolidated group filed on a separate entity basis. See id. Florida

statute indicated that net operating losses allowable for federal income tax purposes under Section

172 of the Internal Revenue Code should be subtracted from taxable income. See id. The Florida

Court of Appeals noted that there was no dispute that federal law “permits an affiliated group filing

a consolidated federal income tax return to deduct from its gross income the net operating losses

that one or more of its members sustained during a year in which those members filed separate tax

returns…” Golden W. Fin. Corp., 570. Nevertheless, the Florida Department of Revenue denied the

refund claim, citing a state regulation that prohibited a consolidated group from deducting a net

operating loss carryover from a year in which a Florida consolidated return was not filed. See

Golden W. Fin. Corp., 571. The Florida Court of Appeals ultimately found that since the regulation

was contrary to the statute’s incorporation of Section 1502 and Section 172 of the Internal Revenue

Code, the regulation was invalid exercise of delegated legislative authority and the regulation did

not prohibit the deduction of the net operating losses. See Golden W. Fin. Corp., 571-572.

However, considering Section 7-2A-2 (H) and Section 7-2A-2 (C) in harmony, there is a

distinction between Florida law and New Mexico law that makes Golden W. Fin. Corp. not

3
As Justice Felix Frankfurter once noted, “[w]isdom too often never comes, and so one ought not to reject it merely
because it comes late.” Henslee v. Union Planters Nat'l Bank & Trust Co., 335 U.S. 595, 600 (U.S. 1949).

In the Matter of the Protest of Covenant Transportation Group, Inc., page 12 of 18
applicable: New Mexico does not adopt Section 172 of the Internal Revenue Code. In fact, Section

7-2A-2 (C) requires a taxpayer to add back any deduction allowed federally under Section 172 to

derive the New Mexico base income. The source of an allowable net operating loss deduction in

New Mexico is not Section 172 (a) of the Internal Revenue Code but Section 7-2A-2 (H).

As the original decision and order indicated, Regulation 3.4.1.9 (C)(1) NMAC appeared to

support Taxpayer’s claim for the net operating loss deduction at issue. Under Regulation 3.4.1.9

(C)(1) NMAC,

[t]he net operating loss carryover of a corporation or corporations acquired
by the taxpayer or otherwise included, as for example, through a change in
reporting method, in the taxpayer's return for a taxable year may be excluded
from New Mexico base income only to the extent the Internal Revenue Code
and regulations issued thereunder would permit deduction of such loss
carryovers for federal income tax purposes for that taxable year by that
taxpayer.

However, in this case, Taxpayer did not acquire other corporations but simply changed its reporting

method for separate entities that it had always owned and operated. The previous returns were made

by a separate entities already controlled by Taxpayer, but not by Taxpayer. Taxpayer still needs to

go through the additions and subtractions as outlined on the return and under Section 7-2A-2 (C)

and Section 7-2A-2 (H). That being said, there is little doubt that the Department’s regulations could

be clearer in this area explaining the interaction between base income under Section 7-2A-2 (C), net

income and net operating loss carryovers under Section 7-2A-2(H), and also in clarifying what

appears to be a potential contradiction between regulations.

In summary of the main issue, Section 7-2A-2 (H) and not Section 172(a) of the Internal

Revenue Code defines the extent of a net operating loss carryover deduction in New Mexico. Since

the deduction at issue in this case is not included under Section 7-2A-2 (H), the Department’s

prohibition of that deduction at issue under Regulation 3.4.1.11 (A) NMAC was proper.

In the Matter of the Protest of Covenant Transportation Group, Inc., page 13 of 18
Alternatively, Taxpayer argued that it be allowed to return to a separate entity reporting

method so that it could still claim the net operating loss carryovers first reported by the separate

corporate entities before 2012. The Department opposed this request because Taxpayer never

requested permission to return to the separate entity reporting method and because such election of

reporting method cannot apply retroactively.

New Mexico allows a taxpayer subject to the Corporate Income and Franchise Tax Act to

elect one of three reporting methods. See Regulation 3.4.10.8 (B) NMAC. The first permissible

reporting method is the separate corporate entity method. See Regulation 3.4.10.8 (B) (1) NMAC

and Regulation 3.4.10.7 (A) NMAC. The second permissible reporting method is the combination

of unitary corporations. See NMSA 1978, § 7-2A-8.3 (2013) and Regulation 3.4.10.8 (B) (2)

NMAC. The third reporting method is the federal consolidated group. See NMSA 1978, § 7-2A-8.4

(1993) and Regulation 3.4.10.8 (B) (3) NMAC. As the testimony on the record in this matter

reflects, these three reporting methods are often referenced as “the ladder” of corporate income tax

reporting options. This is because, while a corporation can elect to report at a higher step of the

three reporting methods, it may not elect to step down to a lower reporting method without express

permission of the Secretary. See NMSA 1978, § 7-2A-8.3 (B) (2013); See NMSA 1978, § 7-2A-8.4

(B) (1993); See also Regulation 3.4.10.8 (C) & (D) NMAC.

In this case, before tax year 2012 the three corporate entities owned by Taxpayer—

Covenant Transport, Inc., CTG Leasing Company, Inc., and Southern Refrigerated Transport,

Inc.— that conducted business in New Mexico reported CIT on the first step of the reporting ladder:

the separate corporate entity method. Because the separate corporate entity method is the first step

of the ladder, Taxpayer was free to elect to report at either of the next two steps of the ladder in

subsequent years without permission. See Regulation 3.4.10.8 (C) NMAC.

In the Matter of the Protest of Covenant Transportation Group, Inc., page 14 of 18
For tax year 2012, apparently in effort to streamline its reporting requirements in numerous

states and maximize the net operating losses of some of the entities, Taxpayer elected to file under

the second, combined unitary corporation method pursuant to Section 7-2A-8.3 and Regulation

3.4.10.8 (B) (2) NMAC. As such, Taxpayer was required to report “the net income of all the unitary

corporations.” § 7-2A-8.3 (A). Although in its protest letter Taxpayer argued that it should be

allowed to return to the separate entity method, by selecting the second step reporting method,

Taxpayer was no longer at liberty to change its election to the first step separate corporate entity

method without obtaining permission from the Secretary to do so pursuant to Section 7-2A-8.3 (B)

and Regulation 3.4.10.8 (D) NMAC, which did not occur. Moreover, even if permission had been

sought and granted, that change of election could not apply retroactively. See Regulation 3.4.10.8

(E) NMAC.

Interest and Penalty.

When a taxpayer fails to make timely payment of taxes due to the state, “interest shall be

paid to the state on that amount from the first day following the day on which the tax becomes

due...until it is paid.” NMSA 1978, § 7-1-67 (2007) (italics for emphasis). Under the statute,

regardless of the reason for non-payment of the tax, the Department has no discretion in the

imposition of interest, as the statutory use of the word “shall” makes the imposition of interest

mandatory. See Marbob Energy Corp. v. N.M. Oil Conservation Comm'n, 2009-NMSC-013, ¶22,

146 N.M. 24 (use of the word “shall” in a statute indicates provision is mandatory absent clear

indication to the contrary). The language of Section 7-1-67 also makes it clear that interest begins to

run from the original due date of the tax until the tax principal is paid in full. The Department has no

discretion under Section 7-1-67 and must assess interest against Taxpayer from the time the 2012

CIT tax was due but not paid until Taxpayer satisfies the CIT tax principal.

In the Matter of the Protest of Covenant Transportation Group, Inc., page 15 of 18
When a taxpayer fails to pay taxes due to the State because of negligence or disregard of

rules and regulations, but without intent to evade or defeat a tax, by its use of the word “shall”,

Section 7-1-69 requires that civil penalty be added to the assessment. As discussed above, the

statute’s use of the word “shall” makes the imposition of penalty mandatory in all instances

where a taxpayer’s actions or inactions meets the legal definition of “negligence.” However, in

instances where a taxpayer might otherwise fall under the definition of civil negligence generally

subject to penalty, Section 7-1-69 (B) provides a limited exception: “[n]o penalty shall be

assessed against a taxpayer if the failure to pay an amount of tax when due results from a mistake

of law made in good faith and on reasonable grounds.”

In this case, Taxpayer rebutted the presumption of correctness as it relates to the assessed

penalty. Although ultimately incorrect, Taxpayer provided a careful legal explanation weaving

through the various statutes and regulations to demonstrate why it believed it was entitled to the

claimed net operating loss deductions. Further, Regulation 3.4.1.9 (C) (1) NMAC has some

consistency with Taxpayer’s legal analysis. Once Taxpayer rebutted the presumption by showing

that its “failure to pay an amount of tax when due results from a mistake of law made in good

faith and on reasonable grounds” under Section 7-1-69 (B), the burden shifted to the Department

to support that Taxpayer was subject to civil negligence penalty. See MPC Ltd., ¶13. The

Department did not meet that burden. Therefore, under the unique facts of this case, civil penalty is

abated.

CONCLUSIONS OF LAW

A. Taxpayer filed a timely, written protest to the assessment. Jurisdiction lies over the

parties and the subject matter of this protest. The hearing was timely set within the time limits

articulated by NMSA 1978, Section 7-1-24.1 (A) (2013).

In the Matter of the Protest of Covenant Transportation Group, Inc., page 16 of 18
B. Taxpayer was not free to return to separate entity reporting method without the

Secretary’s permission once it filed in 2012 as a combination of unitary corporations.

C. Under Section 7-2A-3 and Section 7-2A-8.3, Taxpayer was required to pay CIT on

its “net income” from the unitary corporation.

D. Section 7-2A-2 (C) defines “base income” as taxable income plus the amount of a

deduction for net operating loss as allowed by Section 172 (a) of the Internal Revenue Code. This

section requires Taxpayer to add back the amount of net operating losses claimed on the federal

return pursuant to Section 172(a) of the Internal Revenue Code in order to derive a New Mexico

base income.

E. Under Section 7-2A-2 (H), “net income” includes “base income adjusted to exclude”

the items specified in that section. The net operating loss deduction at issue here is not income that

is to be excluded from base income. Section 7-2A-2 (H) therefore does not expressly allow

Taxpayer’s claimed deduction. See Wing Pawn Shop, ¶16, 111 N.M. 735 (deductions from tax

must construed narrowly in favor of taxing authority and the right to such deduction must be clearly

established by the taxpayer)

F. Moreover, Regulation 3.4.1.11 (A) NMAC prohibits Taxpayer from claiming the

deduction at issue in this case. See Chevron U.S.A., Inc. ¶16 (regulations are presumed proper

interpretation of statute).

G. Under NMSA 1978, Section 7-1-67 (2007), Taxpayer is liable for accrued interest

under the assessment. Interest continues to accrue until the tax principal is satisfied.

H. Under NMSA 1978, Section 7-1-69 (B) (2007) Taxpayer rebutted the

presumption of correctness of the assessed penalty by establishing that its failure to pay CIT tax

when due resulted “from a mistake of law made in good faith and on reasonable grounds.” The

In the Matter of the Protest of Covenant Transportation Group, Inc., page 17 of 18
Department did not reestablish the validity of the assessed penalty, as required under MPC Ltd.,

¶13.

For the foregoing reasons, Taxpayer’ protest IS PARTIALLY DENIED AND

PARTIALLY GRANTED. Pursuant to Section 7-1-69 (B), penalty is abated. As of the date of

hearing, Taxpayer owed $74,313.00 in corporate income tax, and $3,273.89 in interest. Interest

continues to accrue until the tax principal is satisfied.

DATED: March 24, 2015.

Brian VanDenzen, Esq.,
Chief Hearing Officer
Taxation & Revenue Department
Post Office Box 630
Santa Fe, NM 87504-0630

In the Matter of the Protest of Covenant Transportation Group, Inc., page 18 of 18