The Conference Report to H.R. 1, the “Tax Cuts and Jobs Act” (the “Act”), which was agreed to by House and Senate conferees on December 15, 2017, passed the Senate on December 19, 2017, and passed the House on December 20, 2017. The Act enacts the most sweeping federal tax reform since 1986. President Trump signed the bill into law on December 22, 2017. This Alert discusses some of the state and local tax issues that could be presented by key features of the Act.
For corporate income tax purposes, most states will begin the calculation of state taxable income with either “line 28” or “line 30” federal taxable income. To this federal taxable income starting point, states provide various addition and subtraction modifications applicable to particular income, gain, loss, and deduction items that enter into the calculation of federal taxable income. However, in addition to federal taxable income either before (“line 28”) or after (“line 30”) net operating losses and special deductions, the federal taxable income starting point may mean different things in different states depending on the method of state conformity to the Internal Revenue Code (the “IRC”).
For example, a state may adopt “rolling” conformity, which means it will adopt a definition of federal taxable income (as well as addition and subtraction modifications) on the basis of the IRC “as amended.” Such states could automatically conform to the federal tax reform changes contained in the Act unless they enact legislation to expressly decouple from the particular aspects of the Act (most of which will be effective for taxable years beginning after December 31, 2017). Other states conform to the IRC on a “fixed date” basis. For example, if a state’s definition of federal taxable income (as well as addition and subtraction modifications) is to the IRC “in effect on” or “as amended through” December 31, 2016, that state will not conform to any of the federal tax reform changes in the Act unless or until the state updates its conformity date or enacts specific legislation adopting a federal change. Other states only adopt or conform to specific IRC sections on a rolling or fixed date conformity basis. For example, California adopts specific IRC sections only and they are such sections “as amended through” January 1, 2015. Some states simply start the calculation of state taxable income with federal taxable income without any IRC reference. A few states provide their own definition of taxable income or “net income.”
Whether any change in the Act will have an impact on a state corporate income taxpayer will initially be determined on the basis in which the states, where the taxpayer does business and has a corporate income tax return filing obligation, conform to the IRC. Similarly, the Act’s effect on individuals, pass-through entities, and other business entities begins with a state’s method of IRC conformity.
Corporate Rate Reduction
Effective for taxable years beginning after December 31, 2017, the federal corporate rate is reduced to 21 percent from 35 percent. Since state taxes and rates are not a percentage of the federal rate, the federal corporate rate reduction has no direct impact on state rates. Nonetheless, with such a substantial federal rate reduction, state corporate income tax will proportionally be a more significant part of a company’s overall effective tax rate. The effect could be magnified to the extent states adopt a number of the federal base-broadening measures contained in the Act. As a result, the state effective tax rate, utilization of state tax credits, and possibly tax planning will likely demand increased attention. In addition, with the federal corporate rate reduction, a company’s state tax deferred positions will be materially impacted since its state tax deferred balances are recorded after-federal tax effect.
A number of states decoupled from federal bonus depreciation under prior law or provided a modified state-only bonus depreciation calculation. Likewise, many states limited or did not conform to IRC § 179. It is unlikely that such states will conform to the new federal fully expensing capital expenditure regime, but a state’s conformity to or modification of IRC § 168(k)(1)(A) will need to beevaluated. Further, depending on the wording of a state’s statute decoupling from prior law, since full expensing will enter into the calculation of a federal taxable income starting point, a state may need to enact legislation in 2018 to further decouple from federal full expensing. As a result, state legislative responses to amended IRC § 168(k)(1)(A) during their 2018 legislative sessions will need monitoring.
Net Operating Loss (NOL) Deduction Limitation
The Act amends IRC § 172 to limit the NOL deduction to 80 percent of taxable income (determined without regard to the NOL deduction) for losses arising in taxable years beginning after December 31, 2017. The Act eliminates NOL carrybacks, but permits NOLs to be carried forward indefinitely. While most states could be assumed to adopt most of the base-broadening measures in the Act, a number of states provide their own NOL deduction, as well as their own limitations. Thus, states may not be impacted by this federal change. However, states without NOL limitations of their own may be encouraged to adopt new IRC § 172 or similar NOL limitations. For the handful of states that currently allow NOL carrybacks, amended IRC § 172 could also encourage them to eliminate their NOL carryback as well. And, it is unlikely that states will adopt the new federal indefinite NOL carryforward provision. It is anticipated that there will continue to be inconsistency between federal and state NOLs, which will create additional complexity for corporate taxpayers.
Revised Treatment of Contributions to Capital
One of the most far-reaching and negative changes in the Act (for states, localities, and taxpayers alike) is amended IRC § 118. Under prior law and the Act, contributions to capital of a corporation are not included in the corporation’s gross income. However, under the Act’s amendment to section 118, a “contribution to capital” does not include (1) any contribution in aid of construction or any other contribution as a customer or potential customer, or (2) any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such).
Tax incentives, including grants and reimbursements by state and/or local governments to businesses that promote economic development in the state, may be non-shareholder contributions to capital under Detroit Edison Co., 319 U.S. 98 (1943), Chicago, Burlington, & Quincy R.R. Co., 412 U.S. 401 (1973), and other cases. After the Act’s amendment of IRC § 118, such tax incentives are includible in gross income. The amendment is effective for contributions made after the date of enactment, but does not apply to contributions made by a governmental entity after the date of enactment pursuant to a master development plan that was approved prior to the date of enactment. As a result, state and local incentives, grants, and reimbursements after December 22, 2017, will have to be evaluated to determine if there are included in federal gross income. While it would seem unlikely that a state would conform to amended IRC § 118, as that runs counter to a state’s economic development programs, a state would likely have to decouple from this new federal provision. However, if a state only decouples with respect to its incentives, grants, and reimbursements, this could discriminate against interstate commerce by arguably favoring in-state incentives over out-of-state incentives.
Business Interest Deduction Limitation
The Act amended the IRC § 163(j) net business interest deduction limitation to (1) change the limitation to 30 percent of “adjusted taxable income”, (2) apply the limitation to related and unrelated party debt (as well as existing debt), and (3) added an indefinite carryforward provision for excess net interest expense subject to limitation in a taxable year. Until 2022, “adjusted taxable income” will generally mean taxable income computed without regard to depreciation, amortization, or depletion. Beginning in 2022, adjusted taxable income will generally mean income before interest and taxes. Since the limitation will enter into the determination of federal taxable income, “rolling” conformity states will automatically conform unless such a state specifically decouples. However, a “fixed-date” conformity state will not conform unless or until the state updates its IRC conformity date.
Because the new limitation applies to unrelated and related party interest expenses, a state’s related party interest expense add-back statute could further disallow excess carryforward net interest expense at the state level. In addition, it is uncertain whether states will conform to the indefinite carryforward period for excess interest expense, as well as whether states will require the apportionment of any excess interest expense. Last, the determination of “adjusted taxable income” is done at the federal filer level (i.e., federal consolidated group, partnership, etc.) Again, after determining their method of IRC conformity and whether specific state legislation is required, separate return states (and a number of combined reporting states) could require the determination of “adjusted taxable income” be made on a separate entity basis. Moreover, the calculation of the amended IRC § 163(j) net business interest expense limitation at the filer or entity level for federal purposes could add another level of complexity (and increased tax cost) for pass-through entities in states that tax pass-through entities at the entity level. The interaction of amended IRC § 163(j) between the federal level and state level is likely to increase complexity for state compliance.
Deduction for Qualified Business Income
While the state and local tax deduction got most of the press coverage, one of the most pressing state personal income tax issues presented by the Act is whether states will conform to the deduction for qualified business income (QBI) from pass-through entities and sole proprietorships. Subject to certain thresholds and limitations, for taxable years beginning after December 31, 2017, individual taxpayers will be allowed to deduct 20 percent of QBI passed through from partnerships, limited liability companies taxed as partnerships, S corporations, and sole proprietorships (as well as qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income.)
The Conference Report clarifies, however, that the deduction is not allowed in computing adjusted gross income. Rather, it is a below-the-line deduction reducing federal taxable income. This is a key distinction for state personal income tax purposes. While most states begin the calculation of state taxable income of a corporation with federal taxable income, however defined, most states begin the calculation for individuals with federal adjusted gross income. As a result, even for “rolling” conformity states, the federal deduction for QBI may not enter into the calculation of an individual’s state taxable income unless a state decides to amend its statute to allow the deduction. For the handful of states that do start the calculation with an individual’s federal taxable income, the QBI deduction will apply only to “rolling” conformity states, unless they decouple, and only for fixed-dated conformity states after they update their conformity (assuming they do not also decouple.) If the QBI deduction does apply in a state, other questions could be presented, such as whether a resident or non-resident state will subject the deduction to apportionment, whether the deduction could affect withholding tax calculations, and whether the deduction enters into a pass-through entity’s composite return calculation of income of non-resident investors. For the handful of states that tax pass-through entities at the entity level, the federal QBI deduction may not reduce entity level income or earnings for state tax purposes
Federal Change to a “Territorial/Dividend-Exemption” System
There are a number of complex new federal international tax provisions enacted as part of the Act for which state conformity evaluations will be required, including for impact on apportionment calculations and possibly water’s-edge unitary combined reporting purposes. This Alert focuses on only three: (1) the new federal dividends received deduction (DRD); (2) the deemed repatriation transition tax; and (3) the Global Intangible Low-Taxed Income tax.
The Act adopts a new IRC § 245A that will provide a 100 percent DRD for the foreign source portion of dividends received by a domestic corporation that is a 10 percent shareholder in a distributing foreign corporation. After the U.S. Supreme Court’s decision in Kraft General Foods, Inc. v. Iowa Dept. of Revenue and Finance, 505 U.S. 71 (1992), so-called separate return states are required to provide a DRD for foreign source dividends equivalent to any DRD provided for dividends received from domestic U.S. corporations. Failure to do so constitutes discrimination by a state against foreign commerce in violation of the foreign Commerce Clause of the U.S. Constitution. Separate return states that already provide a full DRD for foreign source dividends may see no need to adopt IRC § 245A. A failure to do so by such states may lead to federal/state stock basis differences (see below). However, in an odd twist, some of these separate return state foreign source DRDs may be operative on the inclusion of such foreign source dividends in federal taxable income. As a result, such states will be required to amend their foreign source DRDs, as the foreign source dividend will no longer be included in federal taxable income.
Based on footnote 23 in the Court’s Kraft decision and the mechanics of state “water’s-edge” unitary combined reporting systems, such states are not required to provide a similar DRD for foreign source dividends and a number do not. While separate return states likely will, and are required to, conform to new IRC § 245A, water’s-edge combined reporting states may not conform or may only provide a partial DRD for foreign source dividends. Again, for those combined reporting states that provide a whole or partial foreign source DRD, such DRD may be operative only if the dividends were included in federal taxable income.
As a result, U.S. corporate taxpayers receiving foreign source dividends that will be deductible under new IRC § 245A will need to address (a) whether such dividends are deductible from or includible in state taxable income for state purposes, (b) if, or to the extent, includible, whether such dividends should be treated as business or nonbusiness income under state rules and case law, and (c) if treated as business income whether the dividends are included in the sales factor of the apportionment formula and, if so, the sourcing of the dividends. For states that conform to new IRC § 245A or that already provide a full or partial DRD for foreign source dividends, corporate taxpayers will still need to determine whether any expenses directly or indirectly related to the deductible dividend income are disallowed as deductions for state purposes.
In addition, several water’s-edge combined reporting states will include the income and apportionment factors of certain foreign corporations in the state’s combined report. These may include foreign “tax haven” corporations, foreign corporations that have a certain amount of apportionment factors assigned to U.S. locations (e.g., 20 percent or more), or controlled foreign corporations with Subpart F income. With the federal move to a territorial system while some states retain their existing “water’s-edge” combined reporting systems, there will undoubtedly be increased complexity in tax reporting for U.S. based multinationals.
Further, solely for purposes of determining loss on the disposition of stock in a 10-percent owned foreign corporation, a U.S. corporate shareholder is required to reduce its basis in its foreign corporation stock in an amount equal to the IRC § 245A DRD. As noted, if a separate return state believes there is no need to adopt IRC § 245A because it already provides a full foreign source DRD, then federal and state stock basis will likely be different. Likewise, water’s-edge combined reporting states that have not conformed to IRC § 245A, and are not compelled by Kraft to do so, may also present federal and state stock basis differences.
A question that could arise, however, is whether Kraft prohibits separate return states from conforming to the federal foreign corporation stock basis adjustment when stock basis in a similarly situated U.S. corporation is not reduced for a state DRD.
Deemed Repatriation Transition Tax
The Act enacts a transition tax that generally requires U.S. shareholders of “specified foreign corporations” (as specifically defined in IRC § 965(e)) to increase Subpart F income, as otherwise determined under IRC § 952, and include in federal taxable income under IRC § 951(a)(1)(A) their pro rata shares of such foreign corporation’s accumulated post-1986 foreign earnings. The transition tax is imposed at rates of 15.5 percent on foreign earnings held in cash or cash equivalents and eight percent on all other foreign earnings. Because the deemed repatriation amount is included as Subpart F income under IRC § 951(a)(1)(A), it will be necessary to address how a state currently treats such Subpart F income. However, the individual mechanics of calculating the deemed repatriation transition tax must be individually understood from a state perspective.
In brief, under new IRC § 965(a), a “U.S. shareholder” first increases its federal gross income under IRC § 951 equal to its share of deferred foreign income of a specified foreign corporation or “deferred foreign income corporation” (“DFIC”). The “inclusion amount” is treated as an increase to Subpart F income under IRC § 952 and included in federal taxable income of the shareholder under IRC §951. Next, to arrive at the effective 15.5 percent or eight percent tax rates, the shareholder is allowed a deduction under new IRC § 965(c) based on a calculation referenced to the shareholder’s aggregate foreign cash position equal to an amount that results in an effective tax rate of 15.5 percent on foreign earnings held in cash or cash equivalents and/or eight percent on foreign earnings held in other property. Lastly, the shareholder may elect to pay the transition tax currently or in eight equal annual installments.
The “inclusion year” for the deemed repatriation amount that is included in a U.S. shareholder’s Subpart F income is the last taxable year of a DFIC that begins before January 1, 2018. The Subpart F income of the corporation is increased by the greater of (1) the accumulated post-1986 deferred foreign income of the DFIC as of November 2, 2017, or (2) the accumulated post-1986 deferred foreign income of the DFIC determined as of December 31, 2017. Further, new IRC § 965 is effective for the last taxable year of a foreign corporation that begins before January 1, 2018, and with respect to U.S. shareholders for taxable years in which or with which such taxable years of the foreign corporations end. As a result, the inclusion year for the deemed repatriation is 2017 (although a U.S. shareholder could have an inclusion in more than one taxable year.) Thus, a state’s method of conformity (“rolling,” “fixed-date,” or other) takes on added significance for determining whether, as an initial matter, the deemed repatriation could be included in state taxable income for a U.S. corporation’s 2017 state taxable year.
Initially, after evaluating a state’s method of IRC conformity, taxpayers will need to evaluate how states treat Subpart F income for purposes of whether the deemed repatriation is included or excluded from state taxable income. While most separate return and combined reporting states will exclude Subpart F income, some states may include all or a portion of Subpart F income in state taxable income. For example, California includes the income and apportionment factors of a “controlled foreign corporation” in a water’s-edge combined report based on the ratio of the CFC’s total Subpart F income for the taxable year to the CFC’s current earnings. Some other water’s-edge and separate return states will only exclude a portion of Subpart F income from state taxable income or treat Subpart F income as a foreign source dividend eligible for a less than 100 percent DRD. Further, even if a state excludes all or a portion of Subpart F income, taxpayers will also need to evaluate whether the state disallows deductions for expenses directly or indirectly related to the excluded Subpart F income.
With regard to the deduction, taxpayers will need to evaluate state federal taxable income starting points (i.e., line 28 or line 30) and whether this IRC § 965 deduction is a special deduction or whether a state decouples from IRC § 965.
If the deemed repatriation is included in state taxable income, it is unlikely that a state, without specific legislation allowing taxpayers to do so, will conform to the election permitting a taxpayer to pay the transition tax over eight annual installments. Rather than being a deferral from inclusion in federal taxable income, the election defers the payment of a federal tax liability.
Finally, for federal tax purposes, a subsequent actual repatriation of DFIC earnings that were previously subject to transition tax are not subject to federal income tax, because the earnings are “PTI” under IRC § 959. If a state previously excluded the deemed repatriation “inclusion amount” either based on its method of IRC conformity or based on a whole or partial Subpart F income exclusion, the actual distribution, wholly or partially, could be subject to state income tax (see discussion above regarding new IRC § 245A).
Global Intangible Low-Taxed Income
The Act also imposes another special tax on global intangible low-taxed income (GILTI). Generally, the tax is at a 10.5 percent rate on a U.S. shareholder’s share of a CFC’s GILTI and, while similar to Subpart F income provisions, GILTI is “active” income, not Subpart F. The amount of GILTI and corresponding federal tax is a complicated calculation, but generally impacts U.S. shareholders of CFC’s that have a heavy concentration of intangible assets compared to fixed/tangible assets (or high income relative to low depreciable assets.) Like the deemed repatriation transition tax, GILTI is included in the U.S. shareholder’s federal taxable income under new IRC § 951A, and then a new deduction is provided under new IRC § 250 in an amount under a calculation that arrives at the 10.5 percent effective rate of tax on the GILTI. Unlike the deemed repatriation transition tax, the GILTI tax is effective for taxable years beginning after December 31, 2017.
For states that exclude Subpart F income and/or provide a foreign source DRD (or qualify Subpart F income for such DRD), it is uncertain whether the GILTI inclusion in federal taxable income would be deductible or excludible. For example, if a state only excludes Subpart F income “as defined under IRC § 952” or included under IRC § 951, then GILTI could be included in the state tax base. Further, it is uncertain whether GILTI would qualify as a foreign source dividend for state tax purposes. Without the enactment of specific state legislation, it is uncertain whether existing state Subpart F or foreign source dividend exclusions apply to GILTI. Similar state evaluations applicable to the deemed repatriation transition tax will need to be applied by taxpayers that are subject to the new GILTI tax.
State and Local Tax Deduction
Effective for taxable years beginning after December 31, 2017, and before January 1, 2026, the only state and local taxes that will be deductible for an individual are those incurred in the carrying on of a trade or business, or in an activity described in IRC § 212. Thus, only state and local taxes entered on an individual taxpayer’s Schedule C, Schedule E, or Schedule F will be eligible for a deduction under IRC § 164. This also impacts owners of pass-through entities with respect to their state income taxes on distributive shares of income.
The Act provides an exception for taxpayers that itemize deductions and allows the deduction of state and local property taxes and/or income taxes (or sales taxes in lieu thereof) that are not incurred in a trade or business, or in an activity related to the production of income, in the aggregate amount up to $10,000 ($5,000 for married filing separate).
While the new federal “SALT cap” has no direct state impact, as states already add-back other state taxes to federal taxable income when determining state taxable income, it could encourage a number of different reactions on the part of states and individuals. States could replace their pass-through entity tax structures with entity-level taxes, such as Tennessee and Texas have done for years. Recent reports indicate that some states are considering charitable contribution funds that would allow taxpayers the option to contribute what otherwise would be a personal income tax payment to these funds as ostensible charitable contributions in exchange for an income tax credit. For example, Senate Bill 227 was introduced in the California Senate on January 3, 2018. The bill would create the California Excellence Fund to accept contributions from individuals (and corporations) for public purposes in exchange for a California income tax credit. It is uncertain whether the IRS would view these contributions as qualifying for a federal charitable contribution deduction, which is not subject to the same $10,000 cap. Other states are considering other options (e.g., New York’s consideration of an employer-side payroll tax.) Given the federal corporate rate reduction, individual owners of pass-through entities may consider converting to C corporations whose state tax deductions will not be limited for federal purposes.
• Obviously, the federal tax reform changes enacted by the “Tax Cuts and Jobs Act” will impact all federal taxpayers immediately. However, taxpayers should also account for the impact of the federal changes on their state corporate and personal income taxes, and state tax treatment of pass-through entities and foreign corporations, including foreign source dividends and Subpart F income.
• Despite the differences in how rolling conformity, fixed date conformity, and other states conform or decouple from the IRC, it is expected that state legislatures, most of which will be convening new legislation sessions starting in January 2018, will have an active legislative season as states address their conformity to or decoupling from the myriad federal tax reform changes.
• We anticipate that state economic development efforts will increase reliance on statutory tax credits and other incentives that are not contributions of money or other property, such as favorable filing options, alternative apportionment formulas, and other non-capital incentives.
Taxpayers should consult with their financial statement auditor and tax advisor to evaluate and determine the potential financial statement implications under ASC 740, including the impact on current and deferred taxes, uncertain tax benefits, and disclosures, of state conformity or non-conformity to the Act.