The US States’ Evolving Responses to Tax Reform Present Opportunities and Challenges
This article was written by Korwin Roskos of Andersen, United States.
- The states’ responses to the sweeping changes under the Tax Cuts and Jobs Act (TCJA) are as varied as their own unique tax codes.
- Determining a state’s approach to TCJA conformity is a dynamic process that requires a thorough analysis of the jurisdiction’s tax laws and administrative guidance.
- Monitoring new developments in this area is essential because state positions on key TCJA provisions such as GILTI continue to evolve.
- Also, keep an eye on emerging issues such as the constitutional limitations on the states’ authority to include GILTI in apportionable income.
Since the TCJA was enacted in December 2017, the states have responded by enacting legislation and issuing administrative guidance indicating the parts of the TCJA from which they will adopt or decouple. These state responses have impacted taxpayers because states typically use federal taxable income as the starting point for computing state net taxable income through their adoption of the Internal Revenue Code (Code).
The states take different approaches to adopting the Code. Some states adopt the Code as it currently exists. These jurisdictions are referred to as Rolling Conformity States. Rolling Conformity States automatically adopted the provisions of the TCJA implicating the computation of taxable income when it was enacted. Other states adopt the Code in effect on or as amended through a specific date. Those states are often referred to as Static Conformity States. Static Conformity States did not adopt the provisions of the TCJA implicating the computation of taxable income when the TCJA was enacted. However, some of those Static Conformity States subsequently enacted legislation which updated their conformity date to the Code, including the TCJA provisions implicating the computation of taxable income.
Both Rolling Conformity and Static Conformity States enacted legislation decoupling from some TCJA provisions. Below is an overview of the approaches states are taking in either adopting or decoupling from the TCJA’s limitations on business interest expense, Foreign-Derived Intangible Income (FDII) and Global Intangible Low-Taxed Income (GILTI).
Limitation on Business Interest Expense
The TCJA amends the historical version of Sec. 163(j) to limit business interest expense to no more than 30% of federal taxable income exclusive of business interest income, business interest expense, depreciation and amortization for tax years beginning before January 1, 2022 (after which depreciation and amortization are no longer excluded). Many states conform to the TCJA’s version of Sec. 163(j) as a result of Rolling Conformity. However, some Rolling Conformity States have decoupled from the provision. These states include, but are not limited to, Connecticut (S.B. 11, effective with the 2018 tax year) and Tennessee (S.B. 2119, effective with the 2020 tax year).
In addition, many of the Static Conformity States have updated their conformity to the Code to include the TCJA’s amendments to Sec. 163(j). However, some of these states, such as Wisconsin (A.B. 259) and Georgia (H.B. 918), have decoupled from this provision effective with the 2018 tax year. Virginia currently conforms to the provision, but it also enacted legislation (S.B. 1372) providing for a subtraction for “20 percent of business interest disallowed as a deduction” under Sec. 163(j).
Business Interest Expense Limitation and Consolidated Returns
Differences between federal and state rules for filing consolidated returns can complicate the application of the TCJA’s Sec. 163(j). Proposed U.S. Treasury Regulations provide that the Sec. 163(j) limitation of an affiliated group filing a consolidated return is applied to the group as a whole as if it were a single taxpayer. As a result, intercompany interest between members of a consolidated group is disregarded for purposes of computing the Sec. 163(j) limitation. However, some states that conform to Sec. 163(j) require state income tax returns to be filed on a separate company basis. These states will likely not disregard intercompany interest for purposes of computing the Sec. 163(j) limitation. Also, some separate company states restrict taxpayers’ ability to deduct intercompany interest. These states include Pennsylvania, which recently released guidance (PA Corporation Tax Bulletin 2019-03) specifying that if a taxpayer files its federal return on a consolidated basis and does not report a Sec. 163(j) limitation, then there is no Sec. 163(j) limitation on the separate company Pennsylvania return. This guidance also provides that if the federal consolidated return reflects a Sec. 163(j) limitation, then each separate company included in the federal consolidated return that is required to file a Pennsylvania return needs to compute its own Sec. 163(j) limitation.
The TCJA’s FDII provisions (Sec. 250) can provide a domestic corporation a deduction for a portion of its income derived from tangible and intangible products and services in foreign markets. Many states conform to the FDII provisions through Rolling Conformity or Static Conformity to the IRC as of a date which includes the TCJA. However, some states such as New York (S.7509-C; A.9509-C), Minnesota (H.F. 5) and North Carolina (S.B. 99) have enacted legislation to decouple from the FDII deduction effective with the 2018 tax year. Illinois, which has Rolling Conformity to the Code, enacted a measure (S.B. 689) decoupling from the FDII deduction, but only for tax years beginning on or after December 31, 2018, by requiring an addition modification to the federal taxable income starting point for the FDII deduction under Sec. 250(a)(1)(A) for such years.
The TCJA’s GILTI provisions (Sec. 951A) effectively subject U.S. Shareholders of controlled foreign corporations (CFCs) to taxation on most income earned through the CFC that exceeds a 10% return on the CFC’s tangible assets. Below are some examples of state responses to GILTI:
- Florida (H.B. 7127), Georgia (S.B. 328) and Wisconsin (A.B. 259) generally adopt the TCJA through Static Conformity as of a date that includes the TCJA but decouple from GILTI.
- Illinois, a Rolling Conformity State, has a statutory subtraction modification which predates the TCJA and is applicable to corporations for dividends received or deemed to be received under Secs. 951 through 965 of the Code. The Illinois Department of Revenue has issued guidance specifying this subtraction applies to GILTI.
- Connecticut (SN 2018(7)) and Kentucky (KY-TAM 18-02) issued administrative guidance indicating that because GILTI is similar to Subpart F income, GILTI qualifies for the subtraction modification applicable to corporations for dividend income, and that any expenses attributable to GILTI are not deductible.
- Massachusetts, a Rolling Conformity State, enacted legislation (H. 4930) providing that GILTI is a dividend for purposes of the state’s Dividend Received Deduction applicable to corporations. The legislation is effective for the last taxable year of a taxpayer commencing before January 1, 2018 and subsequent years. As a result, most corporate taxpayers will be able to exclude 95% of GILTI from Massachusetts taxable income.
- New York, a Rolling Conformity State, adopted different rules for the 2018 tax year (S.7509-C; A.9509-C) and tax years on or after 2019 (S.B. 6615). For the 2018 tax year, GILTI (net of the Sec. 250 deduction) will be includable in a corporation’s taxable income for New York purposes. In addition, New York issued guidance providing that GILTI (net of the Sec. 250 deduction) will be included in the denominator, but not the numerator of the New York sales factor for years beginning during the 2018 calendar year if the stock of the CFC generating the GILTI is business capital for New York purposes. For tax years beginning on or after 2019, 95% of a corporation’s GILTI before the application of the Sec. 250 deduction is exempt CFC income and the Sec. 250 deduction is disallowed. Thus, the remaining 5% of GILTI before the application of the Sec. 250 deduction is included in taxable income for New York purposes and is also included in the denominator, but not the numerator of the New York sales factor.
- Maryland, a Rolling Conformity State, issued guidance providing that GILTI is neither a dividend nor deemed dividend. As a result GILTI is includable in Maryland taxable income of a corporation net of the Sec. 250 deduction. Maryland’s guidance also provides Manufacturing Corporations will not include GILTI in the apportionment factor.
Is Including GILTI in State Apportionable Income Constitutional?
Taxpayers may want to consider arguing separate company states are constitutionally prohibited from including GILTI in taxable income if they provide a dividends received deduction for dividends from domestic corporations. This is because the U.S. Supreme Court in Kraft General Foods, Inc. v. Iowa Department of Revenue, held that it was unconstitutional for Iowa to discriminate against foreign commerce by including foreign dividends in apportionable income while also providing a dividends received deduction for dividends from domestic subsidiaries.
Although GILTI is not a dividend under the Code, a taxpayer could assert separate company states are constitutionally prohibited from including GILTI in taxable income if they provide a dividends received deduction for dividends from domestic corporations. It would be much more difficult for a taxpayer to prevail making this assertion in a state that uses combined unitary reporting because these states include income from domestic unitary subsidiaries in taxable income.
In addition, a taxpayer could argue that states are barred from including GILTI in a taxpayer’s apportionable income unless the CFC giving rise to the GILTI inclusion is part of the taxpayer’s unitary business. This is because in Allied-Signal, Inc. v. Director, Div. of Taxation and Meadwestvaco v. Illinois Dept. of Revenue the U.S. Supreme Court held that states cannot include in apportionable income the gain from the sale of an asset unless that asset is part of the taxpayer’s unitary business.
If a taxpayer asserts that a state is prohibited under the U.S. Constitution from including GILTI in apportionable income, the taxpayer should be prepared for the state to disagree with this assertion and potentially issue a tax assessment that includes interest and penalties.
The TCJA presents both complications and opportunities for businesses preparing to file state income tax returns. The states’ responses to the sweeping changes under the TCJA are as varied as their own unique tax codes. Determining a state’s approach to TCJA conformity is a dynamic process that requires a thorough analysis of the jurisdiction’s tax laws and administrative guidance. Monitoring new developments in this area is essential because state positions on key TCJA provisions continue to evolve.
If you have any questions or if you would like to discuss this further, please feel free to contact the author or another member of the Andersen Team.